Brigitte Romani, KPMG Frankfurt

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Stock option programs have become a standard part of the compensation package for a wide range of employees in multinational corporations. A recent decision by the 1st Chamber of Germany's highest tax court reaffirms the position consistently taken by German courts and tax authorities that individuals receiving employee stock options recognise income when the options are exercised, not when they are granted, at least where the option is non-marketable (decision dated 24 January 2001, docket no. I R 100/98 – IStR 2001, 410).

The taxpayer contended that income in the amount of the option's fair market value was derived when the option was granted, arguing that the fact that the option was non-transferrable and could not be exercised until expiration of a waiting period should have led to appropriate valuation reductions in comparison with a similar option not subject to such restrictions. Calling attention to a considerable body of literature favourable to this position, the taxpayer noted inter alia that he could have "cashed in" the option at any time by entering into a contract with a third party to transfer the ultimate economic benefit of the option in return for a fixed payment (so-called "economic close-out" of the employee's stock option position).

The FTC rejected these arguments, however, and analogised the stock option to an open claim by the employee against the employer. Under the principles of cash basis accounting that apply to in such situations, income is realised by the employee when the claim is collected (time of receipt – Zufluß). The "economic close-out" argument was rejected on the grounds that a contractual arrangement would leave the underlying claim untouched. The court did state, however, that it might decide this issue differently once the waiting period for exercise of the option had expired, noting a lower court decision with this tenor (FG Baden-Württemberg, EFG 2000, 64, 65, = 24 June 1999.). In the instant case, the option was exercised immediately upon expiration of the waiting period.

The FTC also stated that it might decide differently in the case of marketable options.

The FTC furthermore held that stock options generally constitute an incentive for future efforts (reward for future achievement and motivation for remaining with the firm), not compensation for work performed in the past, at least where exercise of the option is contingent on an ongoing employment relationship. Where part of the employee's salary in the period between grant and exercise of a stock option is tax exempt in Germany (subject to a progression clause) under the terms of the 183-day clause of an applicable tax treaty (cf. Art. 15 of the OECD model income tax treaty), a rateable part of the income received on exercise of a stock option is likewise tax exempt. The tax exempt portion is equal to the ratio of tax exempt employment income over total employment income in the period between grant and exercise of the option. Whether any income is tax exempt in the year in which the option is exercised is irrelevant.

The FTC agreed with the lower court that income realised on the exercise of stock options constitutes income for a multi-year period and hence qualifies for the income-spreading provision in § 34 of the German income tax law (§ 34 (1) and (2) no. 4 EStG).

Editorial cut-off date: 20 March 2002

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