How do employees earn stock options

Taxation of employee stock options and similar compensation models

Many companies offer their employees the option to purchase stock options (“Employee Stock Option Plan”). This gives the employee the right, after a waiting period, to buy shares in his employer or in the group parent company at a fixed price (purchase option). As a rule, the stock exchange price of the share on the day the option is granted is agreed as the purchase price. If the share price has risen on the day the option is exercised, the employee can either buy the shares at the agreed price or have the difference between the agreed purchase price and the current market price paid out ("exercise and sell"). The companies pursue a twofold purpose in granting options: On the one hand, the stock option is intended to motivate employees to fully commit by giving them a share in the future success of the company (incentive function). On the other hand, the company can pay a lower cash wage, which brings liquidity advantages and, above all, makes the start-up phase easier for young companies (financing function). In return, the employee ideally has the opportunity to earn a small fortune within a few years.

If the value of the company actually rises, then the employer and employee have made good business. In view of this financial success story, it is not surprising that the tax authorities have also developed a keen interest in the stock option programs. There are two main questions: the right time to tax the employee and the taxation of stock options granted by foreign companies, especially US companies. In addition, employers are increasingly using new types of participation models that raise very similar questions.

1. The time of taxation: would you rather have the pigeon on the roof than the sparrow in hand?

As is well known, the charm of a stock option lies in the fact that you can make a large profit with a small investment if the underlying value (the stock to which the purchase right relates) rises. In contrast to the purchase and sale of shares, where you first have to purchase the shares for expensive money in order to realize the capital gain, when purchasing options per share you only have to pay an option premium, which is only a fraction of the share price and the anticipated price increase. In this way, the investor can use his capital for speculative transactions with greater effect (leverage of the option).

The z. In some cases the difference in amount between the option premium and the cash settlement when the option is exercised raises the question of what the employee has to pay tax and when. In principle, everything that the employee receives from his employer as remuneration for his work is subject to income tax as income from non-self-employed work (Section 19 (1) EStG, 2 LStDV). Both current wages and other remuneration that are paid for a special reason or that are only incurred as subsequent income after termination of the employment relationship are taxable. Income tax arises for the calendar year in which the employee receives the cash wages or remuneration in kind (Section 11, Paragraph 1, Sentence 1 of the Income Tax Act); accordingly, the employer must withhold the wage tax when the salary is received and pay it to the tax office (Section 38 (2) EStG).

Two taxation variants are conceivable for the employee stock option:

  • Stock options are financial instruments. One could therefore argue that the granting of the option right already represents a taxable benefit in kind, the value of which can be determined according to the current mathematical models for option valuation or perhaps even based on the current prices on a futures exchange. As a result, the employee would then only have income from work in the amount of the (low) option price paid to him by the employer (“initial taxation”). The later discounted purchase of the shares or the cash settlement would be profits from independent option transactions that are not subject to the full tariff progression, but only to the reduced withholding tax (§§ 20 (2) No. 3, 32d EStG). There is a tax advantage because part of the wages has been converted into low-taxed income from capital assets (25% + (25% * 0.055) = 26.375%, possibly plus church tax).

  • But one can also take the position that the employee initially only received a promise to pay from the employer, which he still has to "earn" through future work. According to this, the inflow of wages would only occur if the employee actually exercises the option and receives the shares or the cash settlement from the employer (“final taxation”). In this case, the tax authorities would be fully involved in the increase in value because the wages are progressively taxed (peak load due to “rich tax” 45% + (45% * 0.055) = 47.25%, possibly plus church tax).

It used to be unclear in which cases the i. d. Usually favorable initial taxation takes effect, and in which cases the cash settlement is taxable when exercised (final taxation). Right from the start, the tax authorities demanded taxation when exercising the option. The tax authorities must be patient until the option is exercised, but then the cash register rings. Since the risk of waiting in the case of generally rising share prices is rather low, and the employee only exercises the share option when it is “in the money” anyway, the state disdains the sparrow in hand and prefers to wait for the pigeon on the roof.

In recent years, the Federal Fiscal Court (BFH) has worked out in several rulings under which circumstances the tax authorities may strike when exercising the option: If the employee stock option can only be exercised after a waiting period (vesting period) and is also not transferable, the employee acquires only a tax-insignificant chance of later wages (judgment of January 24, 2001, BStBl. II 2001, 512). Accordingly, taxation only takes place at the time the stock option is exercised, whereby when shares are purchased, the time at which they are booked into the employee's custody account is important (inflow by acquiring economic power of disposal over the shares). Wages are subject to progressive income tax including the solidarity surcharge (plus church tax, if applicable). Under certain conditions, however, the progressive taxation of the “accumulated income” can be reduced by applying the rule of one fifth in accordance with Section 34 (2) No. 4 of the Income Tax Act (EStG) if it concerns wages for several years of work. Irrespective of this, a small exemption in accordance with Section 3 No. 39 EStG can also be considered (BMF letter of November 12, 2014, No. 199).

