The Bavarian State Tax Office (BayLfSt) is the first German tax authority to issue guidance on the tax treatment of employee participation instruments with a negative liquidation preference, commonly referred to as hurdle shares. The ruling decree provides guidance on the tax treatment of these instruments, distinguishing between their issuance and the receipt of proceeds upon disposal.
- The BayLfSt provides guidance on hurdle-share structures.
- For tax purposes, the issuance of the shares and the receipt of proceeds upon disposal must be distinguished.
- As a general rule, the issuance of shares does not constitute employment income, provided that the shares are not transferred at a discount.
- Proceeds from the disposal of hurdle shares do not necessarily constitute employment income without additional circumstances.
Hurdle Shares as an Employee Participation Instrument
Hurdle shares are used as an employee participation instrument. They are a special form of employee participation in which shares are issued free of charge or at their nominal value with a negative liquidation preference.
This deviating profit and liquidation participation, in the form of a negative liquidation preference, also referred to as a participation threshold, generally corresponds to the difference between the fair market value of the relevant share and the purchase price payable by the employee for acquiring that share. The negative liquidation preference means that the employee participates only subordinately in sale proceeds, as proceeds are allocated to the employee only if the relevant value threshold has been exceeded at the time of an exit. In this way, the employee participates in the future increase in value of the company, but not in the value created before the shares are acquired.
Legal Questions
When hurdle shares are issued, the question regularly arises as to whether the employee has realised income at the time of issuance and at the time of exit, and to which income category any proceeds should be allocated.
From a legal perspective, the following aspects are particularly relevant:
- First, it must be determined whether income is realised by the employee when the shares are issued, which would then be taxable as a benefit in kind. This would give rise to the so-called dry-income issue, since employees would have to pay tax on the benefit in kind without receiving any liquidity.
- Second, it must be determined whether a later receipt of proceeds qualifies as employment income or as a capital gain, which may create uncertainty given the differences between capital gains taxation and potentially higher wage tax on employment income.
Key Statements by the Tax Authorities
In its decree dated 28 May 2026 (S 2332.1.1-29/4 St36), the BayLfSt commented on the tax qualification of hurdle shares.
Issuance of the Shares
The decree clarifies that the issuance of hurdle shares qualifies as employment income only if the shares are issued at a discount and the issuance therefore constitutes a benefit in kind. In this context, the agreed negative liquidation preference must be taken into account because it reduces the market value of the shares. As a result, in the usual case in which the amount of the negative liquidation preference corresponds to the difference between the purchase price and the market value of the shares, no discount is granted and the issuance of the shares should not trigger tax.
Receipt of Proceeds
The BayLfSt states in its decree that the mere existence of a negative liquidation preference does not mean that proceeds from the disposal of the shares must necessarily be treated as employment income. Rather, additional special circumstances must be present for those proceeds to qualify as employment income. The following examples are listed:
- The employee does not have beneficial ownership of the shares.
- Where vesting arrangements apply, the question of beneficial ownership depends on the specific structure in each individual case. The decisive factor is whether material rights attached to the shares can be exercised. Contractual holding periods and liquidation preferences generally do not prevent beneficial ownership.
- The employee participation is not validly established under civil law or is not actually implemented in accordance with the agreement.
- The employee receives profit shares exceeding those owed under corporate law.
- The participation is sold at a price other than the market price.
- The employee participation has no independent economic substance, meaning that there is no acquisition basis independent of the employment relationship.
- This may be the case where proceeds are provided only if work is performed. By contrast, if proceeds are also payable in the absence of work performance, for example in the event of illness, the participation will generally be deemed to have independent economic substance. The termination of the employee participation upon termination of the employment relationship through leaver provisions generally does not preclude such independence.
Practical Implications
With the decree, the BayLfSt takes up the existing case law of the German Federal Fiscal Court (Bundesfinanzhof, BFH) and its application to hurdle-share structures. In doing so, the BayLfSt expressly refers to the decisions of the BFH dated 14 December 2023 (VI R 1/21, BStBl. II 2024, 387) and 21 October 2025 (VIII R 13/23, BStBl. II 2026, 215).
Consistent with these decisions, the guidance reflects the distinction between the acquisition of the participation and the subsequent disposal of the shares. It also largely incorporates the criteria developed by the BFH for the tax classification of proceeds.
Although the decree is an internal administrative instruction and is binding on the tax authorities only within Bavaria, the clarification may provide legal certainty for the issuance of hurdle shares throughout Germany. This may increase the attractiveness of hurdle shares compared with other employee participation programs and further strengthen Germany as a start-up location.