UK: US Jobs Creation Act

Last Updated: 9 January 2006
Article by David Pett

Originally published December 2005

The US Jobs Creation Act of 2004 enacted section 409A of the US Internal Revenue Code of 1986, imposing penal income tax charges on ‘non-qualified deferred compensation’ (see below) which is not structured and paid in accordance with the provisions of that section. The US Treasury has recently published draft regulations which clarify the application of section 409A to share incentive arrangements operated by non-US companies.

This article highlights the key issues in the draft regulations which are likely to affect non-US companies making option grants or share awards to US taxpayers. Please note that the information given in this article is for guidance only; we are not qualified to give advice on US law, so if you are uncertain of the effect on you of section 409A, we can help you to seek advice from US lawyers or tax advisers.

Who is affected?

Section 409A will affect companies who are proposing to grant share options or share awards to employees who are US resident for tax purposes, or are US citizens (referred to below as US taxpayers). Section 409A will also affect existing share options and share awards held by US taxpayers, if such options or awards were either:- n

  • not fully vested by 1 January 2005; or
  • were ‘materially modified’ on or after 4 October 2005.

Action Points

  • decide whether you need to take US advice;
  • identify any actions which need to take place by 31 December 2005
  • identify any actions which need to take place by 31 December 2006; and
  • consider whether any approvals or consents are needed.

If you have granted share options or share awards to US taxpayers, you should review the terms of the options or awards to determine whether section 409A will apply.

You should also consider whether you need to take any actions by 31 December 2005 (for example electing to defer compensation which would otherwise be received in 2006 or terminating non-compliant plans). Public companies should also identify ‘key employees’ based on pay received during 2005.

If you propose to grant share options or share awards to US taxpayers, you should seek advice from US lawyers as to whether any amendments need to be made to the terms or structure of such options or awards to take account of section 409A. You may also need to confirm the ‘fair market value’ of the shares to be put under such awards, in accordance with rules set out in the draft regulations.

Actions before the end of 2005

If any plan caught by section 409A allows participants to terminate participation, the termination must be effective by 31 December 2005. Likewise, if a company intends to modify a plan so that participants can terminate participation, this must also take place by the end of the year.

The regulations also require that certain elections to defer compensation which would otherwise be due in 2006 must be made by 31 December 2005.

It is our understanding that amendments which may need to be made to UK-style share plans will not normally need to be made by 31 December 2005, although companies may need to take action to make such amendments during the course of 2006.

Commencement Date

The regulations will be effective for taxable years commencing on or after 1 January 2007. However, plans adopted before 31 December 2005 have to be operated in good faith compliance with section 409A during 2005, and companies need to ensure that such plans are amended to comply with section 409A by 31 December 2006.

Non-Qualified Deferred Compensation

Section 409A provides that if any non-qualified deferred compensation is paid to a US taxpayer and the terms of such compensation do not comply with the provisions of section 409A, the taxpayer will immediately recognise such compensation as gross (taxable) income. In addition to the taxpayer's normal tax liability, section 409A imposes a 20% penal income tax charge. Interest may also be payable if the income should have been recognised earlier. Non-qualified deferred compensation includes any compensation to which a US taxpayer has a legally enforceable right during a taxable year, but which has not actually been included in his gross income during that year. It excludes any market value awards (although the definition of ‘fair market value’ differs from the UK interpretation of market value) and any compensation which is subject to a substantive risk of forfeiture.

Market Value Share Options

Options which have an exercise price equal to fair market value (determined in accordance with the draft regulations) are not caught by section 409A. However, market value as agreed with HM Revenue & Customs in the UK may not be the same as ‘fair market value’. Unless shares are traded on an ‘established securities market’ (which includes non-US securities exchanges which are officially sanctioned or supervised by governmental authorities) shares will need to be valued using a ‘reasonable valuation method’, carried out by a person with sufficient knowledge, experience and training in carrying out similar valuations. This could increase companies' costs of establishing and operating share plans for US taxpayers.

Discounted Options

Discounted options (ie options with an exercise price which is less than the fair market value at the date of grant) are likely to be caught by section 409A if, following vesting, the optionholder can choose when to exercise the option. If the optionholder actually exercises the option prior to the 15th day of the third month following the end of the taxable year in which the option vests, the option qualifies for the ‘short term deferral exemption’ and will not be caught by section 409A. If US taxpayers participate in a ‘nil-cost’ option plan, it may be beneficial to reduce the exercise period.

Restricted Share Awards

Restricted share awards will not be caught by section 409A if, following vesting, shares are immediately transferred to the awardholder.

Matching Shares under Co-investment Plans

Matching shares awarded under a Co-investment Plan may be caught by section 409A, depending on how the award is structured. If the award is a nil-cost option, it will only be exempt from section 409A if it is exercised within the period for the short term deferral exemption. If it is a restricted share award and shares are transferred immediately following vesting, it will not be caught.

Key Employees - cessation of employment

Section 409A restricts the time period in which ‘key employees’ can receive benefits following termination of employment, so that normally benefits can only be paid out after a period of 6 months has elapsed following the date of cessation.

We understand the definition of a ‘key employee’ broadly includes officers earning more than US $130,000 per year, although this figure is subject to adjustment in accordance with the legislation.

However, we understand that if a ‘key employee’ receives benefits under a share plan on termination of employment, provided the benefits are paid within the time period permitted by the short term deferral exemption, there will be no tax charge under section 409A.

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.

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