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Benefits and Pensions MonitorU.S. Tax Rules Impact Canadian-sponsored PlansBy: Susan Fremes A new U.S. law affects U.S. taxpayers regardless of where they are located. Susan Fremes, of Mercer Human Resource Consulting, explains what Section 409A of the Internal Revenue Code means to Canadian employers. Section 409A of the U.S. Internal Revenue Code could have a significant impact on the U.S. tax treatment of U.S. citizens or other U.S. taxpayers who are members of Canadian compensation or retirement arrangements. Section 409A was added to the code under the American Jobs Creation Act of 2004. This law was enacted to respond to perceived timing abuses on the recognition of income and, perhaps, in response to corporate scandals such as Enron and Worldcom. Section 409A contains a very broad definition of ʻnonqualified deferred compensation.ʼ It affects any U.S taxpayers employed anywhere in the world, including Canada. A U.S. taxpayer can include a citizen of the U.S. or a resident of the U.S. who is employed in Canada; a Canadian resident employed in the United States; or a Canadian resident who has deferred compensation or other entitlements under a plan relating to prior years of employment in the U.S. Americans who work in Canada and Canadians who move to the United States and who participate in nonqualified deferred compensation plans sponsored by their Canadian employers may be adversely affected by Section 409A. The regulations affect compensation on a retroactive basis. If compensation was deferred, but was not “earned or vested” prior to the January 1, 2005, effective date, the plan must comply with Section 409A. The deadline to amend arrangements with respect to U.S. taxpayer members to comply with the requirements of Section 409A is, according to the proposed regulations, December 31, 2006. Thus, Canadian employers would be well-advised to assess the implications of Section 409A for any U.S. taxpayers who are members of their deferred compensation arrangements and to determine whether they should have appropriate amendments and election forms prepared.1 Generally speaking, failure to comply with Section 409A results in harsh consequences for the affected individual. Nonqualified deferred compensation that fails to comply will result in immediate taxation on deferred amounts (even if not yet paid) plus a 20 per cent additional tax, payable by the employee, plus penalties and interest. When the payments are actually received by the employee, they will be subject to tax in Canada. This could result in double taxation unless there is relief under the Canada-U.S. tax treaty. This article summarizes the Section 409A requirements and the implications for Canadian employers with a particular focus on registered and supplementary pension plans (SERPs). It represents our understanding, at this time, regarding Section 409A and its impact on arrangements sponsored by Canadian employers. Since the final regulations have not been released and since it is considered to be ʻearly daysʼ in terms of the preparation of actual amendments, some of the issues remain to be further clarified.
Exemptions For Foreign Plans Treaty Exemption Nonqualified deferred compensation is exempt from Section 409A if it is excludable from U.S. income tax under the Canada-U.S. Tax Convention. This convention exempts income earned in (but not contributions to) a registered pension plan by a U.S. taxpayer, upon the making of an election by the U.S. taxpayer. 2 While the matter is not entirely free from doubt, it is generally accepted that a U.S. taxpayer may participate in a Defined Benefit registered pension plan without immediate U.S. tax consequences (provided that the appropriate election is made under the treaty).3 Foreign Broad-based Retirement Plans There is an exemption under Section 409A for certain “foreign broad-based retirement plans.” For U.S. citizens and lawful permanent residents working in Canada, there is an exception with respect to non-elective deferrals of foreign earned income under foreign broad-based retirement plans, but only if the employee is not eligible to participate in a “U.S. qualified employer plan” and only to the extent that the amount deferred in a year does not exceed the amount that may be provided under a qualified plan under Section 415 of the Internal Revenue Code.4 This exception may assist U.S. taxpayers who participate in such arrangements while employed in Canada, but will generally not be of assistance to U.S. taxpayers employed in the United States who participate in Canadian retirement arrangements. A SERP which covers all employees whose registered plan benefits are capped by the limits under the Income Tax Act (Canada) might be considered to be “broad based” for the purposes of this exemption. However, one which contains selective eligibility conditions would not fit within this category. Having said that, there is currently some question as to whether, in addition, a plan must meet the “non-discrimination” rules which apply to U.S. plans in order to qualify for this exemption. For non-resident aliens working in the United States, amounts deferred under foreign retirement plans for services in the U.S. that do not exceed $10,000 a year are not subject to Section 409A. Funded SERPs Section 409A does not impact vested benefits under a funded or secured SERP. This is due to the fact that the Internal Revenue Code already provides that vested benefits under a funded or secured SERP