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Weekly Updates* No Bad Offshore Trust? Characterizing foreign funded plans as not involving the deferral of compensation is also crucial to avoiding the second weapon of section 409A--the penalty-added taxation of vested assets set aside in an "offshore" trust "for purposes of paying deferred compensation under a nonqualified deferred compensation plan." (34) Section 409A(b)(3) also taxes (with penalty) the annual increase in value or earnings of such assets. The significance of this issue is underscored by a pending technical correction that would, in effect, retroactively subject assets held in a covered foreign trust to taxation under section 409A. (35) Moreover, the statutory language is not literally limited to rabbi trusts, but applies "whether or not such assets are available to satisfy claims of general creditors." This sets up an excruciating tension between the section 402(b) rules (which tax on vesting and, in certain cases, on subsequent accruals) and the section 409A rules (which tax and impose a 20-percent penalty on vesting and on all subsequent accruals), absent a clear rule ceding exclusive jurisdiction to section 402(b). (36)
Separately, the clutches of the offshore funding rules can be avoided if "substantially all the services to which the deferred compensation relates" are performed in the same foreign jurisdiction in which the trust is "located." This escape route may not be available if the individual has worked in other countries for this foreign employer. Centralized asset management by multinational corporations or use of an out-of-country trust to hold assets for local law reasons under standard local practice may also hit a dead end.
The IRS has statutory authority to prescribe regulations exempting arrangements from the funding rules on the basis that there is no improper deferral of U.S. tax and placement of assets effectively beyond the reach of creditors. Situations like this, where the employee benefit trust is intended to be insulated from creditors as a matter of public policy (e.g., a qualified-type plan) or comports with standard business practices, would seem good candidates for regulatory largesse.
* Potential Treaty Protection? To the extent problems remain under section 409A--or to preclude up front the need to consider section 409A--treaties may help. For example, the U.S.-U.K. treaty (Article 18) generally precludes U.S. taxation of U.K. contributions for U.S. employees, or accruals thereon, under competent authority-approved "pension schemes" until distributed. Such "pension schemes" are generally understood to correspond to qualified-type plans. (37) For an employee working in the United States, contributions must have been made to the plan before he begins employment in the United States, limiting the benefit to U.S. "visitors." (38) Although the treaty contains a caveat that the treaty relief cannot exceed the relief that the United States would allow to U.S. residents for contributions/benefits for pension schemes established in the United States, the section 409A exception for qualified employer plans should provide the appropriate analogue. Subject to these limitations, the U.S.-U.K. treaty seems tailor-made to protect USCRs participating in U.K. qualified-type plans from the application of either section 402(b) or section 409A. Similarly broad provisions can be found in the U.S.-Netherlands treaty (2004 protocol).
U.S. treaties with several other countries have provisions along similar lines, though more limited in certain respects. Among the affected treaties are those with Canada, France, Italy (pending), Ireland, South Africa, and Sweden.
The only question is whether section 409A somehow overrides contrary treaty provisions. There is no evidence of such an intention, absent which it is arguable that the treaty cannot be overridden. (39) Section 7852(d) was amended in 1988 to provide that "neither the treaty nor the law shall have preferential status by reason of its being a treaty or law"; section 894(a) was amended at the same time to eliminate priority for treaty obligations and to provide instead that the Code "shall be applied to any taxpayer with due regard to any treaty obligation of the United States which applies to such taxpayer." This situation leaves open the need to review the intent and policy objectives of section 409A and the pertinent treaty provisions, if rescue by the latter is needed. At least in the newer, more sophisticated treaty settings, section 409A should be readily reconcilable with the treaty protections.
Certainly treaty provisions of the above sort have the potential to alleviate section 409A concerns. But such provisions are not yet widespread and in any event do not cover non-qualified-type employee benefit arrangements. Accordingly, the interaction between section 409A and the Code's other tax-on-vest rules remains pivotal.
