Legal Ninja Snapshot: #ESOP & Flips — U.S. ESOPs May Become Available for the Employees of the German Subsidiary

Much has been written about the unsatisfactory tax situation of German employees when it comes to equity-based employee stock (option) programs ("ESOP"). Historically, employees were taxed at the time of issuance of shares below their fair market value, whether based on the exercise of options or whether issued directly. Often times employees were not able to immediately sell the issued shares, e.g., to finance the accruing wage tax. Furthermore, they did not have the option to defer the accruing wage tax in dry-income cases. Thus, ESOPs were less attractive and less effective as a tool for attracting and retaining talent.

In 2021, to address these issues, the German government reformed sec. 19a of the German Income Tax Act ("EStG") to create a more favorable tax environment for start-up employees. The new law (which was amended again in 2022 and will soon be amended again – see below) intends to make ESOPs more attractive and competitive by deferring the taxation of the benefit resulting from a gratuitous or discounted transfer of shares. Here is a simplified description of how it works:

• Deferred Wage Taxation: Under the current sec. 19a EStG, employees are not taxed at the time the shares are being issued to the employee. Instead, taxation is regularly deferred until a "liquidity event" occurs, such as the sale of the shares or an IPO.
• Capital Gains Taxation: When the liquidity event occurs, employees are taxed on the capital gains, i.e., the difference between the value of the shares at the time of the liquidity event and their value at the time they were issued. This typically results in a lower tax burden compared to immediate taxation upon grant (around 27% vs. up to 47%).

So far, the reformed sec. 19a EStG hasn't resulted in the widespread adoption of ESOPs in Germany (rather, virtual stock option programs (VSOPs) still dominate). The main reason is that the issuance of shares in a GmbH creates governance issues and requires notarization. Here, a new approach is emerging, profit participation rights (Genussrechte) which might provide a (lawyers' humor ahead) "option" to realize the benefits under sec. 19a EStG without issuing "real" shares and thereby avoiding the problems that come with having multiple shareholders in a GmbH. For further details, stay tuned – we will soon issue a special OLNS Snapshot on this new approach to issue profit participation rights as alternative to real shares or VSOPs.

You might now think that this sounds very interesting but what if the ESOP is not set up at the level of the GmbH but on the level of its shareholder? And what if that shareholder can issue "real" shares without requiring notarization and without having a problem with multiple small shareholders on the cap table? Most notably, what if we are looking at a German OpCo that has a U.S. HoldCo (in the form of a Delaware C-Corp)? Couldn’t the U.S. HoldCo set up a typical Silicon Valley-style ESOP under which the employees of the German OpCo are issued share options (or directly shares) and still make use of the deferred tax regime under sec. 19a EStG? Issuing share options or shares in a Delaware C-Corp requires no notarization and wouldn’t create any material governance issues for the company or make future financing rounds more complex.

The problem is that under the current law, sec. 19a EStG would not be applicable in such a case. Currently, the tax deferral scheme does not apply to employees who receive shares, etc. in their employer's parent company or in another affiliate of their employer (in our example, this would be U.S. HoldCo). In other words, right now, there is no "group privilege." This essentially bars most international groups from making use of the German tax deferral: German employees of U.S. or other non-German start-ups are typically employed by a local subsidiary, not the U.S. or other non-German start-up corporation that would grant options and issue shares. They are therefore currently not eligible.

The good news is that the German legislator is currently discussing a law bill that will finally introduce a group privilege and close the aforementioned gap. The first chamber of the German parliament (Bundestag) has already passed the bill, with the consent of the second chamber (Bundesrat) pending.  

If enacted, the new law bill foresees the following conditions for the group privilege

• To claim the group privilege, the respective group may – on a consolidated basis – not exceed the thresholds that apply in a single-tier structure for the employer issuing the shares.
• The legal form of a non-EU company that issues shares to the German taxable employees must 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).

If enacted the new law bill foresees a retroactive applicability of the new group privilege as of January 1, 2024.

• A "retroactive" deferral should therefore regularly be possible and wage tax be 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. Specifics should be discussed with tax counsel.
• With respect to future share 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.) This also means that German employees who have received stock options instead of shares to avoid immediate taxation may consider exercising their options now and deferring the wage tax owed upon such exercise in order to achieve a more favorable taxation of future increases in value in a potential exit scenario.

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 (PEO).

In particular German start-ups that have done the flip / implemented a two-tier US/German holding structure and international corporations with a German subsidiary should monitor the situation closely as they might soon be able to offer their employees a more tax-favorable participation option.