The profit participation right is a bond-like instrument. It does not confer shareholder rights or other corporate participation or voting rights. Interest is based on the current business performance. Where a holder is granted enhanced participation rights (liquidation proceeds), such profit participation right is referred to as a “equity-like profit participation right.”
Contractual profit participation right
The holder of a simple (“contractual”) profit participation right provides capital to the company. In return he receives interest based on the company’s performance metrics, such as EBITDA. The holder does not participate in liquidation proceeds or built-in gain. Upon termination, only the par value is redeemed. Typically, profit participation rights are subordinated.
Contractual profit participation rights generate interest income (§ 20(1)(7) EStG, subject to a 25% flat tax). The interest expense is deductible at the debtor’s level.
Equity-like profit participation right
Equity-like profit participation rights are economically similar to a genuine equity interest in a company. The holder participates in the value of the company, including any built-in gain (liquidation proceeds). This distinguishes the equity-like profit participation right from the contractual profit participation right.
Income from equity-like profit participation rights is taxed as profit distributions (Section 20(1)(1) EStG subject to the 25% flat tax or the preferential income regime). The expense is not tax-deductible for the payor.
Investment Income vs. Income from Employment
Key to the scheme’s attractiveness is taxation as capital income, not as wages. The Federal Fiscal Court (BFH) has formulated the conditions under which a payment is attributable to a discrete legal relationship and thus does not qualify as wages (BFH VIII R 14/23 of October 21, 2025, para. 31 et seq.).
In addition to being validly established and properly performed, the discrete legal relationship must have economic substance distinct from the employment relationship. It must reflect the entire exchange of services between the contracting parties, without any service or payment attributable to the employment relationship. The decisive factor is whether the value of the profit participation rights can evolve independently from the employment relationship.
Leaver clauses indicate a close link to the employment relationship, but are not inherently detrimental, undless the redemption value depends on the employee’s conduct (good leaver/bad leaver). In such cases, the compensation is considered a reward for employee performance (see Federal Fiscal Court, judgment of November 5, 2013 – VIII R 20/11).
Unusual remuneration will be challenged, if it is not transparently determined in advance (see BFH judgment of October 21, 2014 – VIII R 44/11). Where the rate of return is transparently agreed in advance, the appropriateness of the ongoing profit share is irrelevant.
Conclusion
Contractual profit participation rights offer opportunities for employee participation schemes. Guidelines for the tax classification of income have been affirmed by recent rulings of the Federal Fiscal Court (BFH) dated October 21, 2025 (VIII R 13/23 and VIII R 14/23). The key factor is a clear and transparent determination of compensation that is linked to company performance metrics, not to the employee’s individual performance metrics.
Key Points in Brief
The structuring of employee participation schemes is complex. In addition to tax law, labor law and corporate law requirements must be respected (Federal Labor Court, March 19, 2025 – 10 AZR 67/24 and Federal Court of Justice, February 10, 2026 – II ZR 71/24). The Federal Fiscal Court’s (BFH) clarification of the tax requirements provides helpful guidance in this regard.