must be reported as taxable income in the year in which the benefits accrue unless the assets of the SERP are available to satisfy the claims of the employerʼs creditors. If the assets of the SERP are available to satisfy the claims of the employerʼs creditors, the existing code provision may not apply, in which case, Section 409A would apply. The Rules Under Section 409A Section 409A pertains primarily to elections to defer compensation and the timing of payments. However, it also includes restrictions on accelerated settlements. Timing of Elections Section 409A governs the timing of deferral elections including the time and form of payment elections. Generally, initial deferral elections, including decisions about the time and form of payment, must be made by the end of the calendar year that precedes the calendar year in which the services to which the compensation relates are performed. Distributions from Plans Section 409A provides that deferred compensation must not be distributed from a nonqualified deferred compensation plan earlier than:
Payments cannot be accelerated to a date before the time or schedule chosen at the time of deferral, except as provided by the regulations. An election to postpone payments and change the form of distribution can only be made if certain prescribed conditions are met. There is six-month payment delay for “specified employees” (typically, the top 50 officers) on a separation from service which applies to employees of a public company, including Canadian public companies. Many U.S. employers have already decided to treat all employees who are subject to Section 409A as “specified employees” for administrative simplicity. Examples Here are a few examples of SERP distribution provisions that could violate the new rules:
Often, the choices available to a SERP participant are linked to the registered pension plan. For example, a SERP may provide that if the participant commutes the benefit out of the registered pension plan, then the SERP benefit is payable by way of a lump sum. For SERP members who are subject to Section 409A, amendments will have to be made to ʻde-linkʼ the timing of distributions and the forms of payments from the registered pension plan. Next Steps Section 409A may affect members of plans that are not commonly associated with traditional deferred compensation. For example, bonus plans, severance and employment agreements, and discount stock options are covered under the definition of “nonqualified deferred compensation” under Section 409A. Employers should take action now to identify which plans or agreements may involve nonqualified deferred compensation and review them for compliance with Section 409A with respect to U.S. taxpayer members. As a first step, Canadian companies should considerwhether any participants under their deferred compensation plans are subject to U.S. federal income tax. Given the broad range of persons who are subject to U.S. income tax, this may be difficult to determine. For example, there may be persons, unbeknownst to the company, who have dual Canadian/U.S. citizenship and who are, therefore, subject to U.S. federal income tax. It may be necessary for companies to have participants in deferred compensation plans attest to their citizenship and tax status. If a Canadian company determines that there are such participants in its deferred compensation plans, amendments to such plans with respect to U.S. taxpayer members will be required prior to December 31, 2006, if the company wishes to avoid adverse tax consequences for these members. In the meantime, plans must be operated in compliance with Section 409A with respect to U.S. taxpayer members. Employees could change the time and, in certain circumstances, the form of payments from plans until December 31, 2006.5 However, as indicated above, any election made in 2006 cannot apply to payments made that would otherwise be received in 2006. With regards to SERPS specifically, sponsors may want to consider the following steps in response to the new legislation:
As a final comment, Canadian entities that have arrangements whose members are impacted by Section 409A may wish to consider moving U.S. taxpayers into plans for U.S. based employees, where this is feasible, or making other alternative arrangements for these employees.
1. While the issuance of the final regulations to Section 409A has been delayed by the U.S. Treasury Department until later this summer, it is unclear whether or not some transitional relief for this delay will be granted and, if so, to what extent. 2. Section 7, Article XVIII of the Canada-U.S. Tax Convention. 3. With regards to a Defined Contribution registered pension plan, accrued investment income is considered to be exempt from immediate U.S. tax consequences while contributions to such a plan would be considered not to be exempt. It is our sense that prevailing practices with regards to the reporting of the contributions are not consistent with the technical position. 4. Effective January 1, 2006, the limitation on the annual benefit under a Defined Benefit plan under section 415 of the code is $175,000. The comparable limitation under a DC plan is $46,000. 5. This deadline could be extended. This will depend upon the provisions of the final regulations under Section 409A which are to be issued in late summer, 2006. |
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Susan Fremes is a lawyer who specializes in the area of pension and benefit law at Mercer Human Resource Consulting. 