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Weekly UpdatesThe American Jobs Creation Act of 2004 (AJCA) contains a set of provisions--new section 409A of the Internal Revenue Code (1)--designed to clamp down on perceived shortcomings and abuses surrounding the taxation of nonqualified deferred compensation arrangements for corporate executives and other individuals. Prior to the legislation, funded nonqualified deferred compensation arrangements were taxed as they vested, but unfunded arrangements were only taxed when amounts were actually or constructively received, typically much later. Section 409A imposes stringent requirements on unfunded arrangements as the price of permitting continued deferral under the constructive receipt rules; otherwise they will be taxed like funded arrangements, that is to say, upon vesting, and subjected to hefty penalties. Additional provisions penalize certain kinds of quasi-funding, that is, through certain types of offshore trusts or through provisions triggering funding if the employer's financial condition deteriorates.
On its face, this legislation addresses classic domestic taxation issues, with only a tangential international aspect related to parking funds in offshore trusts. But in the morning-after light, the breadth of the provision touches many cross-border situations that may not have been in the original sights. IRS guidance and, possibly, technical corrections may eventually clarify the situation. Until then, it is important to explore the potential international scope of section 409A, including the effect of our international tax treaties.
The Four Corners of Section 409A and How It Came To Be
1. Background
"Deferred compensation" generally refers to an arrangement to pay an employee for services well after the services are performed. The tax dynamics are driven by the cash-basis accounting method of individuals (somewhat constrained by matched deduction rules for employers). "Qualified" versions of deferred compensation, such as pension and profit sharing plans, are covered by extensive statutory and regulatory provisions which provide special tax benefits. The taxation of nonqualified deferred compensation has to date been governed by general principles of taxation, sections 61, 83, 402(b), 404(a)(5), and 451 of the Code, and a handful of IRS pronouncements). (2) The basic thrust of these rules in unfunded situations was:
* An employer's "mere promise to pay" future compensation was not currently taxable to the employee. Rather, the employee was only taxed upon actual or constructive receipt (3) of the promised funds (or if "economic benefit" or "cash equivalents" were received). Book "interest" accruals or investment earnings credits were permitted, as long as the arrangement remained unfunded and unsecured.
* Any election to defer compensation had to be entered into before the relevant services were rendered.
* A provision allowing the employee to accelerate payment did not cause the deferred amount to be taxable ab initio if there was a meaningful "cost" to the employee to elect accelerated payment, such as a reduction in the amount payable ("haircut"), or a period of suspended participation. Nor did a provision permitting early distribution for unforeseeable emergencies ("hardship" exception).
* If any other elections could be made by an employee subsequent to the beginning of the service period, the plan had to set forth substantial forfeiture provisions that remained in effect throughout the deferral period.
The IRS guidance was overlaid by a few cases, which suggested the following glosses:
* Taxation of deferred compensation could be further deferred from its original payment schedule (or the form of payment changed) after the underlying services had been performed, if the agreement to defer was entered into more than a de minimis period before the first payment was due. (4)
* Early distributions conditioned upon employer consent might be permissible, if consent was not a "rubber stamp." (5)
If the promise to pay future compensation was funded with property (for example, employer stock) or other forms of security, the benefits of deferral were lost. Instead, taxation occurred under section 83 upon vesting (the absence of "a substantial risk of forfeiture") or earlier transferability. Section 83 is a codification of the "economic benefit" doctrine. The same "tax-on-vesting" concept applies to contributions to a nonqualified employees' trust, under section 402(b).
