Article by the Pension & Employee Benefits Group, ©2005 Blake, Cassels & Graydon LLP
This article was originally published in Blakes Bulletin on Pension & Employee Benefits - December 2005.
On October 22, 2004, President George W. Bush signed the American Jobs Creation Act of 2004 (the Act). Among other things, the Act amended the Internal Revenue Code (the Code) by adding Section 409A, which imposes new restrictions on “nonqualified deferred compensation plans”. In general, Section 409A provides specific rules for deferral elections, distributions and funding mechanisms under nonqualified deferred compensation plans. On December 20, 2004, Treasury and the IRS issued Notice 2005-1, which provided considerable guidance for compliance with Section 409A and also provided some transitional relief. Most recently, on September 29, 2005, Treasury and the IRS issued long awaited proposed regulations to Section 409A (the Proposed Regulations), which incorporate the guidance in Notice 2005-1 and provide additional guidance and transitional relief. Although written compliance generally will not be required until December 31, 2006, for plans which are not fully “grandfathered” under the new legislation, good faith compliance with Section 409A and Notice 2005-1 will be required throughout 2005 and 2006.
These new rules will affect Canadian employers that sponsor a wide variety of incentive, severance, nonqualified retirement income and deferred compensation plans in which persons subject to U.S. federal income tax participate. A U.S. taxpayer can include a citizen of the U.S., a resident of the U.S. who is employed in Canada or even a Canadian resident who has deferred compensation or other entitlements under a plan relating to prior years of employment in the U.S. Canadian employers who sponsor such plans will need to consider whether their plans are non-qualified deferred compensation plans for the purposes of the legislation and, if so, whether or not their plans are in compliance with Section 409A or, at the very least, are in compliance with respect to U.S. taxpayers. As part of this assessment, it will be necessary to consider whether deferred compensation or contributions to a deferred compensation plan are excludable from U.S. federal income tax pursuant to the Canada-U.S. Tax Convention, since such compensation or contributions would not be subject to Section 409A.
This bulletin is intended to assist Canadian employers in understanding the new rules and their impact on deferred compensation arrangements they sponsor. Canadian employers should discuss with their U.S. income tax advisors the potential implication of Section 409A to their nonqualified deferred compensation programmes in which U.S. taxpayers participate. In many cases, it will be necessary to carefully consider the Canadian income tax and plan design implications that could arise from the application of Section 409A including possible plan amendments. For example, certain plans in which U.S. taxpayers participate and which are subject to Section 409A may need to comply with specific Canadian income tax requirements or desired objectives. In some such plans, changes in response to Section 409A could result (if care is not taken) in adverse Canadian income tax results to plan participants who may be both Canadian and U.S. income taxpayers. A number of arrangements that are likely caught by the requirements of Section 409A are subject to advance income tax rulings in Canada and it will be necessary in these situations to address how such rulings could be affected if amendments are required to address the requirements of Section 409A.
“Nonqualified deferred compensation plans”
A nonqualified deferred compensation plan is broadly defined in Section 409A to mean a plan that provides for the deferral of compensation, other than a “qualified employer plan” (e.g., a 401(k) plan, qualified retirement plan or tax-deferred annuity) or certain bona fide welfare plans. As discussed below, the Proposed Regulations also provide exceptions for amounts deferred under certain foreign based plans. Non-qualified deferred compensation plans include nonqualified deferred compensation plans between an employer and its employees, directors or independent contractors (each a “service provider”). It also includes an arrangement for only one person. As discussed below, a broad range of Canadian retirement income and incentive compensation arrangements in which U.S. taxpayers participate could be subject to the new legislation.
