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