Deferred compensation arrangements must be in compliance with final §409A regulations no later than December 31, 2008.1 The scope of §409A is broad, since the term non-qualified deferred compensation plan is defined as any plan that provides for the deferral of compensation other than a qualified employer plan, any bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan.2 The term qualified employer plan is limited to plans that are qualified under the Internal Revenue Code for special tax treatment, e.g., plans described in §401(a), annuity contracts described in §403(b) and arrangements described in §457(b).3 There is no statutory exception for foreign plans, whether qualified under foreign law or not.
The United States employs a worldwide tax system under which U.S. citizens and U.S. resident individuals generally are taxed on all income, whether derived in the United States or abroad. Non-resident alien individuals, however, are taxed in the United States only on income that has a sufficient nexus to the United States.4 Employers with international operations frequently transfer U.S. citizens and residents to foreign locations, and nonresident aliens to the United States, for extended assignment. Because of the broad scope of §409A, U.S. citizens and resident aliens who are covered under foreign plans, whether or not qualified under applicable foreign law, are subject to the §409A sanctions5 if these plans fail to meet the applicable requirements.6 Similarly, non-resident alien individuals working in the United States who accrue benefits under foreign plans during their period of U.S. employment are also subject to the §409A sanctions if these plans do not meet the applicable requirements.
Fortunately, the final regulations contain numerous exceptions that permit both U.S. citizens and resident aliens working abroad, and non-resident alien individuals working within the United States, to accrue benefits under non-complying foreign plans without becoming subject to the §409A sanctions. Where no exception applies, it will be necessary to amend the foreign arrangement to comply with the §409A requirements in order to avoid the §409A sanctions. This article will summarize the available exceptions and the requirements that must be met for them to apply.
Classifying Employees and the Plans in Which They Participate
Before beginning a detailed examination of the §409A international exceptions, it is helpful to classify employees and the types of plans in which they participate This is a necessary first step before determining which, if any, of the international exceptions may apply.
TYPES OF PARTICIPANTS
U.S. citizens and aliens who legally reside in the United States (collectively referred to as “U.S. persons”) are subject to worldwide U.S. taxation.7 A person can be a resident alien in one of three ways: (i) having been granted the privilege of residing permanently in the United States as an immigrant in accordance with the U.S. immigration laws (i.e., a green card holder), (ii) being physically present in the United States for a specified number of days, and (iii) electing to be a resident alien for a year where the requirements of (i) or (ii) are not met for the election year but are met for the immediately succeeding year.8 It is important to distinguish among the types of resident alien status, because certain of the international exceptions are dependent on the type of resident alien status.9 A non-resident alien is an individual who is neither a citizen nor a resident of the United States.10
COVERAGE UNDER A §409A COMPLIANT PLAN
The international exceptions are not relevant for U.S. persons and nonresident aliens covered under §409A compliant plans, e.g., U.S. citizens and resident aliens who are sent overseas but remain covered under plans maintained in the United States that meet the §409A requirements, and nonresident aliens performing services within the United States who accrue benefits under §409A compliant plans.
NONRESIDENT ALIENS ACCRUING BENEFITS UNDER A FOREIGN PLAN FOR SERVICES PERFORMED WITHIN THE UNITED STATES
These persons (hereinafter referred to as “inpatriates”) will need to rely on one or more of the international exceptions in order to escape the §409A sanctions if the foreign plan does not meet the §409A requirements. It is likely that a foreign plan or arrangement providing for the deferral of compensation will fail to meet the §409A requirements for one or more of the following reasons:
i) The absence of a provision deferring payment to “specified employees” (i.e., one or more of the 50 highest paid officers of a publicly traded corporation) on account of separation from service until six months have elapsed from the date of separation
ii) A feature allowing participants to choose at termination of employment when benefits will commence and/or the form in which benefits will be paid
iii) A provision conditioning an employee’s right to payment as of a specified date (e.g., early retirement) on the employer’s approval of the payment
iv) A provision allowing for elective deferrals that does not meet the §409A requirements
U.S. PERSONS ACCRUING BENEFITS UNDER A FOREIGN PLAN FOR SERVICES PERFORMED OUTSIDE THE UNITED STATES
These persons (hereinafter referred to as “expatriates”) will need to meet one or more of the international exceptions in order to escape the §409A sanctions if the foreign plan is not §409A compliant. Expatriate status arises where a U.S. citizen or resident is transferred to foreign employment or where a U.S. citizen or resident is hired directly in the foreign jurisdiction.
Analysis of Inpatriate Exceptions
There are several exceptions that may permit inpatriates to accrue benefits under non-compliant foreign plans and escape the §409A sanctions. In certain cases, multiple exceptions may apply.
