Hurdle Shares Reloaded: Administrative Guidance Finally Provides Tax Certainty

By administrative decree dated May 28, 2026 (S 2332.1.1‑29/4 St36), the Bavarian State Tax Office (Bayerisches Landesamt für Steuern, “BayLfSt”) has, for the first time, formally addressed the tax treatment of hurdle shares (also referred to as growth shares). The guidance materially enhances legal certainty and, importantly, aligns administrative practice with the recent case law of the German Federal Fiscal Court (Bundesfinanzhof, “BFH”).

A. Background and Key Issues

Hurdle shares are equity interests featuring a negative liquidation preference. They are typically granted to managers or employees and participate in all proceeds (including dividends, sale proceeds, and liquidation proceeds) only once a predefined monetary threshold (“hurdle”) has been exceeded. Until the hurdle is reached, all proceeds are allocated exclusively to the existing shareholders (e.g., founders or investors).

From an economic perspective, hurdle shares entitle their holders to participate solely in the future appreciation of the enterprise above a defined baseline value. The hurdle is therefore typically calibrated by reference to the current fair market value of the company (often derived from prior financing rounds and, where appropriate, economically adjusted, e.g., via a notional return), enabling subscription at nominal value.

As with any genuine employee equity participation program (Employee Stock Ownership Plans, “ESOPs”), two principal tax issues arise:

• At grant: whether the issuance gives rise to taxable employment income in the form of a benefit in kind (commonly referred to as “dry income”-issue); and
• On subsequent proceeds: whether subsequent proceeds are to be characterized as employment income within the meaning of Section 19 of the German Income Tax Act (Einkommensteuergesetz, “EStG”) or, instead, as income derived from a separate legal relationship (Sonderrechtsbeziehung), in particular investment income under Section 20 EStG.

This distinction is economically critical given the disparity in applicable tax rates. From a structuring perspective, the objective is typically to avoid “dry income” at grant while ensuring that subsequent proceeds – particularly exit proceeds – are taxed under the preferential investment income regime at the flat tax rate of approx. 25%, rather than as employment income taxable at progressive rates of up to approx. 45%.

In recent years, increasing scrutiny by certain German tax authorities materially undermined the attractiveness of hurdle share structures. While the hurdle mechanism itself was generally accepted as reducing fair market value – thereby mitigating “dry income” concerns – the classification of subsequent proceeds as capital income was frequently denied based on considerations that were often neither economically nor legally persuasive (e.g., allegedly insufficient downside risk due to subscription at nominal value).

B. New Administrative Guidance

In the decree referenced above, the BayLfSt has articulated now its position on the wage tax treatment of hurdle shares. The key message is that, where hurdle shares are structured on arm’s-length terms, hurdle shares do not necessarily give rise to employment income either at grant or with respect to subsequent proceeds. In reaching this conclusion, the BayLfSt largely follows the recent case law of the BFH (see further below under Section C).

I. Wage Tax Treatment

Consistent with current BFH jurisprudence, the decree emphasizes that the grant of the hurdle shares and subsequent proceeds must be analysed as separate and independent events.

1. Grant of Hurdle Shares

The decree makes clear that the fair market value of hurdle shares must be reduced by the agreed negative liquidation preference (i.e., the participation threshold). Where the participation threshold fully accounts for the difference between the subscription price (typically the nominal value) and the fair market value of the shares without considering the participation threshold, no discount – and therefore no taxable benefit – arises.

The decree illustrates this principle with a typical fact pattern: an employee acquires hurdle shares for EUR 1 per share. The fair market value of the shares absent the participation threshold is EUR 10,000, while the hurdle is set at the amount of the difference – i.e., EUR 9,999. Accordingly, the subscription price of EUR 1 per share corresponds to the fair market value of the hurdle shares after considering the value-reducing effect of the participation threshold. In the absence of any discount, no taxable employment benefit in kind arises.

2. Subsequent Proceeds

The BayLfSt further clarifies that the mere existence of a negative liquidation preference does not cause subsequent proceeds to be treated as employment income. Such recharacterization requires the presence of additional, specific factors. In assessing these factors, the decree applies criteria established by the BFH, including:

• Lack of beneficial (tax) ownership by the employee (Section 39 (2) no. 1 of the German Fiscal Code);
• No valid civil law creation of the employment participation, or a failure to implement the arrangement in accordance with its terms;
• Receipt of proceeds exceeding those contractually owed under corporate law;
• Sale of the employment participation at a non-arm’s-length price;
• Absence of independent economic substance of the employee participation; this would be the case where proceeds are effectively contingent upon the performance of labour services (e.g., special provisions providing for a forfeiture of entitlements during sickness). It is further clarified that typical “leaver” provisions – linking the termination of employment to the employee’s participation – are not, in themselves, detrimental.

In practice, the last criterion is often decisive.

II. Scope of Application

It should be noted that the decree constitutes an internal administrative instruction and, as such, does not have binding effect vis-à-vis third parties (e.g., in tax court proceedings). While its formal scope is limited to the Bavarian tax offices, it nevertheless contains a number of highly welcome and practically relevant clarifications.

C. Alignment with BFH Case Law

The decree accurately reflects and consistently applies recent rulings of both the Sixth and Eighth Senates of the BFH on hurdle share programmes:

• In 2023, the Sixth Senate rejected in two leading cases the concept of a “continuity link” between a potentially discounted acquisition of employee participations and the tax treatment of subsequent proceeds (BFH, judgements dated December 14, 2023, VI R 1/21 and VI R 2/21). Instead, acquisition and subsequent returns must be analysed separately. The decisive factor for treating proceeds as employment income is the existence of non-arm’s-length excess returns.
• In 2025, the Eighth Senate – having previously applied a holistic, case-by-case approach without a clear distinction between acquisition and subsequent proceeds – aligned itself with this jurisprudence in three decisions (BFH, judgment dated October 21, 2025 – VIII R 13/23; BFH, judgement dated November 25, 2025 – VIII R 11–12/23 and BFH, judgement dated October 21, 2025 – VIII R 14/23). It further emphasized the absence of any “reasonableness reservation” for qualifying proceeds as investment income and confirmed that “sweet equity” components – common in both hurdle share and leveraged structures – do not in itself result in employment income.

The adoption of this jurisprudence by the tax administration is a highly welcome development.

D. Practical Implications and Outlook

The BayLfSt’s decree significantly enhances legal certainty for the implementation of hurdle share programmes. Its relevance likely extends beyond Bavaria, particularly as an authoritative reference point in obtaining advance wage tax rulings (Lohnsteuer-Anrufungsauskunft). From a policy perspective, a coordinated federal position from the German Federal Ministry of Finance (BMF) would be highly desirable to further strengthen Germany’s competitiveness as a business location.

Of particular importance is the consistent application of the BFH’s doctrine of separating acquisition from subsequent disposition. Where hurdle share arrangements are structured on arm’s-length terms (especially in the absence of employment-driven excess return mechanisms) ESOPs of this nature are likely to regain attractiveness. Despite somewhat higher administrative complexity (e.g., in cap table-friendly pooling structures), such arrangements can offer significant advantages over purely contractual, “virtual” participation programs (Virtual Stock Ownership Plans, “VSOPs”). Given that VSOPs have seen increased use in recent years due to prior uncertainty in relation to hurdle shares, the tax-efficient conversion of existing VSOPs into equity-based (hurdle share) ESOPs may become an increasingly relevant structuring consideration.