The long-awaited regulations under Section 409A of the US Internal Revenue Code relating to deferred compensation were finally issued on April 10, 2007 and are applicable for taxable years beginning on or after January 1, 2008 (the “Final Regulations”). They include a number of significant changes that will affect Canadian employers.
In this Osler Update, we highlight some of the more significant changes introduced in the Final Regulations that will affect Canadian employers. However, Section 409A is a complex topic and this notice is not a summary of the rules. The Final Regulations are massive (almost 400 pages long) and contain detailed nuances and exceptions that cannot be summarized in detail here.
Section 409A regulates the design and operation of a broad array of non-qualified deferred compensation arrangements. It was the topic of two previous Osler Updates: November 30, 2005, and June 14, 2005. These Final Regulations affect every American employer.1 They also affect Canadian employers of U.S. taxpayers who participate in any employer-sponsored deferred compensation arrangements (including stock plans, long-term bonuses, supplemental retirement plans and severance agreements). A U.S. taxpayer includes all U.S. citizens and resident aliens regardless of where they reside. Action Items for Employers
As a result of these Final Regulations, employers should take the following steps:
- Establish a schedule now to amend all nonqualified deferred compensation plans on or before the deadline of December 31, 2007.
- Review stock option grant practices: if the exercise price is based on market value during an averaging period (instead of closing price), there must be an irrevocable commitment to grant the options prior to the beginning of the averaging period.
- Determine “specified employees” annually and amend related employment agreements to require a six-month delay in termination payouts whenever new “specified employees” are identified.
- “Delink” supplemental benefit plans that are related to a registered pension plan from the registered plan so that the supplemental plan complies with all payment timing rules on a stand-alone basis.
- Consider amending plans (in particular, employment agreements) to comply with the “good reason” safe harbor for involuntary termination of employment.
Highlights from the Final Regulations
Timing of Payments and Elections
- Linked Plans. Foreign plans such as Canadian supplemental benefit plans that are related to a registered pension plan may continue to operate their linked payment timing through the end of 2007. We had suspected that this would be the case but are happy to receive confirmation that such plans are to be treated in the same manner as U.S. plans linked to qualified plans. Note, however, that the transition relief for such linked plans has not been extended past January 1, 2008. Accordingly, such plans must be “delinked” from the qualified/registered plan and amended to comply with Section 409A payment timing rules by December 31, 2007. This will severely limit the choices of benefit payment timing for participants in supplemental retirement plans.
- Time and Form of Payment. Generally, only one “time and form of payment” may be designated for each type of permissible payment event. One permitted exception is a limited ability to designate a second time and form of payment if the separation from service occurs (1) during a limited period following a change in control, or (2) before or after a specified date, age or combination of age and service. Further, although Section 409A prohibits acceleration of payments, an early payment will not be deemed to be a prohibited acceleration if it is made no more than 30 days prior to its scheduled date. A plan may also provide that a payment will be made within a designated period so long as the period is either within one tax year or is not more than 90 days after the event triggering payment.
- Annuities. Actuarially equivalent life annuities that have the same initial payment date are treated as one form of payment so that participants may choose from among different annuity forms without regard to the rules on subsequent deferral elections. This will be welcome news for those plans that provide a choice between several actuarially equivalent annuity options.
Payments on Separation from Service
- Separation from Service. The Final Regulations simplify the definition of “separation from service” for purposes of making payments to employees. The general standard for determining whether the employee has separated from service is based on whether the facts and circumstances indicate that the employer and employee reasonably anticipated either (1) that the employee would provide no further services after a certain date, or (2) that the level of services the employee would perform after such date would permanently decrease to no more than 20 percent of the average level of services performed over the preceding 36 months. This rule has significance for those Canadian employers who would otherwise pay severance by leaving an employee on the payroll and who do not therefore consider such employee terminated until after the severance payments end. Such an arrangement could violate Section 409A if the employee is considered a specified employee, since those payments might be required to be delayed for six months.
- Certain Severance Pay for Involuntary Separation not Subject to Six-month Delay. The Final Regulations clarify that severance pay due to involuntary separation up to the lesser of two times the employee’s annual compensation or two times the compensation limit ($450,000 for 2007) is exempt from Section 409A and thus is not subject to the six-month wait, even for “specified employees,” provided that such severance amounts are paid out by the end of the second taxable year following the employee’s separation from service. However, amounts in excess of the limit will be subject to Section 409A, which means that executives of public companies may receive a portion of their severance pay immediately but may need to wait six months for the remainder if they are “specified employees.”
- “Good Reason” Safe Harbor to Avoid the Six-month Delay. Where a severance arrangement provides for payment on voluntary termination as a result of a material breach in the employment contract by the employer (i.e., “Good Reason”), the termination will be deemed to be an involuntary termination. In addition, the Final Regulations provide a safe harbor definition for the types of material events that will qualify as a Good Reason termination, including a reduction in the employee’s compensation, duties, or responsibilities. To meet the safe harbor, the employee must provide notice to the employer of the material breach within 90 days of its occurrence, after which the employer must be given no less than 30 days to rectify the breach.
