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International Aspects of Section 409A — a Deadline Draws Near by Ben Francis, KPMG LLP, Washington, D.C. Section 409A of the U.S. Internal Revenue Code (I.R.C.), enacted as part of the American Jobs Creation Act of 2004 (P.L. 108-357), introduced significant changes to the taxation of deferred compensation. The general rule of section 409A is that a nonqualified deferred compensation plan must satisfy specific requirements as to the timing of elections, the timing of distributions, and funding. If it does not, amounts deferred under the plan for the current tax year and all preceding tax years (with certain exceptions) are includible in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in income.1 Such deferrals are also subject to an additional tax of 20 percent of the amount required to be included in gross income, and interest at the under-payment rate plus 1 percent from the year in which the amount was first deferred or, if later, from the year in which it was no longer subject to a substantial risk of forfeiture.2 In April 2007, final regulations under section 409A were issued ("the Regulations").3 The Regulations are effective for tax years beginning on or after January 1, 2008, so now is the time to ascertain that a company's deferred compensation plans — including certain elements of international assignment compensation — are in full compliance with these rules. An article in the Summer 2007 edition of The Expatriate Administrator discussed the main rules of section 409A and the Regulations, with particular emphasis on the rules applicable to grants of stock rights. This article will discuss certain aspects of section 409A and the Regulations that relate to international assignments. The discussion will be in two parts: first, the rules that relate to tax equalization agreements, and second, the rules that relate to foreign deferred compensation and similar arrangements. Tax Equalization Agreements In observance of the age-old maxim for business presentations of "Tell 'em what you're gonna tell 'em," it can be stated at the outset that the vast majority of tax equalization agreements operated by employers for their international assignees will generally not run afoul of the rules of section 409A and the Regulations, provided certain requirements are met. However, the route by which this conclusion is reached is somewhat more circuitous than might be expected or desired. This is primarily because the provision in the Regulations entitled "Tax Equalization Agreements" is somewhat narrower in scope than its title suggests; whereas the provision entitled "Tax Gross-Up Payments" is somewhat broader in scope than its title suggests. Tax Equalization Agreements Provision According to the provision in the Regulations entitled "Tax Equalization Agreements," a tax equalization agreement does not provide for a deferral of compensation, and is therefore outside the scope of section 409A, if (1) the agreement meets the definition of a "tax equalization agreement", namely that it is an agreement, method, program, or other arrangement that provides payments intended to compensate the employee for (i) some or all of the excess of taxes actually imposed by a foreign jurisdiction on compensation over the taxes that would be imposed if the compensation were subject solely to U.S. federal, state, and local income taxes; (ii) some or all of the excess of the U.S. federal, state, and local income taxes actually imposed on compensation over the taxes that would be imposed if the compensation were subject solely to taxes in the foreign jurisdiction; and (iii) the amount necessary to compensate for any additional taxes on amounts paid under the agreement, i.e., gross-up amounts;4 and (2) payments under the agreement comply with certain time limits, namely that the payments must be made no later than (i) the end of the second taxable year of the employee after the year in which the employee's U.S. federal income tax return is required to be filed (including extensions) for the year to which the compensation subject to the tax equalization payment relates; or, if later, (ii) the end of the second tax year of the employee beginning after the latest tax year in which the employee's foreign tax return is required to be filed (or payment of foreign tax is required to be made) for the year to which the compensation subject to the tax equalization payment relates. Alternatively, if the tax equalization payment arises because of an audit, litigation, or similar proceeding, the time-limit requirement will be met provided the payment is made by the end of the employee's tax year following the tax year in which the taxes that are the subject of the audit are remitted to the taxing authority; or, if as a result of the audit no taxes are remitted, by the end of the employee's tax year following the tax year in which the audit is completed or there is a final settlement or resolution of the litigation.5 The time-limit rules can be illustrated by the following example. If Jane, a U.S. taxpayer, is on assignment in Germany and her 2007 U.S. and German tax returns are filed, together with payment of any tax due, in 2008, then a payment to her under a tax equalization agreement must be made before the end of 2010 to be in compliance with the Regulations, and to mitigate the potential negative consequences of section 