Most employment lawyers are at least somewhat familiar with the US tax rules on deferred compensation under Section 409A of the US Internal Revenue Code (Section 409A). Many fewer understand the additional rules under Section 457A of the US Internal Revenue Code (the 457A Rules). Those rules apply in addition to Section 409A rules, and they effectively preclude more than a 12-month deferral of vested compensation for many persons subject to US tax who work for non-US domiciled companies, including subsidiaries of US entities or who work for non-US owned partnerships (“nonqualified entities”).
The 457A Rules, like Section 409A, apply broadly to “service providers,” including employees, consultants and some service businesses. As with Section 409A, the 457A Rules broadly define deferred compensation. However, unlike under Section 409A, compensation subject to the 457A Rules is generally taxable as ordinary income in the year it vests if the payment is deferred beyond the “Payment Deadline” described below. An exception applies if the amount includable in income is not “determinable” when it vests, in which case the deferred compensation will be taxable when it is paid but it will also be subject to a 20 percent penalty tax and penalty interest. In other words, for compensation subject to the 457A rules, unlike under Section 409A, there is no permissible way to provide for tax-deferred delay of payment until termination of employment, a change in control or other events that would be a permissible trigger for payment under Section 409A.
Comparison of 457A Rules with Section 409A
Deferred compensation payable by nonqualified entities must satisfy both Section 409A and the 457A Rules. The 457A Rules are very similar to the Section 409A rules but there are some key differences, as highlighted in the chart below.
|Section 409A||457A Rules|
|Aggregates all entities in a controlled group and treats as a single entity for purposes of determining whether compensation is deferred.||Applies on an entity-by-entity basis to compensation payable to employees of “tax indifferent” entities (“nonqualified entities”)—those deemed under the rules to be indifferent as to whether they receive a current or delayed deduction for compensation expense.|
|Applies to all employees in “like” plans in the controlled group.||Applies only to employees of nonqualified entities, whether or not part of a controlled group.|
|Broadly defines deferred compensation, but excludes options, stock appreciation rights and restricted stock.||Same definition of deferred compensation, except includes stock appreciation rights settled in cash.|
|Compensation paid by March 15 of the year after the year it vests is not “deferred”.||Compensation paid within 12 months after the end of the employer’s year in which it vests (“Payment Deadline”) is not “deferred”.|
|Vesting can be based on the provision of future services, performance or the occurrence of a condition not certain to occur, such as an IPO.||Vesting conditions other than the provision of future services are ignored.|
|OK to defer payment after March 15 without penalty as long as rules for timing of deferral elections, payment triggers and payment timing are satisfied.||If payment is deferred beyond the Payment Deadline, the payment is taxable as ordinary income in the year it vests if the amount is determinable. If the amount is not determinable, it will be taxable when paid but a 20 percent penalty tax and additional penalty interest will apply.|
As an example, assume a retirement-eligible employee of a non-qualified entity is granted restricted stock units that vest in three years if the company’s cumulative profits over the three-year period exceed a specified target amount. Assume the employer’s usual employment-at-payment date requirement is waived for persons who retire during the three-year period. Payment is in all events made shortly after the end of the three-year period if the cumulative profit goal is attained. This arrangement satisfies Section 409A, but not the 457A Rules. The retirement-eligible employee would be considered fully vested on the date of grant, whether or not he or she actually retires (no requirement to perform future services to receive payment, even though the performance condition will not be satisfied, if at all, for three years). The amount that would be includable in income under the 457A Rules cannot be determined prior to the end of the three-year performance vesting period because the amount of cumulative profits cannot be determined until the three year period ends. Therefore, the employee would be subject to the 20 percent tax and penalty interest under the 457A Rules as soon as the amount payable is determinable.
Definition of nonqualified entity
The 457A Rules apply to deferred compensation from nonqualified entities. There are two types:
- any entity domiciled outside the US unless (a) substantially all its income is subject to a “comprehensive foreign income tax” or (b) at least 80 percent of its income is taxable in the US;
- any partnership (US or non-US) of which more than 20 percent of the gross income is directly or indirectly allocated to US tax-exempt organizations (such as public pension plans) or to foreign persons not subject to a comprehensive foreign income tax.
A non-US entity is subject to a “comprehensive foreign income tax” if it is eligible to benefit from a comprehensive income tax treaty between its country of residence (other than Bermuda or the Netherlands Antilles) and the US, and substantially all its income is actually taxed under the non-US country’s tax regime without special treatment. Thus, for example, US taxpayers employed by a Chinese subsidiary of a US company that enjoys tax incentives or a tax holiday for locating a facility in China would be subject to the 457A Rules, despite the existence of an income tax treaty between the US and China.
Which countries benefit from a comprehensive income tax treaty with the US? The IRS’ most recent list (Notice 2011-64) includes 57 countries which include Canada, Mexico and most European countries. However, the only Dentons locations in Africa with treaties are Morocco, Egypt and South Africa. None of the seven countries in the Middle East where Dentons is located have treaties, nor do Singapore or Hong Kong. In South America, only Venezuela has a treaty.
The other type of entity whose employees are subject to the 457A Rules are partnerships (US or non-US) where at least 80 percent of the income of which is allocable to non-US partners (in a country without a comprehensive tax treaty with the US) or to US tax-exempt entities, such as pension plans.
The 457A Rules should be of concern primarily to US expatriates working in a country without a US tax treaty (for example, Singapore, the UAE, Brazil or Kazakhstan); non-US employees who work for a non-US entity but who become subject to US tax because they work in the US; and US employees who work for partnerships in which non-US or tax-exempt entities own a substantial equity interest.
It may be difficult to know, from year to year, whether the 457A Rules apply or not to a given US taxpayer. For each year, it requires a detailed look at the employer’s tax position and a complex calculus beyond the scope of this article. Companies (and partnerships) should have a procedure in place to make the determination at least annually.