The American Jobs Creation Act of 2004 made changes to the U.S. Internal Revenue Code to curb perceived abuses, like those occurring in high-profile cases such as Enron. New section 409A of the Code imposes limits on "nonqualified deferred compensation", a term that includes many common Canadian share-based forms of incentive compensation. Section 409A will apply to U.S. taxpayers (including U.S. citizens) who participate in Canadian compensation plans.
Many forms of share-based incentive compensation adopted by Canadian companies may constitute nonqualified deferred compensation that may not meet the requirements of section 409A. If this is so, U.S. taxpayers who receive awards under these Canadian plans may lose the benefit of income tax deferral and be subject to additional tax and interest. Canadian compensation arrangements that may constitute nonqualified deferred compensation include deferred share units, restricted and performance share units, phantom stock, stock options and share appreciation rights (SARs). As well, severance payments and supplemental pension arrangements may be subject to section 409A.
Nonqualified Deferred Compensation
Nonqualified deferred compensation is defined as compensation payable to a service provider who has a right to the compensation during the taxation year in which the services were rendered, but has not actually or constructively received the compensation or included it in income.
Section 409A generally affects distributions and timing of deferral elections, and imposes a general prohibition on the acceleration of benefits. Plans must require service providers to elect to defer compensation before the taxation year in which compensation is earned (except for certain performance-based compensation). In general, nonqualified deferred compensation plan distributions are not permitted earlier than separation from service, death, disability, an unforeseeable emergency, a change in corporate control, or at a specified time or age, or according to a fixed schedule.
The grant of equity-based compensation, including options and SARs, is potentially subject to section 409A. However, an option is generally not subject to section 409A if the exercise price can never be less than the value of the stock on the date of grant. An SAR will not be treated as deferred compensation provided (i) the exercise price may never be less than the fair market value of the stock on the grant date; (ii) only the employer’s stock, which is traded on an established securities market, may be delivered upon exercise; and (iii) the right does not include any deferral feature other than the deferral of recognition of income until the exercise of the right.
Consequences of Section 409A
If a nonqualified deferred compensation plan fails to satisfy or is not operated in accordance with section 409A, the U.S. taxpayer participant must immediately include in gross income all amounts deferred under the plan for that year and for all prior years, as well as any notional or actual income attributable to the deferred compensation amount, unless such amounts are subject to a substantial risk of forfeiture or were previously included in income. Additionally, amounts included in gross income are subject to an interest charge and an additional 20% "penalty" income tax.
Section 409A generally applies to amounts deferred in taxation years beginning after December 31, 2004. However, grandfathering is available for awards that were earned and vested by December 31, 2004 and made under a plan in effect on October 3, 2004 (unless the plan is amended after October 3, 2004).
A plan adopted on or before December 31, 2004 can be amended until December 31, 2005 to bring it into compliance with section 409A. As well, participants may terminate participation in a plan or cancel an election under an award until December 31, 2005.
Because of the extensive changes to the nonqualified deferred compensation rules and the draconian tax consequences if an arrangement fails to satisfy these provisions, all existing plans and arrangements (including individual arrangements) that could be affected by this new legislation should be carefully assessed. Before making new awards to U.S. taxpayers, companies should confirm whether those new awards would trigger section 409A. In addition, no material amendments should be made to these plans before the IRS clarifies the application of section 409A.
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