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As the employment marketplace becomes increasingly global, many U.S. companies are hiring foreign workers. Conversely, a number of U.S. citizens now work for foreign companies (whether overseas or in the United States). In such employment arrangements, tax issues can affect not just salary but other aspects of the compensation package. Of current concern are deferred compensation agreements. In the American Jobs Creation Act of 2004, Congress dramatically changed the tax environment for deferred compensation plans through a new Section 409A of the Internal Revenue Code. This new section is extremely broad, and it may affect cross-border situations in ways that Congress never intended. Consequently, all U.S. companies that have foreign workers participating in deferred compensation plans, as well as foreign companies offering such plans for U.S. citizens, need to be aware of the tax issues this new law creates. AFTER ENRON “Deferred compensation” generally refers to arrangements to pay employees for services well after the services have been performed. “Nonqualified” deferred compensation is compensation that does not qualify for the special tax treatment provided for pension and profit-sharing plans. Under prior law, “unfunded” nonqualified deferred compensation arrangements � that is, an employer’s “mere promise to pay” � were taxed only when amounts were actually or constructively received by the employee, rather than earlier when the promise was made or the employee’s rights to the promised compensation vested. Over the years, certain features developed that made unfunded nonqualified deferred compensation agreements even more favorable to taxpayers. An Internal Revenue Service regulatory attempt to rein in certain arrangements was quashed by legislation in 1978. It took the Enron debacle and other corporate scandals to motivate Congress to change its tune. The Senate Finance Committee’s Enron report detailed the ability of executives to cash out deferred benefits as the corporate ship was sinking � albeit with a 10 percent “haircut,” a three-year suspension of participation, and a requirement for the corporate compensation committee’s consent. In light of such real-world examples, the report recommended significant changes to the tax treatment of deferred compensation plans. THE NEW LAW The new Section 409A circumscribes permitted deferrals of compensation by eliminating many of the flexible features that taxpayers had found attractive. Unless strict requirements are met, unfunded deferred compensation will be taxed to the employee as it vests, together with an interest charge and a 20 percent penalty. Deferral of the tax until the employee actually receives the compensation can be achieved only if the following six rules are satisfied: (1) Limited distribution events. Distributions may not be made before the earlier of separation from employment (or six months later for key top employees of publicly traded companies), unforeseeable emergency, disability, death, change in ownership or control of the employer, or a specified date or schedule fixed in the deferred compensation plan. (2) Limited acceleration of payments. The time or schedule of payments may not be accelerated by either the employee or the employer except as provided in the IRS’ pending regulations, which are expected to be quite narrow. (3) Advance deferral elections required. Elections to defer compensation must generally be made before the year in which the employee’s services are performed. For performance-based compensation linked to services carried out over a year or more, the election must be made at least six months before the end of the service period. (4) Restrictions on subsequent payment elections. Subsequent elections to delay or change the form of payment must generally defer payment for at least five years from the date that payment would otherwise have been made, and these elections must be made in a specified window of time. (5) No use of offshore trusts. Placing compensation in an offshore trust will trigger immediate taxation (as the compensation vests) regardless of whether the assets are available to satisfy the claims of the employee’s general creditors. This rule does not apply to assets located in a foreign jurisdiction if substantially all services to which the compensation relates are performed in that jurisdiction. There is also regulatory authority to create exceptions for arrangements considered nonabusive. (6) No triggers based on employer’s financial health. A plan provision for springing restrictions on trust or employer assets after a change in the employer’s financial health will also trigger immediate taxation (as vested). Section 409A is effective for amounts deferred or becoming vested after Dec. 31, 2004. The IRS issued detailed guidance in December 2004 (Notice 2005-1) about the statute’s coverage and effective date. More comprehensive substantive guidance is expected later this year. INTERNATIONAL IMPLICATIONS Although the new Section 409A rules arose in a domestic context, the statutory provisions are also applicable to U.S. citizens or residents working for foreign employers whether in the United States or abroad. Vexing compliance issues may also arise for nonresident aliens performing services in the United States. U.S. persons working for foreign employers frequently participate in foreign retirement plans or other employee benefit arrangements that are funded (through a trust or otherwise). Such funded plans are unlikely to be covered by the Section 409A exemption for U.S.