If executives of a German company are granted equity interests in the company, the tax treatment of payments resulting from such equity interests can prove controversial if the tax authorities launch a tax audit. The payments could either be treated as employment income or as a capital gain. In the first case, the payments will subject to the employee’s individual income tax rate (up to 45%). In the second case, the often more favourable withholding tax rate applies (25% plus 5.5% solidarity surcharge).

In a recent decision, the Fiscal Court of Lower Saxony ruled that bonuses paid by a company established for the purpose of a manager participation program should generally be treated as employment income rather than as a capital gain. Treatment as employment income can only be avoided if the payments are made on a separate basis which is clearly detached from the employment relationship. The payments therefore need to be designed in such a way that they are paid as benefits resulting from the equity interest, rather than being linked to the employment. It is not sufficient for the bonus to depend on the capital expenditure incurred by the employee to acquire the equity interest.

Payments to executives run the risk of being treated as income from non-independent employment where the payments are not based on an employee’s equity interest in the company, but only require the existence of such an equity interest as a matter of form and are only indirectly oriented towards the economic success of the company.