The law of unintended consequences: international implications of section 409A.

The American Jobs Creation Act of 2004 (AJCA) contains a set of provisions--new section 409A of the Internal Revenue Code (1)--designed to clamp down on perceived shortcomings and abuses surrounding the taxation of nonqualified deferred compensation arrangements for corporate executives and other individuals. Prior to the legislation, funded nonqualified deferred compensation arrangements were taxed as they vested, but unfunded arrangements were only taxed when amounts were actually or constructively received, typically much later. Section 409A imposes stringent requirements on unfunded arrangements as the price of permitting continued deferral under the constructive receipt rules; otherwise they will be taxed like funded arrangements, that is to say, upon vesting, and subjected to hefty penalties. Additional provisions penalize certain kinds of quasi-funding, that is, through certain types of offshore trusts or through provisions triggering funding if the employer's financial condition deteriorates.

On its face, this legislation addresses classic domestic taxation issues, with only a tangential international aspect related to parking funds in offshore trusts. But in the morning-after light, the breadth of the provision touches many cross-border situations that may not have been in the original sights. IRS guidance and, possibly, technical corrections may eventually clarify the situation. Until then, it is important to explore the potential international scope of section 409A, including the effect of our international tax treaties.

The Four Corners of Section 409A and How It Came To Be

1. Background

"Deferred compensation" generally refers to an arrangement to pay an employee for services well after the services are performed. The tax dynamics are driven by the cash-basis accounting method of individuals (somewhat constrained by matched deduction rules for employers). "Qualified" versions of deferred compensation, such as pension and profit sharing plans, are covered by extensive statutory and regulatory provisions which provide special tax benefits. The taxation of nonqualified deferred compensation has to date been governed by general principles of taxation, sections 61, 83, 402(b), 404(a)(5), and 451 of the Code, and a handful of IRS pronouncements). (2) The basic thrust of these rules in unfunded situations was:

* An employer's "mere promise to pay" future compensation was not currently taxable to the employee. Rather, the employee was only taxed upon actual or constructive receipt (3) of the promised funds (or if "economic benefit" or "cash equivalents" were received). Book "interest" accruals or investment earnings credits were permitted, as long as the arrangement remained unfunded and unsecured.

* Any election to defer compensation had to be entered into before the relevant services were rendered.

* A provision allowing the employee to accelerate payment did not cause the deferred amount to be taxable ab initio if there was a meaningful "cost" to the employee to elect accelerated payment, such as a reduction in the amount payable ("haircut"), or a period of suspended participation. Nor did a provision permitting early distribution for unforeseeable emergencies ("hardship" exception).

* If any other elections could be made by an employee subsequent to the beginning of the service period, the plan had to set forth substantial forfeiture provisions that remained in effect throughout the deferral period.

The IRS guidance was overlaid by a few cases, which suggested the following glosses:

* Taxation of deferred compensation could be further deferred from its original payment schedule (or the form of payment changed) after the underlying services had been performed, if the agreement to defer was entered into more than a de minimis period before the first payment was due. (4)

* Early distributions conditioned upon employer consent might be permissible, if consent was not a "rubber stamp." (5)

If the promise to pay future compensation was funded with property (for example, employer stock) or other forms of security, the benefits of deferral were lost. Instead, taxation occurred under section 83 upon vesting (the absence of "a substantial risk of forfeiture") or earlier transferability. Section 83 is a codification of the "economic benefit" doctrine. The same "tax-on-vesting" concept applies to contributions to a nonqualified employees' trust, under section 402(b).

In 1978, the IRS attempted, by regulation, to restrain the use of elective salary reduction arrangements by taxing elective nonqualified deferrals at the time of deferral, even if subject to a substantial risk of forfeiture. Congress snuffed this out by freezing the law of private deferred compensation plans in place with the principles set forth in regulations, rulings, and judicial decisions in effect immediately before the publication of Prop. Reg. [section] 1.61-16. (6)

A key subsequent development was the growth of "rabbi trusts" and similar arrangements. These arrangements pushed the envelope on ways to secure deferred compensation without crossing the line of "funding" for either tax or ERISA (7) purposes. In its simplest form, a rabbi trusts sets funds aside to satisfy eventual deferred compensation liabilities safe from the reach of the employer or its creditors except in the case of bankruptcy or insolvency. Sometimes rabbi trusts are established on a revocable or less than fully funded basis that "springs" into more secure or funded status upon specified events, such as an impending change of control or a defined financial or economic event.

Deferred compensation arrangements came into the spotlight in the wake of the Enron debacle and subsequent corporate unravellings. The Senate Finance Committee's Enron report detailed the executives' deferred compensation plans and the fact that many were able to cash out their deferred benefits--albeit with a 10-percent haircut, a 3-year suspension, and a requirement for committee consent--as the ship was sinking, and recommended significant changes to the tax treatment of deferred compensation plans. (9)

2. Section 409A

This attention culminated in the passage of section 409A in October 2004. (10) Section 409A circumscribes the universe of permitted deferrals by lopping off the flexible features that taxpayers found attractive but Congress (spurred by the IRS) found unpalatable. Section 409A taxes unfunded deferred compensation as it vests--together with an interest charge for the benefit of deferral and a 20-percent penalty--unless strict requirements are satisfied. Put another way, the new price of obtaining deferral is adherence to a very structured, inflexible and monovisual arrangement. The first four rules below are referred to in the statute as "rules relating to constructive receipt"; the last two are called "rules relating to funding."

* Limited Distribution Events. Distributions may not be made prior to the earlier of separation from service, unforeseeable emergency, disability, death, change in ownership or control of the employer (to the extent prescribed, probably narrowly, in regulations), or a specified date or schedule--not a named event--that is fixed in the plan at the time of deferral. For key employees of publicly traded companies, distributions cannot be made until six months after separation from service (Enron, anybody?!).

