New Section 457A Limits Tax Deferral for Certain Compensation Paid by Tax Indifferent Parties

As part of the recently enacted Emergency Economic Stabilization Act, commonly referred to as the "bailout" bill for the financial sector, a new section has been added to the Internal Revenue Code ("Code"). Section 457A, Nonqualified Deferred Compensation from Certain Tax Indifferent Parties, taxes employees on compensation that is deferred under a "nonqualified deferred compensation plan" of a "nonqualified entity" when the compensation is no longer subject to a "substantial risk of forfeiture," and potentially imposes an interest charge and a 20% penalty tax with respect to the compensation. The new rules apply in addition to the requirements of existing Code Section 409A and any other provisions with respect to nonqualified deferred compensation, and are effective for amounts deferred that are attributable to services performed after December 31, 2008. For existing deferrals, the deferral amounts will be includible in the later of a) the year 2017, or b) the tax year in which no substantial risk of forfeiture exists concerning the rights to the deferred compensation.

Current Law

Prior to the new legislation, individuals who were entitled to deferred compensation could also defer paying tax on the compensation until it was actually received. The payor corporation's inability to deduct the amount of the compensation until it was taken into account by the employee meant that the expense of the deferral was borne by the corporation. In the case of tax-indifferent payors, such as foreign corporations in low- or no-tax jurisdictions, however, the employee benefited from the deferral but there was no offsetting deduction that could be deferred. As a consequence, the U.S. Treasury effectively incurred the cost of the deferral. Section 457A has been enacted in an effort to remedy this situation.

New Section 457A

A nonqualified deferred compensation plan under Code Section 457A generally includes any plan that provides for the deferral of compensation other than a qualified employer plan—such as a qualified retirement plan, tax-deferred annuity, simplified employee pension and SIMPLE 401(k)—or any bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan. However, compensation is not treated as deferred for purposes of Section 457A if the service provider receives payment of the compensation less than 12 months after the end of the service recipient's taxable year, during which time the right to the payment of the compensation is no longer subject to a substantial risk of forfeiture. The term nonqualified deferred compensation also includes earnings with respect to previously deferred amounts. In addition, a nonqualified deferred compensation plan includes any plan that provides a right to compensation based on the appreciation in value of a specified number of equity units of the service recipient. Thus, stock appreciation rights are treated as nonqualified deferred compensation regardless of their exercise price.

A nonqualified entity is defined as any foreign corporation, unless substantially all of the corporation's income is effectively connected with the conduct of a trade or business in the United States; or is subject to a "comprehensive foreign income tax." The definition also includes any partnership, unless substantially all of the partnership's income is allocated to persons other than foreign persons with respect to whom such income is not subject to a comprehensive foreign income tax, and to tax-exempt organizations. A comprehensive foreign income tax, with respect to any foreign person, is the income tax of a foreign country if a) the person is eligible for the benefits of a comprehensive income tax treaty between the foreign country and the United States, or b) such person demonstrates to the satisfaction of the secretary of the U.S. Treasury that the foreign country has a comprehensive income tax.

For purposes of Section 457A, a substantial risk of forfeiture exists only if the rights to the deferred compensation are conditioned upon the future performance of substantial services by any individual. To the extent provided in regulations, if compensation is determined solely by reference to the amount of gain recognized on the disposition of an investment asset, then a substantial risk of forfeiture will exist until the time of such a disposition.

If the amount of any compensation is not determinable at the time that such compensation is otherwise includible in gross income, then, in addition to income inclusion when the amount is determinable, the tax imposed for the year in which such compensation is includible in income must be increased by the sum of a) the amount of interest at the underpayment rate (currently 6%) plus 1 percentage point on the underpayments that would have occurred had the deferred compensation been includible in gross income for the taxable year in which it was first deferred, or, if later, the first taxable year in which such deferred compensation is not subject to a substantial risk of forfeiture, and b) 20% of the amount of such compensation (not 20% of the tax). An amount of deferred compensation is not determinable if, at the time it is no longer subject to a substantial risk of forfeiture, it varies depending on the satisfaction of an objective condition. This rule applies in lieu of the general rule discussed above under which deferred compensation is taken into account when it is no longer subject to a substantial risk of forfeiture.