The exception for foreign based plans includes exceptions for certain “foreign broad-based retirement plans” as they apply to certain persons. With respect to non-U.S. citizens who are not permanent residents of the United States, amounts deferred under certain broad-based foreign retirement plans and amounts deferred under foreign retirement plans attributable to services in the U.S. that do not exceed $10,000 are not subject to Section 409A. This exception may assist certain Canadian residents employed in the United States who are accruing benefits under particular Canadian retirement arrangements. For U.S. citizens and lawful permanent residents of the United States, 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 “qualified employer plan” and only to the extent that the amount deferred in a given year does not exceed the amount of contributions or benefits that may be provided under a qualified plan under section 415 of the Code. This exception will not assist U.S. citizens and lawful permanent residents of the United States employed in the United States who participate in Canadian retirement arrangements, but may assist such persons who participate in such arrangements while employed in Canada. In general, a “broad-based retirement arrangement” is defined in the Proposed Regulations as a written plan providing retirement benefits that is non-discriminatory insofar as it covers a wide range of employees, substantially all of whom are non-resident aliens (or employees who are resident aliens solely because of their substantial presence in the U.S.), including rank and file employees, and actually provides for significant benefits for the range of employees. Whether a plan is non-discriminatory may be determined based on the plan alone, or, if the employer elects, in combination with other comparable plans.
The Proposed Regulations provide considerable guidance on what constitutes a deferral of compensation. A plan provides for the deferral of compensation if the service provider has a legally binding right during a taxable year to compensation that has not been actually or constructively received and included in gross income, and that, pursuant to the terms of the plan, is payable to or on behalf of the service provider in a later year. If the employer has the ability to reduce unilaterally the amount payable after the services to which the amount payable relates have been performed, there would not generally be a legally binding right to compensation, unless this right lacks substantive significance.
The Proposed Regulations provide a number of exceptions from what constitutes a deferral of compensation. First, a deferral of compensation does not occur if the service provider actually or constructively receives the amount no later than 2-½ months after the end of the taxable year of the employer or the service provider, whichever is later, in which the amount is no longer subject to a substantial risk of forfeiture. Also exempted are options to purchase “stock of the service recipient” where the exercise price may never be less than the fair market value of the underlying stock on the date the option is granted, disregarding lapse restrictions and provided that the option is taxable under §83 of the Code and that the option does not include any feature for the deferral of compensation other than that of the option itself. The Proposed Regulations provide rules for valuing the stock of a service recipient. For publicly traded stock, the valuation may be based on an average of the price of the stock over a specified period beginning no earlier than 30 days prior to the grant date and ending no later than 30 days after the grant date. The Proposed Regulations define “stock of the service recipient” as stock that, as of the date of grant, is common stock of a corporation (public or private) that is a service recipient, including any member of a group of corporations or other entities treated as a single service recipient. The Proposed Regulations reduce the control percentage from 80% to 50%, and further reduce the percentage to 20% if the award is based on legitimate business criteria. Of note, it would appear that options on trust units (for example, publicly traded Canadian mutual fund trusts) would not be eligible for the exemption, since the exemption is restricted to options in stock of a corporation. As a result, trust unit options will be subject to Section 409A.
The Proposed Regulations also exempt a share appreciation right (SAR) on stock of the service recipient provided the SAR exercise price may never be less than the fair market value of the underlying stock on the date the right is granted, disregarding lapse restrictions. As well, the SAR may not include any other feature for the deferral of compensation other than the deferral of recognition of income until the exercise of the right. The Proposed Regulations permit SARs to be settled in either cash or common stock of the service recipient. As with stock options, this exemption is restricted to SARs in respect of corporate shares and would not apply to trust units. As a result, SARs on units of a trust will be subject to Section 409A.
Requirements of 409A and Potential Tax Liability
Section 409A provides that if at any time in a taxation year a nonqualified deferred compensation plan fails to meet certain requirements under Section 409A or is not operated in accordance with such requirements, all compensation deferred under the plan for the taxable year and all preceding taxable years shall be included in the gross income of the participants in respect of whom the failure to comply relates. If compensation is required to be included in income as a result of a plan’s failure to meet such requirements or its failure to be operated in accordance with such requirements, interest (computed at the IRS underpayment rate plus 1 percentage point) and an additional tax equal to 20 percent will be applied to the amount required to be included in gross income.
