Germany: Employee Participation Schemes: Profit Participation Rights Instead of Bonuses?

Ruling of the Federal Fiscal Court (Bundesfinanzhof, "BFH") of 21 October 2025 (VIII R 14/23) on the Tax Treatment of Profit Participation Rights Issued to Employees

"In order for profit participation rights interest on a profit participation right to be based on a special legal relationship under company law alongside the employment relationship, the holder of the profit participation right must be the legal and economic owner of the right. The profit participation rights relationship must furthermore be seriously agreed and implemented and be structured in such a way that it has independent economic substance alongside the employment relationship."

Small and medium-sized enterprises ("SMEs") compete for qualified specialists and therefore require effective tools to attract, retain and motivate employees. Whilst traditional bonus payments are straightforward to implement, they are subject to progressive taxation as employment income with tax rates of up to 45% (plus solidarity surcharge (Solidaritätszuschlag, "Soli") and church tax (Kirchensteuer, "KiSt"), where applicable). Direct participation through limited liability company (Gesellschaft mit beschränkter Haftung, "GmbH") shareholdings, is frequently undesirable and often impractical in practice, inter alia due to the notarial certification requirement and the influence rights that employees would obtain as shareholders.

We explain why this is the case in this article, in which we also examine the ruling of the German Federal Fiscal Court (Bundesfinanzhof, "BFH") of 21 October 2025 (VIII R 14/23) on the tax treatment of ongoing interest payments.

What are profit participation rights?

Profit participation (Genussrechte) rights are a flexible participation instrument that can figuratively be described as a "middle way" between a traditional loan and a genuine equity participation. They are regulated by statute in Sec. 221 of the German Stock Corporation Act (Aktiengesetz, "AktG") for stock corporations, but can also be issued by a limited liability company (GmbH) accordingly. The employee invests a certain amount (the profit participation capital), receives ongoing returns (frequently referred to as "interest") and receives back the capital invested at the end of the term, provided that the company has been economically successful. Participation in the increased company value ("upside") (a notional liquidation proceeds) is also possible. In return, the employee bears a certain entrepreneurial risk. If the company makes losses, the returns may be lower or may even be completely eliminated, and in rare cases the repayment of the capital may also be reduced.

Unlike with a traditional shareholding, however, the employee does not become a shareholder. This means they have no voting rights, do not have to visit a notary to acquire the participation and do not appear in the commercial register.

For companies, profit participation rights are attractive because they can allow employees to participate in success without having to relinquish control. For employees, they are interesting because they can participate in value development without having to commit themselves long-term as shareholders. The tax treatment of these returns can be considerably more favourable for the employee than with a normal bonus payment.

The tax and accounting treatment for the employer also depends on whether equity-like (equity capital) profit participation rights or bond-like (debt capital) profit participation rights are involved. In this regard, it must be examined in particular whether the profit participation rights grant participation in liquidation proceeds.

Taxation of interest payments: New BFH ruling of 21 October 2025 (VIII R 14/23)

In the tax year 2018, the question arose whether profit participation rights interest received by an employee was to be treated as employment income pursuant to Sec. 19 of the German Income Tax Act (Einkommensteuergesetz, "EStG") or as capital income pursuant to Sec. 20 EStG. The BFH classified the interest as income from capital assets and affirmed the applicability of the flat-rate withholding tax (Abgeltungsteuer) of 25% (plus Soli and, where applicable, KiSt) instead of progressive taxation as employment income at up to 45% (plus Soli and, where applicable, KiSt).

In the case under review, the profit participation rights programme was structured as follows:

• Participants had to be in a non-terminated service or employment relationship with the company (a stock corporation) or an affiliated company at the time of subscription.

• Upon conclusion of a profit participation rights agreement, the stipulated base amount of the profit participation rights had to be paid by the participant to the company.