In 1978, the IRS attempted, by regulation, to restrain the use of elective salary reduction arrangements by taxing elective nonqualified deferrals at the time of deferral, even if subject to a substantial risk of forfeiture. Congress snuffed this out by freezing the law of private deferred compensation plans in place with the principles set forth in regulations, rulings, and judicial decisions in effect immediately before the publication of Prop. Reg. [section] 1.61-16. (6)
A key subsequent development was the growth of "rabbi trusts" and similar arrangements. These arrangements pushed the envelope on ways to secure deferred compensation without crossing the line of "funding" for either tax or ERISA (7) purposes. In its simplest form, a rabbi trusts sets funds aside to satisfy eventual deferred compensation liabilities safe from the reach of the employer or its creditors except in the case of bankruptcy or insolvency. Sometimes rabbi trusts are established on a revocable or less than fully funded basis that "springs" into more secure or funded status upon specified events, such as an impending change of control or a defined financial or economic event.
Deferred compensation arrangements came into the spotlight in the wake of the Enron debacle and subsequent corporate unravellings. The Senate Finance Committee's Enron report detailed the executives' deferred compensation plans and the fact that many were able to cash out their deferred benefits--albeit with a 10-percent haircut, a 3-year suspension, and a requirement for committee consent--as the ship was sinking, and recommended significant changes to the tax treatment of deferred compensation plans. (9)
2. Section 409A
This attention culminated in the passage of section 409A in October 2004. (10) Section 409A circumscribes the universe of permitted deferrals by lopping off the flexible features that taxpayers found attractive but Congress (spurred by the IRS) found unpalatable. Section 409A taxes unfunded deferred compensation as it vests--together with an interest charge for the benefit of deferral and a 20-percent penalty--unless strict requirements are satisfied. Put another way, the new price of obtaining deferral is adherence to a very structured, inflexible and monovisual arrangement. The first four rules below are referred to in the statute as "rules relating to constructive receipt"; the last two are called "rules relating to funding."
* Limited Distribution Events. Distributions may not be made prior to the earlier of separation from service, unforeseeable emergency, disability, death, change in ownership or control of the employer (to the extent prescribed, probably narrowly, in regulations), or a specified date or schedule--not a named event--that is fixed in the plan at the time of deferral. For key employees of publicly traded companies, distributions cannot be made until six months after separation from service (Enron, anybody?!).
* No Acceleration of Payments. The time or schedule of payments may not be accelerated by either the employee or the employer except as provided in regulations. Regulatory relaxation is expected to be very limited. (11) Farewell to haircuts.
* Timing of Initial Deferral Election. Deferral elections must be made before the year in which the services are performed (or within 30 days of initial eligibility for the plan), except as otherwise provided in regulations. For performance-based compensation relating to services performed over a year or more, the election may be made no later than six months before the end of the service period.
* Restrictions on Subsequent Payment Elections. Subsequent elections to delay or change the form of payment (a) may only take effect at least 12 months after the initial election, (b) must be deferred for at least five years from the date payment would otherwise have been made (except for disability, death, or hardship), and (c) in the case of scheduled payments, must be made at least 12 months before the first scheduled payment.
* No Use of Offshore Trusts. Placing assets in an offshore trust is treated as the transfer of property triggering immediate taxation (as vested) regardless of whether the assets are available to satisfy claims of general creditors (i.e., offshore rabbi trusts are not permitted). Moreover, subsequent earnings or increases in value are taxed annually (to the extent vested). This rule does not apply to assets located in a foreign jurisdiction if substantially all of the services to which the nonqualified deferred compensation relates are performed in such jurisdiction. (12) There is also regulatory authority to create exceptions for arrangements considered non-abusive.
* No Triggers Based on Employer's Financial Health. A plan provision for springing restrictions on trust or employer assets in the event of a change in the employer's financial health is similarly treated as the transfer of property triggering immediate taxation (as vested) at the date on which the plan so provides or, if earlier, the date on which assets are so restricted. Subsequent earnings or growth are taxed annually.
The legislative history provides a further caveat that purported risks of forfeiture must be real to defer taxation. (13) Q&A-10(b) of Notice 2005-1 incorporates one such rule, ignoring risks of forfeiture in certain cases where the employee owns a significant amount of employer stock.
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