Tax recognition of employee-financed pension commitments

As part of company pension schemes, employees are often granted pension commitments that are financed by converting future remuneration entitlements and a guaranteed interest rate. When such employee-financed commitments are granted to employed managing partners, the tax authorities examine the requirements for their tax recognition very closely with regard to the relevant criteria, such as vesting and arm's length principles. The German Federal Fiscal Court (BFH) has now made tax recognition easier in some respects with two decisions, but at the same time has also set limits.
 

On the arm's length nature of a pension commitment based on deferred compensation

In the dispute in the decision of November 19, 2025 (Ref. I R 50/22), a UG (entrepreneurial company as a special form of GmbH) had made a pension commitment to its sole shareholder and managing director in the form of a direct commitment. The pension contributions were paid exclusively by the shareholder-managing director by way of a monthly salary conversion. The tax office did not recognize the pension provisions taken into account by the UG for this purpose as reducing its profits. In view of the fact that the pension commitment was granted after the managing partner's 60th birthday, the vesting period required under arm's length principles was not guaranteed. The additions to the pension provisions were therefore treated as hidden profit distributions.

The BFH confirmed the decision of the lower court insofar as a commitment is also considered to be in line with arm's length principles and therefore generally tax-deductible if it was granted without a probationary period, but is financed exclusively by converting the remuneration agreed for the managing director's activities. In this case, it is not the company that bears the risk of the managing director's performance, but the managing director himself. However, this is subject to the condition that the overall situation does not pose a significant risk to the company of having to co-finance the managing director's future pension entitlements.

However, in the case in question, the BFH saw concrete indications that the pension commitment was not financed exclusively by converting part of the employee's (reasonable) salary and that the company could not be burdened with increased risks and costs. On the one hand, the initial salary grant and the conversion of remuneration took place in close proximity to each other in terms of time. In connection with the agreement of a potentially unreasonably high salary or the unreasonable total remuneration of the managing partner, it cannot be ruled out that there may be a pension commitment (co-)financed by the employer, which is merely concealed by its structure as deferred compensation combined with the granting of an unreasonably high salary. Furthermore, the agreed guaranteed interest rate must also be included in the economic assessment to determine whether, in individual cases, there is a significant risk that it will have to be cross-financed from company profits. Finally, a direct commitment based on deferred compensation is generally not seriously agreed upon and therefore not recognized for tax purposes if the entitlement to future pension benefits is not protected against insolvency.

Since the findings of the first-instance tax court with regard to these indications were not sufficient for a final assessment by the Federal Fiscal Court, it overturned the ruling and referred the case back.

 

Interest on a direct commitment based on deferred compensation 

The proceedings settled by the decision of December 17, 2025 (Ref. I R 4/23) concerned the question of whether a guaranteed interest rate significantly exceeding the low-risk market interest rate can be classified as a hidden distribution of profits in the case of pension commitments financed by deferred compensation. The company pensions promised by a limited liability company (GmbH) to two employed shareholders were to be financed by converting vacation and Christmas bonuses. However, the GmbH had undertaken to pay interest of 6% p.a. on the capital stock to be built up in this way. Since other employees were only granted interest of 3% p.a. on their employer-financed pension commitments, the tax office considered this to be a violation of the arm's length principle and also considered the employer to be contributing to the financing of the commitments. It treated the provisions formed by the GmbH for future pensions as hidden profit distributions insofar as the interest rate exceeded 3% p.a.

The BFH did not agree with this view without reservation. It is true that a pension commitment based on deferred compensation, in which the capital stock is to be remunerated by the employer at a rate exceeding the low-risk market interest rate, is generally no longer financed exclusively by the employee. However, such “mixed-financed” pension commitments are still recognized for tax purposes if the total benefits provided to the beneficiary employees are reasonable. In addition to pension entitlements, the relevant total benefits include, in particular, the monthly salary and other employer contributions, such as the provision of a company car for private use. Since the lower tax court had not sufficiently examined the appropriateness of the employees' total benefits, the BFH referred the case back.

For the second legal proceeding, the BFH provided further explanations on the assessment criteria to be applied in cases involving mixed-financed pension commitments. In the context of the arm's length comparison, the criteria of vesting and compliance with an appropriate probationary period must also be examined. The modifications to the arm's length comparison developed by case law for exclusively employee-financed pension commitments are not applicable in this respect. In terms of accounting, in the case of mixed-financed pension commitments, the employer-financed portion is not to be included in the special rule applicable to the calculation of the present value of the pension obligation for the purpose of creating provisions for deferred compensation.


 

Notice:

In practice, these rulings mean that when structuring employee-financed pension commitments, companies must comprehensively assess the overall situation at the time the commitment is made in terms of time aspects, the level of the guaranteed interest rate, and insolvency law requirements. They must also take into account the overall financial resources of the beneficiaries and ensure that these are adequate. However, there is still considerable scope for flexibility within this framework.