* No Acceleration of Payments. The time or schedule of payments may not be accelerated by either the employee or the employer except as provided in regulations. Regulatory relaxation is expected to be very limited. (11) Farewell to haircuts.

* Timing of Initial Deferral Election. Deferral elections must be made before the year in which the services are performed (or within 30 days of initial eligibility for the plan), except as otherwise provided in regulations. For performance-based compensation relating to services performed over a year or more, the election may be made no later than six months before the end of the service period.

* Restrictions on Subsequent Payment Elections. Subsequent elections to delay or change the form of payment (a) may only take effect at least 12 months after the initial election, (b) must be deferred for at least five years from the date payment would otherwise have been made (except for disability, death, or hardship), and (c) in the case of scheduled payments, must be made at least 12 months before the first scheduled payment.

* No Use of Offshore Trusts. Placing assets in an offshore trust is treated as the transfer of property triggering immediate taxation (as vested) regardless of whether the assets are available to satisfy claims of general creditors (i.e., offshore rabbi trusts are not permitted). Moreover, subsequent earnings or increases in value are taxed annually (to the extent vested). This rule does not apply to assets located in a foreign jurisdiction if substantially all of the services to which the nonqualified deferred compensation relates are performed in such jurisdiction. (12) There is also regulatory authority to create exceptions for arrangements considered non-abusive.

* No Triggers Based on Employer's Financial Health. A plan provision for springing restrictions on trust or employer assets in the event of a change in the employer's financial health is similarly treated as the transfer of property triggering immediate taxation (as vested) at the date on which the plan so provides or, if earlier, the date on which assets are so restricted. Subsequent earnings or growth are taxed annually.

The legislative history provides a further caveat that purported risks of forfeiture must be real to defer taxation. (13) Q&A-10(b) of Notice 2005-1 incorporates one such rule, ignoring risks of forfeiture in certain cases where the employee owns a significant amount of employer stock.

Enforcement of the new rules is bolstered by onerous tax consequences to the employee in the event of violation: not only is the purported deferral ignored and currently taxed, but imputed interest and a 20-percent penalty are tacked on. The same is true for transfers caught by the funding restrictions--continuing annually for earnings and increases in value if the assets remain set aside in a trust or other proscribed arrangement. Employers will undoubtedly be very sensitive to the risk of exposing a key employee to these consequences.

Section 409A is effective for amounts deferred after December 31, 2004. "Deferred," in this context, means deferred and vested after that date. Thus, amounts deferred before 2005 but not yet vested are subject to section 409A. Moreover, any "material modification" to an otherwise grandfathered plan eliminates the grandfathering.

Of real potential consequence from an international perspective, a pending technical correction would clarify that the grandfather rule does not apply to the section 409A funding requirements, thereby effectively requiring offshore trusts to be "brought back" (physically or by taxation) as of January 1, 2005. (14)

The early effective date and broad scope of section 409A have resulted in intense review of the myriad corporate benefits that do or may fall under the rubric of nonqualified deferred compensation. In December 2004, the IRS quickly issued detailed guidance on some aspects of the rules (Notice 2005-1), focusing on the coverage of the statute and implementation of its effective date. Taxpayers are given until December 31, 2005, to amend plans without triggering section 409A penalties, and are offered a variety of escape hatches during 2005 to avoid continuing subjection to the new regime. This initial guidance contains no provisions directly addressing international issues. More comprehensive substantive guidance is expected later this year. This article does not address the many interpretative issues that remain outstanding under section 409A in general.

The Fifth Corner--International Implications

Section 409A arose in the context of perceived excesses of deferred compensation arrangements in the United States. The only explicit international tinge is the prohibition on certain offshore transfers of funds, designed to foil arrangements that effectively, though not in form, shield assets benefiting U.S. taxpayers from the claims of domestic creditors. (15) The congressional materials do not evince any consideration of implications for foreign employers with employees in the United States or for globally mobile individuals with periodic stints of U.S. employment. Reflection on the new provisions, however, identifies serious international implications.

1. Covered Arrangements

Underlying these implications is the breadth of the threshold definition of nonqualified deferred compensation covered by section 409A. The general concept embraces compensation payable in a year after the employee has a "legally binding right" to it, unless it has already been actually or constructively received and included in gross income. (16) Objective conditions or formulae that could reduce or eliminate the compensation (e.g., those that create a substantial risk of forfeiture) do not keep a right from being legally binding, though discretionary provisions (which frequently are more illusory than real) may.

Specific exclusions include qualified employer plans (e.g., under section 401), bona fide vacation leave, sick leave, comp time, disability pay, death benefit plans, medical reimbursement arrangements, transfers of restricted stock and other property, most types of stock options, and certain stock appreciation rights (SARs) of public companies. Short-term deferrals, where payment occurs within 2-1/2 months after the end of the year in which the amount becomes vested, are not covered, pending further guidance. (17)

Beyond those exceptions, section 409A applies broadly to salary reduction plans, supplemental employee retirement plans (SERPs), parachute payments, phantom stock plans, severance plans, insurance commissions, discounted stock options, certain SARs, non-excluded fringe benefits, etc. Some less obvious types of compensation that may fall within section 409A include promises to reimburse an executive for future financial planning expenses or tax return preparation costs, certain indemnification agreements, and relocation make-whole agreements. (18) The rules are not limited to employer-employee arrangements, but also cover arrangements between a service recipient and an independent contractor or between a partner and a partnership. (19) The issuance of stock or (for the moment) partnership interests in exchange for services, however, is not covered by section 409A, apparently deferring to existing section 83 rules. (20) Similar deference--discussed below--applies to contributions to employee trusts taxed under section 402(b). (21)

2. Amplification of Errors

A troubling aggregation rule considers all deferred compensation arrangements of an individual to be a single plan for purposes of section 409A, divided only between account balance (i.e., defined contribution type), nonaccount balance (i.e., defined benefit type), and other (e.g., equity-based) plans. (22) This means that a foot fault with respect to a small perk can trigger a section 409A avalanche for much larger plans of the same type. (23)

3. Regulatory Authority

Section 409A(e) directs the Secretary to prescribe regulations as necessary or appropriate to carry out the purposes of the section, including exempting arrangements from the application of the funding restrictions "if such arrangements will not result in an improper deferral of United States tax and will not result in assets being effectively beyond the reach of creditors."

