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Guest Article

Deloitte logo

(From the May 21, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Issues Final 409A Regulations -- Part IV

In [this, the] fourth installment of our series on the final IRC 409A regulations, we'll interrupt our summarizing of their content to look at their practical impact in the international realm. In a globalizing economy, many non-U.S. companies maintain deferred compensation arrangements in which U.S. citizens or residents participate, while many Americans participate in their foreign employers' plans. Section 409A is thus more than domestic tax law. Were it applied with maximum rigor, the U.S. legal regime would dictate executive compensation practices around the world.

Not aspiring to that role, the IRS has tried in the final regulations to give leeway to plans and practices in which the United States has little tax or regulatory interest. The end product still contains many international pitfalls, however, so it is important for both overseas employers and expatriate employees to understand how they are and are not affected. There are several variations to explore, depending on the individual's citizenship or residence, where the pertinent services are performed, and where he or she resides when the deferred compensation is distributed.

U. S. Participants in Foreign Plans (Working Abroad)

Many Americans now work in other countries, participating in deferred compensation plans established and maintained in accordance with the laws of their place of employment. Unfortunately, there is more than a minimal risk that their employers won't know about, or won't take the trouble to comply with, IRC 409A. Many foreign plans have impermissible features, such as stock option exercise prices that don't meet the conditions for an IRC 409A exemption, flexibility in electing the time and manner of distribution, or provisions for securing benefits in the event that the employer's financial condition deteriorates. Keeping them in place for U.S. taxpayers runs a risk of a tax disaster.

Four provisions of the final regulations offer a modicum of relief, though their scope is limited.

  • The regulations state explicitly that tax treaty provisions override IRC 409A. That exception may be useful where the pertinent treaty classifies nonqualified deferred compensation as "pension income" taxable only in the jurisdiction of the taxpayer's residence, and he or she is considered, for treaty purposes, a resident of the foreign country both while he or she is accruing the compensation and when it is distributed.

    Example: The U.S.-Australia income tax treaty provides that "pensions and other similar remuneration paid to an individual who is a resident of one of the Contracting States in consideration of past employment shall be taxable only in that State" (Article 18(1)). It defines "pensions and other similar remuneration" broadly as "periodic payments made by reason of retirement or death, in consideration for services rendered" (Article 18(4)). Mr. A is an American citizen who works in Australia, meets the treaty's criteria for classification as a resident of Australia, and accrues benefits under an unfunded pension plan. If he retires in Australia, the treaty will safeguard his pension distributions from IRC 409A. Unhappily, if he moves back to the United States or, for that matter, relocates to any country that does not have a similar treaty with the U.S., he will lose the treaty protection. Since treaties change and the future of one's residence is unpredictable, it will rarely be prudent to rely on a particular treaty for long-term planning.

    Recently negotiated treaties have tended to limit "pensions" to those provided under tax-recognized plans, which makes this exception nearly coterminous with the next one.

  • Section 409A does not apply to benefits accrued under a "broad-based" foreign retirement plan (one in which substantially all participants are nonresident aliens). A plan falls into this category if its coverage is "nondiscriminatory", it provides meaningful, nondiscriminatory benefits to a substantial majority of participants, and its terms, or applicable foreign tax law, discourage the receipt of benefits before retirement age. U.S. citizens and permanent residents are ineligible for the exclusion if they simultaneously participate in a U.S. qualified plan. Furthermore, it is available only to the extent that their deferrals are nonelective, are made from foreign earned income and do not exceed the maximum accrual or allocation permitted under IRC 415(b) or (c).

    In most countries, as in the United States, broad-based plans are customarily funded, which puts them beyond the reach of IRC 409A. (Participation may lead to other tax problems, since contributions made on a U.S. taxpayer's behalf are taxable under IRC 402(b) as soon as they vest, unless a treaty provides differently. So far, the U.S.-U.K. treaty is the only one with helpful provisions.) Where plans are customarily unfunded -- Germany is the most conspicuous example -- the exclusion obviates what would otherwise be an insoluble problem, as there is little possibility that any rational employer will restructure a plan that covers the generality of its work force for the sake of complying with a U.S. law aimed at high-paid executives.

  • A U.S. citizen's or permanent resident's deferrals of foreign earned income are exempt from IRC 409A as long as the total of his current and deferred compensation does not exceed the IRC 911(b) exclusion. This exception is useful, of course, only for relatively low-paid personnel. While largely redundant with the exclusion for broad-based plans, it should be helpful when dealing with deferred bonuses, small stock option grants and similar items.

    Example: Mr. B is an American citizen employed in Uzbekistan, with which the United States has no tax treaty, in 2009. Assume that the IRC 911(b) exclusion for foreign earned income is $90,000. B's salary is $75,000, plus a $10,000 bonus, which he elects to defer until termination of employment. He makes this election after the beginning of the year, meaning that it does not comply with IRC 409A. Nevertheless, he suffers no adverse consequences, because the total of his current and deferred foreign earned income is no greater than the IRC 911(b) exclusion. If the bonus had been $15,000, he would have had $5,000 in income subject to tax under IRC 409A.

  • As a small concession to international comity, the final regulations provide that a stock option exercise price may be determined retrospectively, before the employer is committed to granting the option, if applicable foreign law requires it to be based on the average price during a past period and the period is no longer than 30 days. France is mentioned in the preamble as an example of a jurisdiction where this rule is needed.

