Profit from management participation is not wages

To ensure that employees have a vested interest in the company's success, they are given a financial stake in it. By linking a potential increase in value to the value of the company, companies can prevent conflicts of interest between investors and management.

However, management shareholdings raise tax law issues. In particular, it has not yet been clear whether returns and capital gains from the shareholding are to be attributed to income from employment or capital income. Income from employment is subject to the progressive tax rate. This can lead to marginal tax burdens of 45 per cent (plus solidarity surcharge and church tax, if applicable). Capital income, on the other hand, is generally subject to the flat-rate withholding tax of 25 per cent (plus solidarity surcharge and church tax, if applicable).

In two judgements dated 14 December 2023 (case no. VI R 1/21 and case no. VI R 2/21), the Federal Fiscal Court (BFH) ruled that the profit from the sale of an employee shareholding at arm's length is not a benefit subject to income tax. This is also not the case if the employee had previously acquired the shareholding at a reduced price. An advantage subject to income tax can only exist if the employee realises an excess price from the sale of the employee shareholding that is not at arm's length due to the employment relationship.

In each case, an executive employee who had participated in a management participation programme had filed a lawsuit. The programme had given him the opportunity to acquire shares in a so-called Manager KG in the course of a planned IPO. After a successful IPO, the plaintiff received shares in this corporation, which he sold at a high profit. The tax office treated the difference between the sales price achieved and the capital invested by the plaintiff as taxable wages. Wrongly, as the BFH has now ruled.

The reasoning of the BFH is as follows: In order for income from employment to be assumed, an inducement from the individual employment relationship must be recognisable. On the other hand, there is no salary if the benefit is based on a special legal relationship that exists independently of the employment relationship. However, the prerequisite for a special legal relationship is that the employee participation was effectively agreed under civil law and was actually carried out. The employee shareholding then represents an independent basis of income that is independent of the employment relationship. In this case, any income in the form of profit distributions or capital gains is not taxable in accordance with Section 19 EStG, but solely in accordance with the relevant provisions of the Income Tax Act. Contractually agreed leaver clauses, which link the continuation of the participation relationship to the continuation of the employment relationship, would not prevent the employee participation from being recognised for tax purposes as a special legal relationship.

For the tax assessment of the sale proceeds, it is also irrelevant whether the employee has previously acquired the shareholding at a reduced price. However, it should be noted that a discounted acquisition is a taxable non-cash benefit. The benefit therefore falls under wages. According to the BFH, however, the acquisition and sale must be considered separately. A discounted acquisition of the shareholding does not mean that the capital gain is also attributable to wages.

However, the BFH has named one exception: If the employee receives an above-market price when selling the shareholding, this can be caused by the employment relationship even if a special legal relationship exists. The amount in excess of the market price is then taxable as wages.

The BFH's judgement is to be welcomed. Nevertheless, the tax treatment remains dependent on the individual case. In particular, the approach of some tax offices and tax courts remains difficult to assess, also because there is currently no statement from the Federal Ministry of Finance. Companies should therefore continue to structure the establishment of a management participation carefully.

Shareholdings are a common remuneration instrument not only for employees, but also for board members and management. Here, too, the supervisory board should take the BFH's reasoning into account when structuring the programme.