ESOP, VSOP & Co.: Employee share ownership options

Many companies are looking for qualified and motivated employees and junior staff − the 'war for talents' has been going on for a long time. Especially for start-ups and young companies that cannot pay top salaries, the participation of employees in the success of the company can be very attractive. What is known as the skin-in-the-game effect motivates employees to invest long-term and intense effort in the company.

However, the general conditions for employee profit sharing in Germany are considered unfavourable in an international comparison. There are no wide-ranging tax benefits. Yet even in Germany an employee participation programme may be implemented in Germany through professional contractual arrangements.

Below you find an overview of the typical employee share ownership schemes.

Direct equity ownership

A company may give employees a direct stake in the company's capital by granting employees a share in the company's capital. The employees become shareholders. In addition to the employment relationship between the company and the employee, this also creates a direct link within the company’s structure. As shareholders of the company, the employees do not only have a direct share in the profits of the company, but can also exercise far-reaching information, control and co-determination rights. For the company and the existing shareholders, a direct equity ownership of employees typically leads to increased administrative work. They have to deal with additional shareholders through such employees' direct equity ownership, which makes uncomplicated, quick decision-making more difficult than in a small circle of shareholders.

From a tax point of view, it should be noted that the employee must pay income tax on the difference between the price and the value of the share at the time of its acquisition. The transfer of company shares at a discount or free of charge is deemed to be hidden employment remuneration. This leads to what is known as the dry-income issue: the employee must pay income tax on their capital share without receiving an increased net salary in return. The legislative has given small and medium-sized enterprises the option to defer the payment of wage tax for 12 years under certain circumstances (s19a EstG (German Income Tax Act)). Yet this is no sufficient solution to the dry-income issue. The tax-free allowance to which the employee is entitled if the employee receives shares in the company free of charge or at a discount, which has now been increased to EUR 1,440 per calendar year, does not change that. The capital gains from the sale of the shares are subject to withholding tax (25%) or the partial-income procedure (Teileinkünfteverfahren) (only 60% of the capital income is taxed), depending on the size of the holding (1% threshold).

A (not yet publicly available) key point paper from the German Federal Ministry of Finance, according to which tax benefits will be available also to larger companies than in the past, raises hopes for a future minimisation of tax disadvantages in the granting of shares. In order to alleviate the dry-income problem, it is planned to extend the period of taxation by 8 years to 20 years and even beyond that if the company assumes liability for the wage tax owed. In addition, the tax-free allowance to which the employee is entitled is planned to be raised to EUR 5,000 per calendar year. However, these positive proposals are only an internal discussion paper of the Ministry of Finance. For the time being, the focus should therefore be on other forms of employee participation.

Option rights

As it were, options are a preliminary stage to direct equity participation. Option rights are regularly issued as part of employee stock option plans (ESOP). The employees get an entitlement to receive shares at a previously determined exercise price on specified conditions. The entitlement may, for instance, be linked to a certain number of service years or the achievement of certain economic key figures. Only when the option is exercised does an option holder receive real shares in the company, which convey the shareholder rights defined for direct equity participation.

From a tax point of view, option rights differ from direct equity participation insofar as wage tax regularly only accrues at the time the option is exercised (on the difference between the actual value and the exercise price). The dry-income problem also exists at this time. Here too, the tax payment may be deferred under certain circumstances (s19a EstG). The capital gains from the sale of the shares received from exercising the option are also subject to withholding tax (25%) or the partial-income procedure (only 60% of the capital income is taxed), depending on the size of the holding (1% threshold).

Virtual share option plans

Especially in the start-up sector, virtual company shares, called phantom shares or virtual stock option plans (VSOP) are often chosen as a form of employee participation. Phantom shares are merely modelled on a direct equity participation - it is a purely debt-based capital transfer relationship. This means that the employees do not participate in the company in terms of company law, but only in mere economic terms. If certain pre-determined requirements are met (typically in the event of the sale of a majority stake in the company), the employee is treated as if they held real shares in the company by receiving a payment equal to the value of their virtual shares.

Unlike in the case of direct equity participation, the granting of virtual shareholdings does not directly lead to the accrual of wage tax; the relevant point in time here is the receipt of the remuneration. This is a major advantage of this type of employee participation: it avoids the dry-income issue because the employee is only taxed once there is a corresponding liquidity flow. All payments based on phantom shares, on the other hand, are subject to wage tax, as they are income from employment.

Conclusion

The common feature of all three forms of employee share ownership is that the direct or indirect participation in the economic success of the company is meant to be an incentive for employees. Due to the current legal situation, a virtual participation in a company seems particularly attractive from a legal point of view. It is less complex than ESOPs and avoids the (still) unresolved dry-income issue. However, which form of employee participation is the most suitable always depends on the individual circumstances. It should be assessed and tailored in consideration of the structure and specific concerns of the company in question.

Christian Burmeister
Stephan Strubinger