The requirements under Section 409A for nonqualified deferred compensation plans relate to elections, distributions and funding.
Timing of Elections
Subject to certain exceptions, any election to defer compensation for services performed in a taxable year must be made prior to the beginning of that taxable year. There is an exception for the first year in which a participant becomes eligible to participate in the plan. In such cases, an election must be made within 30 days after the participant becomes eligible to participate in the plan and the deferral must apply to compensation with respect to services performed after the election. As well, for “performance based compensation” with a performance period of at least 12 months, the election may be made up to 6 months before the end of the service period to which the performance based compensation relates. Performance based compensation is defined in the Proposed Regulations to mean “compensation where the amount of, or entitlement to, the compensation is contingent on the satisfaction of preestablished organizational or individual performance criteria relating to a performance period of at least 12 consecutive months in which the service provider performs services.” It does not include compensation that will be paid either regardless of performance or based on a level of performance that is substantially certain to be met. The performance criteria may be established up to 90 days after the commencement of the performance period of 12 months or more. Finally, in a change from Notice 2005-1, the Proposed Regulations provide that performance-based compensation may be based solely upon an increase in the value of the service recipient or the stock of the service recipient, after the date of grant or award.
Distributions from Plans
Section 409A provides that deferred compensation must not be distributed from a nonqualified deferred compensation plan earlier than (i) separation from service; (ii) disability of the participant; (iii) death of the participant; (iv) a specified time (or pursuant to a fixed schedule) under the plan at the date of the deferral of such compensation; (v) a change in control of the corporation; or (vi) the occurrence of an unforeseeable emergency. A plan may provide for more than one distribution event (e.g., distribution on the earliest of the permitted distribution events) and can provide for a different form of payment for each distribution event.
Separation from Service. For “specified employees” of a corporation, any stock of which is publicly traded on an established securities market or otherwise, a distribution may not be made before the date which is 6 months after separation from service, except in the case of the participant’s death. The Proposed Regulations adopt the definition for “established securities market” in U.S. Treasury Regulation § 1.897-1(m), which includes a foreign national securities exchange officially recognized, sanctioned, or supervised by governmental authority. This would include Canadian stock exchanges. The 6-month delay rule would therefore apply to a specified employee of a Canadian corporation listed exclusively on a Canadian stock exchange. In general, a specified employee is (i) an employee or a non-executive director who owns greater than 5 percent of the stock of the corporation; (ii) an employee who receives compensation of greater than $USD 150,000 a year and owns more than 1 percent of the stock of the corporation; or (iii) an officer of the corporation who receives annual compensation in excess of $USD 135,000 ($USD 140,000 in 2006) a year. However, an employer will have no more than 50 specified employees (or, if less, the greater of 3 or 10% of the employer’s employees).
The restriction for specified employees applies only to employees of a publicly traded corporation. As a result, it would appear that an employee of a partnership or trust, the units of (or interests in) which may be publicly traded, would not be caught by this restriction. In certain situations, employees of a management services corporation that provides services to a publicly traded trust, but which is not publicly traded itself, may also be exempt. This could be a useful exception for executives employed in connection with Canadian income trusts who participate in nonqualified deferred compensation arrangements.
Disability. A participant is considered disabled if, as a result of a medical or physical impairment which is expected to last at least 12 months or result in death, the participant is (i) unable to engage in any substantial gainful activity or (ii) is receiving income replacement benefits for not less than 3 months under an accident and health plan covering employees of the participant’s employer. In addition, a plan may provide that an employee is deemed to be disabled if the employee is determined to be totally disabled by the U.S. Social Security Administration.
A specified time (or pursuant to a fixed schedule) under the plan. The date of payment must be selected or stipulated in the applicable plan terms at the time the election deferral is made. Payments may be made pursuant to a schedule or on a fixed date. However, a plan may designate a year of payment rather than a specific payment date.