• The profit participation rights granted a claim to interest on the profit participation capital that took priority over the profit share of the shareholders and was dependent on the business development of the company in the respective financial year. The interest was to be determined according to a formula deposited in the profit participation rights agreement that was linked to EBITDA and equity capital figures from the individual financial statements.

• The profit participation capital participated in the loss of the company according to a calculation formula specified in the profit participation rights agreement.

• From the profit participation rights, the participant could derive neither participation, involvement and voting rights in the general meeting nor participation in liquidation proceeds.

• Upon termination of the profit participation rights programme, the profit participation capital was to be repaid by the company.

• If the participant's service or employment relationship ended during the term, the company could terminate all of that participant's profit participation rights by written declaration (so-called "leaver provision"). In the event of termination, the participant could demand repayment of their profit participation capital, calculated as the nominal amount of the profit participation rights plus any interest amounts not yet paid out and minus losses not yet offset.

In the BFH's opinion, the profit participation rights relationship had independent economic substance (a so-called special legal relationship), such that no (concealed) employment income was present.

In the BFH's view, this was supported by the fact that the employee had invested their own capital, bore genuine loss risk and the interest was calculated according to a transparent formula determined in advance. The leaver provision was also not detrimental because the employee retained their capital and interest already received upon departure.

The BFH also clarified that the amount of interest does not, in principle, lead to reclassification (even on a pro rata basis) as employment income. Sec. 20 para. 1 no. 7 EStG does not contain any appropriateness reservation. A limitation of profit participation rights interest falling under Sec. 20 para. 1 no. 7 EStG by means of a return cap, including allocation of any excess amount to income pursuant to Sec. 19 EStG, is ruled out. Even high returns therefore remain capital income as long as the payments are based on a special legal relationship. An above-market premium is irrelevant for the ongoing remuneration.

Tax treatment of the acquisition and payment of profit participation capital

If an employee acquires bond-like profit participation rights at a reduced price, this generally results in a benefit in kind that is taxable as employment income. At market interest rates, the tax value corresponds to the nominal value of the profit participation rights (Sec. 3 no. 39 sent. 4 EStG in conjunction with Secs. 9, 12 para. 1 of the German Valuation Act(Bewertungsgesetz, "BewG")). If the interest rate deviates from the market level, a complex valuation must be carried out – one reason why market interest rates are preferable in practice.

If the participation programme is offered to all employees with at least one year's service, the exemption pursuant to Sec. 3 no. 39 EStG of up to EUR 2,000 per year and employee can be utilised. This significantly increases the attractiveness of employee participation. Young companies – whose formation occurred no more than 20 years ago and which comply with the thresholds of Sec. 19a EStG (maximum of 1,000 employees, maximum turnover of EUR 100 million or balance sheet total of EUR 86 million) – can also benefit from tax deferral pursuant to Sec. 19a EStG. This defers taxation, but not the liability for social security contributions, to a later date and relieves the liquidity burden on employees.

A payment equal to the nominal value of the profit participation capital is tax-neutral. However, if the profit participation capital has been reduced by loss participation, a disposal loss arises. Due to the loss offset restriction in Sec. 20 para. 6 sent. 1 EStG, this can only be offset against other capital income – not, however, against income from employment.

Recommendations for practice

In implementing profit participation rights programmes, both the contractual structure and the tax framework conditions are crucial for the success of the instrument. The contractual structure should be chosen in such a way that an independent legal relationship arises that can be clearly distinguished from the employment relationship. The BFH has now provided practical criteria in this regard. It is important to maintain the balance between attractive terms for employees and tax certainty. Particular attention should be paid to the interest terms, the risk distribution between company and employees and the provisions for the case of employee departure.

At the tax level, the various allowances and concessions should be systematically examined and - where possible - integrated into the programme design.

The tax-optimised structuring of employee participation programmes requires sound expertise at the intersection of employment, company and tax law. We would be pleased to provide you with comprehensive advice on the conception and implementation of legally secure participation models, from selecting the appropriate instrument via contract drafting through to ongoing tax support.