In the opinion of the BFH, final taxation should also apply if the employee is granted an immediately exercisable and freely transferable stock option (ruling of November 20, 2008, Federal Tax Gazette II 2009, 382). In this case one cannot argue that the employee still has to earn the benefit in the future. Nonetheless, the relevant pecuniary benefit only becomes concrete when the stock option is exercised, because the employee receives the price reduction or cash compensation at this point in time. The fact that the immediately exercisable and tradable stock option is to be classified as an “economic asset” according to general income tax principles and thus could in itself be a benefit in kind does not stand in the way of final taxation. The decisive factor is probably the fact that the employer himself has taken on the role of the “writer” in the decided case. The result was just another promise to pay wages by the employer, which, like the promise to pay wages, does not yet result in an inflow of wages. The case can be assessed differently if the employee is given a legal position vis-à-vis a third party. Therefore, the BFH has expressly left open whether the grant of a stock option from which a third party is obliged to deliver the shares is also subject to final taxation (e.g. grant of a stock option for which a bank is the writer). Building on this, the FG Köln in a judgment of March 24, 2017 (7 K 2603/14, rkr.) Denied taxable wages in the event that the employer gives the employee the opportunity to purchase stock options of the parent company from a bank at the market price. In this case, no taxable benefit is given to the employee when purchasing the stock options, because he is not purchasing the stock options at a reduced price. And the profit from the later sale of the options does not represent wages, but falls into the private property sphere, where it is subject to the withholding tax in accordance with §§ 20 Paragraph 2 Sentence 1 No. 3, 32d Paragraph 1 EStG.

On the other hand, it is undisputed that initial taxation occurs if the employee has received a transferable stock option and realizes it immediately after it has been granted by transferring it to a third party or in some other way (judgment of September 18, 2012, Federal Tax Gazette II 2013, 289). This results in a certain degree of design leeway. If an employee has the opportunity to negotiate the content of the option plan with the employer, he should seek tax advice before granting the stock options.

Unfortunately, many employee stock option programs contain standardized provisions that prevent the stock options from being transferred immediately. This means that the initial taxation is eliminated, so that the financial administration has ultimately prevailed with its "dove-on-the-roof" strategy. From the point of view of taxpayers, the rulings of the BFH mean that the alleged wealth is almost halved, since the tax authorities participate in the exchange rate gains through the progressive income tax. If the income from exercising options is added to an already high basic salary, the progression-mitigating one-fifth rule is useless for extraordinary income. If the employee receives shares instead of a cash settlement, he also lacks the liquidity to settle the tax liability ("dry income"). It becomes particularly problematic if the price of the shares has fallen sharply between the inflow of income and the due date of the income tax liability. Then the proceeds from the sale of the shares may not even be enough to pay off the tax liability.

Finally an example:

Single employee A is employed by X-AG. His basic salary is 60,000 euros a year. At the beginning of the year 01 he received 1,000 stock options from X-AG, which entitle him to purchase 1,000 shares in X-AG between July 1st, 2003 and December 31st, 2004 at a price of EUR 50 per share (stock exchange price on January 2nd, 2001) . The exercise of the options is subject to the proviso that A is still working for X-AG on July 1, 2003; the options are not transferable. A exercises the options on December 31, 2003. At this point in time the price is 150 euros per share.

a) As agreed, X-AG pays A the difference between the stock exchange price on the day the option is granted and the stock exchange price on the day the option is exercised (cash settlement). A "earns" 100 euros per share, i.e. a total of 100,000 euros, which is subject to wage tax deduction and leads to income from employment that is subject to income tax. The one-fifth rule for extraordinary income in accordance with Section 34 (2) No. 4 EStG does not lead to a tax reduction because the basic salary already reaches the regular top tax rate of 42%.

b) The option contract does not provide for any cash settlement. Instead, A buys 1,000 shares from X-AG on December 31, 2003 at a price of EUR 50 each, which are booked into his custody account on the same day. Since A received 1,000 shares with a value of 150,000 euros, but only has to pay 50,000 euros for the purchase price, the difference of 100,000 euros represents taxable income from employment. With regard to the tax burden, it makes no difference whether A is a Receives cash settlement or exercises the option by purchasing shares. Since it is not possible to withhold wage tax on the shares, X-AG has to deduct wage tax from A's basic salary. If this is not enough to pay the wage tax, A owes the tax and has to use his savings.

c) As in case b), A sells the 1,000 shares on December 31, 2005 for EUR 200,000. Since A was already taxed when purchasing the shares, he has acquisition costs equal to the taxed amount (150,000 euros). The capital gain of 50,000 euros, like any dividends, does not belong to income from non-self-employed work, but to income from capital assets, because the shares have become a separate, independent source of income in private assets when they are posted to the custody account. The capital gain is subject to the final withholding tax.

2. Grant of Options by the US Parent Company

The employees of domestic subsidiaries of US corporations are often included in the US parent company's Employee Stock Option Plans (ESOPs). With this arrangement, it was initially disputed whether the later exercise profit is subject to German wage tax at all. The domestic subsidiaries with whom the employment relationship exists argued that these were “voluntary” third-party services (the parent company) that they could not monitor at all. This dispute has now been resolved: Payments made by the foreign parent company to the employees of the domestic subsidiaries are also to be included in the income from non-self-employed work (“third-party wages”). The domestic employer is responsible for the withholding of income tax, who must obtain the necessary information from the parent company if necessary (Section 38 (1) sentence 3 EStG).

