What is the one-fifth rule about?
If severance payments are agreed with employees, the question of how to correctly calculate the wage tax deduction often arises during payroll accounting: income tax law provides for the possibility of a so-called one-fifth rule, which reduces the progression effect for recipients of severance payments. This involves first calculating the tax due on the first fifth of the severance payment, which is then multiplied by five. In terms of progression, the effect is roughly the same as it would be if over five years one fifth of the severance was taxed. The tax advantage can be particularly significant for employees whose regular income is in the lower and middle range and who can expect high severance payments due to many years of service. This can amount to several thousand euros or even a smaller five-digit sum.
Practical problems with the application
In practice, the one-fifth rule has sometimes presented employers with problems: whether the employee actually benefits from the rule ultimately depends on whether there is a so-called
“accumulation of income”. Such an accumulation requires that the income in the relevant assessment period is increased by the severance payment, i.e. the severance payment is higher than the salary that the employee would normally have earned up to the end of the year. Whether this is the case may depend on whether the employee enters into a new employment relationship by the end of the year and how high the earnings will be in this relationship. The employer must therefore make a certain forecast decision.
Simplification through the Growth Opportunities Act
The Act to Strengthen Growth Opportunities, Investment and Innovation as well as Tax Simplification and Fairness (the so-called Growth Opportunities Act) aims to improve the framework conditions for more growth, investment and innovation from a tax perspective through targeted measures. At its meeting on March 22, 2024, the Bundesrat also adopted the Growth Opportunities Act as amended by the Mediation Committee (Bundestag parliamentary paper 87/24). The Bundestag had previously adopted the Mediation Committee’s recommendation at its meeting on February 23, 2024 (Bundestag parliamentary paper 87/24).
The package of measures adopted includes changes to the so-called fifth rule for multi-year remuneration (Sec. 34 para. 1 in conjunction with para. 2 no. 4 German Income Tax Act – EStG), according to which Sec. 39b para. 3 sent. 9 and 10 EStG and thus the obligation to apply the one fifth rule for certain wages (compensation, remuneration for multi-year activities) in the wage tax deduction procedure will be abolished with effect from January 1, 2025.
From the legislator’s point of view, the background to the amendment is that the calculation is complicated, employers often do not make use of the one-fifth rule, as it is not legally possible to establish a concentration and employers are to be relieved of the burden of checking and calculating (Bundestag parliamentary paper 20/8628, 137).
What practical implications does the change in the law have for employers?
Possible future application in the wage tax deduction procedure?
Whether the one-fifth rule applies in individual cases previously had to be clarified as part of the annual wage tax adjustment (Lohnsteuer-Jahresausgleich). From the employer’s point of view, however, there may still be an interest in allowing a deserving employee to benefit from the tax advantages of the one-fifth rule at an earlier stage. This can be a decisive advantage when negotiating the amount of severance pay. Many employees also request the application of the rule during the payroll deduction process.
It is currently unclear whether employers will have the option of continuing to apply the one-fifth rule in the wage tax deduction procedure. The deletion of the previous Sec. 39b para. 3 sent. 9 EStG could indicate that only the obligation to apply the one-fifth rule should be lifted and that employers will therefore have the right to choose in future. Some authors draw the conclusion from the wording in the federal government’s draft bill (Bundestag parliamentary paper 20/8628, 137), which provides for “a repeal without replacement of the regulations for calculating wage tax in connection with wages to be taxed at a reduced rate”, that a voluntary continued application of the one-fifth rule in the context of the wage tax deduction procedure is now ruled out (e.g. Rösch/Betz/Radü, DB 2023, 2660 (2660)).
Obligation to disclose the wages eligible for the tariff reduction under Sec. 34 para. 1 EStG
Furthermore, the employer should continue to be obliged to report the wages eligible for the tariff reduction under Sec. 34 para. 1 EStG separately. This is derived from Sec. 41b para. 1 sent. 2 no.3 EStG. The corresponding Decree from the Federal Ministry of Finance dated 09.09.2019 (IV C 5- S 2378/19/10002:001, BStBl. I 2019, 911, para. 7) is likely to be amended soon. In future, the German tax office will be responsible for deciding whether to grant the one-fifth rule in the assessment procedure.
For the separate reporting of wages for which the one-fifth rule is applicable, for example in the case of long-term incentives (LTI), the corresponding vesting period must still be reviewed in accordance with the respective agreements made, which is why the scope of the relief for employers in terms of the administrative burden in accounting is likely to be less than originally hoped for. According to the intention of the legislator, at least the review of an accumulation of income, which is difficult or impossible to assess during the year, should be omitted.
It remains unclear to what extent the employer is obliged to check which wages are eligible for the tariff reduction in accordance with Sec. 34 para. 1 EStG and must therefore be shown in the wage tax statement. A blanket approach that lists all potentially qualifying remuneration as multi-year remuneration is unlikely to be welcomed by the German tax authorities. In such cases, the German tax authorities could quickly impose employer liability in accordance with Sec. 42d para. 1 no. 2 EStG. Whether this is justified, however, is likely to depend on the overall circumstances of the individual case. It should be borne in mind that – as the legislative reasoning expressly states – it is the German tax authorities that are responsible for deciding whether to grant the allowance.
Practical tip
Even in the past, it was not advisable to agree an obligation to apply the one-fifth rule in the termination agreement, even if many employment lawyers demand this. This now applies even more.
If the application of the one-fifth rule in the wage tax deduction procedure is being considered, it is recommended to obtain a free wage tax information call (Lohnsteueranrufungsauskunft) in order to avoid liability risks for the employer. The answer provided binds the German tax office in the payroll tax deduction procedure.
Outlook
While the application of the one-fifth rule for similar cases could previously be checked once at employer level, in future this check must be carried out individually for each employee by the relevant German tax office as part of the tax assessment procedure. This is likely to increase the already long processing times for tax returns, to the frustration of employees, but will lead to an – at least minor – simplification of payroll accounting for employers.
To date, the generally welcome abolition of the obligation to apply the one-fifth rule in the wage tax deduction procedure still gives rise to a number of legal uncertainties that need to be addressed. This article is intended to raise awareness of this and encourage you to keep an eye on the future development of the issues raised. Internal processes and systems in payroll accounting should already be reviewed in light of the change in the law.
For further information, please contact:
Dr. Barbara Geck, Partner, Bird & Bird
barbara.geck@twobirds.com