Change in Control. A plan may permit a payment upon a change in control of the ownership of the corporation, a change in the effective control of the corporation or a change in the ownership of a substantial portion of the assets of the corporation (each a “change in control event”). The relevant corporation for purposes of the change in control event is the corporation for which the service provider performed the services, the corporation or corporations liable for the payment of the deferred compensation at the time of the change in control event, or a corporate majority shareholder of one such corporation. In order to qualify as a change in control event, the occurrence of the event must be objectively determinable and not be left to the judgment of the plan administrator or the board of directors of the corporation. Some plans contain a change in control provision which, in addition to a specified objective test for change in control, permits the board of directors (or its delegate) to declare a change in control. The mere inclusion of such a provision is not permitted with respect to any compensation subject to 409A.
In general, a change in control of the ownership of the corporation occurs when one person, or more than one person acting as a group, accumulate greater than 50 percent of the total fair market value or voting power of the stock of the corporation.
A change in effective control of a corporation occurs on the date that either (i) any one person, or more than one person acting as a group, acquires ownership of the stock of the corporation possessing 35 percent or more of the total voting power of the stock of such corporation over a 12-month period or (ii) a majority of the members of the board is replaced during any 12-month period by directors whose appointment or election is not endorsed by a majority of the board in place prior to the appointment or election. The applicable board in this case is the ultimate parent corporation’s board, if any.
A change in the ownership of a substantial portion of a corporation’s assets occurs when any one person, or more than one person acting as a group, acquires assets from the corporation that have a total gross fair market value of 40% or greater of the fair market value of the corporation’s assets immediately prior to such acquisition. A transfer of assets to a related person is not considered a change in the ownership of a substantial portion of a corporation’s assets.
Since this permissible distribution is restricted to a change in control of a corporation, it would not apply to a change in control of a publicly traded trust. s a result, payments from a nonqualified deferred compensation arrangement sponsored by publicly traded trust, for example, or by a management company which is controlled by an income trust, may not be made on a change in control of the trust, irrespective of how the change in control provision in the plan is worded. The Proposed Regulations provide that the rule can be extended by analogy to partnerships, but no mention is made of trusts. The Treasury Department and IRS are requesting comments with respect to the application of the change in control rule to non-corporate entities, so there remains the possibility that the rule will be extended to trusts in the final regulations.
Occurrence of an unforeseeable emergency. Section 409A defines the terms “unforeseeable emergency” to mean a severe financial hardship to the participant resulting from an illness or accident of the participant, the participant’s spouse or a dependant, the loss of the participant’s property due to casualty, or other similar extraordinary and unforeseeable emergencies “arising as a result of events beyond the control of the service provider.” To qualify for the unforeseeable emergency condition, a distribution cannot exceed the amount needed to satisfy that emergency plus taxes resulting from the distribution.
In addition to restrictions on elections and distributions, Section 409A imposes restrictions on the funding media for nonqualified deferred compensation plans. Of most importance to Canadian employers is the restriction on the use of offshore trusts to fund nonqualified deferred compensation plans. Assets in an offshore trust set up for such purposes will be treated as property transferred in connection with the performance of services and included in the income of the participants at the time such assets are set aside or at the time they are transferred from the United States to the foreign trust. There is an exemption for offshore assets where substantially all of the services to which the nonqualified deferred compensation that is subject to Section 409A relate are performed in such jurisdiction.
A supplemental pension arrangement that is funded or secured through a letter of credit held in a Canadian resident trust may not (in certain circumstances) be subject to these new funding restrictions. Instead, because under a typical funded Canadian supplemental retirement plan the amount, or the letter of credit, held under the trust is not subject to the claims of the employer, the value of the service provider’s interest in the trust could be included in the service provider’s income for U.S. tax purposes when the service provider vests in the benefits secured by the funds, or the letter of credit, held under the trust.
