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By Kimberly Tan Majure and Anne G. Batter
Internal Revenue Code section 457A is a recent Congressional effort to clamp down on deferred compensation arrangements but has received less attention than it deserves. Its provisions should concern any company with US citizens and other US taxpayer-employees working overseas, in other words, US expats.
In essence, section 457A is an income accelerator that applies to US expats. The accelerated US tax applies if the US expats are employed by a "nonqualified entity," i.e., a foreign employer not "subject to" US tax or a "comprehensive foreign income tax." Thus, when US companies send US expats to work for a foreign affiliate, the provision can apply. Even if otherwise eligible to defer income under a nonqualified deferred compensation plan, those US expats are taxed in the year of vesting -- possibly years before they receive the related cash. And the US employers that sponsor the deferred compensation arrangement may be required to withhold tax on the compensation and ultimately bear responsibility for its payment under contractual arrangements with the expats.
Although section 457A is currently in effect, the IRS has published very little useful guidance. The IRS issued Notice 2009-8 early last year, but the notice raises as many questions as it resolves. In this article, we will discuss some of the common myths and lingering mysteries related to section 457A.
Section 457A is an employee, not a company, issue (not). Although section 457A tags employees with the accelerated tax, the employer does not go unscathed. If section 457A applies, the employer is obligated to report the income on the employee's Form W-2 in the year of vesting. Further, although the statute does not explicitly require withholding, IRS personnel indicate that an employer withholding obligation may be forthcoming -- no small task in a situation where income inclusion and cash flow are deliberately mismatched. The cost related to the tax acceleration would almost surely be covered by a tax equalization arrangement, meaning an arrangement under which the US employer promises to compensate the expat for any additional taxes that arise as a consequence of the foreign assignment. Consequently, the US expat may take the initial tax hit, but the US employer likely will bear the ultimate burden of section 457A.
An expat by any other name... Section 457A applies if the US expat works for a foreign employer, regardless of the expat's formal employment arrangement. Consequently, inclusion on a US payroll is not determinative, and secondment arrangements will not protect a US expat (particularly if an affiliate is charged for the expat's expenses). Instead, companies must sift through their expats' responsibilities to determine whether the expat is acting on behalf of the US company (e.g., in a stewardship capacity) or working under the affiliate's direction and control. Finally, companies can't assume that their US expats are protected if they remain in a US-sponsored plan. If a US expat is in fact employed by the foreign affiliate, the expat is treated as if he or she were in a foreign plan, and subject to section 457A.
The "treaty out." An employer must be "subject to" a "comprehensive foreign income tax" -- two separate concepts -- to escape nonqualified entity status. Notice 2009-8 is silent as to how the comprehensive tax standard is to be applied (or what it even means), but provides a limited safe harbor for an employer resident in a country having a tax treaty with the United States. This treaty exception can be misleading. For one thing, it's not the end of the story; the employer must prove that it's "subject to" the foreign income tax, i.e., its residence country must tax substantially all of its gross income. Tax holidays, special regimes, beneficial letter rulings, or substantial deductions could trigger nonqualified entity status, and employers must assess their foreign tax returns annually to confirm their status. Holding companies of "checked" entities (e.g., corporations electing branch treatment, or partnerships electing corporate treatment, for US tax purposes) are particularly vulnerable, as their US-style "income" will not match and be taxed as part of the holding company's foreign tax return.
"Foreign" means "foreign." Section 457A has a deliberately broad reach, and tests the tax profile of foreign employers. For these purposes, "foreign" includes US territories and possessions, so companies with Puerto Rican operations need to test them. Moreover, section 457A applies in relation to foreign corporations, and to foreign or domestic partnerships -- including checked entities and contractual JVs treated as partnerships for US tax purposes -- with foreign partners. Whether a partnership's income is subject to a comprehensive income tax must be tested at the partner level, another wrinkle to an already complicated process.
US expats tagged by section 457A must include their otherwise deferred income on their individual tax returns in the year of vesting. Although the deadline for employer W-2 reporting has passed, the employee's April 15 return-filing deadline is coming up fast, and the required determinations can be very complicated. Companies should use the time remaining to determine areas of potential liability.
Kimberly Tan Majure is a partner focusing on international tax law and Anne G. Batter a partner focusing on executive compensation and other benefits in the DC office of the law firm Miller & Chevalier Chartered.
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