International Aspects and 2008 Action Steps Relative to Section 409A

by Teresa Lodes, KPMG LLP, Kansas City
(KPMG LLP in the United States is a KPMG International member firm)

The U.S. Congress passed the American Jobs Creation Act of 2004 (AJCA), P.L. 108-357, on October 11, 2004. The AJCA added section 409A to the Internal Revenue Code (I.R.C.), which significantly changed the rules for nonqualified deferred compensation (NQDC) plans. By now, in 2008, many employers are likely familiar with the code section and have attempted to understand what the changes made to the NQDC plan rules mean for them.¹ Several Internal Revenue Service (IRS) notices providing guidance to the changed rules have been issued since the AJCA was enacted. On April 10, 2007, Treasury issued the final regulations under section 409A.

Many domestic employers doing business in the United States likely only have reviewed and revised their domestic NQDC plans to be compliant with the new rules. It is important to note, however, that section 409A also pertains to many policies and plans that apply to multinational employers' international assignment programs. Section 409A must be considered — and adhered to — to assure compliance for these programs, otherwise there is a risk of triggering the 20-percent penalty plus interest tax.

This article provides a summary of the rules and the action steps that ought to be considered before the end of 2008.

Background

Section 409A was added to the I.R.C. by Congress in reaction to real and perceived abuses regarding the timing and recognition of compensation payments received pursuant to NQDC plans. Section 409A generally applies to amounts deferred under a NQDC plan to the extent the amounts deferred under the plan were not earned and vested before January 1, 2005. The code section imposes rules regarding the timing and recognition of compensation payments pursuant to company plans that are included in the definition of NQDC plans as defined in the section. If a company plan fails to meet the requirements of section 409A, all compensation deferred under the plan for the taxable year and all preceding taxable years shall be includible in gross income for the current taxable year to the extent not subject to a substantial risk of forfeiture and as long as the income was not previously included in gross income.

In addition to the "regular" income tax that would be imposed on this compensation, section 409A also imposes a 20-percent additional income tax on this additional compensation plus a "penalty" interest charge for the period deferred after the amount vests. The tax, interest, and penalties are assessed on the individual taxpayers who are otherwise participants in the plan. The employer has regular withholding responsibilities and must report that the amount failed section 409A using Form W-2 Box 12, Code Z.

These rules pertain to:

• Phantom stock
• Discounted stock options plans
• Restricted stock units plans
• Section 457(f) plans (relating to ineligible plans for state and local governments and tax-exempt organizations)
• Separation pay agreements (subject to certain exceptions), and
• Other agreements to defer compensation.

These rules do not pertain to:

• Grandfathered plans
• Short-term deferrals (paid 2-½ months after close of vesting year)
• Stock rights in service recipient (i.e., employer) stock that are not discounted and have no deferral feature (also incentive stock options (ISOs) and employee share participation plans (ESPPs))
• Certain separation payments (including foreign) and fringe benefit plans
• Property transfers with substantial risk of forfeiture
• Restricted stock (but not restricted stock units (RSUs))
• Section 402(b) plans (mostly foreign employee benefit trusts)
• Qualified plans and certain foreign plans (e.g., subject to a treaty, or mandated social security systems — but only to the extent of the treaty protection)
• Death benefits, sick leave, disability pay.

The definition of deferred compensation plans is interpreted very broadly to include a number of arrangements, some of which were not previously thought to be traditional deferred compensation arrangements. The international assignment arena is replete with such arrangements — tax equalization policies or other types of tax reimbursement arrangements are part of many, if not most, international assignment programs. In addition, the regulations also may apply to certain foreign plans in which international assignees may be participating.

NQDC and Tax Equalization Policies

Section 409A defines NQDC as a legally binding right to compensation earned in one taxable year that provides for receipt of the promised compensation more than 2-½ months into a later year (a substantial risk of forfeiture is ignored in determining whether there is a legally binding right). Most, if not all, tax equalization policies provide that, as a result of the international assignment, the assignee is promised that if his/her hypothetical tax is over-withheld during the year, the employer will owe him/her a settlement payment for the amount that is over-withheld. Most tax equalization policies also provide that the employer will pay all actual home and host country taxes. Accordingly, the settlement payment will be earned in Year 1, but the tax returns will not be finalized or the settlement payment determined until well into Year 2 or later.

The good news is that the regulations provide that the compensation paid under a tax equalization agreement does not provide for a deferral of compensation, as long as:

• The payment satisfies one of the two examples provided in the definition of "tax equalization agreement" (e.g., excess of foreign over U.S. tax or excess of U.S. over foreign tax), and
• The payment satisfies the requirements as to time of payment, that is, not later than:
  • –  the end of the second tax year after the year the U.S. federal income tax return is due (with extensions), or
  • –  the end of the second tax year after the latest tax year in which the employee's foreign tax return is required to be filed (or payment is required to be made).

The regulations also provide that if the payment arises because of audit or litigation, payment must be made by the end of the employee's tax year following the tax year in which the taxes subject to audit are remitted, or, if no additional taxes are remitted, by the end of the year after the year in which the audit is completed or the litigation is settled.

Because of the way tax equalization policies actually operate, the payments pursuant to these policies won't always meet this definition. However, there is another type of payment defined in the regulations that should cover other payment amounts, namely "gross-up" payments.

