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Guest Article

Deloitte logo

(From the February 2, 2009 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

New IRC Section 457A: Unanswered Questions Abound


New IRC § 457A imposes more restrictive income timing rules on nonqualified deferred compensation from "tax indifferent" entities, effective for amounts deferred that are attributable to services rendered after December 31, 2008. This article discusses some of the issues that employers face as they try to understand how IRC § 457A will apply to their own particular compensation arrangements.

Background

New IRC § 457A was included with the tax provisions that accompanied the Emergency Economic Stabilization Act of 2008. It generally provides that any compensation that is deferred under a nonqualified deferred compensation plan of a nonqualified entity is includible in gross income upon vesting or, if the amount is not determinable, when the amount becomes determinable (in which case additional taxes apply). Although IRC § 457A was directed at deferrals of fees payable by offshore hedge funds, its scope and application are considerably broader.

In Notice 2009-8, the IRS issued interim guidance to assist taxpayers in applying new IRC § 457A. The notice is effective from the date of the statute's enactment, October 3, 2008, and is intended as interim guidance to assist taxpayers in applying IRC § 457A while IRS and Treasury consider further guidance.

Foreign Corporations in Controlled Groups with U.S. Corporations

Under IRC § 457A(b)(1), a foreign corporation is a nonqualified entity unless substantially all of its income is: (a) effectively connected with the conduct of a trade or business in the United States ("ECI"), or (b) subject to a comprehensive foreign income tax. Under Notice 2009-8 substantially all generally means 80 percent so that a corporation is not a nonqualified entity if 80 percent or more of its income is ECI or, if it is a foreign corporation subject to a comprehensive foreign income tax, no more than 20 percent of its income is excluded as nonresidence income or otherwise. There is also a general exception applicable to compensation that would have been deductible under the principles of §882 (imposition of tax on ECI) had the compensation been paid in cash when vested.

Whether an entity is nonqualified is determined at the sponsor level. Notice 2009-8, Q&A-14, provides that an entity is considered the sponsor of a nonqualified deferred compensation plan if it is the entity that would be entitled to a compensation deduction under U.S. federal income tax principles if the amounts were paid during the year. This determination is not based on which entity is identified as the plan sponsor in the plan documents or, for equity plans, which entity's equity is used as compensation. Status as a nonqualified entity is determined as of the last day of the service provider's taxable year.

The Notice does not provide for application of IRC § 457A on an aggregate or controlled group basis. IRC § 457A(d)(5) provides that rules "similar to" the aggregation rules under IRC § 409A(d)(6) (which, in turn, provides that rules "similar to" IRC § 414(b) and (c) shall apply) shall apply. Thus, some employers expected IRC § 457A to be applied to corporations on a controlled group basis. Instead, Notice 2009-8 limits the analysis to the corporation that would be entitled to the compensation deduction under U.S. federal income tax principles. This interpretation is beneficial to some employers and detrimental to others.

For example, suppose a foreign corporation is a nonqualified entity with significant operations in the United States through wholly-owned U.S. subsidiaries that are not nonqualified entities. Under Notice 2009-8, IRC § 457A will not apply to the deferred compensation plan of the U.S. subsidiaries on account of their nonqualified entity parent to the extent the US subsidiaries would be entitled to claim deductions for the compensation. In this context, testing on an aggregated basis might require an assessment of US income relative to the worldwide income of the aggregated group.

On the other hand, suppose a U.S. corporation that is not a nonqualified entity has significant international operations through wholly-owned foreign subsidiaries that are nonqualified entities. In this case, the US corporation cannot use the aggregation rules to show that substantially all of the aggregated group is subject to tax. Instead, teach subsidiary's status as a nonqualified entity needs to be evaluated independently. As the test is applied on an annual basis, this approach could impose complexity for entities with internationally mobile employees. For example, if a US employee is sent on assignment to a nonqualified entity, it will be important to determine if the employee has been transferred to the foreign entity, so that it would be entitled to any compensation deductions under US principles, or if the employee is continuing at the US corporation and providing services under a secundment arrangement. If the employee is transferred to the nonqualified entity, it will then be necessary to ensure that compensation earned for services at that entity complies with IRC § 457A.