PARTICIPATION ADDRESSED BY TREATY
Plans are excluded from §409A to the extent contributions and/or accruals are excludable for federal income tax purposes pursuant to any bilateral income tax convention to which the United States is a party.11 The United States has entered into comprehensive income tax treaties with more than 50 countries. The Treasury Department’s 2006 model income tax convention (and several treaties that have been amended or entered into in recent years, e.g., with Canada, Germany, France and the United Kingdom), provides exclusions from U.S. income for benefits accrued under a foreign country pension plan for services performed in the United States so long as the person was participating in the foreign plan before entering the United States.12 This relief is conditioned upon the United States finding that the pension plan corresponds to a plan recognized in the United States, and is limited to the extent relief is otherwise provided to U.S. residents for benefits earned under a U.S. pension plan. Thus, deferred compensation accrued under a foreign plan for services performed in the United States will generally not qualify for treaty relief unless the foreign plan corresponds to a plan recognized as such under U.S. laws, e.g., one qualified under §401(a). Relief under the treaty, therefore, would be limited to broad-based plans, and it is doubtful that any meaningful relief will be provided under this exception that is not otherwise available under the broad-based foreign retirement plan exception discussed below.
COMPENSATION COVERED BY TREATY
A foreign plan is not subject to Code §409A to the extent that the compensation earned under the plan would have been excluded from gross income under a treaty provision if it had actually been paid to the employee at the time the legally binding right to the compensation first arose or, if later, became vested.13 In order for this provision to apply, the treaties require that the cost of the compensation and benefits not be borne by an employer located in the host country (i.e., the United States) where the services are performed, and that the employee’s stay in the host country not exceed 183 days.14 Thus, this exception applies only when the inpatriate is compensated by an employer in a foreign country rather than one located in the United States, and where the period of employment in the United States is limited to 183 days.
COMPENSATION THAT WOULD NOT HAVE BEEN INCLUDIBLE IN GROSS INCOME UNDER CODE §872
Section 872 limits the gross income of a nonresident alien to amounts earned from U.S. sources and to amounts effectively connected to the conduct of a trade or business in the United States. Amounts earned under a foreign plan with respect to the performance of services outside of the United States that would not have been subject to U.S. taxation if paid at the time the amounts are earned or, if later, become vested, are excludable from §409A.15 Thus, if a nonresident alien earns deferred compensation during a period of foreign employment and is later subject to U.S. taxation when the deferred amounts become payable, the deferred amounts will not be subject to the §409A sanctions if the plan fails to meet the applicable requirements, e.g., by offering a choice of payment options that includes a lump sum or failing to delay payment to a specified employee for six months.
PARTICIPATION IN BROAD-BASED RETIREMENT PLAN
This is the exception that is most likely to remove a foreign plan from coverage under §409A, and applies not only to nonresident aliens but also to resident aliens classified as such only under the substantial presence test of §7701(b)(1)(A)(ii) and to bona fide residents of U.S. possessions.16 For it to apply, the foreign plan must be in writing, be non-discriminatory in terms of coverage and amount of benefit (either alone or in combination with other comparable plans), provide significant benefits for a substantial majority of the covered employees and contain provisions, or be subject to tax law provisions or other restrictions, that generally discourage employees from using plan benefits for purposes other than retirement and restrict access to plan benefits before separation from service.17
There is no guidance addressing the standard to apply in determining non-discriminatory coverage and benefits, or the rules to apply in determining whether plans are comparable. Presumably, rules similar to those that exist under §§401(a)(4) and 410(b) govern these determinations. Questions remain, however, as to the determination of non-discriminatory benefits in foreign plans that are integrated with local social security benefits, and the limitations on aggregating and disaggregating plans. For example, should the limitations of §§401(a)(5)(C) and 401(1) be applied in determining the extent to which foreign plans can be integrated with local social security benefits? Should the ability to aggregate plans be limited to plans maintained within the same country, or could a plan maintained in France by one subsidiary be aggregated with a plan maintained in China by another subsidiary to determine comparability of benefits? Should the §414(q) standard apply for determining highly compensated status? There is also uncertainty as to whether a plan permitting in-service distributions contains provisions, or is subject to restrictions or tax-law provisions, discouraging employees from receiving payments before separation from service. Are provisions of a type addressed in Rev. Rul. 71-295, 1971-2 C.B. 184 (amounts accumulated under a profit sharing plan for at least two years can be distributed), and Rev. Rul. 68-24, 1968-1 C.B. 150 (completion of five or more years of participation under a profit sharing plan is a distribution event) permitted? In many cases, it will be difficult to obtain a U.S. translation of the foreign plan. Practitioners are likely to experience difficulty in making definitive determinations as to whether the requirements of this exception have been met.
A funded plan that fails to meet either the non-discriminatory coverage requirements of §410(b), or the minimum participation requirements of §401(a)(26), is excluded from §409A as a short-term deferral.18 Thus, a plan that fails to meet the broad-based exception may nevertheless qualify as a short-term deferral if it is a funded arrangement.
PLANS SUBJECT TO TOTALIZATION AGREEMENTS
Plans mandated by foreign governments are excluded from §409A to the extent that the benefits provided under, or contributions made to, the arrangement are subject to a social security totalization agreement entered into pursuant to Section 233 of the Social Security Act.19 Other arrangements provided as part of a foreign jurisdiction social security system, whether or not subject to a totalization agreement, are also excluded.
