Editor: Kevin F. Reilly, J.D., CPA
Imagine this scenario: A foreign multinational sends a senior executive to the United States to become president of its U.S. subsidiary. The executive goes on the payroll of the U.S. company and becomes a U.S. tax resident. He also continues to be the beneficiary through the parent company of various stock options and other nonqualified deferred compensation (NQDC) plans. The foreign parent’s executive compensation plans do not conform with the Sec. 409A rules.
Can Sec. 409A tax and penalize employees if an employer does not itself have a U.S. taxable presence? The short and clear answer is yes. While the regulations under Sec. 409A do provide helpful exceptions to this result, it is clear that U.S. citizens or tax residents and their non- U.S. employers are required to comply with Sec. 409A or be subject to its consequences since the rules apply based upon the U.S. tax status of the employee.
Application of Sec. 409A is not limited to plans maintained in the United States, nor is it necessarily limited to deferred compensation earned for service performed in the United States. Therefore, Sec. 409A can come into play in the case of deferred compensation agreements for either inbound or outbound employees as long as the employee is a U.S. tax resident or a citizen.
The consequences of failure to comply with Sec. 409A rules can be significant. Sec. 409A, in summary, governs tax results of NQDC plans. It covers the manner and circumstances under which elections or agreements to defer compensation can be made and the timing and circumstances under which distributions can be made. Furthermore, the rules provide that an employee participant in any NQDC plan that does not comply with Sec. 409A will be taxed currently upon the deferred income amount when the amount is vested and no longer subject to a substantial risk of forfeiture (Sec. 409A(a)(1)(A)). In addition to the tax, the employee will owe interest and a 20% additional tax (Sec. 409A(a)(1)(B)). The deferred income amount includes any amounts deferred after October 21, 2004, less any amounts previously taxed under Sec. 409A.
The Sec. 409A regulations do provide relief in a number of instances. Regs. Sec. 1.409A-3(h) provides that an NQDC plan will be deemed to meet the requirements of Sec. 409A for the first year that the service provider is considered to be a U.S. tax resident as long as, by the end of the first year that the employee is a U.S. tax resident, the plan is amended to meet the Sec. 409A requirements. This helps in the case of an inbound foreign national who becomes a U.S. tax resident but does not provide relief on the outbound side where a U.S. tax resident or citizen becomes employed by a non-U.S. company.
Regs. Sec. 1.409A-2(c) provides similar relief in the timing of the initial deferral election. Again, this would apply only in the inbound instance because it requires that the election be made by the end of the first tax year that the employee becomes a U.S. tax resident.
Regs. Sec. 1.409A-1(a)(3) defines cases in which certain foreign plans can be exempted based on treaties or on the terms and provisions of the plans. Regs. Sec. 1.409A-1(a)(3)(i) excludes any foreign “scheme, trust, arrangement or plan” from the definition of NQDC if the contributions or other benefits of the plan are excludible by the employee based on a bilateral income tax convention or other mutual agreement. Reporting, however, may be required as a treaty-based return position under Sec. 6114 unless the exception provided by Regs. Sec. 301.6114-1(c)(1)(iv) regarding the taxation of income derived from dependent personal services would be deemed to apply.
Regs. Sec. 1.409A-1(a)(3)(ii) provides an exception for any “broad-based foreign retirement plan” for nonresident aliens, resident aliens (by means of the physical presence test under Sec. 7701(b)(1)(A)(ii)), or bona fide residents of U.S. possessions. Broad-based foreign retirement plans are defined in Regs. Sec. 1.409A-1(a)(3)(v). The requirements are that the plan must be nondiscriminatory; that it must provide significant benefits for a substantial majority of covered employees; that the benefits actually provided are nondiscriminatory; and that the plan provisions include restrictions that generally discourage the use of plan benefits for purposes other than retirement or restrict access to benefits before separation from service. Exceptions to this last requirement are permitted in circumstances in which inservice distributions are permitted for U.S. plans. The plan may meet these requirements either alone or in combination with other plans.
Regs. Sec. 1.409A-1(a)(3)(iii) applies to U.S. citizens and permanent residents who are participants in broad-based foreign retirement plans with additional restrictions that limit contributions and benefits to those required of U.S. plans. The rules also preclude the employee from eligibility for participation in both a U.S. qualified plan and a broad-based foreign retirement plan.
Regs. Sec. 1.409A-1(a)(3)(iv) excludes foreign social security systems from the definition of NQDC plans.
