Employee shareholdings in startups
Draft fund location law: Problem recognized! Danger averted?
When employees of startups receive shares in the company free of charge or at a discount, the joy is quickly caught up with tax reality. The granting of the shares triggers taxes without the employees receiving any financial resources to settle them. This phenomenon is known as dry income, which the German government is now addressing in a legislative initiative.
Tax status quo Employee shareholdings
Granting company shares to strategically important employees is an important measure for startups to attract and retain employees and let them participate in the company's success. The so-called "Fondsstandortgesetz" (Fund Location Act) is now intended to significantly improve the tax framework for employee shareholdings in start-up companies and thus make them more attractive at the same time.
Such an employee participation is certainly always accompanied by the dream of being part of - or rather participating in - the next Unicron (startup with a market valuation of more than one billion US dollars). In this case, one can not only enjoy rich capital gains, but also the tax privilege that these gains are not subject to the standard tax rate of up to 45% plus solidarity surcharge and, if applicable, church tax, but to reduced taxation of up to a maximum of 27% plus solidarity surcharge and, if applicable, church tax. Only the value at the time the shares are granted is subject to the standard tax rate of up to 45% as income from non-independent work and is deductible as acquisition costs if the shares are sold.
At the time the shareholding is granted free of charge or at a discount, the employee must pay tax on the non-cash benefit - the term used for parts of the salary that are not in cash - at the standard tax rate. The non-cash benefit is valued at the fair market value of the shares. Unless it can be derived from financing rounds or share sales between unrelated third parties, this value is subject to uncertainty and - since the individual valuations now directly trigger a tax burden - is susceptible to dispute. However, any challenges that may exist in the valuation of shares are usually overshadowed by the fact that, under current legislation, employees who are granted shares in the company first have to pay "up front" financially. Although they receive shares with the hoped-for, significant potential for value enhancement, they do not receive any liquid funds from which the resulting tax burden can be paid. As the shares are not granted for immediate sale, but as a strategic and long-term investment, there is a so-called "tax advantage".dry income before. The resulting tax burden must then be met from other liquid assets, which, depending on the current valuation of the investment, can be a small or even a medium-sized disaster. As shown below, the legislator intends with the present draft law to at least remove the second obstacle mentioned - the immediate taxation of adry income - counteract.
Design of the planned new regulation
According to the draft law, income from the free or reduced-price transfer of equity interests in the employer's company is not to be taxed in future at the time of granting, but only at a later point in time, i.e. at the time of disposal; at the latest, however, after ten years or in the event of a change of employer. The conditions for this temporary tax relief are complex:
The participation must be paid in addition to the salary that is owed anyway; deferred compensation is not possible.
The preferential treatment is limited to certain asset participations. In particular, investments in a limited liability company with its registered office and management in Germany are included; virtual investments, for example, are not. The exercise of stock options may be favored.
The participation must be granted in the company which is the employer.
Waiver of income tax withholding requires the employee's consent.
Deferral of taxation is possible only if the enterprise at the time of granting shares as a micro, small or medium-sized enterprise does not exceed or has not exceeded in the previous calendar year the following size criteria
Medium-sized company: less than 250 employees and annual sales not exceeding EUR 50 million or annual balance sheet total not exceeding EUR 43 million or
Small company: less than 50 employees and annual sales and annual balance sheet total not exceeding EUR 10 million or
Microenterprises: less than 10 employees, annual sales and annual balance sheet total not exceeding EUR 2 million.
In addition, the company may not have been founded more than ten years ago. However, no conditions are attached to the duration of the employment relationship.
The bill is rounded off by a provision for the case of losses, i.e. the case when the value at the time of sale of shares (or other act triggering taxation) is lower than the value of the shares at the time of granting of shares. In this case, taxation is limited to the value of the shares at the time of sale. Additional payments made by the employee shall be taken into account. Restricting the basis of assessment for income tax at the standard rate to the granting of shares also eliminates the risk for employees that the value of the shares may be comparatively high at the time the shares are granted, for example due to a successful financing round, but that the business model proves to be uneconomic in subsequent years and the shareholding loses value.
The new regulation is to be rounded off by an increase in the tax allowance from EUR 360 to EUR 720 p.a. for the granting of asset shares to employees. This regulation will probably only have a significant effect if the shares are issued over several years, i.e. over a longer period of time.
Other contents of the draft law
The levying of VAT on the management services of venture capital funds has proven to be a disadvantage for Germany as a fund location. The VAT exemption for the management services of investment funds is therefore to be extended to the management of venture capital funds.
In addition to the tax regulations, the Fund Location Act essentially implements EU Directive 2011/61 and makes adjustments to the Transparency and Taxonomy Ordinance. In addition, further amendments are being made to the German Investment Code (Kapitalanlagegesetzbuch - KAGB) to reduce bureaucracy and digitize supervision. For example, numerous written form requirements will be abolished, which should save investors costs. Finally, the range of products offered by fund providers is being expanded: Open-end infrastructure investment funds and closed-end master-feeder constructions will be introduced. For closed-end funds, the option of using the legal form of a special fund for professional and semi-professional investors will be introduced. All in all, cost drivers will be abolished and the scope for fund managers and thus the investment opportunities for investors will be expanded. The aim of these measures is to strengthen Germany as a fund location.
The present bill can certainly be seen as a promising start to 2021 from a tax perspective. Thedry income in the course of granting free or discounted shares to startups was "recognized as a problem" by the legislator and is being addressed in a targeted manner with the new regulation: The income tax on the granting of shares is initially not levied, the size criteria should typically be met by startups and in the case of sale at a loss, only the lower sale price is used as the basis for assessment.
However, the term "danger averted" can only be used with restrictions: The benefit from the granting of shares free of charge or at a reduced price remains taxable, taxation is only postponed - limited to a maximum of ten years. If sufficient marketability of the shares has not yet been achieved during this period or the hoped-for increase in value is still imminent, nothing is gained by the new regulation. Nor does anything change with regard to the challenges of determining and documenting the objectively "correct" value of the investment at the time the shares were granted. The fact that a tax is levied when the employee leaves the company is - to keep it value-free - an interesting aspect of employee retention.
Finally, it remains to be noted that the contribution of the shareholding immediately after receipt to a holding company for subsequent sale with privileged tax treatment also constitutes a harmful act, which in turn immediately triggers the tax burden from the granting of the shareholding. This runs counter to the German government's self-imposed goal of "sustainably increasing the innovation and growth potential of the German economy". After the shares have been contributed to a holding company and sold, the capital gain is privileged for tax purposes and virtually tax-free; however, without further distribution and taxation, it is not available for private consumption, but only for reinvestment purposes - for example, in startups with innovation and growth potential. The combination of increased reinvestment volume - thanks to low taxation - and successful startup experience makes this group of people first-class investors. It would be a courageous step on the part of the legislator not to immediately levy the tax on the granting of shares for this group of people, even in the case of an investment in a holding company, and thus pave the way for a tax-privileged reinvestment - but if Germany's founders are already courageous, why shouldn't the German government be too?