In analyzing the international implications of section 409A, there are different ways to slice the issues--by type of individual, type of plan (funded or unfunded, qualified-type or nonqualified-type), type of employer, or place of services--and overlap is inevitable. The discussion below is divided between U.S. citizens and residents (USCRs) on the one hand, and nonresident aliens (NRAs) on the other, with interior breakdowns.

U.S. Citizens and Residents

USCRs are generally subject to the U.S. tax regime with respect to their worldwide income, regardless of source. (24) Section 409A compliance issues may be particularly challenging for USCRs working for foreign employers, whether in the United States or abroad.

1. Funded Plans

USCRs working for foreign employers (or U.S. subsidiaries of foreign companies) frequently participate in foreign retirement plans or other employee benefit arrangements funded through a trust or other secured arrangement. Even if a trusteed plan is locally "qualified" (i.e., a type of broad employee plan preferred under tax and other laws of the employer's foreign jurisdiction), it will not be covered by the section 409A exclusion for U.S.-qualified employer plans since a foreign trust generally is involved. (25) The only exception would be if the foreign plan in fact meets all of the U.S. qualification requirements apart from the requirement of a U.S.-situs trust (26)--a rare case.

Nevertheless, foreign employees' funded plans, particularly qualified-type ones, may turn out to be the easiest foreign arrangements, relatively, to wrest from the grasp of section 409A.

* No "Deferral of Compensation"? In a perverse turn of the screw, escape may lie in the fact that these plans have always been subject to the U.S. tax rules for nonqualified funded plans found in section 402(b) for employees' trusts and section 83 for transfers of restricted property. (27) Under these rules, the USCR participant (absent treaty protection, discussed below) is taxed as vested transfers or contributions are made or as the participant's interest vests.

In addition, in the case of an employees' trust, section 402(b)(4) will annually tax "highly compensated" participants on the increase in value of their vested interests, if the plan's coverage is not sufficiently non-discriminatory. (28) Employees who are NRAs with no U.S.-source earned income are excluded from the coverage computations. (29) Thus, whether a USCR participant's accruals will be taxed annually depends on the precise configuration of the plan as to the type, compensation level, and number of other employees covered (if any). If subsequent earnings are not taxed currently, they will be picked up in income on later distributions pursuant to the section 72 annuity rules. Post-vesting appreciation of section 83 restricted property is handled under the capital gain rules, with no annual taxation risk.

The key point here is that because the USCR's interest in the main is already being taxed as it vests, section 409A probably does not apply. Q&A-4(e) in Notice 2005-1 seems designed to exclude section 83 and 402(b) transfers from the "deferral-of-compensation" concept, and hence from section 409A coverage, though the language is somewhat indirect. (30) Exclusion is supported by the statutory premise that section 409A only captures vested deferrals of compensation "not previously included in gross income," (31) and contributions to these plans are, at worst, being taxed simultaneously. The logic of excluding from section 409A arrangements that are already subject to tax-as-vest rules is undeniable. Since the objective of section 409A is to impose a tax-as-vest regime on targeted arrangements, there is no point in superimposing it on arrangements already governed by such a regime. (32)

Even if the deferrals themselves are outside of section 409A, a technical question remains whether accumulated earnings under the plan (apart from currently taxed section 402(b)(4) amounts) or appreciation in the value of restricted property are similarly protected. Ceding jurisdiction to all facets of the long-established taxation framework for nonqualified employee trusts and restricted property seems both logical and practical. Notice 2005-1, Q&A-4(f), which ties references to deferrals to references to the attributable income, embodies an analogous principle. Indeed, the effective date provisions of section 409A literally protect these earnings: "The [new provisions] shall apply to earnings on deferred compensation only to the extent that [the new provisions] apply to such compensation." Since the stakes are high--annual taxation, plus 20-percent penalty and interest--confirmation of this point is sorely needed. (33)

* No Bad Offshore Trust? Characterizing foreign funded plans as not involving the deferral of compensation is also crucial to avoiding the second weapon of section 409A--the penalty-added taxation of vested assets set aside in an "offshore" trust "for purposes of paying deferred compensation under a nonqualified deferred compensation plan." (34) Section 409A(b)(3) also taxes (with penalty) the annual increase in value or earnings of such assets. The significance of this issue is underscored by a pending technical correction that would, in effect, retroactively subject assets held in a covered foreign trust to taxation under section 409A. (35) Moreover, the statutory language is not literally limited to rabbi trusts, but applies "whether or not such assets are available to satisfy claims of general creditors." This sets up an excruciating tension between the section 402(b) rules (which tax on vesting and, in certain cases, on subsequent accruals) and the section 409A rules (which tax and impose a 20-percent penalty on vesting and on all subsequent accruals), absent a clear rule ceding exclusive jurisdiction to section 402(b). (36)

Separately, the clutches of the offshore funding rules can be avoided if "substantially all the services to which the deferred compensation relates" are performed in the same foreign jurisdiction in which the trust is "located." This escape route may not be available if the individual has worked in other countries for this foreign employer. Centralized asset management by multinational corporations or use of an out-of-country trust to hold assets for local law reasons under standard local practice may also hit a dead end.