Grandfathering for Existing Plans
Section 409A applies only to amounts deferred in taxable years beginning after December 31, 2004 or amounts deferred prior to January 1, 2005 if the plan under which the deferral is made is materially modified after October 3, 2004. As well, earnings credited after December 31, 2004 are not subject to Section 409A to the extent that the earnings relate to compensation that is not subject to Section 409A. An amount will be considered deferred prior to January 1, 2005 if, before that date, the service provider has a legally binding right to be paid the amount and the amount is earned and vested. An amount will be considered earned and vested only if it is not subject to substantial forfeiture or a requirement to perform further services. In cases where the requirements for a bonus had been met prior to December 31, 2004, but the distribution did not take place until the beginning of 2005, the amount will likely be considered earned and therefore grandfathered provided that all that remains is the distribution of the amount. However, if the requirements have been met prior to December 31, 2005, but the payment is still subject to a genuine discretion to be exercised by the employer after December 31, 2005, the amount will not likely be considered earned in 2004 and therefore not grandfathered.
Notice 2005-1 provided that a plan adopted before December 31, 2005 will not be treated as violating the election and distribution requirements if the plan was operated in good faith compliance with the provisions of Section 409A and Notice 2005-1 during 2005 and the plan was amended prior to December 31, 2005 to conform to the requirements in Section 409A. The Proposed Regulations extend this transitional period through 2006. Accordingly, a plan that is adopted on or before December 31, 2006 will be considered to be operated in good faith compliance up to December 31, 2006, if it is operated in accordance with Section 409A and Notice 2005-1 until such time. The deadline by which plan documents must be amended to comply with the provisions of Section 409A and the final regulations, which will likely be issued by mid-2006, is December 31, 2006.
Effect of 409A on Canadian Plans
The new rules will likely affect a number of the following deferred compensation arrangements sponsored by Canadian employers in which persons subject to U.S. federal income tax participate.
Stock Options. In Canada, due to requirements under the Income Tax Act (Canada) (the ITA) and stock exchange rules, stock options are generally not issued with an exercise price in excess of the fair market value of the underlying stock at the date of grant. As a result, such stock options would not likely be subject to Section 409A. On the other hand, stock options granted by Canadian private controlled corporations are sometimes granted at a discount and, if such an option were granted to a U.S. taxpayer, Section 409A could be applicable. As well, options on trust units will be subject to Section 409A. In addition, employers should be careful with respect to any amendments they may wish to make to a grandfathered stock option, such as extending the exercise period. This may cause the option to lose its grandfathered status.
SARs. Although Notice 2005-1 took a more restrictive view, the Proposed Regulations provide that SARs, including tandem SARs, are exempt from 409A if they meet the same requirements that apply to nonstatutory options, regardless of whether the underlying stock is traded on an established market. As with stock options, SARs on trust units do not fall within this exemption.
Restricted Share Units (“RSUs”) and Performance Share Units (“PSUs”). RSUs and PSUs are a form of phantom shares (i.e., they represent a contingent right on the part of an employee to receive shares, or the value of shares in cash, of the company). Both RSUs and PSUs are typically granted with vesting conditions. In the case of PSUs, the vesting conditions often include performance objectives. Upon the satisfaction of the vesting conditions, the RSUs and PSUs are settled in cash or shares of the company. To avoid an immediate income inclusion under Canadian income tax laws, RSUs and PSUs that are settled in cash sometimes include bona fide performance-based vesting requirements or ensure that payment is made prior to the end of the third year following the year in which the RSUs or PSUs are granted.
Certain RSU and PSU plans may be exempt from Section 409A. In particular, plans that settle RSUs or PSUs within 2-½ months after the end of the year in which the RSUs or PSUs vest will generally be exempt since they are not considered nonqualified deferred compensation plans due to the fact that there is only a short period of deferral of income. For example, an RSU granted in January 1, 2005 with a 3-year cumulative vesting period that is paid out by March 15, 2008 will not be subject to Section 409A. However, if there is graduated vesting over a number of years, which is common under RSU and PSU plans, with payment at the end of the 3-year period, the plan will be subject to 409A. Furthermore, plans that have a cumulative vesting period often include provisions for earlier vesting in the case of retirement, disability, or leaves of absence; those plans may not be able to rely on the short-term deferral exception to Section 409A.