-qualified employer plans. While the foreign plans may be largely exempt from Section 409A (per Notice 2005-1) if they are already subject to the U.S. tax rules for nonqualified funded plans (Internal Revenue Code, Sections 83 and 402[b]), it should be noted that the latter rules incorporate a similar tax-on-vesting regime � albeit without the penalty features of Section 409A. Another issue is whether funded foreign plans will be caught separately by Section 409A’s penalty-added taxation of vested assets set aside in an offshore trust. The escape route for services performed in the same foreign jurisdiction in which the trust is located may not be available in many common factual patterns. A few U.S. tax treaties (for example, with the United Kingdom) may foreclose the applicability of Section 409A to certain types of plans, assuming that Section 409A does not override contrary treaty provisions. If they are subject to Section 409A, foreign funded plans may foot-fault over Section 409A proscriptions such as elections at the time of retirement, distribution of benefits on events not specified in the statute, in-service distributions, and distribution timing for key employees. Unfunded foreign deferred compensation arrangements attributable to a U.S. person’s services almost certainly will be subject to Section 409A for accruals or vesting after 2004, if not covered by generally applicable exemptions. Possible Section 409A tripwires include the tying of plan payments to elections under foreign qualified-type plans, employer discretion to adjust payment timing, acceleration provisions, and subsequent payment elections. Corrective steps may be difficult to arrange if the plan primarily affects non-U.S. persons. A nonresident alien who becomes a U.S. citizen or resident 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 the person was a nonresident alien. Although there are arguments to take at least funded arrangements out of the scope of Section 409A, clarification by the IRS would be helpful. Fortunately, the Section 409A effective-date rules would grandfather pre-2005 vested accruals (absent “material modification” of the arrangement). The problematic situations for nonresident aliens in general involve nonqualified deferred compensation from services rendered in the United States. A nonresident alien is subject to U.S. taxation whenever such deferred compensation is “taken into account,” even if he is not performing U.S. services in that year. Thus, the rules of Section 409A must be followed to avoid accelerated taxation in the year that deferred amounts become vested. The effective-date provisions should protect pre-2005 vested accruals. Treaty provisions regarding dependent or independent personal services may also considerably reduce the reach of U.S. taxation of nonresident aliens � e.g., for certain limited-duration U.S. work. Employers of nonresident aliens rendering U.S. services should review the information reporting and withholding requirements imposed on both U.S. and foreign employers under Section 409A. NEXT STEPS IRS and Treasury Department personnel have indicated that some international issues related to Section 409A will be addressed in guidance this summer. What can we hope for from this guidance? Most important is to confirm that arrangements already subject to the tax-as-vest provisions of Section 83 or 402(b) are not covered by Section 409A. The statutory opening to resolve certain issues by regulation under the offshore trust provisions may also help at the fringes and could be applied to bless common centralized foreign funding arrangements that might not strictly satisfy the same-country requirement. Many of the remaining problems could be eliminated by exempting compensation for foreign services from the reach of Section 409A, as well as by exempting participation in foreign qualified-type plans. Policy considerations could readily be mobilized to justify regulatory exemptions of this sort. But nobody can afford to simply wait for clarifying regulations. Section 409A is already in effect, subject to a one-year grace period for corrective amendments. Employers with foreign connections 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 in some cases. International deferred compensation issues are not a particularly well articulated area of U.S. taxation to begin with. The potential application of Section 409A in this context provides abundant opportunities for IRS guidance.
Patricia Gimbel Lewis and Michael G. Pfeifer are members in the D.C. office of Caplin & Drysdale. They can be reached at [email protected] and [email protected], respectively.

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