German Federal Fiscal Court: Profit from sale of an employee shareholding at arm’s length conditions does not qualify as wage or salary

  • 03/06/2024
  • Reading time 8 Minutes

Important conclusions for designing employee and management programs

In the private equity and venture capital sector, employee and management participation programs are very popular tools to incentivize the company’s staff. Start-ups, too, often use corresponding programs to attract experts and talents. The employee share ownership schemes’ great importance for growth companies has recently also been recognized by the legislator with an extension of the tax privileges pursuant to Art. 19a EStG (German Income Tax Act) through the Future Financing Act for genuine employee share ownership schemes received as wage or salary (non-cash benefit).

However, the individual tax evaluation of employee participation schemes is quite complex and involves various pitfalls. For example, the question arises as to whether the receipt of real company shares or options to such shares (e.g., as part of an ESOP) or other forms of participation programs (e.g., phantom stocks as virtual participations as part of a VSOP or hurdled shares) qualify as wage or salary within the meaning of Art. 19 EStG for the beneficiary employees and when such wage or salary accrues.

With its decisions published on February 27, 2024 (BFH, decisions of December 14, 2023 – VI R 1/21 and VI R 2/21), the German Federal Tax Court (“BFH”) now provided useful guidelines for the tax classification of employee share ownership programs.

In particular, the court ruled that profits from the sale of employee participations (management participations) at arm’s length conditions do not qualify as benefit subject to payroll tax, even if the employee previously acquired the participation in the employer company at a discount and the contract included so-called leaver clauses in the event of an employee’s premature termination. 

Decision in brief:

  • The sale of an employee shareholding at arm’s length conditions does not result in income from employment.
  • No indicative effect for the existence of wages and salaries due to the originally discounted transfer of the employee shareholding upon sale.
  • An employee shareholding’s sale within the scope of a special legal relationship of the employee to be recognized for tax purposes can supersede the causal link to the employment relationship.
  • No indicative effect of good and bad leaver clauses for causation by the employment relationship.

The plaintiff worked in an executive position (manager) at T-GmbH. T-GmbH was acquired by an international group of investors (X) through various subsidiaries. The Luxembourg X-S.a.r.l. (S), in which the group of investors held an interest through Holding Ltd. (H), served as investment vehicle. X-S.a.r.l. held an indirect share in T-GmbH through Y-GmbH (subsequently Y-AG). 
The plaintiff and other selected executives of T-GmbH (managers) were granted the option to participate in the investment through a “management participation program” (MPP) in order to incentivize the success of the investment in T-GmbH. To that end, the plaintiff and the other managers were offered to become limited partners in a separate GmbH & Co. KG (Manager KG). The Manager KG acquired, inter alia with the contributions made by the limited partners, shares in X-S.a.r.l. as investment vehicle. In doing so, the plaintiff and the other managers were able to acquire – measured against the total capital invested – proportionately more equity in X-S.a.r.l. than the group of investors through Holding Ltd. (“sweet equity”). 

As usual in these cases, the MPP’s conditions provided, however, that the participating managers have to withdraw from the Manager KG upon termination of their employment relationship with T-GmbH and transfer their respective shareholding (so-called good/bad leaver clause). 

Following T-GmbH’s successful restructuring and Y-GmbH’s subsequent IPO (following the IPO: Y-AG), the Manager KG withdrew from X-S.a.r.l. – as contractually agreed upon under the MPP – by X-S.a.r.l. repurchasing its shares at undisputed arm’s length conditions. As consideration for its shares in X-S.a.r.l., the Manager KG received shares in Y-AG corresponding to its respective shareholding, which in turn were transferred, inter alia, to a custody account of the plaintiff in accordance with the respective limited partnership interest. 

The tax office treated the difference from the share value received and the previously made limited partner’s capital contribution as salary subject to tax. 

BFH decision

The BFH did not uphold the tax office’s legal opinion and rejected the appeal. 

Non-cash benefit only in the amount of an excess price over the market price upon sale
In accordance with its previous case law, the BFH emphasized that, in case of a shareholding’s transfer, the non-cash benefit required in order to qualify as income from employment was not the transferred shareholding per se. Rather, when acquiring employee shares, the reduction in price and the associated discount qualified as non-cash benefit. The acquisition of such shareholding at arm’s length conditions, however, could not effectuate any non-cash benefit in such sense. Accordingly, the Manager KG and the limited partners did not acquire the shares in Y-AG at a discount, as X-S.a.r.l. – which is undisputed in the present case – repurchased its shares from Manager KG at an arm’s length price. 

No indicative effect due to the originally discounted transfer of the employee participation upon sale
By reference to the different dates of receipt, the BFH did not answer the question as to whether or not the participation in Manager KG as limited partner was originally granted at a reduced price. Insofar, Manager KG was able to acquire more equity in X-S.a.r.l. in proportion to the capital it had invested in relation to the capital invested by Holding Ltd. and thus also achieve proportionately higher profits upon redemption (so-called sweet equity). The issue in dispute was not the assessment period of the plaintiff’s becoming a limited partner, but the repurchase of the shares in X-S.a.r.l. in return for the corresponding transfer of the shares in Y-AG. Even if there was a causal link resulting in a classification as wages or salaries upon becoming a limited partner, such link did not continue to apply in the context of a subsequent sale. 

Recognition of limited partnership interest as independent special legal relationship for tax purposes supersedes causation due to the employment relationship
The BFH concluded that the plaintiff’s limited partnership interest in Manager KG was an independent means and source of income which is independent from his employment relationship with T-GmbH. The plaintiff’s limited partnership interest in Manager KG and the latter’s participation in X-S.a.r.l. were effectively agreed upon under civil law and had actually been performed in accordance with the agreements. The plaintiff had made the agreed contributions and, in particular, according to the content of the (partnership) agreements bindingly established by the tax court, he was entitled to the essential control, voting, participation and dividend rights as a limited partner. 

Leaver clauses do not prevent the special legal relationship’s recognition for tax purposes
When recognizing the limited partnership interest as material special legal relationship, the BFH did not consider the so-called leaver clauses which are usually part of such programs as being relevant. Although such leaver clauses linked the shareholding’s continued existence to the employment relationship’s continued existence, they were not suited in order to eliminate an existing shareholding's independent legal nature. The participation did not lose its economic substance through such clauses alone: the leaver clauses did not call into question the purposes regularly pursued with employee participation schemes, namely to bind the employees to the company through their participation as shareholders and to enable them to participate in the company’s profit or value development through their participation.

Consequences for practice
When determining a causal link to the employment relationship, the case allows for important conclusions to be drawn for the structuring of employee and management programs in terms of tax consequences for the parties involved. For example, the BFH sets certain criteria for the tax recognition of an employee/management KG which is in practice often used as vehicle in order to bundle the issued employee shares. On the one hand, this is important for the benefit-granting company with regard to the deduction of operating expenses as well as any payroll-related obligations; on the other hand, the beneficiary employees are subject to various tax obligations, depending on whether the income constitutes a wage or salary or meets relevant sales criteria (in particular Art. 17, Art. 20, Art. 23 EStG). Ultimately, however, the causal connection will probably continue to be the subject of a case-by-case assessment and will thus involve inevitable discussions with the tax authorities. Fortunately, there is more legal certainty with regard to the agreement of leaver clauses and their tax implications.

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Authors of this article

Benedikt Hoffmann


Steuerberater, Rechtsanwalt, Fachanwalt für Steuerrecht

Daniela Stephan, LL.M.

Senior Manager

Attorney-at-Law (Rechtsanwältin)

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