Issues for Tiered Partnerships

Under IRC § 457A(b)(2), a partnership is a nonqualified entity unless substantially all of its income is allocated to persons other than: (a) foreign persons with respect to whom such income is not subject to a comprehensive foreign income tax, and (b) organizations which are exempt from tax under the Internal Revenue Code. Notice 2009-8, Q&A-11(d), allows income to be treated as allocated to any direct or indirect owner of a partnership that takes the income into account on a current basis, even if it is not actually distributed to that owner. In some cases, this rule will allow partnerships that would otherwise be treated as nonqualified entities to avoid IRC § 457A. In many cases, however, it will not be possible for the partners of a partnership to know how their partnership partners allocate income.

For example, suppose the AB partnership allocates its income equally between its two partners: A, a U.S. individual, and BC, a foreign partnership that allocates its income equally between its two partners B and C, two U.S. individuals. Because A, B, and C are all U.S. individuals, the AB partnership is not a nonqualified entity, and IRC § 457A does not apply to its nonqualified deferred compensation plans. However, if the AB partnership does not know who the partners of the BC partnership are or how the BC partnership allocates income (which may include alloctions to additional partnership), the AB partnership may not be able to substantiate that it is not a nonqualified entity.

As with corporations, whether a partnership is a nonqualified entity is determined as of the last day of the service provider's taxable year. This determination is based on the allocations (or deemed allocations) of gross income by the partnership for the partnership's taxable year ending with or within the service provider's taxable year (or with respect to a newly established partnership that does not yet have a taxable year that has ended or ends on the last day of the service provider's taxable year, a reasonable, good faith estimate of such allocations for the current taxable year).

This year by year determination of status as a nonqualified entity also raises difficulties in compliance of partnership because of the need to track any changes in the members of a partnership and allocations of income among partners.

Hedge Fund Side Pockets

A hedge fund is a private investment fund. Fund managers invest assets from investors -- typically wealthy individuals and institutions -- in exchange for fees. Unlike private equity funds, hedge funds usually invest in relatively liquid assets and allow investors to come and go. Sometimes, however, fund managers invest in illiquid assets, such as delisted shares of a public company. In that case, an arrangement known as a "side pocket" may be created. The investors in the fund at the time the side pocket is created will receive a portion of the proceeds when the asset in the side pocket is sold -- even if the sale occurs after they withdraw from the fund. New investors, however, have no financial interest in the asset.

IRC § 457A authorizes the IRS and Treasury to provide rules allowing assets in side pockets to be treated as subject to a substantial risk of forfeiture (and, therefore, not subject to IRC § 457A) until substantially all the gain on disposition of the asset is allocated to investors. Notice 2009-8, however, does not address side pockets. Therefore, pending further guidance, there is no exception applicable to side pockets and such arrangements are subject to IRC § 457A in the same manner as other deferred compensation arrangements.

Transition

Notice 2009-8 provides transition with respect to a number of issues. Of particular relevance to the issues addressed in this article is the ability for a plan subject to IRC § 409A to include a provision that allows payment in the event amounts are included in income under IRC § 457A, provided that the provision is established in writing and effective on or before December 31, 2011. Inclusion of such a provision will protect participants in the event that an entity changes status and becomes a nonqualified entity.

Conclusion

Notice 2009-8 provides helpful information on compliance with IRC § 457A. Application of this section in practice, however, may be complicated for multinational corporations with operations and subsidiaries in different jurisdictions, including corporations that have a US corporation as the parent entity, and for tiered partnerships.


Deloitte logoThe information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.

If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

Copyright 2009, Deloitte.


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