409A. However, if Jane filed Form 2350 to obtain an extension until January 2009 to file her 2007 U.S. tax return under section 911 of the I.R.C., then a payment to her under a tax equalization agreement must be made before the end of 2011. This provision of the Regulations does not apply to all payments that might be made under a tax equalization agreement because its definition of the scope of payments that are exempt from section 409A — the excess of foreign over U.S. taxes, or the excess of U.S. over foreign taxes, together with the gross-up on such amounts — is too narrow to encompass the full range of payments that an employer might make to an employee on international assignment while covered by a tax equalization agreement. The following example illustrates this point. Jim, a U.S. taxpayer, is on assignment to a foreign country that has a higher tax rate than the United States. On his 2007 tax returns, his foreign tax liability is $140,000 and his U.S. tax liability (after claiming a foreign earned income exclusion and foreign tax credits) is $20,000. The excess of Jim's foreign tax liability over his U.S. tax liability is therefore $120,000. If Jim's employer compensates Jim only for this excess, together with the corresponding gross-up amount, then this will meet the definition set out above and will not amount to a deferral of compensation under section 409A provided, of course, that the time-limit requirements are observed. However, under a traditional tax equalization agreement, the total amount paid to an employee in Jim's situation might exceed this amount. If Jim's hypothetical stay-at-home U.S. tax liability is $25,000, and his employer has agreed to compensate him for his actual U.S. tax liability to the extent this exceeds his hypothetical stay-at-home liability, then the total amount paid to Jim under the tax equalization agreement will be $135,000, calculated as follows:
To the extent the amount of $135,000 is more than the "excess" amount of $120,000 described above, it falls outside the scope of a permissible payment under a tax equalization agreement as defined in the Regulations. It is therefore necessary to look to another provision in the Regulations — the tax gross-up payments provision — to find relief from the adverse consequences of section 409A. Tax Gross-Up Payments Provision The provision in the Regulations entitled "Tax Gross-Up Payments" states that a plan with a right to a gross-up payment will be treated as providing for payment at a specified time or on a fixed schedule of payments, and will be, therefore, a deferral of compensation that meets the exceptions in the Regulations and therefore avoids the negative provisions of section 409A, if (1) it meets the definition of a "tax gross-up payment", namely (i) a payment to reimburse an employee for all or a designated portion of the U.S. federal, state, local, or foreign taxes imposed on the employee as a result of compensation paid to the employee by the employer, and (ii) the amount of any additional taxes imposed on the employee by reason of the employer's payment of the initial tax;6 and (2) it complies with the required time limits for payment, namely (i) the plan provides that payment will be made, and payment is made, by the end of the employee's tax year following the tax year in which the employee remits the related taxes, or (ii) if the payment arises because of an audit, litigation, or similar proceeding, the time-limit requirement will be met as long as the payment is made by the end of the employee's tax year following the tax year in which the taxes that are the subject of the audit are remitted to the taxing authority; or, if as a result of the audit no taxes are remitted, by the end of the employee's tax year following the tax year in which the audit is completed or there is a final settlement or resolution of the litigation.7 It should be noted that the time limits under the rules for tax gross-up payments are generally one year shorter than the time limits under the rules for tax equalization agreements. Thus, in the example above, the deadlines applicable to Jane would occur a year earlier under the tax gross-up payment rules. In observance of that other maxim of business presentations — "Tell 'em what you just told 'em" — this section can be concluded by observing that, although the time limits applicable to tax gross-up payments are generally one year shorter than those applicable to tax equalization agreements, the scope of payments covered by the definition of tax gross-up payments is broader in that it covers reimbursements of all taxes, both U.S. and foreign, and is not limited to the excess of one over the other. In addition, it includes all related gross-ups. The tax gross-up payments provision of the Regulations is therefore likely to provide relief from the adverse consequences of section 409A for payments made to assignees under a tax equalization agreement in situations where the tax equalization agreement provision (which might seem like the logical place to look for relief) does not. It is important to note that, whether relying on the tax equalization provisions or the tax gross-up provisions of the Regulations, the written tax equalization plan must identify the time of payment, and the time of payment must itself conform to the requirements of the Regulations. Rules Applicable to Foreign Arrangements The Regulations