Dry Income | Employee Compensation via Cryptocurrencies in Germany

Consider this example: If Harry Hardwork receives a condominium valued at EUR 100,000 from his employer as a bonus for his services, in addition to his monthly salary of EUR 7,000, it’s evident that Harry Hardwork must pay tax on this (approximately 45 percent = EUR 45,000).

In this instance, he receives an in-kind benefit (condominium) and hence no cash, so he would have to pay the tax of approximately 45,000 euros from his own pocket. His assets increase, but his liquidity decreases. Theoretically, he pays more tax than his salary of 7,000 euros would permit. As he is also typically unable to sell the flat immediately, this initially results in a liquidity burden. This is the dry income problem.

A realistic example is employee share ownership in the form of shares. In the gratuitous case, the full market price at the time the share is received constitutes wages, which are then taxable in the employee’s payroll. If the employee does not sell the share immediately, his net income is reduced by the tax on the share - hence, he has even less net income available than usual, although he receives more wages than usual. Without selling the share, the dry income problem also arises here.

The issuance of a virtual currency inherently involves the creation of “digital money” seemingly out of thin air. The source code and the embedded consensus rules alone determine the “money supply” of the new currency.

This virtual currency’s value is solely determined by what external third parties are willing to pay for it. During an ICO, the initiators set the values, and investors decide whether they’re willing to pay these prices. If they’re not, the ICO fails.

The prices set by the initiators are somewhat arbitrary, and their success in the market relies heavily on the initiator’s marketing skills. To entice early investors, large “discounts” are often offered as part of the marketing strategy. For instance, in a private sale, early investors may receive a discount of 60 percent or more on the final target price set for the ICO:

• An early investor might pay EUR 0.40 for a token, while a later investor might have to pay EUR 1.00. This is based on the idea that the earlier an investor gets involved, the higher the risk that the project will fail during the implementation phase.
• The higher risk taken by early investors is compensated by a lower price. With a presumed final target price of EUR 1.00, any price from EUR 0.0001 up to the full amount can be considered during the ICO process.
• This vast range from potential worthlessness to full value forms the basis for discussions with the tax office when tokens become part of an employee’s salary or are given “at a discount” to employees or founders.

So, if every price from EUR 0 to 1 in our example is economically justifiable, how does the tax office first determine and compare a value? If employees, founders, or directors receive tokens at a price different than the final price, they first compare what third parties paid at the same time. In most ICOs, the earliest phase in which external funds are raised is the private sale.

As mentioned earlier, investors can buy a token in a private sale for EUR 0.40 instead of EUR 1.00. It would therefore make sense for the tax office to consider this as the “real” market price of the new currency. This can be a significantly lower value than the final issue price of the token.

In the above example, approximately 45 percent of EUR 400,000 would have to be taxed (EUR 180,000). This means EUR 180,000 would be due without a single cent going to the founders and the team.
As the vCU, that is, the currency tokens, are not currently traded on any exchange, neither founders nor employees can sell the tokens they receive on the market. This results in an uncomfortable pre-financing of taxes until a potential future sale. This is the dry-income problem:

• This issue has been recognized for a long time in the context of share issuance. In practice, this is mitigated with option models or phantom shares. Instead of a share, an option or virtual share is promised, which only becomes taxable when its value is realized through a sale. Could this also be a feasible solution in an ICO?
• The question thus arises whether the dry income problem could be resolved by postponing the inflow time to a moment when the new virtual currency can be resold.
• The unsatisfactory answer is: “In principle, yes, but only in theory.”

If we delay the inflow date to a later time, for instance, to the end of the ICO process, the employees could immediately sell the received tokens (entirely or partially) and pay the tax from the sale price. The “income” would no longer be “dry”. However, the tax base would now be the current arm’s length price. This would now be EUR 1,000,000 instead of the previous EUR 400,000.

This means: time and liquidity gained, but euros lost on balance because the tax has more than doubled.

Moreover, an option right to a token would likely trigger additional authorization obligations with BaFin. Despite many similarities, the classic option model from the share world is therefore not a genuine solution to the underlying problem with ICOs.

Instead of adopting the solution approach from the equity world, issuers who consult with us take a different approach as part of an ICO:

• We are investigating the extent to which we can advance the timing of the allocation of funds.
• This necessitates a rethink by the initiators on several levels.
• This modifies the structure of the entire ICO.
• The addition of another ICO stage - a seed phase - can establish the conditions for a further arm’s length comparison.

The specific structure and practical implementation is not a one-size-fits-all solution and is customized to the respective company by our advisors, taking into account regulatory aspects. Depending on the individual timetable, assets can be transferred to the founders and employees at virtually no cost, and an additional cash injection can be obtained for the initial costs of the new company.

If team members are also shareholders of the company or related parties, the rules on hidden profit distributions and the formal requirements to avoid them must be adhered to. In particular, the written form requirement must be taken into account in good time. Additionally, the provisions of the German Commercial Code, especially Section 107, should be observed. According to this, wages must be paid in cash and remuneration in goods or benefits in-kind is only possible under certain restrictions.

Under no circumstances should the offsetting of benefits in-kind against the wages owed fall below the garnishment limit. Furthermore, offsetting against the salary is only possible if this has been agreed in writing. The purpose of the regulation is to ensure that the employee is not left without any money at the end of the month or has to convert the benefits in-kind received back into euros to cover their living expenses.

Special rules apply to employees who are employed abroad for more than one month. Analogous application of the Evidence Act permits remuneration payment in the respective national currency. However, this regulation cannot be applied to Bitcoin and cryptocurrencies, as these virtual currencies are not easily and unproblematically used for consumption, at least at the present time. There is no obligation to accept cryptocurrencies as there is with conventional money.