Update on employee shareholdings: Current developments in tax law, company law and labor law

The structuring and implementation of employee participation programs (and often also in the case of management participation) requires a complex consideration of the general conditions and effects under corporate, tax and employment law. In the following article, we provide information on the German Federal Ministry of Finance’s (“BMF”) updated letter on the implementation of capital and start-up participations from 2024 as well as an interesting ruling by the Munich Higher Labor Court (LAG Munich) on the forfeiture of option rights after termination of the employment relationship.

I. Revised BMF letter with clarifications on employee shareholdings pursuant to Art. 19a EStG

The BMF has revised its original letter dated November 16, 2021, regarding the treatment of an assignment or transfer of capital participations for payroll tax purposes. The letter’s content remains largely unchanged; however, the new BMF letter dated June 1, 2024 (Federal Tax Gazette 2024 I page 946) contains clarifications and case studies on the changes for employee participations resulting from the German Financing for the Future Act and the Growth Opportunities Act. The BMF’s explanations, which are to be understood as instructions for the tax offices, apply to circumstances from January 1, 2024. In the following, we provide an overview of the most important amendments. 

1. Clarifications on employees to be included, Art. 3 no. 39 p. 2 EStG
The letter includes the new BMF note that the exclusion of employees having insider information pursuant to the EU Market Abuse Regulation or other applicable laws was necessary as a preventive measure in order to prevent/avoid criminal and administrative offenses and therefore did not prevent the other employees to be included from claiming the tax-free amount. Furthermore, the letter states that, for reasons of simplification, the participation offer does not have to address employees seconded to a foreign company. 

The BMF has now clarified that provisions of a so-called veto right in employee participation programs, according to which the employer can exclude certain employees or groups of employees from the program at its discretion, only prevent the tax allowance from being claimed if the employer actually exercises this veto right. From this point onwards, all employees participating in the program are excluded from claiming the allowance. However, the use of the allowance in previous salary payment periods remains unaffected, i.e., the exercise of the veto right only constitutes a “harmful event” for the future (ex nunc effect).

2. Accrual in the event of restrictions on disposal (Art. 19a (1) sentence 3 EStG)
The BMF letter contains a new section on the time of the wages’ accrual in the case of restrictions on disposal (so-called shares with restricted transferability) due to the legal changes made in this regard under the German Financing for the Future Act (Art.  19a (1) sentence 3 EStG, as amended). Accordingly, for asset participations transferred as of January 1, 2024, a benefit from the free or discounted transfer of capital participations pursuant to Art. 19a (1) sentence 1 EStG is deemed to have accrued for payroll tax purposes, provided the other requirements of Art. 19a EStG are met, even if it is legally impossible for the employee to dispose of the capital participation. This was a legal amendment that was introduced largely at the instigation of representatives of the start-up sector. The final case study illustrates the calculation scheme in this case.

3. Acquisition costs in the event of repurchase (Art. 19a (4) sentence 1 no. 3 EStG)
The BMF clarifies that in the case of the taxable event “termination of the employment relationship with the previous employer” (Art. 19a (4) sentence 1 no. 3 EStG) and the exercise of a repurchase right by the employer (or a shareholder of or a company affiliated with the employer pursuant to Art. 18 AktG(German Stock Corporation Act)), the remuneration granted (Art. 19a (4) sentence 4 second half-sentence EStG) is to be recognized as the capital participation’s acquisition cost instead of the fair market value. The repurchase does not have to be made by the original seller. Rather, it is sufficient that the participation is sold to one of the three named (groups of) persons. According to the BMF letter, this also applies to capital participations transferred before 2024.

4. Assumption of liability by the employer and further deferral of taxation (Art. 19a (4a) EStG)
The new Art. 19a (4a) EStG, which has been introduced under the German Financing for the Future Act, regulates that taxation on the basis of the taxable events “expiry of 15 years” and “termination of the employment relationship” (Art. 19a (4) sentence 1 no. 2 and 3 EStG) is not required if the employer irrevocably declares to be liable for the payroll tax to be withheld and paid under Art. 42d EStG. In these cases, taxation is only triggered by the subsequent taxable event “transfer against or without consideration” (Art. 19a (4) sentence 1 no. 1 EStG). The BMF letter now regulates the procedural details by transmitting the employer’s irrevocable declaration on the assumption of liability (no. 21 of the payroll tax return) to the permanent establishment’s tax office. The employer’s declaration must be made no later than in the payroll tax return following the relevant event. This is the payroll tax return in which the payroll tax to be withheld due to the subsequent taxation should have been declared. This process is explained using a case study.

5. Intended introduction of a group clause through the Annual Tax Act 2024
Both the original BMF letter and the updated letter currently still exclude the applicability of Art. 19a EStG for the free or discounted transfer of capital participations in companies affiliated with the employer. However, this understanding could become obsolete if the introduction of a group clause provided for in the government draft of the Annual Tax Act 2024 (JStG 2024) actually becomes law.

With the introduction of the group clause in Art. 19a (1) sentence 3 EStG-E, the scope of application of the tax relief in Art. 19a EStG is also to be extended to the transfer of shares in affiliated companies within the meaning of Art. 18 AktG. In future, a deferred taxation of non-cash benefits from capital participations would not only be possible if shares in the employer’s company are transferred, but also if shares in affiliated companies are transferred and the thresholds of Art. 19a (3) EStG are not exceeded in relation to the entirety of all group companies. In addition, the formation of any group company must not date back more than 20 years.