For RSU and PSU plans subject to Section 409A, elections and distributions will have to meet the requirements in Section 409A. With the exception of plans that provide performance based compensation, if an election to defer compensation is permitted, such election must take place before the beginning of the taxable year to which the compensation relates, or, if the award vests over a period that lasts at least 13 months, the election may take place within the first 30 days following the date the award is granted. As well, the distribution dates must either be elected at the time the election is made or set out in the plan. Where the election relates, for example, to a conversion into PSUs or RSUs of compensation that would constitute performance based compensation, elections will be permitted up to 6 months before the end of the performance period to which the compensation is based. As noted above, in order to qualify as performance-based compensation, the compensation must be contingent on the satisfaction of pre-established organizational or individual performance criteria relating to a performance period of at least 12 consecutive months in which the service provider performs services.
Distributions from an RSU or PSU plan (that are caught by Section 409A) will have to meet the requirements in Section 409A. It is quite common for RSU and PSU plans to provide for vesting and payments upon a change in control, upon the disability of a participant or at the discretion of the company. Discretionary accelerations of payments will not be permitted. Payments as a result of change in control or the disability of the participant will be permitted. However, the RSU or PSU plan will likely need to be modified to ensure that the definition of change in control or disability complies with Section 409A and the Proposed Regulations. As well, distributions to specified employees may, depending on the service recipient, need to comply with the 6-month waiting period prescribed under Section 409A. Finally, we would note that RSU or PSU plans which are funded pursuant to a trust will need to be aware of the new foreign trust rules.
Deferred Share Units (“DSUs”). DSUs, like RSUs, are a form of phantom shares (i.e., they represent a contingent right on the part of an employee to receive shares, or the value of shares in cash, of the company). DSUs are understood to refer to arrangements which meet the requirements in Income Tax Regulation 6801(d), which provides an additional exception to the salary deferral arrangement rules. In general, in order to meet the requirements of 6801(d) and avoid taxation under Canadian income tax laws before the date of payment: (i) the DSU must be payable no earlier than the date of the employee’s retirement, termination of employment or death, or in the case of a director, resignation, retirement from the board or death, (ii) payment must be no later than the end of the calendar year following the year in which the employee terminates employment, retires or dies, or in the case of a director the end of the calendar year following the year in which the individual ceases to be a director and is not otherwise employed by the company or dies; and (iii) the value of the DSU must be based on the fair market value of the share of the employer or a corporation related to the employer determined at any time within the period that commences up to one year before the date of termination of employment and ends on the date of payment. DSUs are issued by Canadian employers to both directors and employees and are usually settled in cash.
It is common for directors and employees of a Canadian corporation, some of whom may be U.S. taxpayers, to be included in DSU plans sponsored by the Canadian employer. Many such DSU plans will be subject to Section 409A and will have to meet the election and distribution requirements. Under many (but not all) DSU plans, elections to defer under the plan are made prior to the year in which the amount being deferred relates. This would be permissible under Section 409A. However, DSUs may permit elections to be altered during a taxation year and DSUs frequently permit participants to elect the date or dates on which all or some of the DSUs will be settled after the participant has terminated employment within the timeframe permitted under Canadian income tax regulation 6801(d). While these choices are permissible under the ITA, they are not permissible under Section 409A. DSUs subject to U.S. federal income tax must only permit elections prior to the beginning of the calendar year (except for the first year as noted above) and must be settled and paid at a predetermined date.
In accordance with Income Tax Regulation 6801(d), DSU plans only permit a distribution following the participant’s death, retirement or loss of office or employment. No distribution is permitted solely as a result of disability or change in control of the corporation. Where termination of employment occurs in the normal course or following a change in control, distributions to specified employees will need to comply with the 6-month waiting period mandated under Section 409A and will also need to comply with the requirement under Income Tax Regulation 6801(d) that payment be made no later than December 31 of the calendar year following the year in which the termination of employment occurs.