Gross-up Payments

A gross-up payment is defined as a payment to reimburse an employee for all or a designated portion of the U.S., state, local, or foreign taxes imposed on the employee as a result of compensation paid to the employee, and the amount of any additional taxes imposed by reason of the employer's payment of the initial tax (tax on the tax). Although this definition should be broad enough to encompass most payments made under a tax equalization program that are not covered by the definition of a tax equalization payment, the required time-frame for payment is shorter. The regulations provide that payment must be made not later than:

• The end of the tax year following the tax year in which the employee remits the related taxes, or
• If the payment arises because of audit or litigation, payment must be made by the end of the tax year following the tax year in which the taxes subject to audit are remitted, or, if no additional taxes are remitted, the year after the year in which the audit is completed or the litigation is settled.

Documentation Compliance: Tax Equalization Plans Included

The final section 409A regulations require that deferred compensation plan documentation (including tax equalization plans) be in writing. If a deferred compensation plan is operated without plan documentation that conforms to the regulations, all payments under the plan will be considered to be in violation of section 409A, and may be subject to penalty and interest charge taxes, as noted above. If the plan document is in conformity, then only payments that are not made in compliance with the plan are subject to the penalty and interest charge taxes.

Extended Deadline for Compliance under Notice 2007-78

Notice 2007-86 gives taxpayers until December 31, 2008, to satisfy the documentation requirements of the final regulations. Although taxpayers are not required to satisfy the documentation requirements of the final regulations during 2008, this extension does not relieve taxpayers from good faith operational compliance with section 409A. Where an issue is not addressed in any applicable guidance, the taxpayer must "apply a reasonable, good faith interpretation" of section 409A. For 2008, compliance with the final regulations, although not required, will be deemed good faith compliance with section 409A.

Foreign Plans

As noted above, the regulations provide exemptions for foreign deferred compensation plans from the application of section 409A, subject to the proviso that such plans will not result in an improper deferral of U.S. tax and will not result in assets being effectively beyond the reach of creditors. Under the regulations, foreign plans do not provide for a deferral of compensation to the extent that the deferred compensation under the arrangement meets the following requirements:

In addition, a plan that is "funded" (set aside in a trust under which the trust assets are not available to creditors of the employer in bankruptcy), is not subject to section 409A.

Because of these exceptions, many foreign plans are not subject to the section 409A regulations. However, all plans should still be reviewed to confirm that the plans meet the exceptions in view of the participation of international assignees.

Action Steps for 2008

In view of the above, employers should consider the following action steps during 2008 regarding plans pertaining to international assignees.

Tax Equalization Policies Must Be in Writing

Often, tax equalization policies may be by mutual agreement between the employer and the international assignee and not be in writing. It may be that different assignees of the same employer will have different agreements pertaining to their international assignments. Also, often a brief summary of the tax equalization policy is found in a few sentences in the assignee's letter of understanding instead of "verbalized" in a separate policy. Given the section 409A rules, however, tax equalization policies should be written since they may include elements of deferred compensation.

Tax Equalization Policies Must Reflect Maximum Allowable Deferral Requirements

As noted above, payments pursuant to tax equalization policies and tax gross-up payments must meet certain definitions and timing requirements in order to not be considered deferred compensation under the section 409A rules. Accordingly, all policies should be reviewed and amended before end of 2008 to reflect these requirements.

Certain Foreign Plans Must Be Reviewed

Broad-based foreign retirement plans are generally not subject to the regulations. However, this exception is not applicable for U.S. citizens or permanent residents (greencard holders) who participate in these plans unless certain conditions are met. That is, there is an exception for participation in certain foreign broad-based plans by a U.S. citizen or greencard holder to the extent that the deferrals are non-elective and made from "modified foreign earned income," and the individual is not eligible to participate in a U.S. plan. Accordingly, a review of the participants in the plans should be conducted to determine whether international assignees are participating in the plans and what alternatives are available if exceptions do not apply.

Equity Compensation Plans Should Be Reviewed

Generally stock options are not subject to section 409A. However, discounted stock option plans are subject to these rules. Accordingly, employers should carefully review these plans in view of all participants, including international assignees, to assure that all requirements are continuously met. It is not uncommon for non-U.S. equity plans to include a discount element. Some European Union (EU) employers also have agreements that are essentially restricted stock unit plans. If such plans have U.S. taxpayer participants, the plans need to be reviewed to make sure they meet one of the exceptions or satisfy the section 409A rules.

Conclusion

The changes to section 409A ushered in by the AJCA and subsequent regulations have obliged employers to take a critical look at their deferred compensation plans. The impact has been keenly felt not only by domestic employers doing business only in the United States, but also by multinational employers with international assignment programs. With tax equalization programs, other types of tax reimbursement arrangements, and foreign plans common for many multinational employers with globally mobile employees, the new rules added more complex dimensions. Such employers should be taking concrete steps to meet their compliance obligations under section 409A. As the rules are nuanced and complex, employers may wish to consider contacting their local tax service providers so that they may better understand where a compliance "gap" exists and what needs to be done to bridge that gap.

Footnote:

1 For other articles on section 409A, see: B. Francis, "International Aspects of Section 409A — a Deadline Draws Near," The Expatriate Administrator 2007-03 (Autumn 2007), and T. Stecher, "U.S. IRS Releases Final Section 409A Deferred Compensation Regulations," The Expatriate Administrator 2007-02 (Summer 2007).

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