A corresponding regulation was already provided for in the draft of the Financing for the Future Act, but was ultimately not adopted. However, the planned retroactive effect from January 1, 2024 of the JStG 2024 (Art. 45 (6) JStG 2024) would now result in the originally planned start of application by other means.

II. Current decision of the LAG Munich on the forfeiture of option rights after termination of the employment relationship

1. Structure of the ESOP and other facts
The plaintiff employee participated in an employee stock option program that the defendant employer (a stock corporation) had set up for employees in 2016. According to the “allowance letter” dated August 24, 2019, the plaintiff received a total of 23 virtual option rights to shares in the defendant in accordance with the Employee Stock Option Plan’s (ESOP) provisions.

The allowance letter stated that the virtual options were granted exclusively as an incentive for the future and not for services rendered in the past and that the plaintiff did not have to provide any consideration for the virtual options. As an incentive for the future, the options could not be exercised immediately, but only after a vesting period in accordance with the ESOP’s general terms and conditions.

In the event of a termination of the employment relationship and irrespective of the reasons for termination, a so-called leaver clause in the ESOP stipulated that options that were not exercised or for which no exercise event had occurred would be forfeited after 15 years at the latest or, in the event of leaving the company, after two years at the latest with a reduction of 12.5 % of the option rights per quarter after termination of the employment relationship. 

The employment relationship ended by the plaintiff tendering his resignation on May 29, 2020 with effect from August 31, 2020. As no exercise event for the virtual options occurred either during the employment relationship between the parties or within two years of its termination, they were forfeited in full in accordance with the ESOP’s provisions.

In 2022, the defendant amended the ESOPs for all existing employees and waived the leaver clause for the automatic forfeiture of option rights for all future resignations from March 1, 2022 (“ESOP 2022”).

In his lawsuit, the former employee sought a declaration that the virtual options allocated and vested to him had not been forfeited due to his resignation. He referred to the fact that they were an essential component of the remuneration package, and that the leaver clause was an inadmissible withdrawal of remuneration already earned, thus contradicting the basic idea of Art. 611a BGB (German Civil Code). In addition, the abolition of the leaver clause by the ESOP 2022 resulted in an unequal treatment of employees.

2. ESOP as a voluntary benefit merely an opportunity to earn money
However, the LAG Munich ruled in favor of the employer. The LAG Munich confirmed that the employee participation program’s (ESOP and ESOP 2022, respectively) provisions constituted General Terms and Conditions as defined in Art. 305 (1) BGB which were fully subject to the control of contents, to which Art. 310 (4) BGB did not apply. Contrary to the plaintiff’s opinion, the forfeiture provision in the ESOP’s leaver clause did not violate the transparency requirement pursuant to Art. 307 (1) sentence 2 BGB, nor did it unreasonably disadvantage the plaintiff in deviation from fundamental legal principles. 

The basic principle under labor law, according to which wages already earned must not be withdrawn, does not contradict the leaver clause as the granting of virtual option rights as a voluntary benefit by the employer merely constituted a speculative opportunity to earn remuneration and no wages already earned. The purpose of (virtual) options was specifically not to make up for the failure to realize a profit during the employment relationship after termination of the employment relationship.

Therefore, with regard to the speculative nature, a forfeiture provision as provided for in the present leaver clause, which merely cuts off a longer “speculation period” (in this specific case more than 24 months), was generally admissible. This applied irrespective of the cause of termination. A continuation of the subscription right despite a termination of the employment relationship was possible, at best, in exceptional cases if the occurrence of the termination pursuant to Art. 162 (2) BGB was brought about by the employer in bad faith. However, this could not be established in the present case.

The principles for certain special benefits developed in the German Federal Labor Court’s (BAG) case law could not be adopted in unrestricted form for share options or virtual options as regards the admissibility of forfeiture clauses, as these have a significantly higher speculative character.
Furthermore, the ESOP 2022 did not constitute an unlawful unequal treatment of employees. Such cut-off date regulations as so-called “typification in time” were admissible for the purpose of restricting the group of beneficiaries, provided the choice of the cut-off date was based on the facts to be regulated and the affected parties’ interests were adequately taken into account. The objective associated with a forfeiture clause in the specific case by granting virtual option rights to reward existing employees, who were still employed at the time, for remaining loyal to the company throughout its growth phase was compatible with the purpose of retaining employees, which is generally associated with options, and was therefore in line with their interests.

3. Significance for practice
The granting of virtual options as part of General Terms and Conditions is gaining increasing importance, both for established companies and, in particular, for start-ups and scale-ups. Some ESOP contracts provide for options to be forfeited (without replacement) after several years (often only after 15 to 20 years) from granting or after leaving the company (so-called long-stop dates). So-called devesting clauses, where (already fully vested) virtual options of an employee are forfeited over the course of time, are less common. In the case recently decided by the LAG Munich, the options were forfeited over a relatively short period of (only) two years after the employee left the company. The LAG Munich considered such provision to be effective. The LAG Munich allowed an appeal to the BAG due to the fundamental importance of the questions to be clarified; the appeal is pending at the BAG under case no. BAG, AZR 67/24. The oral hearing is currently scheduled for March 2025. The supreme court’s clarification of the present constellation will therefore still take some time and should be kept in mind. Furthermore, before concluding ESOP contracts, the provisions according to which virtual options are forfeited (sometimes quite quickly) in full (and without replacement) after leaving the company should be carefully examined.