The IRS has statutory authority to prescribe regulations exempting arrangements from the funding rules on the basis that there is no improper deferral of U.S. tax and placement of assets effectively beyond the reach of creditors. Situations like this, where the employee benefit trust is intended to be insulated from creditors as a matter of public policy (e.g., a qualified-type plan) or comports with standard business practices, would seem good candidates for regulatory largesse.

* Potential Treaty Protection? To the extent problems remain under section 409A--or to preclude up front the need to consider section 409A--treaties may help. For example, the U.S.-U.K. treaty (Article 18) generally precludes U.S. taxation of U.K. contributions for U.S. employees, or accruals thereon, under competent authority-approved "pension schemes" until distributed. Such "pension schemes" are generally understood to correspond to qualified-type plans. (37) For an employee working in the United States, contributions must have been made to the plan before he begins employment in the United States, limiting the benefit to U.S. "visitors." (38) Although the treaty contains a caveat that the treaty relief cannot exceed the relief that the United States would allow to U.S. residents for contributions/benefits for pension schemes established in the United States, the section 409A exception for qualified employer plans should provide the appropriate analogue. Subject to these limitations, the U.S.-U.K. treaty seems tailor-made to protect USCRs participating in U.K. qualified-type plans from the application of either section 402(b) or section 409A. Similarly broad provisions can be found in the U.S.-Netherlands treaty (2004 protocol).

U.S. treaties with several other countries have provisions along similar lines, though more limited in certain respects. Among the affected treaties are those with Canada, France, Italy (pending), Ireland, South Africa, and Sweden.

The only question is whether section 409A somehow overrides contrary treaty provisions. There is no evidence of such an intention, absent which it is arguable that the treaty cannot be overridden. (39) Section 7852(d) was amended in 1988 to provide that "neither the treaty nor the law shall have preferential status by reason of its being a treaty or law"; section 894(a) was amended at the same time to eliminate priority for treaty obligations and to provide instead that the Code "shall be applied to any taxpayer with due regard to any treaty obligation of the United States which applies to such taxpayer." This situation leaves open the need to review the intent and policy objectives of section 409A and the pertinent treaty provisions, if rescue by the latter is needed. At least in the newer, more sophisticated treaty settings, section 409A should be readily reconcilable with the treaty protections.

Certainly treaty provisions of the above sort have the potential to alleviate section 409A concerns. But such provisions are not yet widespread and in any event do not cover non-qualified-type employee benefit arrangements. Accordingly, the interaction between section 409A and the Code's other tax-on-vest rules remains pivotal.

To the extent concern remains about the application of section 409A to foreign funded plans, the plans should be reviewed for compliance with the section 409A rules. Some possible tripping points with respect to the distribution/ acceleration/election restrictions are: elections of form or timing of payment at the time of retirement, rather than as the services are rendered; distribution of benefits on "events" such as plan termination; in-service distributions in certain circumstances; and distribution timing for key employees. The "location" (residence?) of the trust must be compared with the individual's work place(s) to assess the risk posed by section 409A's funding rules (pending further IRS guidance). Individuals working in the United States have the greatest exposure.

2. Unfunded Plans

Unfunded deferred compensation arrangements attributable to the USCR's services will almost certainly be subject to section 409A for accruals or vesting after 2004, if not covered by generally applicable exemptions such as for certain welfare benefits, stock options and short-term deferrals. And failure of the section 409A requirements is certainly possible, absent corrective action. Trip wires could include: the tying of plan payments to elections under foreign qualified-type plans (an impermissible election or event-based distribution under section 409A (40)); employer discretion to adjust the timing of payments; acceleration provisions; or subsequent payment elections.

Section 409A captures a wide range of unfunded plans and employer promises, and a flaw with respect to a minor benefit, such as deferred payment of fringe benefits, could pull down larger ones under the aggregation rule. Corrective steps may be constrained if the plan primarily affects non-U.S. persons. While the legal issues are the same as when working for a U.S. employer, the practical difference is that the foreign employer may either be unaware of section 409A or have little interest in complying with it for a few employees.

Treaty protection for unfunded benefits, which are probably not qualified-type arrangements, may also be less likely, though the contours of the pertinent "pension" definition may vary. (41) Thus unfunded foreign plans for USCRs must be reviewed with the same thoroughness as U.S. nonqualified arrangements.

3. Equity-Based Deferred Compensation

Certain kinds of stock options and SARs are exempt from section 409A. These exemptions, however, turn on requirements that need to be evaluated carefully if foreign equity is used. For example, nonstatutory stock options are exempt only if the exercise price at least equals or exceeds the fair market value of the underlying stock on the grant date. Although Notice 2005-1 states that reasonable valuation methods may be used for this purpose, this may not cover foreign plans that, by local law or practice, use multi-day averages.

SARs have similar pricing requirements; moreover, the employer stock involved must be traded on an "established securities market," and only such stock may be delivered in settlement of the right upon exercise. The acceptability of trading on foreign exchanges, and the ability to deliver ADRs, have not yet been addressed by the IRS, although favorable analogies exist in other tax contexts. (42)

4. Persons Becoming USCRs

The United States exercises its taxing jurisdiction on residents regardless of their source of income. Accordingly, once an NRA becomes a USCR, he or she must worry about the application of section 409A to vested accumulations (or ongoing vesting or funding) under pre-existing foreign deferred compensation arrangements--even if derived from services rendered outside the United States while an NRA--since the previously vested amounts were not subject to U.S. tax. Arguably, however, at least with respect to funded arrangements, the NRA should be considered to have effectively included the vested amounts in gross income even though he or she was not taxed thereon, since section 402(b), for example, directs that vested amounts "shall be included in the gross income of the employee...." (One would need to take a similarly broad reading of the exception in Notice 2005-1 for transfers "subject to [section] 83, [section] 402(b) or [section] 403(c).") This is an intriguing conceptual issue that merits clarification by the IRS.

