3559 / What are the deferred compensation rules applicable to foreign nonqualified entities under Section 457A?

In the Emergency Economic Stabilization Act of 2008, Congress created new IRC Section 457A to impose immediate taxation on deferred compensation where the employer is a foreign “nonqualified entity” (as defined in the law) that is not subject to U.S. taxation. This section is comparable to Section 409A, which potentially applies to nonqualified deferred compensation paid by any entity, U.S. domestic or foreign. In addition, 457A applies to both cash and accrual method taxpayers while Section 409A applies to just cash method taxpayers.

Under IRC Section 457A, all compensation deferred under a nonqualified deferred compensation plan of a nonqualified entity is includable in gross income of a plan participant when there is no longer any Section 457A substantial risk of forfeiture of the rights to such compensation. IRC Section 457A has its own definition of substantial risk of forfeiture that defines a substantial risk of forfeiture as applicable “only if” a person’s rights are conditioned on the future performance of substantial services.¹ This definition is therefore not exactly the same as that in Section 409A but is generally consistent. For instance, Section 409A includes attainment of performance goals in addition to performance of substantial services. However, the 2016 409A technical amendments make it clear that these types of plans may also be covered by both Sections 409A and 457. The 2016 proposed regulations for 457(f) and those for nonelective deferred compensation plans² under Section 457(e)(12) do not substitute for or supersede 409A compliance requirements. In such cases, the plan must comply with Section 409A and 457 in addition to Section 457A, if and as necessary, which makes for complex compliance coordination indeed.³

IRC Section 457A defines a nonqualified entity as (1) any foreign corporation, unless substantially all of its 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,” or (2) any partnership, unless substantially all of its 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 “organizations which are exempt from tax under this title.”⁴ (IRC Section 457A provides a limited exception for deferred compensation payable by foreign corporations that have “effectively connected income” under IRC Section 882.)

A “comprehensive foreign income tax” is the income tax of a foreign country if there is an applicable comprehensive income tax treaty between that country and the United States or the Secretary of the Treasury is otherwise satisfied that it is a comprehensive foreign income tax.⁵

IRC Section 457A generally applies to nonqualified deferred compensation within the same broad scope as IRC Section 409A. IRC Section 457A explicitly applies to all stock options and stock appreciation rights, even those issued with the option price or measurement price at fair market value.⁶ IRC Section 457A also extends the 2½ month short term deferral exemption in IRC Section 409A to 12 months, meaning that IRC Section 457A does not apply to compensation received during the taxable year following that year in which the compensation is no longer subject to a substantial risk of forfeiture.⁷

If the amount of any deferred compensation taxable under IRC Section 457A is not determinable at the time it is otherwise includable under that section, it is subject to a penalty and interest when so determinable. In addition to the normal tax, the amount includable is subject to a 20 percent penalty tax and interest on the underpayment of taxes at the normal underpayment rate plus 1 percent.⁸

IRC Section 457A applies to deferred amounts attributable to services performed after December 31, 2008. Congress also directed the IRS to provide guidance within 120 days on amending plans to conform to IRC Section 457A and providing a limited period of time to do so without violating IRC Section 409A.

In 2017, the Treasury Department and the IRS indicated they would issue regulations applicable as of December 8, 2017 providing the relief for plan distributions made for taxes on pre-2009 457A foreign deferred compensation. The agencies also indicated taxpayers can rely on the relief until the regulations are finalized. The coming regulations will permit the acceleration of payments under a nonqualified deferred compensation plan to pay federal, state, local, and foreign income taxes due on pre-2009 section 457A deferrals that are includible in gross income.

Specifically, the Notice indicates Treasury Department and the IRS intend to issue regulations providing that a change in the time and form of payment under a nonqualified deferred compensation plan to pay federal, state, local, and foreign income taxes on pre-2009 Section 457A deferrals will not be treated as an impermissible acceleration under Sections 409A(a)(3) and 1.409A-3(j)(1). These regulations will also provide that, to the extent a deferred amount attributable to services performed before January 1, 2009, was earned and vested before December 31, 2004, and is not otherwise subject to the requirements of Section 409A due to the effective date rules under Section 1.409A-6, a change in the time and form of payment of the deferred amount to pay federal, state, local, and foreign income taxes on pre-2009 Section 457A deferrals will not be treated as a material modification of such arrangement under Section 1.409A-6(a)(4). The relief provided in these regulations will apply only to the extent that that the amount of any distribution to pay federal, state, local, and foreign income taxes on pre-2009 section 457A deferrals is not more than an amount equal to the federal, state, local, and foreign income tax withholding that would have been remitted by an employer if there had been a payment of wages equal to the income includible by the service provider under section 801(d)(2) of TEAMTRA.⁹