U.S. Participants in Foreign Plans (Working in the U.S.)

For U.S.-based employees of foreign companies, there is almost no way to escape from IRC 409A, other than a couple of minor relief provisions discussed below. All that one can do is try to make the terms of any covered plan compliant. Aside from all of the regular issues, a potential trap for the unwary is the prohibition against funding benefits through offshore rabbi trusts. A U.K. employer might, for instance, maintain a British trust, subject to the claims of its creditors, to accumulate assets to meet its deferred compensation liabilities. For U.S. participants, that not-too-meaningful gesture is disastrous, since the contributions for their benefit will be immediately taxable and will also be subject to a 20 percent additional tax and an interest charge. In later years, further taxes will have to be paid on the increase in the value of trust assets. The only way to avoid those consequences is to set up the trust in the United States. (If, however, a participant performs substantially all of his services in a different country, the trust may be domiciled there.)

Participants in Foreign Plans Who Become U.S. Residents

A nonresident alien's deferrals of non-U.S. source income (along with any credited earnings or similar increases in value) are exempt from IRC 409A, but that exclusion is not available where services are performed in the United States or deferred compensation vests after the participant becomes a U.S. citizen or permanent resident.

To give new entrants time to adjust to our tax system, the final regulations allow a plan's provisions regarding the time and manner of the distribution of deferred compensation to be altered freely during the year in which a participant changes from nonresident to resident alien status. The changes may be made at the participant's election or unilaterally by the employer. The normal rules governing the acceleration or postponement of distributions do not apply, and the new distribution elections may apply to deferrals earned during the initial year as well as to those that were earned previously but not yet vested.

This privilege is available only in the first year of permanent residency following a period of at least three full tax years during which the individual has not been a resident. Thus a new resident could make an election in 2008, leave the country and cease to be a resident in 2011, then return in 2015 and make the election again.

Example: Mr. C is a British citizen who is assigned to work for his firm's American branch. He obtains a green card and becomes a permanent U.S. resident on January 1, 2008. His compensation package includes an unfunded, nonapproved pension scheme providing benefits in excess of those permitted under an approved scheme (much like a SERP for benefits beyond those allowed under our IRC 415). The scheme includes two features that are inconsistent with IRC 409A. First, the pension will be paid at the same time and in the same form as under the approved scheme. Second, if the employer fails to meet specified financial minima in any future year, benefits will be secured through the transfer of assets to a trust.

Thanks to the transition rule for first-year resident aliens, the scheme can be amended (for Mr. C only; the other participants' rights need not be disturbed) to substitute distribution provisions that conform to IRC 409A (e. g., distribution in the form a life annuity beginning at the later of severance from service or age 65). The modification must be made by the end of the initial year, that is, by December 31, 2008.

On the other hand, the security provision is outside the scope of the transition rule. It needs to be amended out of Mr. C's plan before he gets his green card.

Plan Participants Who Cease to be U.S. Taxpayers

The final regulations include no special relief for participants who work in the United States, then become nonresident aliens. Any deferred compensation that they accrued while residents remains subject to IRC 409A forever, save where a treaty provision exempts it from U.S. tax after expatriation.

Example: Mr. C, having properly reformed his plan provisions, remains in the U.S. through 2015. In that year, he surrenders his green card and goes back to England. The U.S.-U.K. treaty furnishes no protection for pensions paid under nonqualified plans. As U.S. source income, Mr. C's supplemental pension remains subject to U.S. income tax, including IRC 409A. Hence, his employer could not restore the security feature or let him change the time or manner of distribution in a way the contravened the IRC 409A restrictions.

By contrast, if he retired to Australia, the U.S.-Australia treaty would make the pension taxable only in his country of residence, and IRC 409A would not matter.

Nonresident Alien Participants in U.S. Plans

Nonresident aliens who work intermittently or for short periods in the United States, without becoming U.S. residents, are taxable on their U.S. source income, and any deferral of that income is generally subject to IRC 409A. The final regulations contain a de minimis exception: A nonresident alien's U.S. source deferred compensation is exempt from IRC 409A to the extent that it doesn't exceed the IRC 402(g) limit on elective deferrals ($15,500 in 2007). To be eligible, the plan that provides the deferred compensation must have a "substantial number of participants", and substantially all of them must be either nonresident aliens or individuals who are classified as resident aliens (by virtue of the "substantial presence" test) but are not green card holders.

Example: Ms. D is a British subject who works primarily in Europe but spends a few days each month performing services in New York. He participates in the same nonapproved scheme as Mr. C. A portion of his accruals under the scheme is attributable to his U.S. source income. Unless the value of those accruals in a particular year exceed the IRC 402(g) maximum, no revisions to conform her plan to IRC 409A are necessary.

Note, however, that she could not make an ad hoc, IRC 409A-exempt agreement to defer all of her U.S. source income, so as not to be bothered by U.S. taxes, unless a substantial number of nonresident aliens and non-green card resident aliens were eligible to do the same.

The moral of these tales is that any company that employs U.S. citizens or residents anywhere in the world and remunerates them with unfunded deferred compensation must be alert to IRC 409A. Some potential problems are ameliorated by the final regulations, but many complications and traps for the unwary remain.

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, 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, Erinn Madden 202.572.7677, Laura Morrison 202.879.5653, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

Copyright 2007, Deloitte.

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