The law of unintended consequences: international implications of section 409A.

Enforcement of the new rules is bolstered by onerous tax consequences to the employee in the event of violation: not only is the purported deferral ignored and currently taxed, but imputed interest and a 20-percent penalty are tacked on. The same is true for transfers caught by the funding restrictions--continuing annually for earnings and increases in value if the assets remain set aside in a trust or other proscribed arrangement. Employers will undoubtedly be very sensitive to the risk of exposing a key employee to these consequences.

Section 409A is effective for amounts deferred after December 31, 2004. "Deferred," in this context, means deferred and vested after that date. Thus, amounts deferred before 2005 but not yet vested are subject to section 409A. Moreover, any "material modification" to an otherwise grandfathered plan eliminates the grandfathering.

Of real potential consequence from an international perspective, a pending technical correction would clarify that the grandfather rule does not apply to the section 409A funding requirements, thereby effectively requiring offshore trusts to be "brought back" (physically or by taxation) as of January 1, 2005. (14)

The early effective date and broad scope of section 409A have resulted in intense review of the myriad corporate benefits that do or may fall under the rubric of nonqualified deferred compensation. In December 2004, the IRS quickly issued detailed guidance on some aspects of the rules (Notice 2005-1), focusing on the coverage of the statute and implementation of its effective date. Taxpayers are given until December 31, 2005, to amend plans without triggering section 409A penalties, and are offered a variety of escape hatches during 2005 to avoid continuing subjection to the new regime. This initial guidance contains no provisions directly addressing international issues. More comprehensive substantive guidance is expected later this year. This article does not address the many interpretative issues that remain outstanding under section 409A in general.

The Fifth Corner--International Implications

Section 409A arose in the context of perceived excesses of deferred compensation arrangements in the United States. The only explicit international tinge is the prohibition on certain offshore transfers of funds, designed to foil arrangements that effectively, though not in form, shield assets benefiting U.S. taxpayers from the claims of domestic creditors. (15) The congressional materials do not evince any consideration of implications for foreign employers with employees in the United States or for globally mobile individuals with periodic stints of U.S. employment. Reflection on the new provisions, however, identifies serious international implications.

1. Covered Arrangements

Underlying these implications is the breadth of the threshold definition of nonqualified deferred compensation covered by section 409A. The general concept embraces compensation payable in a year after the employee has a "legally binding right" to it, unless it has already been actually or constructively received and included in gross income. (16) Objective conditions or formulae that could reduce or eliminate the compensation (e.g., those that create a substantial risk of forfeiture) do not keep a right from being legally binding, though discretionary provisions (which frequently are more illusory than real) may.

Specific exclusions include qualified employer plans (e.g., under section 401), bona fide vacation leave, sick leave, comp time, disability pay, death benefit plans, medical reimbursement arrangements, transfers of restricted stock and other property, most types of stock options, and certain stock appreciation rights (SARs) of public companies. Short-term deferrals, where payment occurs within 2-1/2 months after the end of the year in which the amount becomes vested, are not covered, pending further guidance. (17)

Beyond those exceptions, section 409A applies broadly to salary reduction plans, supplemental employee retirement plans (SERPs), parachute payments, phantom stock plans, severance plans, insurance commissions, discounted stock options, certain SARs, non-excluded fringe benefits, etc. Some less obvious types of compensation that may fall within section 409A include promises to reimburse an executive for future financial planning expenses or tax return preparation costs, certain indemnification agreements, and relocation make-whole agreements. (18) The rules are not limited to employer-employee arrangements, but also cover arrangements between a service recipient and an independent contractor or between a partner and a partnership. (19) The issuance of stock or (for the moment) partnership interests in exchange for services, however, is not covered by section 409A, apparently deferring to existing section 83 rules. (20) Similar deference--discussed below--applies to contributions to employee trusts taxed under section 402(b). (21)

2. Amplification of Errors

A troubling aggregation rule considers all deferred compensation arrangements of an individual to be a single plan for purposes of section 409A, divided only between account balance (i.e., defined contribution type), nonaccount balance (i.e., defined benefit type), and other (e.g., equity-based) plans. (22) This means that a foot fault with respect to a small perk can trigger a section 409A avalanche for much larger plans of the same type. (23)

3. Regulatory Authority

Section 409A(e) directs the Secretary to prescribe regulations as necessary or appropriate to carry out the purposes of the section, including exempting arrangements from the application of the funding restrictions "if such arrangements will not result in an improper deferral of United States tax and will not result in assets being effectively beyond the reach of creditors."

