Tax Bulletin (October 2005)
Proposed Regulations Clarify
Application of Section 409A to
Foreign Benefit Arrangements
By Mark C.
Jones, a senior associate in
the New York office of Pillsbury Winthrop
Shaw Pittman LLP.
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for links to the text of the proposed regulations,
Notice 2005-1 and section 409A and its legislative
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Proposed Section 409A
Regulations Provide Increased Flexibility
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This article discusses the key provisions of the proposed section 409A regulations applicable to foreign benefit arrangement and related issues raised by the proposed regulations. The proposed regulations clarify, among other things, that certain non-U.S. plans and arrangements and certain arrangements with non-U.S. residents are excluded from section 409A's scope. The proposed regulations also set forth conditions for the exclusion of stock options and stock appreciation rights on foreign stock.
Section 409A's Restrictions on Nonqualified Deferred Compensation Plans
In general, section 409A permits the deferral of taxation on benefits provided under a nonqualified deferred compensation plan only if the plan imposes certain restrictions on the distribution of benefits and the employee makes a timely election as to the form and time of payment. Section 409A defines "nonqualified deferred compensation plan" as "any plan that provides for the deferral of compensation," subject to certain narrow exceptions. Shortly after the IRS issued its initial guidance on the restrictions, benefits practitioners requested clarification on the circumstances in which plans maintained by non-U.S. employers would be considered "nonqualified deferred compensation plans" for this purpose. One concern was that foreign employers with benefit plans covering only a few U.S. taxpayers would be unduly burdened by the requirement to amend their plans for the new rules.
The regulations address this concern and related concerns by carving out certain exemptions from the definitions of "nonqualified deferred compensation plan" and "deferral of compensation." In particular, the regulations exclude the following:
- Plans and arrangements covered by tax treaties, if the contributions to the plan are exempt from U.S. income tax pursuant to the treaty or the compensation deferred would have been exempt at the time the employee first had a nonforfeitable right to the compensation.
- Foreign social security systems, if the contributions or benefits are exempt from U.S. income tax pursuant to a totalization agreement or the contributions are mandated by the foreign jurisdiction.
- Non-U.S. source income, if the employee was a nonresident alien and the compensation deferred would have been exempt at the time he or she first had a nonforfeitable right to the compensation.
- Foreign earned income, if the compensation deferred would have been exempt at the time the employee first had a nonforfeitable right to the compensation, and, when combined with the foreign earned income claimed for the year of vesting, would not have exceeded the maximum exclusion permitted under section 911 (currently, $80,000).
- Foreign funded plans, if contributions to the trust are taxable under section 402(b) of the Code.
- Broad-based foreign retirement plans maintained by a non-U.S. employer, to the extent they cover non-U.S. citizens who are not lawful residents. Otherwise, this exclusion applies only to nonelective deferrals of foreign earned income and only to the extent the deferrals would not exceed dollar limits applicable to U.S. qualified retirement plans under section 415. For this purpose, "broad-based retirement plan" means any written plan that (i) provides significant benefits to a wide range of employees, including rank and file employees, substantially all of whom are nonresident aliens, (ii) limits the ability of employees to withdraw their benefits prior to retirement or separation from service and (iii) provides for payment of a "reasonable level of benefits" at death, a stated age or a change in work status and requires minimum distributions to ensure that any death benefits provided to the employee's beneficiaries are incidental to the retirement benefits provided to the employee.
- Compensation of employees of foreign governments and international organizations, if the compensation deferred would have been exempt at the time the employee first had a nonforfeitable right to the compensation.
- Compensation from certain U.S. territories, including Puerto Rico, Guam, American Samoa and the Northern Mariana Islands, if the compensation deferred would have been exempt at the time the employee first had a nonforfeitable right to the compensation.
- Tax equalization arrangements, if the payment is made by the end of the second calendar year after the calendar year in which the employee's U.S. federal income taxes are due and the payment does not exceed the difference between the foreign taxes actually imposed on the employee's compensation and the amount that would have been due under the U.S. federal income tax.
- De minimis amounts contributed by a nonresident alien to a plan maintained by a non-U.S. employer, to the extent the amounts deferred do not exceed $10,000 per year.
Foreign Funded Plans
Participation in a foreign funded plan is not subject to section 409A. As a nonqualified plan funded with a nonexempt trust, taxation of participants is governed by section 402(b) of the Code.
Incoming Resident Aliens
Benefits practitioners also asked the IRS to clarify how section 409A would apply to employees who were not U.S. residents when they initially earned or vested in the compensation deferred but became U.S. residents before the benefits were distributed. The concern was that the deferred amounts would become immediately taxable under section 409A when the employee became a resident of the United States because the plan or the employees' election was not required to meet the statutory requirements at the time of deferral.
The proposed regulations provide relief for this situation by allowing employers to amend their plans for section 409A as late as December 31 of the year in which the employee is first classified as a resident alien. The employee also has until December 31 of the year in which he or she becomes a U.S. resident to make a deferral election as to compensation on services performed for that year and as to deferred amounts that are still subject to a substantial risk of forfeiture as of January 1 of that year.
Options and SARs on Foreign Securities
In its initial guidance under section 409A, the IRS stated that nonqualified stock options and stock appreciation rights (SARs) would not be considered "deferred compensation" if the exercise price could never be less than the fair market value of the underlying stock at the date of grant and certain other requirements were met. If the stock is readily tradable on an established securities market, then "fair market value" for this purpose is to be determined by the stock's trading price. Benefits practitioners asked for clarification as to how this exemption might apply to options and SARs on American Depository Receipts (ADRs) and securities traded on a foreign exchange.
The proposed regulations clarify that the exemption for nonqualified stock rights applies to options and SARs on ADRs if the other criteria of the exemption are met. They also clarify that a foreign national securities exchange is considered to be an "established securities market" for purposes of determining the fair market value of the underlying stock as long as the exchange is officially recognized, sanctioned or supervised by governmental authority.
To qualify for exemption under the initial guidance, the exercise price of options and SARs on stock readily tradable on an established market had be based on the closing price of the underlying stock on the trading day before or the trading day of the date on which the stock right was granted, last sale before or the first sale after the date of grant, or any other reasonable basis using reported transactions. It was noted that these methods would conflict with laws in certain foreign jurisdictions that require the exercise price of compensatory options to be based on an average of the underlying stock over a period of time in order to receive favorable tax treatment. To allow compliance with these requirements, the proposed regulations provide that employers may comply with the exemption for options and SARs if the exercise price is based on an average of the price of the underlying stock over a specified period, as long as the period falls within 30 days before and 30 days after the date of grant, the terms of the grant are fixed before the beginning of the measurement period, and the same valuation method is used consistently for all grants of stock rights.
In addition to imposing income and penalty taxes on certain deferred compensation benefits, section 409A imposes income and penalty taxes on any assets set aside in an offshore trust to pay for deferred compensation benefits. The proposed regulations do not cover these provisions. The IRS has promised to address them in later guidance.
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