Supplemental Executive Retirement Plans (SERPs). SERPs provide pension benefits that are in excess of those provided under an employer’s registered pension plan. Benefits that may be provided under a registered pension plan are capped under the ITA. In Canada, SERPs are often unfunded arrangements, since there is no tax effective funding vehicle under the ITA.
A number of Canadian SERPs may be subject to Section 409A since they provide for a deferral of compensation and are not qualified arrangements for U.S. tax purposes. However, certain amounts deferred under particular “broad-based foreign retirement plans” are not subject to Section 409A. These exceptions may be helpful with respect to certain amounts deferred under SERPs. Of course, if other amounts under the SERP are subject to Section 409A, the terms of the SERP with respect to such amounts will have to comply with Section 409A.
Assuming the SERP is subject to Section 409A, a number of issues will have to be considered. First, SERPs often include flexible distribution options, which permit the election, prior to retirement, of a lump sum instead of an annuity at retirement. This type of discretion will not be permitted under the new rules for benefits accrued after December 31, 2004. Furthermore, grandfathered amounts for U.S. taxpayers remain subject to other U.S. tax laws. In this regard, care should be taken to avoid constructive receipt of a deferred amount under a SERP or other arrangement.
The amount of benefits that may be treated as grandfathered under a SERP is the present value of the participant’s vested, accrued benefit as of December 31, 2004. This benefit is determined as if the participant voluntarily terminated employment without cause on December 31, 2004 and received benefits in the most valuable form available and at the earliest payment time allowed under the plan. This amount may be increased, due to the passage of time by interest and, if applicable, mortality adjustments. However, the grandfathered amount cannot be increased on account of any services performed after December 31, 2004.
The Proposed Regulations permit a nonqualified deferred compensation arrangement that ties the form and distribution of payment to the participant’s election under a qualified plan to continue to operate in accordance with the current plan during the transition period that ends December 31, 2006.
This temporary exemption will be of no use to Canadian SERPs which are tied to Canadian registered pension plans, since Canada registered pension plans are not considered qualified plans. As a result, distribution elections in respect of accruals beyond 2004 will likely need to be made by participants.
All the other distribution events under the SERP will have to comply with Section 409A. These include the change in control provisions and the 6-month specified employee restriction. This will likely require amendments to most plans for participants subject to U.S. federal income tax. The distribution requirements under Section 409A will also prohibit a discretionary commutation option that is quite common in SERPs.
Funding requirements under Section 409A may also be an issue for many funded SERPs. Assets in the trust that are held outside the U.S. may be treated as transferred property unless all or substantially all of the services to which the SERP benefits relate are performed in the jurisdiction in which the trust assets are held. This may be an issue where the executive is performing services outside Canada but accrues benefits under a SERP funded pursuant to a trust resident in Canada. As noted above, if a SERP is funded or secured through a letter of credit, the funding arrangement may not subject to the new funding requirements in Section 409A but instead to taxation under Section 402(b), which requires the value of the employee’s interest in the trust to be included in income when the employee vests.
Actions Required by Canadian Employers in 2005
As a first step, Canadian companies should consider whether 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 extremely 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.
If a Canadian company determines that there are such participants in its deferred compensation plans, the company should consult its U.S. tax advisors to determine whether such plans are subject to and in compliance with Section 409A. Amendments to such plans may be required prior to December 31, 2006. In the meantime, plans must be operated in compliance with Section 409A. Accordingly, advance planning is required to ensure that deferral and distribution elections that are currently being made comply with Section 409A.
Finally, when making any amendments to their deferred compensation plans to comply with Section 409A and the regulations, companies should consult with their Canadian tax advisors to ensure that any such amendments also comply with the ITA and do not adversely affect any Canadian participants under such plans.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.