Legal Ninja Snapshot: #ESOP & Flips - U.S. ESOPs for Employees of the German Subsidiary Now Available

Good news! The second chamber (Bundesrat) has now paved the way for the eagerly awaited and much-debated inclusion of a group privilege in sec. 19a of the German Income Tax Act (“EStG”). German start-ups that have done the flip/implemented a two-tier U.S./German holding structure and (inter)national multi-tier structures with a German subsidiary may now be able to offer their employees in Germany a more tax-favorable participation option.

If you're not up to speed on why the Bundesrat's approval is good news, these publications will give you a quick overview of sec. 19a EStG and its significance for equity-based employee stock option programs ("ESOP") and for profit participation rights (Genussrechte) as an alternative to issuing "real" shares under an ESOP (and thereby avoiding the problems that come with having multiple shareholders in a German GmbH).

In a nutshell: Sec. 19a EStG allows for the deferral of German taxation on the benefit derived by an employee when receiving shares (or profit participation rights) at a discount or free of charge until a later “liquidity” event, like the sale of the shares (or profit participation rights). Without this deferral, wage tax would be due on the difference between what the employee paid for the shares/profit participation rights (if anything) and their fair value at issuance (dry-income taxation). Upon a liquidity event, the deferred wage tax becomes due and is calculated using standard income tax rates (which can be as high as 45% for top earners, plus the solidarity surcharge and possibly church tax) but any increase in value of the shares/profit participation rights after the transfer to the employee will be subject to the more favorable capital gains taxation (about 27%).

What is the New "Group Privilege" and Why Does it Matter?

So far, the German tax authorities have taken the position that sec. 19a EStG in its current version is only applicable to shares (profit participation rights) in the employer company. This means that sec. 19a EStG was not available when for example, a U.S. holding intended to issue shares in that U.S. holding to the employees of a German subsidiary. The same was true in a purely national multi-tier structure (which might, for instance, be chosen for regulatory reasons) with shares to be issued in a German HoldCo to the employees of the German OpCo subsidiary (more on why it can be beneficiary for German startups to have a U.S./German two-tier structure). There was no so-called "group privilege", i.e., a concept that sec. 19a EStG shares or profit participation rights can come from another group entity (in particular the group holding) rather than only from the employer entity. That is going to change now.

What is New and What to Consider?

The new group privilege expands the scope of sec. 19a EStG to include group companies that are affiliated with the employer company – in any case – as the controlling entity provided that

• The thresholds of sec. 19a para. 3 EStG (annual turnover up to 100 million euros, balance sheet total up to 86 million euros, and less than 1,000 employees) are not exceeded with respect to the entirety of all group companies either in the year the shares (or profit participation rights) are granted or in any of the six preceding years, and
• None of the group companies was founded more than 20 years ago (which may exclude corporate venture undertakings or certain spin-outs).

Furthermore, the legal form of a non-EU company which issues shares to the German tax resident employees needs to be comparable to a German stock company (Aktiengesellschaft). This should for example regularly be the case for entities in the legal form of a Delaware C-Corp. or a UK plc. (for EU companies, the situation may be slightly better yet is more complex).

The new group privilege is retroactively applicable as of January 1, 2024.

• A "retroactive" deferral should be possible and wage tax refundable for 2024 share issuances.
• Timing wise, retroaction to 2024 share issuances will regularly be applicable as long as the wage tax certificate for the year 2024 has not been transmitted or announced. This means that any group that contemplates retroactively applying for a wage tax refund / deferral for 2024 issuances will need to act swiftly: The wage tax certificate for 2024 will be issued, and the window for retroaction will therefore close, in Q1 2025. As always, the specifics should be discussed with a tax advisor.
• With respect to future share or option issuances, whether based on the exercise of past or future options or whether issued directly, the group privilege will apply without any specific timing issue (beyond the timing issues applicable to the general tax deferral already in place).

Please note that the tax deferral as per sec. 19a EStG does not apply for freelancers (i.e., application only with respect to employees) and is also not available for employees that are employed by an employer of record.