Recent Trends in German Employee Compensation
By Dr. Jessica Ohle *
First published: October 2,2008
The Current Scenario
This article begins with a short outline on the tax and social security treatment of the regular base salary, followed by an overview over the most recent changes and developments concerning employee remuneration. It then addresses four specific topics that are currently of importance for all employers when designing new employment schemes.
In Germany, the salary of an employee is subject to income tax and social security deductions. The income tax is borne by employees according to their personal income tax rate and deducted by the employer. The tax rate is linear progressive starting with 15% and ending with the top tax rate of up to 42%. Compulsory social security payments of up to 42% of the gross income are borne at equal parts by employer and employee. They are deducted by the employer. These social security payments include health insurance, state pension and unemployment insurance. The employer is obliged to remit the income tax and the social security payments directly to the authorities.
Recent changes and developments in Germany include:
— The gradual raise of the retirement age in the state pension from currently 65 years to 67 years in 2029. Employees who wish to receive the social security funded pension before this age have to accept deductions from their full pension payment. And like in many other countries, the value of the state pension is decreasing due to longer life expectancy and longer education.
— The Federal Equal Treatment Act (Allgemeines Gleichbehandlungsgesetz, 18.08.2006) has come into force also influencing employee remuneration. This legislation is in accordance with three EU directives against discrimination on various grounds including age and sex. As a consequence, employee remuneration schemes have to be reviewed for all aspects of discrimination.
— Starting with the annual report for 2006, the compensation received by board members of public corporations has to be published for each individual member of the board (with an opt out possibility at 75%). Formerly, it was sufficient to publish the overall compensation of the board.
— There is also a discussion to introduce legal minimum wages. The discussion mainly centers on the Arbeitnehmer-Entsendegesetz. This federal law allows declaring the minimum wages results from labor union agreements binding for all members of certain parts of the economy (e.g. construction workers, painters or roofers) by statutory regulation. However, the law is only applicable on the industrial sectors named in it. If another industrial sector plans to implement a minimum wage the law has to be amended. Recently, the Deutsche Post attempted to implement a minimum wage for mailmen. However, the amendment was considered invalid by a German court. Currently, the lowest wages start with hourly rates of 3.06 EUR (hairdresser in Saxony).
In general, there was a high unemployment rate in Germany in the recent years. However, with an average of currently 6% in the former German West and up to 13% especially in the economically weaker regions of the former German East (German average in June 2008: 7,5%), the situation is improving. Yet, on the other hand, there is a rising lack for skilled labor in some branches. This has led to a discussion about stronger support for employees with children, thus enabling especially female employees to return to their workplaces after the maternity and educational leave.
In the following, four topics that are currently of importance to all employers are outlined in a short overview.
Variable or Incentive Compensation: Bonus Payments
Currently there are two trends concerning the remuneration of employees: (i) Employers wish to stay as flexible as possible with regard to the employee-related costs and (ii) employers try to motivate employees by including performance based bonuses in employment contracts.
(i) Employers include "at-will" or discretionary payments in employment contracts. Yet in some cases courts have found that employees are entitled to these gratifications since they are part of the agreed salary or since the bonus conditions did not meet the requirements of equitable discretion or because they have been paid for several consecutive years without being clearly defined as variable and discretionary.
(ii) Performance based bonuses have become increasingly common for a wider range of employees in the last few years. Until the mid-nineties, bonuses were mostly to be found in the employment contracts of board members, leading employees and sales representatives. Now, there is a wide range of models for performance based salary components. The bonus can be based on the performance of the employer's company in general and/or on the individual performance of the employee.
— The company performance can be measured by reference to annual company performance results (the profit before or after tax, the annual turnover) or by the reference to the share price in comparison to a certain index or other factors.
— To measure the individual performance, more recently introduced incentive compensation contracts usually include a frame agreement outlining the maximum bonus and other general rules. In addition, a target agreement has to be closed with the employee each year to enumerate targets for the individual performance. In some cases, the bonus is also dependant on the performance of the team (e.g. the sales department). Recently, the German Federal Labor Court (Bundesarbeitsgericht or BAG) ruled that an employee is entitled to compensation for a lost bonus payment if both parties of the contract fail to close a target agreement although this has been announced in the frame agreement and the employer is responsible for the failure. On the other hand, a possible responsibility of the employee for the failure has to be taken into account, too (BAG, 12.12.2007 - 10 AZR 97/07).
A bonus payment is regarded part of the salary. Taxes and social security payments have to be deducted at the usual rate.
Stock Option Plans and Other Equity Compensation
Equity compensation schemes have become more common in Germany in the "New Economy" during the mid-nineies. A legal change in 1998 (Gesetz zur Kontrolle und Transparenz im Unternehmensbereich, KonTraG, 1.5.1998) has led to some changes in favor of stock option plans. Today, most international corporations and about 60% of the German DAX30 companies have a stock option plan at least for their German board members and leading employees.
The classical way to install a stock option plan was to grant convertible bonds in connection with a conditional raise of share capital. Since 1998, it is also possible to create "naked" warrants. An alternative are stock appreciation rights (SAR) or phantom stocks, giving the employee a title to a cash payment covering the actual rise of the share.
The advantage of equity compensation schemes is - like in all countries - higher motivation and higher identification with the company, ideally resulting in successful management and less fluctuation among the employees. There is no special prospectus requirement arising out of an employee stock option program but the program is usually described if a prospectus is issued for other reasons. Additionally, as there is no legal title to a severance payment in Germany, stock options do not have to be taken into account at its calculation. The main disadvantage for the employing company and its shareholders is of course the cost involved in implementing and maintaining an employee stock option plan.