Regs. Sec. 1.409A-1(b)(8) excludes certain foreign plans from the application of Sec. 409A based on the nature of the compensation that is paid to or derived from the foreign plan. Regs. Sec. 1.409A-1(b)(8)(i) provides that the plan is not considered an NQDC plan to the extent that the compensation would have been excluded from the employee’s gross income under the terms of a bilateral income tax convention at the time that the employee had a legally binding right to the compensation or the time the compensation was no longer subject to risk of forfeiture, if later.
Regs. Sec. 1.409A-1(b)(8)(ii) excludes compensation if the compensation would not have been subject to U.S. tax if it had been paid at the time that the employee had a legally binding right to the compensation or the time that the compensation was no longer subject to risk of forfeiture, if later. This exemption applies in four circumstances. First, the compensation is excluded if the service provider was a nonresident alien at that time and if the income would have been considered to be non-U.S. source income under Sec. 872. A second exception is provided for income that is or would have been subject to exclusion as foreign earned income under Sec. 911, but only to the extent that the taxpayer had not utilized the entire foreign earned income exclusion in that year. Note also that additional tax could be due if the additional foreign earned income exclusion were to cause the nonexcluded income to be taxed at a higher marginal rate.
A third exception applies to income that would have been excludible under Sec. 893 for employees of foreign governments or certain other international organizations. The final exception applies to income that would have been excluded under Secs. 931 or 933, which apply to income from Guam, American Samoa, the Northern Mariana Islands, and Puerto Rico.
Regs. Sec. 1.409A-1(b)(8)(iii) provides that a payment pursuant to a tax equalization agreement does not provide for a deferral of income if the payment must be made no later than the end of the second tax year beginning after the tax year in which the employee’s U.S. return (including the compensation on which the equalization is based) is required to be filed. However, if later, the payments can be made by the second tax year of the service provider, beginning after the latest such tax year in which the service provider’s foreign tax return or payment is required to be filed or made.
There is also an additional exception for equalization reimbursements arising from audits or litigation as long as the requirements of Regs. Sec. 1.409A-3(i)(1)(v) are met. This section defines what is required to make a tax gross-up payment a permissible payment excepted from the provisions of Sec. 409A.
Regs. Sec. 1.409A-1(b)(8)(iv) provides a de minimis deferral exception for nonresident aliens working in the United States based on their U.S. source income. The rules permit a deferral not to exceed the elective deferral limit under Sec. 402(g).
Regs. Sec. 1.409A-1(b)(8)(vi) excludes earnings on compensation excluded based on these rules.
Regs. Sec. 1.409A-1(b)(9)(iv) addresses foreign separation pay plans. A foreign separation pay plan is also not considered to provide for deferred compensation as long as the payments under the plan are prescribed by the law of the foreign jurisdiction. These payments can be due to either voluntary or involuntary separation.
Application of Sec. 409A
With such potentially broad exceptions to the general rules, when does Sec. 409A apply in the international context? For outbound U.S. citizens or tax residents, Sec. 409A would apply to a foreign plan on the same basis as a domestic plan unless the plan meets the definition of a broad-based foreign retirement plan or the plan benefits are excludible by the service provider based on a tax treaty. For inbound employees, the same will apply once they are considered to be permanent U.S. tax residents, with the exception that they would be entitled to exclude amounts hypothetically earned under Sec. 409A before becoming a U.S. tax resident under the regulations or the provisions of a U.S. bilateral tax treaty, or both.
For inbound employees or service providers who are treated as U.S. tax residents under the physical presence test, there is the added potential of participation in a broad-based retirement plan without the application of the additional limitations applied to U.S. citizens or permanent residents for this purpose. The greatest exposure would appear to be with inbound service providers who are participants in a foreign plan that does not meet any of the exceptions and who are not fully vested in their plan benefits at the time of becoming a U.S. tax resident. These would run the risk of being taxed under Sec. 409A on accumulations while a nonresident in addition to accumulations post-residency if they become vested while a U.S. tax resident. The best tax planning opportunity in this case would appear to be to ensure that such employees are fully vested before becoming U.S. tax residents and that further vesting is frozen while the employees are U.S. tax residents.
The regulations mitigate the exposure that could have faced international service providers and their employers, but they clearly do not eliminate it. Foreign plans that do not qualify for the treaty or the broad-based retirement plan exceptions are left with few options other than being modified to meet the requirements of Sec. 409A.
Kevin F. Reilly, J.D., CPA, is a member of PKF Witt Mares in Fairfax, VA.
Unless otherwise noted, contributors are members of or associated with PKF North American Network.
For additional information about these items, contact Mr. Reilly at (703) 385-8809 or firstname.lastname@example.org.