In any event, the section 409A effective date rules would grandfather pre-2005 vested accruals, and subsequent earnings thereon, absent a material modification of the arrangement.

A newly minted USCR will also have a non-section 409A-related concern about the taxation of ultimate distributions from such arrangements, whether or not earlier vested or funded. (43)

Unless the IRS grants administrative relief for situations like this, it may be impossible to correct prior elections to comply with section 409A and difficult to otherwise tune up the foreign plan. Treasury personnel have described this as a "most sympathetic situation" for consideration of relief, (44) because it involves non-U.S.-source compensation for services that would not have been taxed here when deferred. The situation certainly does not involve the legislatively-targeted opportunities to manipulate deferral.

Non-Resident Aliens

The threshold issues are different for NRAs. The problematic situations involve nonqualified deferred compensation attributable to services rendered in the United States by an NRA. (45)

1. Basic Taxation Rules

Absent treaty protection for independent or dependent personal services, NRAs are taxable in the United States for a taxable year on: (1) U.S.-source income received that is not effectively connected with a U.S. trade or business, via 30-percent withholding (pursuant to section 871(a)(1)); and (2) income from any source that is effectively connected with a U.S. trade or business, if the NRA is engaged in a U.S. trade or business during such taxable year, via net basis taxation (pursuant to section 871(b)).

Under this structure, one must start with section 871(b). Rendering personal services in the United States generally constitutes a U.S. trade or business (Treas. Reg. [section] 1.864-2(a)). (46) Moreover, section 864(c)(6) provides that in the case of income taken into account for one year that is attributable to services in another year, the determination of its taxability under 871(b) shall be made as if such income were taken into account in such other year and without regard to the requirement that the individual be engaged in a U.S. trade or business during the current year. In short, the NRA individual will incur U.S. taxation on such income under section 871(b) simply because the services were rendered in the United States, even if he or she is not rendering U.S. services in the current year.

The time for taxing deferred compensation is determined in the first instance under the regular provisions such as section 61, 83, 402(b), 451, or 457(f), subject to acceleration if section 409A is violated. The income amounts potentially taxable under any of those sections will constitute section 871(b) effectively connected income taxable here in the pertinent year if the underlying services were rendered in the United States. (47) The distinction between funded and unfunded arrangements will simply affect the timing of the income inclusion as well as the applicability of section 409A (e.g., tax-as-vest exception), as for any U.S. taxpayer. Thus, the rules of section 409A must be reviewed and followed to avoid accelerated taxation of the NRA in the year such amounts become vested, regardless of his or her U.S.-related status during that year. The effective date provisions of section 409A should protect pre-2005 vested accruals.

2. Treaty Exceptions

Of course, treaty provisions with respect to dependent or independent personal services may trump these rules. For example, if the NRA worked for a foreign employer that did not have a U.S. permanent establishment or fixed base and the NRA was present in the United States for less than 183 days in the year in which the services were rendered, most U.S. treaties will exempt from U.S. tax the income from such services. This exemption should include deferred compensation attributable to the income as well. (48) Compensation (including deferred compensation) for independent (non-employee) personal services is subject to source-country taxation under most treaties only if the individual has a fixed base in that country regularly available for performing his or her services. (49) These treaty provisions considerably reduce the reach of U.S. taxation in the NRA context.

If compensation for the underlying services is not so exempted, one other possibility is the typical provision in U.S. treaties that pensions are to be taxed only by the country of residence. To the extent deferred compensation falls into the pertinent "pension" definition, (50) section 409A would be trumped (absent a treaty override). Many kinds of nonqualified deferred compensation, however, would not be covered by such definitions. Thus, treaty protections for pensions may be of limited assistance in this context.

3. Implications

Absent treaty protection, NRAs must review any deferred compensation arrangements derived from U.S. services that remain unvested as of December 31, 2004, or accrue thereafter. If the deferred compensation is provided by a foreign employer, the same analysis discussed above for USCRs (differentiated between funded and unfunded arrangements) would apply. If the deferred compensation is provided by a U.S. employer, the situation will be identical to that for purely domestic situations, including the exclusion for U.S. qualified plans. Allocations may be needed if the deferred compensation relates to a mix of U.S. and foreign service.

The need to undertake this daunting task may well be one of which potentially affected NRAs are unaware. Importantly, section 409A imposes information reporting and withholding requirements on the NRA's employer, whether U.S. or foreign. (51) Complicated foreign tax credit situations abroad could also arise.

Squaring the Corner--Putting the Genie Back in the Box

The most inequitable situations noted above involve foreign qualified-type plans benefitting USCRs, or NRAs who later become USCRs, to the extent not exempted by reason of the tax-on-vesting feature or applicable treaty provisions. The most nettlesome practical problems are related to foreign unfunded plans benefiting USCRs and any plans benefiting NRAs with respect to U.S. services.

1. IRS Help

The only explicit statutory opportunity to resolve these issues is in the context of the offshore trust funding provisions, if either substantially all the benefited services are foreign or the situation is ultimately determined in regulations not to "improperly" defer tax. This may help at the fringes, but foreign employer usage of foreign trusts is not the biggest problem, given the pre-existing taxability of most such structures. Most important is to confirm that arrangements subject to the tax-as-vest provisions of sections 83 and 402(b) are not covered by section 409A, and to clarify that earnings are exempt if the underlying deferral is not covered. It would also make sense to clean up situations involving centralized funding for services in multiple jurisdictions. (52)

Many of the remaining problems could be eliminated by exempting compensation for foreign services from the reach of section 409A. Section 409A(e) gives the IRS broad authority to "prescribe such regulations as may be necessary or appropriate to carry out the purposes of" section 409A. As a policy matter, the basic thrust of section 409A as a deterrent to coerce employers into revising widely-used employee plans and practices may be lost on--and ineffectual with respect to--foreign employers. This is particularly true where the plans are locally qualified or cover many foreign employees under conventional foreign arrangements. Exempting foreign services could readily be justified under this policy to the extent the underlying compensation would not have been taxed by the United States if received when earned, for example, for periods before an individual becomes a USCR. (53) Participation in foreign qualified-type plans (54) similarly would not seem to violate the section 409A "abuse-like" targets.