Stock options and other forms of equity compensation are considered taxable income in Germany. Stock options are taxable at the moment of their exercise even if they cannot be sold for a certain period after. Social security contributions have to be deducted at exercise, too. For stock appreciation rights and phantom stocks, the moment of payment is relevant for these contributions.
Company Pension Plans
Because of the massive cutbacks in the public pension system, occupational pension schemes have become more and more important in Germany. According to a survey in December 2008, 65 % of all employees were entitled to an occupational pension.
Since 2004, according to a major legal change (Alterseinkünftegesetz, 05.07.2004), all contributions to pension schemes are tax free when they are granted but will be taxed when they are paid (deferred taxation). Due to this legal change, all employees are entitled to convert up to 4% of their annual income up to a certain amount (EUR 2,544 in 2008) into a claim for future pension payments. Apart from this, there is still no legal obligation for German employers to install a pension scheme. Another change is the raised "portability", the opportunity to take along earned pension claims when changing to a new employer.
There are five major forms of German company pension schemes: <
— A direct pension (Direktzusage) is the employer's promise to pay a pension when the employee reaches the retirement age.
— A direct insurance (Direktversicherung) is an insurance contract funded by the employer and giving the employee a direct claim against the insurance company.
— A pension institution (Pensionskasse) is an institution founded and funded by one or several employers while the employee has direct claim against the funds.
— Another form is the so-called benefit fund (Unterstützungskasse), which is also funded by the employer. The employee has no direct claim against the fund, but against the company.
— A fifth and more recent form is the pension funds (Pensionsfonds). It is a legally independent corporation organized and funded by one or several employers giving the employees a direct claim for payments while enjoying greater flexibility with regard to capital investment.
All forms of pension schemes are protected against defaulting. Since 1999, the Pension Guarantee Fund (Pensionssicherungsverein) is securing pension claims in case of the insolvency of the employer.
Benefits Avoiding Income Tax and Social Security Contributions
With an individual income tax rate of up to 42% and social security contributions of approximately 42%, borne in half by employer and employee, German companies are trying to lower the tax and social security rate by granting fringe benefits while adjusting to the ever changing tax legislation.
A company car for professional and private use is a standard benefit for higher ranking employees. The so-called financial advantage is subject to income tax. The advantage is calculated with 1% of the manufacturer list price, adding an average of EUR 200 to EUR 600 (depending on the size of the car) to the taxable monthly income. If the employer also reimburses all car-related costs (i.e. fuel, maintenance, parking), this will provide the employee with a significant financial advantage, as there are no extra deductions on these payments. There are full social security contributions on this financial advantage, however.
Reimbursements of work-related costs are mostly free of tax and social security payments. This applies to work related travel costs as well as to cell phone or home phone costs. If the employee is given a laptop or if the cost of a high speed online connection at home are reimbursed, there is a reduced flat tax rate that the employer can chose to pay, thus leaving the advantage tax free for the employee. The same applies, within certain boundaries, for other advantages granted by the employer like a canteen or lunch vouchers for the employees, or free transportation to work. Incentives like Christmas parties, weekend events, sports tickets or presents can also be taxed at a reduced flat rate that is borne by the employer. A housing allowance is quite unusual in Germany except for relocation cases and for a certain period of time. In case of relocation, especially from abroad, the employer often reimburses the relocation cost including the moving cost or the cost for a real estate agency. These relocation costs are tax free and not subject to social security contributions.
Other benefits that do not cause any income taxes or social security payments are language courses or weekend including the cost for travel and lodging as long as the there is a professional advantage for the employer. This may even be the case for a Yoga course or for an English course in Canterbury.
Contributions to a pension scheme are benefits that are subject to a reduced or no tax rate depending on the form of the pension scheme. Contributions to a direct pension or a benefit-fund are tax free and not subject to social security contributions. The same applies for the employer's contributions to a group insurance for accidents or a life insurance unless the employees themselves have a claim of entitlement towards the insurance company. In this case the contributions are subject to taxation. Contributions to a direct insurance, a pension institution or a pension fund are subject to a reduced tax rate, however.
Basically, advantages granted by third parties in connection with traveling (frequent traveler bonus programs) belong to employers; they are obligated to deduct taxes unless they allow a private use. In practice however, employers often leave the advantages granted by third parties to their employees. In this case, employees have to borne the tax if the private use exceeds the amount of 1,080 EUR.
Not a benefit, but an advantage nevertheless is to be granted higher flexibility for example due to a home office agreement and/or flexible working hours.
Private Healthcare is considered to be a benefit in Germany, although in a very limited way. Employers may promote the health of their employees up to an amount of 500 EUR per employee per year. This amount is not subject to taxation or social security payments.
Mandatory social security contributions include payments to the state "legal" health care insurance. Employees with a higher income (EUR 48,150 p.a. in 2008) can chose not to be a member of the legal health insurance and become a member of a private health insurance instead. In this case, they are entitled to a contribution of 50% of their monthly fee from the employer.
* The author is German lawyer and certified employment law specialist. Dr. Ohle has many years' experience in employment law, gained at the Berlin and Cologne offices of Heuking Lüer Wojtek. She has worked at U.S. law firms, including Berliner, Corcoran & Rowe LLP in Washington D.C. and Holland & Knight LLP in New York. In 2002, she joined Kliemt & Vollstädt one of Germany's leading employment law boutiques. She can be reached at Jessica.Ohle \at/kliemt.de
Zitierweise / Cite as Ohle, Recent Trends in German Employee Compensation, 17 German American Law Journal (Oct. 2, 2008), http://amrecht.com/ohlecompensation2008.shtml.