On January 8, the Internal Revenue Service (IRS) issued interim guidance on the application of recently enacted Section 457A of the Internal Revenue Code. Section 457A imposes immediate taxation, and in certain circumstances a 20 percent penalty plus interest, on deferred compensation arrangements maintained by certain partnerships and corporations.
Congress enacted Section 457A as part of the Tax Extenders and Alternative Minimum Tax Relief Act of 2008 to assist in offsetting the costs of the bailout legislation. Provisions of Section 457A were originally targeted at U.S. managers of offshore hedge funds. The aim was to eliminate tax deferrals received on offshore hedge funds maintained in tax favorable jurisdictions. However, Section 457A has much broader application.
Section 457A provides that deferred compensation under a "nonqualified plan of a nonqualified entity" will be includible in the U.S. taxpayer's gross income at the time that the compensation is no longer subject to a substantial risk of forfeiture. Section 457A can apply to a U.S. taxpayer who receives deferred compensation from a foreign employer, as well as a nonresident alien with an existing deferred compensation arrangement who becomes a U.S. resident.
Deferred compensation that would be subject to Section 457A, except that it is attributable to services performed before January 1, 2009, will be included in gross income in the later of (a) the last taxable year beginning before 2018 or (b) the taxable year in which there is no longer a substantial risk of forfeiture to the amounts deferred. Under Section 457A the amount is taxable when the amount becomes determinable and, at the time, is subject to an additional 20 percent tax and an interest charge.
Nonqualified Deferred Compensation Plans
Notice 2009-8 provides interim guidance on the application of Section 457A to nonqualified compensation plans of nonqualified entities. Section 457A provides that any that compensation that is deferred under a "nonqualified compensation plan" or a "nonqualified entity" is taxable when there is no substantial risk of forfeiture of the rights to such compensation.
The definition of "nonqualified deferred compensation plan" for Section 457A purposes has the same meaning as set out in IRC Section 409A and the interim guidance includes a number of rules that coordinate the application of IRC 457A with IRC 409A when both sections are applicable. Notice 2009- 8 sets out several scenarios and answers several questions on the interplay between Section 409A and Section 457A. However, there are differences in the scope and application of Section 457A.
Application of Section 457A to Equity and Equity Appreciation Rights
Section 457A applies to any deferred compensation that is attributable to services performed by a U.S. taxpayer after December 31, 2008, and has a wider scope than Section 409A. Section 457A generally applies to the same arrangements subject to IRC 409A, however Section 457A also includes a right to receive cash compensation based on stock appreciation rights and other equity units, which are not subject to IRC 409A.
Notice 2009-8 provides that the deferred compensation provided by a foreign employer or other
Plans that "provide a right to compensation based on the appreciation in value of a specified number of equity units of the service recipient" are subject to Section 457A. However, there are exceptions. Notice 2009-9 provides that (i) certain stock appreciation rights and nonstatutory stock options on service recipient stock and (ii) incentive stock options will not be subject to Section 457A.
Definition of Short-Term Deferrals
The interim guidance excludes "short-term deferrals" but defines this term differently that applied in Section 409A. Section 457A does not treat compensation as deferred if the service provider receives payment of the compensation within 12 months after the end of the first taxable year of the service recipient during which the right to payment of the compensation is no longer subject to a substantial risk of forfeiture.
Under Section 457A's short-term deferral rule, if a service provider's right to payment from a calendar year service recipient is no longer subject to a substantial risk of forfeiture on December 31, 2009, a deferral until December 31, 2010 ,will not cause the payment to be subject to Section 457A.
Section 457A applies only to nonqualified deferred compensation plans of "nonqualified entities." Under the interim guidance, a "nonqualified entity" includes:
(1) any foreign corporation unless substantially all of the foreign corporation's income is (A) effectively connected with the trade or business in the United States, or (B) subject to a comprehensive foreign income tax; and
(2) any partnership unless substantially all of its income is allocated to persons other than (A) foreign persons with respect to whom such income is not subject to a comprehensive foreign income tax, and (B) organizations which are exempt from tax under the Internal Revenue Code.
Notice 2009-8 provides that deferred compensation provided by a foreign employer or other service recipient is not subject to Section 457A if:
(1) the foreign corporation is a resident in a jurisdiction that is subject to a comprehensive income tax treaty with the United States (excluding Bermuda and the Netherlands Antilles);
(2) the foreign corporation is not taxed by the foreign corporation's country of residence under any arrangement that is materially more favorable than the corporate income tax otherwise generally imposed by such country; and
(3) the foreign corporation must not be based in a country wherein the aggregate amount of nonresident source income for the foreign corporation that is excluded for the relevant tax year exceeds 20 percent of the gross income of the foreign corporation.
Under the interim guidance, the determination of whether a corporation is a nonqualified entity is made as of the last day of each of the service provider's taxable years in which the deferred compensation is no longer subject to a substantial risk of forfeiture. Accordingly, under Section 457A, the foreign corporation will have to confirm that all of the conditions are satisfied for each taxable year the deferred compensation is not subject to a substantial risk of forfeiture. This is a difficult standard and it is noteworthy that the determination is made under U.S. federal income tax principles, although the entity many have no connections to the US, other than employing a U.S. taxpayer.
Next Steps and Action Points
The application of IRC Section 457A should be a concern for employers that operate through any non-U.S. entities and have employees or other service providers that are U.S. taxpayers.
Corporations (foreign and domestic) as well as partnerships, should confirm whether they are "nonqualified entities" and if they are, whether they maintain nonqualified deferred compensation plans that are subject to IRC Section 457A.
Notice 2009-8 provides transitional relief to employers and provides a limited grandfather rule available to service providers that have a deferred compensation arrangement in place that is conditioned upon the future of substantial services after December 31, 2008. The Notice gives employers an opportunity to amend deferred compensation agreements in writing by July 1, 2009, to accelerate the vesting of the deferred compensation benefits retroactive to December 31, 2008 to avoid the tax penalty and consequences of Section 457A.
An opportunity currently exists for employers that are subject to IRC Section 457A to review and identify any arrangements, contracts or agreements that may fall within the parameters of Section 457A and make necessary written amendments before July 1, 2009 to accelerate the vesting of the deferred compensation benefits retroactive to December 31, 2008, in order to avoid the application of immediate income taxes for U.S. taxpaying employers under Section 457A. The guidance also permits employers to change the time and form of payment of deferred amounts attributable to services performed before January 1, 2009, provided that payment is made no later than December 11, 2011.