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Guest Article


(From the April 10, 2006 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Foreign Trusts and Section 409A Compliance

Since the American Jobs Creation Act of 2004 ("AJCA") added new restrictions on trusts associated with deferred compensation arrangements, U.S. taxpayers' participation in foreign sponsored deferred compensation arrangements has received significantly more attention than in the past. Many employers outside of the U.S. use trusts in connection with deferred compensation arrangements which permit employees to delay recognition of income until distribution occurs. However, there are two sections of the U.S. Internal Revenue Code, one recently added as part of the AJCA, which affect the use of a trust with respect to deferred compensation for U.S. taxpayers.

Section 402(b)

Long before the AJCA added section 409A(b) to the U.S. Internal Revenue Code, section 402(b) governed the taxability of employee trusts other than qualified trusts. Under this section, contributions to trusts not exempt from taxation under section 501(a) are included in gross income in the first taxable year in which there is no longer a substantial risk of forfeiture or amounts are transferable. In addition, if the trust is discriminatory, the employee will also include any increases in his benefit under the trust annually.

Section 409A(b)

Section 409A(b) regulates the use of rabbi trusts in two circumstances involving deferred compensation for the benefit of U.S. taxpayers. First, section 409A(b) provides that a trust that is located outside the U.S. results in current income, regardless of whether the trust is subject to the claims of the employer's creditors. This rule does not apply if substantially all of the services that gave rise to the deferred compensation were performed in the jurisdiction in which the assets are held. Second, trusts that hold assets that would be placed beyond the reach of the employer's creditors if the company's financial condition deteriorated ("financial health trigger") also result in current income. In either case, income results in the year the assets are transferred offshore or a financial heath trigger is added. These amounts are subject to an additional 20% rate of tax plus tax based on interest at the underpayment rate plus 1% for the period from vesting under the deferred compensation plan to inclusion in income.

The definition of "deferred compensation" for section 409A(b) excludes incentive stock options ("ISOs"), employee stock purchase plans ("ESPPs"), certain foreign plans and short-term deferral arrangements. Additionally, there is a proposed amendment before Congress which aims to exempt foreign-approved plans that operate in a manner substantially similar to ISOs and ESPPs from section 409A. The intention is that SAYE plans, a very common arrangement for many UK companies, would be exempted from section 409A and the related trust rules. However, it is unclear as to when, or if, the amendment might be adopted and incorporated into law so it is not suggested that companies wait or rely on this change.

Section 409A(b) is effective January 1, 2005. It applies to trusts related to nonqualified deferred compensation as of that date, regardless of if the amounts deferred were vested as of December 31, 2004.

Notice 2006-33

Notice 2006-33 (the "Notice"), released on March 21, 2006, provides guidance on how trusts subject to 409A(b) can come into compliance with the new trust restrictions. The Notice grants a transition relief period through December 31, 2007 for assets and earnings credited to such assets (1) set aside or transferred to an offshore trust on or before March 21, 2006; or (2) placed in a trust with a financial health trigger on or before March 21, 2006.

If assets are located in the U.S. or are not subject to a financial health trigger on or after March 21, 2006, subsequent transfer outside of the U.S. or addition of a financial health trigger is not protected by the Notice. For example, assets that were located outside the U.S. as of December 31, 2004 and were subsequently transferred to the U.S. and were within the U.S. as of March 21, 2006, cannot be transferred back out of the U.S. in order to take advantage of the transition period in the Notice. Additionally, if a financial health trigger was removed from a trust in order to be in "good faith" compliance with section 409A(b), such trust provision cannot be added back to the trust, even if removed by the end of the transition period.

Plans can comply on or before December 31, 2007 with section 409A(b) by bringing grace period assets back to the U.S. (or a proper service jurisdiction), using such assets to make payments of the nonqualified deferred compensation (including payments upon termination of the plan), decoupling the assets from the plan, or eliminating any applicable financial health restriction.

Note that there is no relief for amounts that are transferred to a trust subject to section 409A(b) after March 21, 2006 even if the trust is brought into compliance by December 31, 2007. Therefore, it is important that no new contributions or transfers be made to an offshore trust that is related to a deferred compensation plan with participants who are U.S. taxpayers or to a trust with a financial health trigger clause. This applies even if the employer intends to amend the plan to exclude U.S. taxpayers.

Definition of "Trust"

The Notice does not provide further guidance on the application of section 409A(b), although it states that future guidance is intended. Specifically, the Notice does not provide guidance on when trust assets are considered "offshore" or what is required to bring them "onshore" or into a proper service jurisdiction. The Notice also does not provide guidance on what constitutes a "trust." Specifically, although the statute specifically allows Treasury to issue guidance determining what other arrangements would be considered a trust, the Notice does not include a determination that any other arrangement should be treated in the same way as a trust.

Action Steps

Employers should review arrangements that are offshore to determine if they are subject to section 409A(b). Employer assets that are not held in a trust are not affected by this provision (pending further guidance).

There is no transition relief for assets in trusts subject to section 402(b). Therefore, income must be recognized in the first year in which the assets are no longer subject to a substantial risk of forfeiture.

If assets are held in a trust, they are not affected by section 409A(b) if the trust is in the jurisdiction where substantially all services are performed, if the trust relates to a plan that is not a nonqualified deferred compensation plan subject to section 409A (e.g., because it is a shortterm deferral plan), or because it does not have a financial health trigger.

For trusts that are subject to section 409A(b), it is important that the employer freeze contributions and prepare to make changes to the arrangement by December 31, 2007.

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

If you have 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, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608 , Bart Massey 202.220.2104, Diane McGowan 202.220.2077, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Carlisle Toppin 202.220.2067, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

Copyright 2006, Deloitte.

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