To the extent concern remains about the application of section 409A to foreign funded plans, the plans should be reviewed for compliance with the section 409A rules. Some possible tripping points with respect to the distribution/ acceleration/election restrictions are: elections of form or timing of payment at the time of retirement, rather than as the services are rendered; distribution of benefits on "events" such as plan termination; in-service distributions in certain circumstances; and distribution timing for key employees. The "location" (residence?) of the trust must be compared with the individual's work place(s) to assess the risk posed by section 409A's funding rules (pending further IRS guidance). Individuals working in the United States have the greatest exposure.
2. Unfunded Plans
Unfunded deferred compensation arrangements attributable to the USCR's services will almost certainly be subject to section 409A for accruals or vesting after 2004, if not covered by generally applicable exemptions such as for certain welfare benefits, stock options and short-term deferrals. And failure of the section 409A requirements is certainly possible, absent corrective action. Trip wires could include: the tying of plan payments to elections under foreign qualified-type plans (an impermissible election or event-based distribution under section 409A (40)); employer discretion to adjust the timing of payments; acceleration provisions; or subsequent payment elections.
Section 409A captures a wide range of unfunded plans and employer promises, and a flaw with respect to a minor benefit, such as deferred payment of fringe benefits, could pull down larger ones under the aggregation rule. Corrective steps may be constrained if the plan primarily affects non-U.S. persons. While the legal issues are the same as when working for a U.S. employer, the practical difference is that the foreign employer may either be unaware of section 409A or have little interest in complying with it for a few employees.
Treaty protection for unfunded benefits, which are probably not qualified-type arrangements, may also be less likely, though the contours of the pertinent "pension" definition may vary. (41) Thus unfunded foreign plans for USCRs must be reviewed with the same thoroughness as U.S. nonqualified arrangements.
3. Equity-Based Deferred Compensation
Certain kinds of stock options and SARs are exempt from section 409A. These exemptions, however, turn on requirements that need to be evaluated carefully if foreign equity is used. For example, nonstatutory stock options are exempt only if the exercise price at least equals or exceeds the fair market value of the underlying stock on the grant date. Although Notice 2005-1 states that reasonable valuation methods may be used for this purpose, this may not cover foreign plans that, by local law or practice, use multi-day averages.
SARs have similar pricing requirements; moreover, the employer stock involved must be traded on an "established securities market," and only such stock may be delivered in settlement of the right upon exercise. The acceptability of trading on foreign exchanges, and the ability to deliver ADRs, have not yet been addressed by the IRS, although favorable analogies exist in other tax contexts. (42)
4. Persons Becoming USCRs
The United States exercises its taxing jurisdiction on residents regardless of their source of income. Accordingly, once an NRA becomes a USCR, he or she must worry about the application of section 409A to vested accumulations (or ongoing vesting or funding) under pre-existing foreign deferred compensation arrangements--even if derived from services rendered outside the United States while an NRA--since the previously vested amounts were not subject to U.S. tax. Arguably, however, at least with respect to funded arrangements, the NRA should be considered to have effectively included the vested amounts in gross income even though he or she was not taxed thereon, since section 402(b), for example, directs that vested amounts "shall be included in the gross income of the employee...." (One would need to take a similarly broad reading of the exception in Notice 2005-1 for transfers "subject to [section] 83, [section] 402(b) or [section] 403(c).") This is an intriguing conceptual issue that merits clarification by the IRS.
In any event, the section 409A effective date rules would grandfather pre-2005 vested accruals, and subsequent earnings thereon, absent a material modification of the arrangement.
A newly minted USCR will also have a non-section 409A-related concern about the taxation of ultimate distributions from such arrangements, whether or not earlier vested or funded. (43)
Unless the IRS grants administrative relief for situations like this, it may be impossible to correct prior elections to comply with section 409A and difficult to otherwise tune up the foreign plan. Treasury personnel have described this as a "most sympathetic situation" for consideration of relief, (44) because it involves non-U.S.-source compensation for services that would not have been taxed here when deferred. The situation certainly does not involve the legislatively-targeted opportunities to manipulate deferral.
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