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

Non-Resident Aliens

The threshold issues are different for NRAs. The problematic situations involve nonqualified deferred compensation attributable to services rendered in the United States by an NRA. (45)

1. Basic Taxation Rules

Absent treaty protection for independent or dependent personal services, NRAs are taxable in the United States for a taxable year on: (1) U.S.-source income received that is not effectively connected with a U.S. trade or business, via 30-percent withholding (pursuant to section 871(a)(1)); and (2) income from any source that is effectively connected with a U.S. trade or business, if the NRA is engaged in a U.S. trade or business during such taxable year, via net basis taxation (pursuant to section 871(b)).

Under this structure, one must start with section 871(b). Rendering personal services in the United States generally constitutes a U.S. trade or business (Treas. Reg. [section] 1.864-2(a)). (46) Moreover, section 864(c)(6) provides that in the case of income taken into account for one year that is attributable to services in another year, the determination of its taxability under 871(b) shall be made as if such income were taken into account in such other year and without regard to the requirement that the individual be engaged in a U.S. trade or business during the current year. In short, the NRA individual will incur U.S. taxation on such income under section 871(b) simply because the services were rendered in the United States, even if he or she is not rendering U.S. services in the current year.

The time for taxing deferred compensation is determined in the first instance under the regular provisions such as section 61, 83, 402(b), 451, or 457(f), subject to acceleration if section 409A is violated. The income amounts potentially taxable under any of those sections will constitute section 871(b) effectively connected income taxable here in the pertinent year if the underlying services were rendered in the United States. (47) The distinction between funded and unfunded arrangements will simply affect the timing of the income inclusion as well as the applicability of section 409A (e.g., tax-as-vest exception), as for any U.S. taxpayer. Thus, the rules of section 409A must be reviewed and followed to avoid accelerated taxation of the NRA in the year such amounts become vested, regardless of his or her U.S.-related status during that year. The effective date provisions of section 409A should protect pre-2005 vested accruals.

2. Treaty Exceptions

Of course, treaty provisions with respect to dependent or independent personal services may trump these rules. For example, if the NRA worked for a foreign employer that did not have a U.S. permanent establishment or fixed base and the NRA was present in the United States for less than 183 days in the year in which the services were rendered, most U.S. treaties will exempt from U.S. tax the income from such services. This exemption should include deferred compensation attributable to the income as well. (48) Compensation (including deferred compensation) for independent (non-employee) personal services is subject to source-country taxation under most treaties only if the individual has a fixed base in that country regularly available for performing his or her services. (49) These treaty provisions considerably reduce the reach of U.S. taxation in the NRA context.

If compensation for the underlying services is not so exempted, one other possibility is the typical provision in U.S. treaties that pensions are to be taxed only by the country of residence. To the extent deferred compensation falls into the pertinent "pension" definition, (50) section 409A would be trumped (absent a treaty override). Many kinds of nonqualified deferred compensation, however, would not be covered by such definitions. Thus, treaty protections for pensions may be of limited assistance in this context.

3. Implications

Absent treaty protection, NRAs must review any deferred compensation arrangements derived from U.S. services that remain unvested as of December 31, 2004, or accrue thereafter. If the deferred compensation is provided by a foreign employer, the same analysis discussed above for USCRs (differentiated between funded and unfunded arrangements) would apply. If the deferred compensation is provided by a U.S. employer, the situation will be identical to that for purely domestic situations, including the exclusion for U.S. qualified plans. Allocations may be needed if the deferred compensation relates to a mix of U.S. and foreign service.

The need to undertake this daunting task may well be one of which potentially affected NRAs are unaware. Importantly, section 409A imposes information reporting and withholding requirements on the NRA's employer, whether U.S. or foreign. (51) Complicated foreign tax credit situations abroad could also arise.

Squaring the Corner--Putting the Genie Back in the Box

The most inequitable situations noted above involve foreign qualified-type plans benefitting USCRs, or NRAs who later become USCRs, to the extent not exempted by reason of the tax-on-vesting feature or applicable treaty provisions. The most nettlesome practical problems are related to foreign unfunded plans benefiting USCRs and any plans benefiting NRAs with respect to U.S. services.

1. IRS Help

The only explicit statutory opportunity to resolve these issues is in the context of the offshore trust funding provisions, if either substantially all the benefited services are foreign or the situation is ultimately determined in regulations not to "improperly" defer tax. This may help at the fringes, but foreign employer usage of foreign trusts is not the biggest problem, given the pre-existing taxability of most such structures. Most important is to confirm that arrangements subject to the tax-as-vest provisions of sections 83 and 402(b) are not covered by section 409A, and to clarify that earnings are exempt if the underlying deferral is not covered. It would also make sense to clean up situations involving centralized funding for services in multiple jurisdictions. (52)

Many of the remaining problems could be eliminated by exempting compensation for foreign services from the reach of section 409A. Section 409A(e) gives the IRS broad authority to "prescribe such regulations as may be necessary or appropriate to carry out the purposes of" section 409A. As a policy matter, the basic thrust of section 409A as a deterrent to coerce employers into revising widely-used employee plans and practices may be lost on--and ineffectual with respect to--foreign employers. This is particularly true where the plans are locally qualified or cover many foreign employees under conventional foreign arrangements. Exempting foreign services could readily be justified under this policy to the extent the underlying compensation would not have been taxed by the United States if received when earned, for example, for periods before an individual becomes a USCR. (53) Participation in foreign qualified-type plans (54) similarly would not seem to violate the section 409A "abuse-like" targets.

Beyond that, regulatory relief could be based on practical administrative and enforcement considerations. For instance, regulations could be issued to restrict the definition of covered deferred compensation from foreign employers to amounts in excess of a dollar threshold, or by category (e.g., SERPs only). Something like this would address the practical problems faced by foreign employers temporarily sending NRAs to the United States, where legal justification for exemption is harder.

In all events, it would be desirable for the IRS to expressly reject any treaty override.

IRS and Treasury personnel have suggested that some international issues related to section 409A will be addressed in the next tranche of guidance, expected sometime this summer.

2. Employer/Employee Tasks

Section 409A is already in effect, subject to the one-year grace period for corrective amendments set forth in Notice 2005-1. Pending further clarifying guidance, employers should be tentatively reviewing their compensation arrangements for trouble spots. This review should not be limited to persons employed after 2004, since post-2004 accruals for pre-2005 employees could be reached. Based on this analysis, a logical sequence of review would be:

* Foreign companies employing USCRs

** Identify deferred compensation arrangements in which the USCR participates.

** Carve out clearly excluded types (e.g., short term deferrals, specified welfare benefits, most stock option plans) and grandfathered (pre-2005) vested amounts.

** Determine whether remaining arrangements would be characterized as funded or unfunded under U.S. tax principles.

** If funded, review pre-AJCA U.S. tax situation (section 402(b) or section 83?).

** If trusteed, determine "location" of trust and assets and compare to place where services performed.

** Evaluate possible treaty protections.

** Review likely-covered unfunded arrangements for compliance with section 409A, and identify necessary revisions; be sensitive to illusory forfeiture provisions.

** Do the same for funded arrangements, depending on level of comfort with the tax-as-vest exception, the location of any trust, and treaty protections.

** For equity-based plans, review type of equity and trading status, valuation provisions, etc.

* Foreign Companies Employing NRAs in the United States

** Review employee's status under any applicable U.S. treaty (e.g., 183-day rule).

** If underlying services are not exempt, perform same analysis as with foreign companies employing USCRs.

** Check that current salary was reported in the United States.

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