Amounts earned by a non-resident alien under a foreign plan with respect to services performed in the United States are excluded from §409A to the extent such amounts do not exceed the dollar amount specified under §402(g)(1)(B) for the taxable year ($15,500 for 2007).20 Earnings on amounts eligible for this exception are also excluded. For this purpose, a foreign plan is limited to one covering a substantial number of participants where substantially all of the participants are either non-resident aliens or resident aliens classified as such solely under the substantial presence test. This exception will apply to cases where the inpatriate’s period of service in the United States is of a short duration.
FOREIGN SEPARATION PAY PLANS
Separation pay (including payments upon a voluntary termination of employment) that is required to be provided under the applicable law of a foreign jurisdiction is not subject to §409A.21 This exception is generally limited to the portion of the separation pay that relates to foreign earned income, i.e., income received from sources within a foreign country that is attributable to services performed within such country. Unlike the general exception for separation pay contained in Reg. §1.409A-1(b)(9), there is no requirement that the separation be involuntary and no limit on the amount of separation pay or the period over which the payments can be made.
TAX EQUALIZATION AGREEMENTS
Compensation paid under an arrangement that makes an inpatriate whole for the additional taxes imposed as a result of services performed in the United States is not subject to §409A provided that the payments are made no later than (i) the end of the employee’s second taxable year beginning after the employee’s taxable year in which the U.S. return is required to be filed (including extensions) for the year to which the compensation subject to the agreement relates or, if later, (ii) the employee’s second taxable year beginning after the latest such taxable year in which the employee’s foreign tax return or payment is required to be filed or made for the year to which the compensation subject to the agreement relates.22 A failure to timely file the U.S. or foreign return does not extend the time for making payments under the Tax Equalization Agreement. Special rules apply where payments arise due to an audit, litigation or similar proceeding.
Analysis of Expatriate Exceptions
Many of the same exceptions applicable to inpatriates apply to expatriates as well.
PARTICIPATION ADDRESSED BY TREATY
This is the same exception applicable to the inpatriates.23 Many treaties provide exclusions from U.S. income for benefits accrued in a foreign country pension plan by U.S. persons who are resident in the foreign country, where the cost of such benefit is borne by an employer resident in the foreign country. For example, see the treaties with Germany, France and the United Kingdom mentioned above. This relief is contingent upon the competent authority of the United States agreeing that the foreign pension plan corresponds to a pension plan established in the United States, e.g., one qualified under §401(a),24 and is limited to that allowed by the United States to its residents for benefits accrued under a corresponding U.S. plan, i.e., in a defined contribution plan, $45,000 per year, and in a defined benefit plan, a life annuity of $180,000 per year commencing no earlier than age 62. Any benefits accrued under the foreign plan are treated as having been accrued under the U.S. plan for purposes of determining the individual’s eligibility to receive benefits under the U.S. plan. These treaty provisions may provide additional relief in cases where the broad-based retirement plan exception discussed below does not apply, e.g., where the person is eligible to participate in a U.S. qualified plan.
COMPENSATION THAT WOULD HAVE BEEN EXCLUDABLE UNDER §§911, 931 OR 933
To the extent amounts earned under a deferred compensation plan would have been excludable from income under §911 (which permits a limited exclusion—$82,400, as adjusted for inflation—of foreign-earned income by U.S. persons for services performed outside of the United States), or under §§931 or 933 (compensation earned in certain U.S. possessions or territories), if paid at the time earned or, if later, vested, the amounts will not be subject to §409A.25 This is similar to the exception applicable to nonresident aliens for amounts that would have been excludable under §872 if paid when earned or, if later, vested.
BROAD-BASED FOREIGN RETIREMENT PLAN
Benefits earned by a U.S. citizen or lawful permanent resident (i.e., a green card holder) under a broad-based retirement plan as defined above are not subject to §409A provided the person is not eligible to participate in a U.S. qualified plan, the deferral is non-elective and relates to foreign earned income, and the accrual does not exceed the amount permitted under §415 (for 2007, $45,000 of annual additions under a defined contribution plan; an annuity of $180,000 commencing no earlier than age 62) under a defined benefit plan.26 As noted above, the treaty exception may provide relief in circumstances where the broad-based retirement plan exception is not available by reason of the person’s coverage under a U.S. qualified plan.
The same requirements that apply to inpatriates also apply here.
TAX EQUALIZATION AGREEMENTS
The same requirements that apply to inpatriates also apply here.
Employers with international operations should determine the extent to which any person covered under a foreign plan is subject to the U.S. tax law by reason of either inpatriate or expatriate status. If any such persons exist, the foreign plan should be reviewed to determine whether any of the international exceptions discussed herein are applicable. If no exception applies and all or a portion of such a participant’s benefit is subject to Code §409A, the plan should be amended, if possible, to conform to Code §409A for those persons subject to the U.S tax law. Otherwise, the §409A sanctions will be imposed.
This article will be reprinted in the December 2007 issue of Compensation Planning Journal