contain several provisions that offer exemptions from section 409A for certain foreign arrangements that might otherwise amount to deferred compensation arrangements subject to section 409A. These provisions are outlined below. Contributions Excluded by Treaty Pension and other similar plans are exempt from section 409A to the extent contributions to the plan by or on behalf of an employee are excludible for U.S. federal tax purposes under an income tax treaty to which the United States is a party.8 The United States is a party to a number of income tax treaties that contain provisions relating to such exclusions, including the treaties with the following countries: Austria, France, Ireland, Netherlands, South Africa, Sweden, Switzerland, and the United Kingdom. This list is subject to change as new treaties and protocols enter into force. Other Broad-Based Foreign Plans Not Covered by Treaty Certain other foreign plans not covered by treaty are exempt from section 409A provided:
Where U.S. citizens and greencard holders who are not bona fide residents of a U.S. possession participate in a broad-based foreign plan (as defined in the previous paragraph), the contributions are exempt from section 409A provided:
Foreign Social Security Plans The social security system of a foreign country is not subject to section 409A provided either (1) benefits provided under or contributions made to the system are subject to a totalization agreement between the United States and the foreign country; or (2) benefits provided under or contributions made to the plan are government-mandated as part of that foreign country's social security system.11 Deferrals in Respect of Income Excluded under Treaty Deferrals of income under a plan that might otherwise be a deferred compensation plan are exempt from section 409A if made from income that would have been excludible from gross income for U.S. federal income tax purposes under the terms of an income tax treaty or other bilateral or multilateral agreement to which United States is a party if paid to the employee at the time the legally binding right to the compensation first arose or, if later, when the legally binding right was no longer subject to a substantial risk of forfeiture.12 This exemption would apply, for example, to deferrals of income that would be exempt under the dependent personal services or independent personal services articles of an income tax treaty, or income that is exempt under a Status of Forces agreement ("SOFA") to which the United States is a party. Deferrals in Respect of Income Excluded under I.R.C. Deferrals of income under a plan that might otherwise be a deferred compensation plan are exempt from section 409A if made from income that would have been excludible from gross income for U.S. federal income tax purposes under certain provisions of the I.R.C., if paid to the employee at the time the legally binding right to the compensation first arose or, if later, when the legally binding right was no longer subject to a substantial risk of forfeiture.13 The relevant provisions of the I.R.C. for these purposes are:
Limited Deferrals by Nonresidents Deferrals by a nonresident individual under a foreign plan in respect of compensation for services performed in the United States are exempt from section 409A provided (1) the amounts deferred do not exceed the annual limit for 401(k) employee contributions under section 402(g)(1)(B), which is $15,500 for 2007, and (2) the foreign plan must be maintained by an employer for a substantial number of participants, substantially all of whom are either nonresident individuals, or residents under the substantial presence test (i.e., not greencard holders).15 Additional Foreign Plans Designated by IRS Finally, the Regulations confer on the U.S. Internal Revenue Service the power to add to the list by designating additional foreign plans that are exempt from section 409A. Such additions would be made by the publication of Revenue Procedures, Notices, or other guidance published in the Internal Revenue Bulletin.16 Conclusion The consequences of running afoul of section 409A can be severe. The Regulations provide significant relief from these adverse consequences in many situations that may arise in the context of international assignments. However, it is always important to ensure that the precise terms of the Regulations are complied with to obtain the relevant relief. Because the Regulations are effective for tax years beginning on or after January 1, 2008, employers of international assignees should review their tax equalization policies as soon as possible to be sure that they contain payment deadlines that conform with the Regulations to prevent the negative consequences of section 409A from applying to routine tax equalization and gross-up payments. Footnotes: 1 I.R.C. § 409A(a)(1)(A). 2 I.R.C. § 409A(a)(1)(B), (b)(4)(B). 3 T.D. 9321, April 17, 2007. 4 Treas. Reg. § 1.409A-1(b)(8)(iii). 5 Treas. Reg. §§ 1.409A-1(b)(8)(iii), 1.409A-3(i)(1)(v). 6 Treas. Reg. § 1.409A-3(i)(1)(v). 7 Ibid. 8 Treas. Reg. § 1.409A-1(a)(3)(i). 9 Treas. Reg. §1.409A-1(a)(3)(ii), (v). 10 Treas. Reg. §1.409A-1(a)(3)(iii), (v). 11 Treas. Reg. §1.409A-1(a)(3)(iv). 12 Treas. Reg. §1.409A-1(b)(8)(i). 13 Treas. Reg. §1.409A-1(b)(8)(ii). 14 Ibid. 15 Treas. Reg. §1.409A-1(b)(8)(iv). 16 Treas. Reg. §1.409A-1(b)(8)(v). ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. |