Tokenised Profit Participation Rights – The Future of Employee Participation in the German Market?

Profit participation rights are an attractive form of employee participation

Equity-like profit participation rights are a way of dynamically issuing employees with a stake in a business while at the same time eliminating the possibility that they can influence corporate management and policy. These profit participation rights combine the (tax) advantages of real shares with the flexibility of pure instruments of participation under the law of obligations.

• Comparison with real shares: Profit participation rights generally only come with information rights under exclusion of other possible ways of exerting influence. In contrast to real shares, an employee who obtains equity-like profit participation rights does not become a shareholder of the employer company and is therefore not entitled to the pecuniary and administrative rights of a shareholder. Instead, they share in the company's success on the basis of a relationship under the law of obligations – similarly to a shareholder. In this respect – unlike with shares – there is no need for a pooling vehicle controlled by the principal shareholders or a separate class of shares without voting rights.
  
  Furthermore, no notarisation is required to grant or transfer profit participation rights, in contrast to shares. Profit participation rights are therefore much more flexible and can be directly granted or withdrawn at any time as a matter of principle.
  
  In addition, the earnings generated by employees from the equity-like profit participation rights (including participation in increases in value after rights are granted) are taxed in a similar way to investment income from real shares, i.e., they are subject to a flat rate tax of around 26.4 % or, if the minimum participation of 1 % is satisfied, capital gains of around 28.5 % (excluding church tax in each case). The granting of equity-like profit participation rights is also taxed in a largely identical manner to the granting of real shares and may be tax-privileged under certain conditions (see below).
   
• Comparison with VSOP and ESOP: Virtual stocks and option programmes are also very flexible in how they are structured and handled, although notarisation is advisable for options on shares due to existing uncertainties. From the beneficiary's point of view, it is advantageous to avoid immediate taxation without a corresponding inflow of liquidity ("dry income"), as is the case when shares or profit participation rights are issued free of charge or at a reduced price (subject to a deferral of taxation, see below). A disadvantage, however, is the taxation of income as wages at a progressive tax rate of up to around 47.5 % (excluding church tax), which leads to a difference in the return after tax of up to approx. 21 % (without taking opportunity costs into account).

Profit participation rights can be combined with options

For an increased flexibility, profit participation rights can be issued in combination with options. By exercising a discretionary option, the employee can be given the opportunity to co-determine the timing of allocation of the profit participation right and thus the inflow of a non-cash benefit (dry income) subject to income tax so that the inflow taxation aligns with the employee's personal liquidity situation. However, there exist certain practical restrictions with regard to when the profit participation rights are issued due to valuation requirements for allocated profit participation rights.

Profit participation rights can be tokenised as a digital asset

As a technical supplement, the profit participation rights can be turned into digital assets in the form of security tokens. This allows the profit participation rights to be transferred to other persons via blockchain and the employee to monetise his/her profit participation right before an exit event without causing a liquidity outflow at the employer company. In addition, this format allows payments for profit participation rights to be processed automatically through smart contracts.

In the option model, exercising the options can be combined with mining tokens for profit participation rights which can be controlled by the employees themselves. The relevant time for the inflow of wages is when the token is booked into the wallet; this gives the employee the economic power of disposal over the profit participation right.

Equity-like profit participation rights issued to employees by young companies are tax-privileged in Germany

As of July 2021, the granting of a qualifying participation in a company free of charge or at a reduced price is not subject to immediate taxation in accordance with section 19a Income Tax Act (EStG); instead, it is subject to a deferral on taxation. The scope of application has been extended by the Future Financing Act (ZuFinG) with effect from 2024. Besides stocks and shares, qualifying participations also include equity-like profit participation rights in the company of the domestic employer, provided that repayment at par value is not assured; a minimum interest rate independent of profit is possible subject to limitations (see section 2 (1) no. 1 letter l) in conjunction with section 1 (4) of the Fifth Act on Encouraging Asset Formation for Employees (VermBG). A deferred taxation becomes applicable once:

• the profit participation right is transferred in whole or in part,
• 15 years have passed since the profit participation right was granted or
• the employment relationship with the previous employer is terminated.