- Determining the Specified Employees. Determining the “specified employees” can be challenging for employers. The Final Regulations allow employers to make an over-broad list of employees, which may include up to 200 individuals. An employee on the list who is not actually required to be treated as a specified employee on the date of his separation from service and who has his payment delayed by six months, will not be treated as having a change in the time and form of his payment for purposes of the subsequent deferral rules. On the other hand, if an employee is actually a specified employee but does not have his payments delayed because he was not included on the list, the arrangement will fail to be in compliance with Section 409A. Accordingly, it remains important for employers to accurately identify their specified employees and, as new individuals are added to the list, amend their employment agreements and other arrangements to include the six-month delay in a written provision. The Final Regulations also provide helpful guidance for determining the specified employees in a variety of different corporation transactions.
Stock Options and Other Stock-Based Rights
- Expanded definition of employer stock. Certain types of stock options and stock appreciation rights (“SARs”) are exempt from Section 409A if they are granted with an exercise price that is not less than the fair market value of the underlying stock on the date of grant. The Final Regulations expand the classes and issuers of stock that may be used in granting exempt stock options or SARs. First, the Final Regulations now provide that any class of employer common stock generally may be used as long as it does not have any preferences other than liquidation preferences. This is a significant change from the proposed regulations, which provided that employer stock was limited to publicly-traded stock or, if no class of stock of the corporation (or any member of its controlled group) was publicly traded, to that class of common stock with the highest aggregate value. Second, the Final Regulations clarify that the stock used may be that of the corporation receiving services from the employee or any other corporation “up” the corporate chain (but not “down” or “sideways” in the chain). Generally, the corporations must be connected by at least a 50% ownership interest, or 20% for a legitimate business purpose. Note that for stock options or SARs issued on or after April 10, 2007 the underlying stock must satisfy the requirements of the Final Regulations for the stock options or SARs to continue to be exempt from Section 409A after 2007. If the underlying stock does not satisfy the requirements, such stock options or SARs will be required to be modified either to be excluded from Section 409A or to comply with all of the requirements of Section 409A.
- Setting Option Exercise Prices. The exercise price of a stock option may never be less than “fair market value” on the date of grant, as determined under the Final Regulations. Employers who set option exercise prices using an averaging period prior to the grant date, instead of the closing market price, will need to ensure that the grant date occurs after the company has irrevocably established the terms of the option, identified the recipients and set the number of shares and class of stock that is subject to the option. Generally, this means that the board or committee approving option grants must establish a future grant date. The Final Regulations provide relief from this rule for stock rights granted in a jurisdiction that requires an averaging period by law. Note that although the Toronto Stock Exchange (“TSX”) permits an averaging method, it is not required; the TSX will also accept the closing market price on the grant date.
- Extension of Option Exercise Period. An option exercise period may be extended until the earlier of the original maximum term of the option or 10 years from the original date of grant. This welcomed development will give employers flexibility to extend option exercise periods in connection with a separation from service.
- Corporate Transactions. A substituted stock option in a successor company may be treated as a continuation of the original option even where the option holder is not employed by that successor company, provided that certain requirements are met.
- Material Modification Prior to Enactment of Section 409A. Prior to the release of the Final Regulations, there was concern that any material modification made to a stock right prior to October 3, 2004 could prevent the stock right from qualifying for the grandfathering rule that exempted from Section 409A stock rights that were vested as of December 31, 2004. The Final Regulations clarify that any modifications and extensions made to stock rights as of October 23, 2004 will be disregarded for purposes of determining whether Section 409A applies. This means that the stock right will be treated as if granted with the terms and conditions in effect on October 23, 2004.
- Plan Aggregation Rules. Under Section 409A, certain types of deferred compensation arrangements are aggregated and treated as one plan for various purposes. For instance, a failure to comply with Section 409A will result in immediate taxation and penalties on all deferred income for an employee not only under the arrangement that contained the Section 409A violation but also under any other plan that must be “aggregated” with that arrangement. Under the Final Regulations, some non-U.S. plans are now counted separately, so that inadvertent plan violations do not affect other categories of deferrals.
What’s Not in the Final Regulations?
As comprehensive as they are, the Final Regulations do not offer any additional guidance on: the calculation of income inclusion on a violation of the rules; employer wage reporting obligations; funding with offshore trusts; or treatment of compensatory partnership interests. Deadline for Compliance.
The Final Regulations are applicable for taxable years beginning on or after January 1, 2008. Accordingly, all plans must be amended to be in documentary compliance with the Final Regulations by the December 31, 2007 deadline. For periods before January 1, 2008 compliance with the proposed regulations, the Final Regulations and other guidance issued under Section 409A will constitute good faith compliance with Section 409A. In addition, certain transition rules will continue to apply for payment elections and other matters.