Deferred compensation arrangements must be in compliance with final U.S. Internal Revenue Code Section 409A regulations no later than 31 December 2008. The scope of Section 409A is broad, and there is no statutory exception for foreign plans, whether qualified under foreign law or not.
Employers with international operations frequently transfer U.S. citizens and residents to international locations, and non-resident aliens to the United States. Because of the broad scope of Section 409A, U.S. citizens and resident aliens (U.S. persons) who are covered under foreign plans (expatriates) and non-resident aliens working in the United States who accrue benefits under foreign plans during their period of U.S. employment (inpatriates) are subject to the Section 409A sanctions if these foreign plans fail to meet the applicable requirements. These sanctions include the following:
- A requirement to include all deferred Income for the taxable year in which such amounts cease to be subject to a substantial risk of forfeiture to the extent not previously included in income
- An additional tax equal to 20 per cent of the amounts includible in income
- An additional tax equal to the interest, as determined using the Internal Revenue Service (IRS) underpayment rate, plus 1 per cent, which would have been imposed during the deferral period if the amounts had been includible in income when first deferred or, if later, when they ceased to be subject to a substantial risk of forfeiture
Fortunately, the final regulations contain numerous exceptions that permit both expatriates and inpatriates 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 plan to comply with the Section 409A requirements in order to avoid the 409A sanctions.
There are several exceptions and, in certain cases, multiple exceptions may apply.
Participation Addressed by Treaty
Plans are excluded from Section 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. Relief under the treaty exception is generally limited to broad-based plans. 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 Section 409A to the extent that the compensation earned would have been excluded from gross income under a treaty provision if it had actually been paid to the inpatriate at the time the legally binding right to the compensation first arose or became vested. 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 inpatriate’s stay in the host country not exceed 183 days.
Compensation That Would Not Have Been Includible in Gross Income
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 the United States that would not have been subject to U.S. taxation if paid at the time the amounts are earned or become vested are not subject to Section 409A. To the extent amounts earned under a deferred compensation plan would have been excludable from income under Section 911 (which permits a limited exclusion—U.S. $82,400, as adjusted for inf lation—of foreign-earned income by U.S. persons for services performed outside of the United States), or under Sections 931 or 933 (compensation earned in certain U.S. possessions or territories), if paid at the time earned or vested, the amounts will not be subject to Section 409A.
Participation in Broad-Based Retirement Plan
This is the exception that is most likely to remove a foreign plan from coverage under Section 409A. For it to apply, the foreign plan must meet the following criteria:
- 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
For this exception to apply to an expatriate, the person must not be eligible to participate in a U.S. qualified plan, the deferral must be non-elective and relate to foreign-earned income, and the accrual must not exceed the amount permitted to be earned under a U.S. qualified plan.
A funded plan that fails to meet either the non-discriminatory coverage requirements of Section 410(b) or the minimum participation requirements of Section 401(a)(26) is excluded from Section 409A as a short-term deferral. 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 Totalisation Agreements
Plans mandated by non-U.S. governments are excluded from Section 409A to the extent that the benefits provided under, or contributions made to, the arrangement are provided as part of a foreign jurisdiction social security system.
Amounts earned by a non-resident alien under a foreign plan with respect to services performed in the United States are excluded from Section 409A to the extent such amounts do not exceed the dollar amount specified under Section 402(g)(1)(B) for the taxable year (U.S. $15,500 for 2008).
Tax Equalisation Agreements
Amounts paid under an arrangement to compensate an inpatriate or expatriate for the additional taxes imposed as a result of services performed outside of his or her home country is not subject to Section 409A provided that the payments are made no later than: 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, 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. Special rules apply where payments arise as a result of an audit, litigation or similar proceeding.
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 Section 409A. This exception is generally limited to the portion of the separation pay that relates to income received from sources within a non-U.S. country that is attributable to services performed within that country. Unlike the general exception for separation pay, there is no requirement that the separation be involuntary and no limit on the amount of separation pay or the period over which the payment can be made.
Employers with international operations should determine the extent to which any person covered by a foreign plan is subject to U.S. tax law by reason of either inpatriate or expatriate status. If anyone is subject to U.S. law on this basis, the foreign plan should be reviewed to determine whether any of the international exceptions outlined above are applicable. If no exception applies and all or a portion of the participant’s benefit is subject to Section 409A, the plan should be amended, if possible, to conform to 409A for those persons subject to the U.S. tax law. Otherwise, Section 409A sanctions will be imposed on the affected employees.