The first tax authority guidance on the tax consequences of hurdle/growth shares

Hurdle/growth shares – a stake in future increases of value only

Hurdle/growth shares are a particular form of employee share ownership. The aim is to allow employees to share in the business’s future increases in value only – but not in its existing value.

This is typically achieved by issuing the shares at their nominal value or at a reduced price but agreeing a liquidation preference at the same time.

This means that the employees have only a subordinate share in dividends, sales and liquidation proceeds. The return is only paid when a liquidation preference is exceeded. And the part of the return that comes under the liquidation preference falls to the other shareholders.

Example according to the notice: 
Fair market value of a share: EUR 10,000
less liquidation preference: EUR 9,999
= fair market value: 1 EUR per share

If the employee pays 1 EUR, the issuance is not discounted – a non-monetary benefit is not created.

For taxation, two points in time should be strictly distinguished:

• the issuance of the shares and
• the later receipt of returns.

Both actions are evaluated separately for tax.

When shares are issued, this only brings about employment income if the shareholding is granted at a discount. This is determined by the fair market value, taking into account the liquidation preference. If the purchase price equates to this value, there is no non-monetary benefit. A reliable valuation – such as a well-founded valuation report – is essential for this. The Bavarian Tax Office notice thereby confirms that low purchase prices by themselves do not create an issue for payroll tax. It is the market value that is determinative, taking into account the limited economic shareholding.

Companies should therefore document a logical valuation and transparently present the economic effects of the liquidation preference.

Not automatically treated as employment income

For later returns too, such as from dividends or disposals, it depends on how they are specifically structured. The notice clarifies that the liquidation preference in itself does not result in future returns being classified as employment income.

Rather, it should be checked whether the returns result from a special legal relationship independent of the employment. If this is the case, income under the general rules for shareholdings (sections 17 and 20 of the Income Tax Act [Einkommensteuergesetz–EStG]) come into consideration in particular. This is typically subject to a lower tax liability than employment income (up to 45% plus surcharge taxes).

However, it may be classified as employment income under particular circumstances. It becomes critical if:

• the employee does not obtain economic ownership of the shares (section 39(2) no. 1 of the Fiscal Code [Abgabenordnung–AO])
• the shareholding was not validly created under civil law or is not actually vested in this way
• the employee receives higher shares of profits than he is entitled to under company law
• a disposal takes place not at the market price.

The shareholding’s own economic contents are also crucial. This is more the case when investment income or gains are received independent of actual work, such as during sickness.

According to the notice, the circumstance that the shareholding ends when employment ends does not automatically stand in the way of its stand-alone status for tax purposes, however.

Implication for practice:

Hurdle/growth share programmes should be designed to comply not only with employment and company law but also be consistent for tax purposes. It is crucial to have clear contractual provisions, reliable valuations, conditions in line with the market, and actual vesting that is in accordance with the agreements.

Conclusion: Structuring hurdle/growth shares carefully for tax

The notice gives specific practical direction for the first time. It confirms that hurdle/growth shares do not automatically result in employment income.

But both in issuing the shares and also for later returns a careful tax assessment is necessary. The following is crucial in particular:

• the liquidation preference is presented accurately
• the shareholding was created validly
• it is actually vested in line with the market 

Although the notice does not apply across the whole of Germany, it offers an important practical basis for argumentation and for discussion with the tax authorities in other federal states.

Businesses running or planning employee share ownership schemes should check existing schemes and get tax advice for new models early. This particularly applies to start-ups, growth companies,  management shareholdings and private equity structures.

Errors in designing them can harbour considerable tax risks, both to businesses and to their employees.

We will be glad to support you with tax analysis, structuring and the valuation of employee share ownership schemes.