Beyond that, regulatory relief could be based on practical administrative and enforcement considerations. For instance, regulations could be issued to restrict the definition of covered deferred compensation from foreign employers to amounts in excess of a dollar threshold, or by category (e.g., SERPs only). Something like this would address the practical problems faced by foreign employers temporarily sending NRAs to the United States, where legal justification for exemption is harder.

In all events, it would be desirable for the IRS to expressly reject any treaty override.

IRS and Treasury personnel have suggested that some international issues related to section 409A will be addressed in the next tranche of guidance, expected sometime this summer.

2. Employer/Employee Tasks

Section 409A is already in effect, subject to the one-year grace period for corrective amendments set forth in Notice 2005-1. Pending further clarifying guidance, employers should be tentatively reviewing their compensation arrangements for trouble spots. This review should not be limited to persons employed after 2004, since post-2004 accruals for pre-2005 employees could be reached. Based on this analysis, a logical sequence of review would be:

* Foreign companies employing USCRs

** Identify deferred compensation arrangements in which the USCR participates.

** Carve out clearly excluded types (e.g., short term deferrals, specified welfare benefits, most stock option plans) and grandfathered (pre-2005) vested amounts.

** Determine whether remaining arrangements would be characterized as funded or unfunded under U.S. tax principles.

** If funded, review pre-AJCA U.S. tax situation (section 402(b) or section 83?).

** If trusteed, determine "location" of trust and assets and compare to place where services performed.

** Evaluate possible treaty protections.

** Review likely-covered unfunded arrangements for compliance with section 409A, and identify necessary revisions; be sensitive to illusory forfeiture provisions.

** Do the same for funded arrangements, depending on level of comfort with the tax-as-vest exception, the location of any trust, and treaty protections.

** For equity-based plans, review type of equity and trading status, valuation provisions, etc.

* Foreign Companies Employing NRAs in the United States

** Review employee's status under any applicable U.S. treaty (e.g., 183-day rule).

** If underlying services are not exempt, perform same analysis as with foreign companies employing USCRs.

** Check that current salary was reported in the United States.

** Consider allocation between U.S. and non-U.S. services.

* U.S. Companies employing NRAs in the United States

** Evaluate in same way as regular USCR employees.

** 183-day treaty exemption is unavailable, because the employer is U.S. treaty resident.

* NRAs who Become USCRs

** Identify any ongoing deferred compensation arrangements for prior U.S. or foreign service.

** Determine if there are likely to be any post2004 accruals or vesting.

** Consider application of section 409A; contact former employer to determine if defects can be remedied.

How to remedy or plan around section 409A when it might otherwise be applicable is a whole other topic, not addressed in this space.

This article highlights only some of the international permutations under section 409A. Since international deferred compensation issues are not a particularly well articulated area of U.S. taxation and treaties to begin with, the potential application of section 409A in this context provides ample fodder for future debates and abundant opportunities for IRS guidance.

(1) All section references are to the Internal Revenue Code of 1986, as amended, unless otherwise indicated.

(2) E.g., Rev. Rul. 60-31, 1960-1 C.B. 174, modified by Rev. Rul. 70-435, 1970-2 C.B. 100; Rev. Proc. 71-19, 1971-1 C.B. 698.

(3) Treas. Reg. [section] 1.451-2(a).

(4) Viet v. Commissioner (I), 8 T.C. 809 (1947), acq. 1947-2 C.B. 4; Viet v. Commissioner (II), 8 T.C.M. 919 (1949); Commissioner v. Oates, 207 F.2d 711 (7th Cir. 1953); Commissioner v. Olmstead Inc. Life Agency, 304 F. 2d 16 (8th Cir. 1962); Goldsmith v. United States, 586 F.2d 810 (Ct. Cl. 1978); Martin v. Commissioner, 96 T.C. 814 (1991).

(5) Metcalfe v. Commissioner, 43 T.C.M. 1393 (1982). There is a natural sensitivity to situations involving a controlling shareholder, and the IRS would not issue private rulings in that case. Rev. Proc. 2005-3, 2005-1 I.R.B. 118, [section] 3.01(36). But see Cosale v. Commissioner, 247 F.2d 440 (2nd Cir. 1957), acq. Rev. Rul. 59-184, 1959-1 C.B. 65.

(6) Revenue Act of 1978, [section] 132.

(7) An arrangement that is "funded" for ERISA purposes becomes subject to extensive requirements.

(8) The name comes from the first private letter ruling on the subject (PLR 8113107), issued in 1980 with respect to deferred compensation provided by a congregation for its rabbi. The IRS eventually published a model rabbi trust document in Rev. Proc. 92-64, 1992-2 C.B. 422, to stem the flood of ruling requests for similar treatment.

(9) Joint Committee on Taxation, Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations (JCS-3-03) (February 2003).

(10) Although section 132 of the 1978 Act was not repealed, the statutory provisions and broad grant of regulatory authority are understood to supersede the strictures of section 132 prospectively. Tax Management Educational Institute Roundtable, 23 BNA Tax Management Weekly Report No. 45, at 1756 (November 8, 2004) (TMEI Roundtable).

(11) H.R. Rep. No. 108-755, 108th Cong., 2d Sess. 521 (2004).

(12) Presumably this exception refers to the services of the individual involved, not the collective services of any larger group that might be covered by the plan, but clarification would be helpful. See IRS Notice 2005-1, 2005-2 I.R.B. 274, Q&A-9.

(13) H.R. Rep. No. 108-755, at 525.

