In 2005 the United States Congress approved new section 409A of the United States Internal Revenue Code, principally in response to Enron and similar situations where executives were able to benefit from deferred compensation arrangements, while other employees were not.
Section 409A is directed at ‘non-qualified deferred compensation’ arrangements (plans, commitments or agreements under which compensation for services could be paid to an employee in a year subsequent to the year in which the services are performed).
It applies to companies which have a listing of any kind in the United States, as well as to United States citizens or tax residents working abroad who are taxed on their worldwide income and to non-residents working in the United States and subject to United States tax.
What are the potential applications?
Section 409A could cover bonus arrangements, severance/termination payments, superannuation, share and option plans, reimbursement of relocation costs, private equity/IPO arrangements, and any other deferred remuneration that is not subject to a ‘substantial risk of forfeiture’ or a substantial risk that it will not vest.
If a compensation arrangement is not exempt from section 409A, it must comply with a number of operational rules. If any of the operational rules or other requirements of section 409A are not satisfied in respect of a particular compensation arrangement then recognition of all deferred income, and the associated tax, is immediately accelerated and a penalty tax of at least 20 per cent will also be applied.
How do you comply?
The transitional period for section 409A compliance ends on 31 December 2008. Documents need to be amended and updated by 31 December 2008 so that the penalty tax does not apply.
Compliance with section 409A is not a simple process. Each compensation related document (including employment contracts) will need to be reviewed to determine if the arrangement is prima facie caught by section 409A, if an exemption applies or if amendments are necessary.
Due to its broad application, section 409A could affect many companies and individuals. Some may be aware of section 409A and have implemented programs to update their compensation documentation to address its requirements. Others may not be aware at all, or may not have completed all the steps to ensure compliance with section 409A. While the penalty tax impost is on the employee, responsibility for collection of the section 409A tax is to an extent passed back to the employer, through an obligation to withhold the appropriate amount from remuneration payments.
This article was written by Peggy Haines, Partner, Melbourne, and Alexandra Moule, Senior Associate, Melbourne.
More information
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