In analyzing the international implications of section 409A, there are different ways to slice the issues--by type of individual, type of plan (funded or unfunded, qualified-type or nonqualified-type), type of employer, or place of services--and overlap is inevitable. The discussion below is divided between U.S. citizens and residents (USCRs) on the one hand, and nonresident aliens (NRAs) on the other, with interior breakdowns.

U.S. Citizens and Residents

USCRs are generally subject to the U.S. tax regime with respect to their worldwide income, regardless of source. (24) Section 409A compliance issues may be particularly challenging for USCRs working for foreign employers, whether in the United States or abroad.

1. Funded Plans

USCRs working for foreign employers (or U.S. subsidiaries of foreign companies) frequently participate in foreign retirement plans or other employee benefit arrangements funded through a trust or other secured arrangement. Even if a trusteed plan is locally "qualified" (i.e., a type of broad employee plan preferred under tax and other laws of the employer's foreign jurisdiction), it will not be covered by the section 409A exclusion for U.S.-qualified employer plans since a foreign trust generally is involved. (25) The only exception would be if the foreign plan in fact meets all of the U.S. qualification requirements apart from the requirement of a U.S.-situs trust (26)--a rare case.

Nevertheless, foreign employees' funded plans, particularly qualified-type ones, may turn out to be the easiest foreign arrangements, relatively, to wrest from the grasp of section 409A.

* No "Deferral of Compensation"? In a perverse turn of the screw, escape may lie in the fact that these plans have always been subject to the U.S. tax rules for nonqualified funded plans found in section 402(b) for employees' trusts and section 83 for transfers of restricted property. (27) Under these rules, the USCR participant (absent treaty protection, discussed below) is taxed as vested transfers or contributions are made or as the participant's interest vests.

In addition, in the case of an employees' trust, section 402(b)(4) will annually tax "highly compensated" participants on the increase in value of their vested interests, if the plan's coverage is not sufficiently non-discriminatory. (28) Employees who are NRAs with no U.S.-source earned income are excluded from the coverage computations. (29) Thus, whether a USCR participant's accruals will be taxed annually depends on the precise configuration of the plan as to the type, compensation level, and number of other employees covered (if any). If subsequent earnings are not taxed currently, they will be picked up in income on later distributions pursuant to the section 72 annuity rules. Post-vesting appreciation of section 83 restricted property is handled under the capital gain rules, with no annual taxation risk.

The key point here is that because the USCR's interest in the main is already being taxed as it vests, section 409A probably does not apply. Q&A-4(e) in Notice 2005-1 seems designed to exclude section 83 and 402(b) transfers from the "deferral-of-compensation" concept, and hence from section 409A coverage, though the language is somewhat indirect. (30) Exclusion is supported by the statutory premise that section 409A only captures vested deferrals of compensation "not previously included in gross income," (31) and contributions to these plans are, at worst, being taxed simultaneously. The logic of excluding from section 409A arrangements that are already subject to tax-as-vest rules is undeniable. Since the objective of section 409A is to impose a tax-as-vest regime on targeted arrangements, there is no point in superimposing it on arrangements already governed by such a regime. (32)

Even if the deferrals themselves are outside of section 409A, a technical question remains whether accumulated earnings under the plan (apart from currently taxed section 402(b)(4) amounts) or appreciation in the value of restricted property are similarly protected. Ceding jurisdiction to all facets of the long-established taxation framework for nonqualified employee trusts and restricted property seems both logical and practical. Notice 2005-1, Q&A-4(f), which ties references to deferrals to references to the attributable income, embodies an analogous principle. Indeed, the effective date provisions of section 409A literally protect these earnings: "The [new provisions] shall apply to earnings on deferred compensation only to the extent that [the new provisions] apply to such compensation." Since the stakes are high--annual taxation, plus 20-percent penalty and interest--confirmation of this point is sorely needed. (33)

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