(14) [section] 2(a)(10) of November 19, 2004, discussion draft bill; Joint Committee on Taxation Staff, Description of the Tax Technical Corrections Act of 2004, at 4 (November 19, 2004). See TMEI Roundtable, at 1784.

(15) H.R. Rep. No. 108-755, at 518.

(16) Notice 2005-1, Q&A-4.

(17) Notice 2005-1, Q&As 3 and 4.

(18) Barker, O'Brien & Sollee, Executive Employment Agreements Must Comply With Section 409A, BNA Daily Tax Report No. 26, J-11 (February 9, 2005). Split-dollar insurance plans may also be covered. See Bianchi, Anatomy of a Paradigm Shift: An Overview of the Deferred Compensation Provisions of the American Jobs Creation Act of 2004, 33 Tax Management Compensation Planning Journal 31, 44 (2/4/05).

(19) Notice 2005-1, Q&As 3, 7 and 8.

(20) Notice 2005-1, Q&As 4 and 7.

(21) Notice 2005-1, Q&A-4(e).

(22) Notice 2005-1, Q&A-9.

(23) Possible revisiting of this rule was recently suggested by a Treasury official. BNA Daily Tax Report No. 23, G-6 (February 4, 2005).

(24) The only pertinent exception is section 911 with respect to certain foreign earned income and employer-provided housing costs, with relatively low exclusion limits. "Foreign earned income" may not include constructively taxed deferred compensation vesting amounts under section 409A. Cf. I.R.C. [section] 911(b)(1)(B) and Treas. Reg. [section] 1.911-3(e)(4)(i).

(25) I.R.C. [section] 401(a). An intriguing question is whether governmentally sponsored social security-type schemes could constitute deferred compensation for purposes of section 409A. This question was answered in the negative in outstanding proposed regulations regarding deductions for contributions to certain qualified-type foreign plans under section 404A(Prop. Reg. [section] 1.404A-l(e)). This conclusion seems appropriate for the section 409A context as well.

(26) I.R.C. [section] 402(d).

(27) Section 83 deals with transfers of "property" in connection with the performance of services, where "property" is defined as real and personal property other than either money or an unfunded and unsecured promise to pay money or property in the future. "Property" also includes a beneficial interest in assets, including money, which are transferred or set aside from the claims of creditors of the transferor, for example, in a trust or escrow account. Employee trusts and annuity plans are taxed under section 83 in coordination with sections 402(b) and 403(c). Treas. Reg. [subsection] 1.833(e) and -8.

(28) "Highly compensated" employees are defined in section 414(q): loosely speaking, a 5-percent owner or a person having compensation in excess of $95,000 (and also being in the top 20 percent of employees ranked by compensation, if elected). The applicable coverage rules are sections 410(b)(10) and 401(a)(26).

(29) I.R.C. [section] 414(q)(8).

(30) Q&A-4(e) says "there is no deferral of compensation merely because the value of the property ... is not includible in income (under [section] 83) in the year of receipt by reason of the property being nontransferable and subject to a substantial risk of forfeiture, or is includible in income (under [section] 83) solely due to a valid election under [section] 83(b).... For purposes of this paragraph, a transfer of property includes the transfer of a beneficial interest in a trust or annuity plan, or a transfer to or from a trust or under an annuity plan, to the extent such a transfer is subject to [section] 83, [section] 402(b) or [section] 403(c)." Notice 2005-1, part I.B. in referring to a different exception for nonstatutory stock options, says "[t]his exception is consistent with the further exception covering transfers of restricted property, as the taxation of transfers of nonstatutory stock options and transfers of restricted property generally both are governed by [section] 83." (Emphasis added.)

(31) I.R.C. [section] 409A(a)(1)(A)(i); Notice 2005-1, Q&A-1.

(32) Section 83 only covers actual transfers of restricted property. Q&A-4(e) of Notice 2005-1 makes clear that plans under which a service provider obtains a legally binding right to receive property in a future year may be a nonqualified deferred compensation plan covered by section 409A.

(33 Compare TMEI Roundtable, at 1777.

(34) The priority between these funding rules and the distribution/ acceleration/election constructive receipt rules requires clarification, though presumably the amounts will not be taxed twice.

(35) See note 14 supra.

(36) The same issue could arise for section 83 restricted property, to the extent the IRS decides, as permitted by statute, to bring "other arrangements" within the funding rules.

(37) Treasury Department Technical Explanation, Art. 18, [paragraph] 3.

(38) See Treasury Department Technical Explanation to the 1996 United States Model Income Tax Convention (September 20, 1996), Art. 18.

(39) Cook v. United States, 288 U.S. 120 (1933); Snap-On Tools, Inc. v. United States, 26 Cl. Ct. 1045 (1992). Compare S. Rep. No. 100-445, 100th Cong., 2d Sess. (Aug. 3, 1988), to accompany S. 2238 (Technical Corrections Act of 1988), [section] 112(aa).

(40) Notice 2005-1, Q&A-23 provides transition relief during 2005, but only with respect to a section 401(a) qualified plan.

(41) What constitutes a "pension" for treaty purposes has been addressed in a number of IRS private letter rulings. These establish that a payment will be treated as a "pension" if: (i) the employee has been employed by the same employer for five years or, if less, has attained age 62 (or was first employed by the employer after reaching age 60) (see, e.g., PLRs 9644050, 9644051, 9541043, and 9041041); (ii) the payment is made on account of death or disability, paid as part of a series of substantially equal payments over the employee's lifetime, or made after the employee attains age 55; and (iii) the payment is made either after separation from service or on or after the employee attains age 70-1/2 (see, e.g., PLRs 9644050 and 9644051). For this purpose, "separation from service" precludes employment with a related employer for five years. See PLRs 9644050, 9644051, and 9041041. These rulings generally have not expressly required that a plan be nondiscriminatory. These criteria were generally included in the commentary to Treasury's 1996 Model Income Tax Convention, but Treasury added a requirement that a plan, "alone or in combination with other comparable plans" be nondiscriminatory. Whether this indicates a change in policy is unclear. See Treasury Department Technical Explanation to 1996 United States Model Income Tax Convention Treaty, Art. 18, [paragraph] 1. See also 2003 US-UK Income Tax Convention, Art. 3(0) (definition of"pension scheme") and Art. 18(5)(d) (U.S. Competent Authority must agree that U.K. pension scheme "generally corresponds" to U.S. pension scheme; accompanying notes appear to limit equivalent treatment to U.K. qualified plans).