This gives rise to the same question as when options are granted by a domestic employer: Does the initial taxation apply when options are granted, or does the later exercise of options lead to income from non-self-employed work (final taxation)? Here, too, the final taxation generally applies at the time of exercise, not only if the options are non-transferable and forfeitable, but also in the case of stock options that are transferable from the start. The mere foreign reference of the options (American payment debtor) does not lead to a restriction of the German tax law.

However, if the employee has performed part of the work that is rewarded with the option abroad, only part of the cash settlement or the pecuniary benefit may be taxable in Germany due to double taxation agreements. A pro-rata distribution of income is possible if the taxpayer worked abroad in the period between the granting of the option and the first possible exercise of the option (e.g. posting to another group company), the tax right for the income generated by the foreign activity is assigned to the other country, and that applicable DTA provides for the exemption of this income (BMF letter of November 12, 2014, marginal number 200 et seq.). In such a case, as a precaution, you should consult your lawyer or tax advisor so that they can examine the legal situation and prevent any over-taxation.

3. Option-like remuneration models

In practice, more and more compensation models are used that are based on the share price (or another performance indicator) without allowing the employee to purchase shares. From the company's point of view, such “stock appreciation rights” or “virtual stock options” have the advantage that wages and salaries build up slowly and any dilution of the shareholders is excluded. The actual objective, however, is also the motivation of the employees. Therefore, the granting of the virtual stock option is usually followed by a vesting period, after which the employee can request a cash payment. The inflow principle also applies here, which leads to final taxation. If the employee has worked partly in Germany and partly abroad, another division must be made (BMF letter of November 12, 2014, No. 209).

The allocation of share rights, “stock awards” and “restricted shares” also has an incentive function. In this case, the employee is initially credited with entitlements to a special account, which only establish the prospect of employment ("units") and, in the absence of transfer of beneficial ownership of the shares, do not result in an inflow of wages (neither voting nor profit-sharing rights; FG Cologne, judgment of 2.10. 2014, Az. 15 K 2686/11). The inflow relevant for income tax purposes occurs as soon as the employee receives a payment or the legal status of a shareholder. In practice, delimitation problems often arise when the shares are subject to disposal restrictions. In any case, the economic power of disposal required for the inflow is lacking if the employee is legally unable to transfer shares under American law (BFH ruling v.June 30, 2011, Federal Tax Gazette. II 2011, 923). On the other hand, restrictions under the law of obligations such as contractual minimum holding periods cannot prevent the inflow if the employee has already received the voting and profit-sharing rights associated with the shares (BMF letter of November 12, 2014, marginal number 215).

A special case of option-like remuneration models are the so-called management equity programs, which are only ever offered to a selected group of high performers. The participation program is usually set up immediately after the takeover of a company by a private equity investor and offers executives the opportunity to participate in the company taken over from the start via a trust vehicle. As a result, the executives become “co-investors” who, like the private equity investor, benefit from subsequent increases in value and can achieve a high profit, especially in the case of resale (“exit”) or initial public offering (“IPO”). Since the executives have paid the same purchase price that the private equity investor paid when they bought the company, they will not receive any income tax-relevant benefit by participating in the participation program. If the exit or IPO succeeds a few years later, their share of the proceeds is classified as a capital gain, which is subject to the withholding tax. In this context, however, it was disputed whether the bundling of the holdings of all executives in the hand of a single trustee "diluted" the rights of the individual executives to such an extent that beneficial ownership of the shares does not pass to the executives. The tax authorities had denied the acquisition of beneficial ownership and treated the exit proceeds attributable to the executives as fully taxable wages. In contrast, the BFH recognized the "pooling" of trustor rights and assigned the shares to the executives for tax purposes from the start. The profit from the sale of the shares is therefore subject to the more favorable withholding tax (judgment of May 21, 2014, I R 42/12). A similar case (participation through a management GbR) had also been decided by the Cologne Regional Court in favor of the executives (judgment of May 20, 2015, 3 K 3253/11). The revision of the financial administration was also unsuccessful. In the appeal judgment, the BFH even expressly stated that the linking of participation with the employment contract by means of a “leaver scheme” is not a decisive argument for qualifying the income as wages (judgment of October 4, 2016, IX R 43/15). Rather, the decisive factor is whether the manager acquired the stake at a fair market price and - like the main investor - bears an effective risk of loss.

The tax classification of foreign employee share rights or management participation programs ultimately always depends on a detailed examination of the contractual documents and the actual structure of the remuneration model. Experience shows that German tax offices are not always able to correctly assess the sometimes quite complicated contracts that are written in English. If the tax office requires more information or even a translation (Section 87 (2) AO), legal advice should be sought as a precaution. The same applies to the drafting of the contract when setting up the participation program.

Dr. Reimar Pinkernell LL.M.,
Bonn (as of January 13, 2018)