New Act in Germany

After some delays, the “Growth Opportunities Act” (“Wachstumschancengesetz”) cleared the final hurdle on 22 March 2024 and will come into force. It contains numerous tax changes for companies, including an important change to the taxation of severance payments. Unlike previously, employers will no longer have to apply the “one-fifth rule” when paying severance payments as of 2025.

Previously: Application of the one-fifth rule in the wage tax deduction procedure by the employer

If a severance payment is made, employers must, under certain conditions, observe the so-called "one-fifth rule" when calculating wage tax. In very simplified terms, this special taxation rule means that the income tax is lower than it would be if the severance payment were taxed normally. Specifically, the income is notionally spread over five years when calculating the income tax rate in order to mitigate the effects of tax progression.

The procedure leads to increased effort in payroll tax accounting and is sometimes prone to errors. In a worst-case scenario, employers can be exposed to wage tax liability risks. As the employer and employee are jointly and severally liable, there is a risk of claims from the tax office if, for example, the one-fifth rule was applied in error. If the employer's claim for reimbursement against the (former) employee can not be enforced, employers are left with the costs in these cases.

Changes due to the Growth Opportunities Act

From 2025: Application of the one-fifth rule only in the employee's income tax return

The new “Growth Opportunities Act” does not abolish the one-fifth rule, but shifts it to the income tax declaration. As a result, employers will no longer have to carry out the previous procedures and calculations when paying severance payments. This eliminates the associated liability risk for employers. Instead, employees will in future have to apply for the one-fifth rule when submitting their individual tax return.

For employees, this means that they must claim the tax reduction themselves. Until the tax refund is received, there is usually less "net" left over from the severance payment. Particularly in the case of severance payments at the beginning of the year, it can take more than a year before the tax reduction is actually reflected in their accounts.
The severance payment will continue to be shown separately in the wage tax statements. Nothing will change with regard to social security either. Severance payments are still exempt from social security contributions.

Our recommendation

As an employer, you should point out to your employees in connection with the payment of severance pay that the privileged taxation of severance pay must be claimed in the tax return. If (former) employees do not submit a tax return, they may miss the possible tax advantages. However, there is no legal obligation for employers to inform employees.
We also recommend reviewing internal processes and any template termination agreements, social compensation plans or similar in good time and adapting them accordingly if necessary.