Interestingly, the 1995 third protocol to the U.S.-Canada treaty expanded the definition of retirement plan to include "other retirement arrangement," which might capture retirement-type deferred compensation, such as SERPs. The pertinent treaty provisions, however, relate only to payments under the plan, not contributions or accruals.

(42) See, e.g., PLRs 8537010 and 9243026 (section 422 incentive stock options and section 423 employee stock purchase plans, respectively).

(43) An additional twist is provided by new section 72(w), added by the AJCA. Section 72(w) revamps the rules for taxing distributions to USCRs under section 72, e.g., in the event of distributions from nonqualified plans (including foreign qualified-type plans). Amounts distributed will now be taxable by the United States (through the mechanism of excluding them from the employee's basis, i.e., "investment in the contract") if they are attributable to contributions (or earnings thereon) with respect to compensation for foreign services performed while the individual was an NRA that were not subject to tax by the United States or a foreign country (but would have been taxable if paid to the NRA in cash when the services were performed). Section 409A(c) should prevent later taxation of any amounts taxed under section 409A.

(44) TMEI Roundtable, at 1784; BNA Daily Tax Report No. 23, G-7 (February 4, 2005); 33 Tax Management Compensation Planning Journal 17 (January 7, 2005).

(45) As previously discussed, deferred compensation derived from foreign services is unlikely to be taxed by the United States absent a peculiar "effectively connected" situation or subsequent conversion to USCR status.

(46) Section 871(b) has a small 90-day/$3,000 exception for services for certain foreign entities or offices (section 864(b)(1)).

(47) Of note, however, the IRS treats that portion of a distribution allocable to earnings within a U.S. qualified plan as U.S. source income not effectively connected with a U.S. trade or business and therefore subject to 30-percent FDAP withholding (absent treaty protection). See, e.g., Rev. Rul. 79-388, 1979-2 C.B. 270; Rev. Proc. 2004-37, 2004-26 I.R.B. 26. By comparison, earnings on a nonqualified plan--whether U.S. or foreign--generally are sourced in the same manner as the underlying compensation (i.e., based on the place where services were performed.)

(48) See Treasury Department Technical Explanation to 1996 United States Model Income Tax Convention, Art. 15, [paragraph] 1, stating the converse rule in non-exempt situations: "[A] person who receives the right to a future payment in consideration for services rendered in a Contracting State would be taxable in that State even if the payment is received at a time when the recipient is a resident of the other Contracting State." A more subtle issue is presented if the individual is no longer a resident of the foreign treaty country (or any treaty country with a comparable provision) in the year the deferred compensation is received, since the exemption is only available to treaty residents.

(49) See, e.g., Treasury Department Technical Explanation of the 1996 United States Model Income Tax Convention, Art. 14, [paragraph] 1.

(50) See generally note 41 supra.

(51) New I.R.C. [subsection] 6051(a)(13) and 3401(a) (flush sentence at end) (employees) and [section] 6041(g) (non-employees). A more liberal grandfather rule applies for reporting purposes (pre-2005 actual deferrals, whether or not vested, and regardless of post-October 3, 2004, material modifications) than for section 409A in general, per Q&A-28 of Notice 2005-1. Reporting for nonaccount balance plans may be deferred until the amount thereof becomes reasonably ascertainable (Q&A-26), and aggregate deferrals for an individual employee of $600 or less need not be reported (Q&A-27). For general provisions subjecting foreign employers to withholding rules, see, e.g., Treas. Reg. [subsection] 31.3401(a)-1(b)(7) and 31.3401(a)(6), and Rev. Rul. 92-106, 1992-2 C.B. 258.

(52) See TMEI Roundtable, at 1783.

(53) Similar concepts can be found in section 871(f) (annuities under U.S. qualified plans) and, somewhat perversely, in new section 72(w).

(54) Pertinent definitions could be borrowed from the section 404A definitions.

PATRICIA GIMBEL LEWIS is a member of the Washington, D.C., law firm of Caplin & Drysdale, Chartered. She received J.D. and M.B.A. degrees from Harvard University in 1971, with honors, and her undergraduate degree from Wellesley College. Mrs. Lewis was a member of the 1994-1996 IRS Commissioner's Advisory Group, and co-chaired the Taxation Section of the District of Columbia Bar from 1992 to 1995. Mrs. Lewis's prior articles for The Tax Executive include: "What's New? What's Missing? The IRS Updates APA Procedures" (2004); and "Second First??? Transfer Pricing Issues in Secondment of Personnel" (2002).

MICHAEL G. PFEIFER is also a member of Caplin & Drysdale, having joined the firm in 2004. He received a J.D. from Cornell University in 1975, an LL.M. in taxation from New York University in 1981, and his undergraduate degree from Yale University. His practice focuses on the international tax issues of wealthy individuals. Before joining Caplin & Drysdale, Mr. Pfeifer was an international tax partner in the National Tax Department of Ernst & Young LLP. From 1993-1995, Mr. Pfeifer was the Special Assistant to the Associate Chief Counsel (International) at the Internal Revenue Service. He has spoken and written extensively on tax matters; this is his first article for The Tax Executive.