I. Basics

By granting generally non-tradable “stock options,” the employer grants certain employees the right to acquire company shares in the form of real shares (ESOP) or virtual shares (VSOP) at a later date and at a price determined in advance. Between the granting and the first time the options can be exercised, there is usually a vesting period of several years, during which the options must be “earned”, for example, through longer service with the company or by reaching certain milestones (vesting period).
Irrespective of whether ESOPs or VSOPs are involved, for tax purposes wages (income from employment pursuant to § 19 para. 1 sentence 1 no. 1 German Income Tax Act (Einkommensteuergesetz – EStG)) in the form of other remuneration (§ 38a para. 1 sentence 3 EStG) exist to the extent that the (virtual) shares are subsequently acquired at a discount. According to established case law of the Federal Fiscal Court (Bundesfinanzhof – BFH), the “other payments” are deemed to have accrued for tax purposes (§ 11 para. 1 sentence 1 EStG) and are to be taxed if the options are actually exercised and, as a result, either shares become the property of the employee, e.g. with entry in the employee’s securities account, or compensation on virtual shares is paid. The non-cash benefit is generally calculated as the difference between the market value of the shares at the time of exercise and the exercise price paid by the employee. As a rule, taxation is at the individual, “regular” (but progressive) income tax rate.
If the period between the granting and first exercisability of the stock options exceeds twelve months, this is a multi-year purchase to which the tariff reduction of § 34 para. 1 in conjunction with para. 2 no. 4 EStG can be applied.
Employees who work in several countries may be subject to different taxation rules and, as the BFH ruling of 21 December 2022 makes clear, the question always arises as to which country of activity or residence has the right of taxation in whole or in part.

II. Facts of the BFH ruling

Employee (A) worked for the U.S.-based subsidiary (T) of a German parent corporation (M) from June 2001 to April 2005. During this period, A had changed his place of residence from Germany to the USA. A undertook business trips outside the USA and stayed in Germany for one third of these (less than 60 days per calendar year). The salary was always paid by T. In May 2005, A returned to Germany and from then on worked in Germany again.
In April 2003, T granted non-tradable stock options to A, 50% of which could be exercised from April 2005 and 100% from April 2006. The actual exercise of part of these options took place in 2011, the year in dispute, and a taxable surplus was generated as a result. The resulting income was taxed in the USA to the extent that it was attributable (pro rata) to the working days in the USA.
The German tax office treated the income from the stock options, which was not taxed in the USA, as taxable in Germany. The Baden-Württemberg Tax Court (Finanzgericht – FG) of 21 May 2019, case no. 6 K 488/17, upheld the action brought against this and considered that the income as a whole should be exempt from domestic taxation and only subject to the progression proviso. For the question of residency, it was not the year of receipt (2011) but the residency in the vesting period that was decisive. Therefore, all of A’s income from the stock options, and not only the income attributable to activities in the USA, should be exempt from domestic taxation. The BFH did not follow this view.

III. Decision of the BFH

At the time the option was exercised in 2011, A was again subject to unlimited tax liability in Germany on his worldwide income due to his place of residence. Accordingly, under national law, the non-cash benefit from the discounted purchase of the shares was also taxable in Germany.
Assuming that A is resident in Germany, the domestic right of taxation for the income from the stock options is therefore only restricted in accordance with Article 15, para. 1 in conjunction with Article 23, para. 3, sentence 1 a Double-Taxation Treaty Germay-USA 1989/2008 (“DTT”) to the extent that the activity was carried out in the USA during the vesting period. However, Germany has the right of taxation for the days on which the claimant was on a business trip in Germany or in third countries.
The legal consequence of a change of residence prior to the time of the actual exercise of the option has been disputed to date. While the tax court focused on the residence during the vesting period, according to the literature and the OECD, the state in which the taxpayer is resident at the time of earning the income is always to be regarded as the state of residence. The BFH now agreed with the literature and the OECD and does not base the criterion of residency within the meaning of Article 15 para. 1 sentence 1 DTT on the vesting period, but on the inflow date, i.e. the exercise date.

IV. Consequences for the practice

For a person’s residence under Article 4 DTT and for the purposes of Article 15 DTT (and thus presumably also for other Double Taxation Treaties which in this respect correspond to the OECD Model Convention), the decisive factor is the time at which the salary accrues (exercise of the stock options) and not the vesting period. Germany may therefore tax (only) those working days in the vesting period that were not performed in the other contracting state (in this case: USA). The vesting period is to be determined by means of the respective contractual provisions of the ESOP and the working days are to be determined according to the physical presence of the employees on site.
Based on the BFH ruling, the taxation of stock options can be structured by a change of residence before exercising the option. The applicable treaty protection and exemption mechanism under the distribution standard of Article 15 DTT is influenced by the change of residence and thus of domicile prior to the exercise of the option. The ruling is likely to apply accordingly to subsequent bonus payments.
In order to assess the advantageousness of moving to another state, the individual situation (family, residence, etc.) as well as the relevant double taxation agreement (distribution norms, exemption mechanisms, reversion clauses, etc.) must be examined. In addition, difficulties may arise in the area of double taxation if the foreign state does not follow the approach of the BFH and, vice versa, assumes residency in the vesting period as the benchmark for residency. Finally, it should be noted that the ruling has not yet been published in the Federal Tax Gazette and it is therefore not certain whether it will be generally recognized by the tax authorities.