As business becomes increasingly globalized, multinational corporations are sending more executives on international assignments and hiring more expatriates to fill local positions overseas. Compensation connected to these employment patterns can create a series of legal and regulatory challenges. For example, unless an exception applies, U.S. citizens and U.S. residents are subject to U.S. federal income tax on their worldwide income, regardless of where they perform services or earn their compensation. Significantly, this extraterritorial reach of U.S. federal income tax extends to the complex and confounding deferred compensation rules of section 409A of the Internal Revenue Code.
Section 409A was originally enacted in response to the collapse of Enron, WorldCom, and other companies in similar circumstances in the early 2000s. However, the section’s reach is not limited to the special circumstances that bred its adoption. Section 409A can apply to traditional deferred compensation plans in which executives elect to defer a portion of their pay until a later year. It can also apply to severance, annual bonuses, benefits in kind, reimbursements, equity compensation, and nonqualified retirement arrangements, among other benefits. Most of its provisions apply to employees of public and private companies, whether inside or outside of the United States. (Compensation paid to certain independent contractors, such as non-employee directors or some consultants, may be subject to section 409A as well.)
The penalties for an employee if an arrangement runs afoul of section 409A are steep. If deferred compensation is subject to section 409A and fails to comply with its requirements, the compensation is included in the individual’s income as soon as it is earned and vested (rather than when it is paid). The employee must pay regular U.S. federal income tax, an additional income tax equal to 20% of the amount included in income, and, in some cases, an adjustment designed to recapture the economic benefit of the tax deferral.
Given the worldwide reach of U.S. federal income tax, absent an exception, foreign compensation of U.S. citizens and residents can be subject to section 409A. There are a number of special exclusions under section 409A that may apply to a foreign deferred compensation arrangement. For example:
- Deferred compensation that is excluded from U.S. tax (or would be if it had been paid when earned or vested) under the terms of a treaty is excluded from section 409A.
- Foreign separation pay required by law, including pay for voluntary separations, is exempt from section 409A.
- Certain amounts deferred under a broad-based foreign plan covering a wide range of employees (including rank-and-file employees) may be excluded from section 409A.
These exclusions are limited, however, particularly for U.S. citizens. If one of the exclusions for foreign arrangements is not available, in order to avoid the 409A penalties, the compensation must be structured to meet one of the general exemptions from section 409A or to comply with section 409A’s requirements regarding the time and form of payment. As will be familiar to benefits and tax practitioners in the U.S., compensation arrangements must be structured carefully to be exempt from or to comply with section 409A.
U.S. expertise should be brought in to avoid section 409A violations whenever an executive (or other employee) working abroad is a U.S. citizen or U.S. resident. Given the steep costs of a section 409A violation for the individual, employers might also wish to encourage executives who will be on a foreign assignment to seek individualized U.S. tax advice. Reimbursement for this advice is often a part of the foreign assignment package (beware though, as reimbursement arrangements can also be subject to section 409A).
Ex-pat appointments are attractive to many employers for a variety of business reasons. These arrangements should be structured to address the unique legal, regulatory, and tax implications of bringing people across borders — including section 409A. Employers who are sending U.S. taxpayers on international assignment might wish to review the compensation arrangements for these individuals for potential section 409A issues. (Note that U.S.-source income earned by nonresident aliens can be subject to section 409A as well, so compensation arrangements for foreign employees on assignment in the U.S. can also be implicated.) And employers should stay tuned to InsideCompensation for more on foreign compensation and benefits arrangements.