If the fair market value of the profit participation right (less any additional payments made by the employee) is lower at the time when it is subsequently transferred compared to the deferred taxable wage income at the time when the profit participation right was granted, only the lower fair market value of the profit participation right (less any additional payments made by the employee) becomes subject to taxation or, if the profit participation right is repurchased upon termination of employment, only the remuneration actually paid is subject to taxation (taking into account bad leaver deductions).

Taxation that becomes due after the expiry of the 15 years deferral period or upon termination of the employment relationship can be postponed to a subsequent later transfer of the profit participation right provided that the employer irrevocably declares, at the latest with the wage tax return following the relevant event, that he will be liable for the wage withholding tax applicable upon a later transfer of the profit participation rights.

Deferral of taxation is granted on the condition that:

• the qualifying participation in the employer company is granted by the employer company (or a shareholder of the employer company) free of charge or at a reduced price in addition to the wage already owed (i.e., no conversion of compensation),
• the employer company was founded no more than 20 years ago and
• the employer company does not exceed and did not exceed these thresholds in one of the six preceding calendar years the following thresholds at the time the profit participation right is granted: annual revenue of EUR 100 million, balance sheet total of EUR 86 million and 1,000 employees.

Employers and employees have the option of requesting a payroll tax ruling (Anrufungsauskunft) from the company's tax office free of charge in accordance with section 42e Income Tax Act (EStG) to confirm the amount of the untaxed benefit by the employer for the purposes of the withholding tax deduction procedure. This requires that both the calculated benefit and the documents used to determine such value are submitted to the company's tax office and that the valuation chosen by the employer company complies with the applicable valuation provisions and regulations.

Profit participation rights of up to EUR 2,000 p.a. can be issued to employees tax-free

Granting equity-like profit participation rights in the employing company free of charge or at a reduced price is tax-free up to an allowance of EUR 2,000 in accordance with section 3 no. 39 Income Tax Act (EStG) if the non-cash benefit accrues within the framework of a current employment relationship. The tax exemption is granted under the condition that the participation is available to (at least) all employees who are in an employment relationship with the company at the time the offer is announced and have been employed for one year or longer without interruption. An allowance in accordance with section 3 no. 39 Income Tax Act (EStG) needs to be deducted to determine any benefit that is subject to deferred taxation in accordance with section 19a German Income Tax Act (EStG).

It is questionable whether the exemption threshold for tax-free benefits in kind pursuant to section 8 (2) sentence 11 Income Tax Act (EStG) applies to (tokenised) profit participation rights alongside or in addition to the tax exemption pursuant to section 3 no. 39 Income Tax Act (EStG). However, this would only make sense if profit participation rights were issued monthly, as the exemption limit of EUR 50 is assessed monthly and cannot be carried forward to subsequent months or extrapolated to an annual amount. In view of ongoing valuation requirements, however, issuing profit participation rights monthly is limited in terms of technical implementation and is therefore unsuitable in practice.

Granting profit participation rights leads to tax-deductible wage expenses

The equity-like profit participation rights issued to employees are recognized as debt in the employer company's tax accounts. An economic burden should regularly be assumed particularly in cases of a termination right after a minimum term, a put option and/or an exit participation. The initial recognition as a liability should be at the fair market value of the granted profit participation right and represent a wage expense that is tax-deductible at the amount of the non-cash benefit (i.e., less any additional payments made by the employee). Compared to issuing shares, it could be advantageous from a tax perspective for the employer company to issue equity-like profit participation rights. Once the profit participation right has been issued, it is taxed in accordance with the accounting and income determination provisions generally applicable to profit participation rights (see German Federal Ministry of Finance letter dated 11 April 2023).

Conclusion: Tokenised profit participation rights are an ideal instrument of employee participation

Tokenised profit participation rights are a new instrument of employee participation with a variety of opportunities. In addition to a tax-privileged treatment comparable to real shares, they offer the flexibility of participation instruments purely under the law of obligations and – in contrast to shares – do not require notarisation to be granted and transferred.

In our opinion, the tax benefit under section 19a German Income Tax Act (EStG) for young companies (especially start-ups) issuing profit participation rights will be decisive for the future success of these instruments. This benefit should gain additional momentum from the recent expansion of scope that come along with the German Future Financing Act (ZuFinG).