Notice 2009-8 Provides Interim Section 457A Guidance But the Devil Is in the Details

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By Michael G. Kushner, Esq. Curtis, Mallet-Prevost, Colt & Mosle LLP, New York, NY

I. Introduction

The IRS has issued Notice 2009-8, providing interim guidance on the application of new §457A1 to certain nonqualified deferred compensation (“NQDC”) plans or arrangements. This article examines the provisions of Notice 2009-8 and their importance to affected taxpayers.

The enactment of §457A constituted a dramatic and sudden change in the U.S. income taxation of offshore entities and persons. Notice 2009-8 attempts to fill in some of the details of this hastily enacted statute, at least on an interim basis as Notice 2005-1 did with respect to §409A. Notice 2009-8, however, unlike Notice 2005-1, may really raise as many new questions as it answers. As they say, the devil is in the details, and the issuance of Notice 2009-8 demonstrates that there will be many details, with still more to come in the form of further IRS guidance.

Under §457A, compensation deferred under a NQDC plan of a “nonqualified entity” becomes taxable when it is not subject to a substantial risk of forfeiture (“nonforfeitable”), unless the amount of NQDC is not determinable, in which case it is taxed when it becomes determinable.2 Congress enacted §457A to limit taxpayers' ability to defer compensation by using offshore entities, such as foreign corporations, in tax-haven jurisdictions. One example of such an entity would be an offshore feeder fund in corporate form that is part of a “master-feeder” hedge fund structure. Until IRS issues further guidance, taxpayers may rely on the Notice effective from October 3, 2008.3 Future guidance that is more restrictive than the Notice will only apply prospectively.

Under §457A, NQDC has the same meaning as under §409A,4 except that the exemption 5 for stock appreciation rights (“SARs”) generally is not available unless they must be, and are, settled in the form of service recipient stock. In applying the other equity based pay exemptions from §409A to an equity interest in an unincorporated person or entity, the Notice states that §409A principles are to apply by analogy.6

II. Short Term Deferrals

The Notice clarifies that a “§457A short-term deferral” is not deferred compensation under §457A. Unlike §409A which uses a 21/2-month rule, a §457A short-term deferral is compensation paid no later than 12 months after the end of the service provider's (e.g., an employee) taxable year during which the service recipient's (e.g., an employer) right to payment is nonforfeitable. The Notice also clarifies that a service recipient is the person for whom the service provider directly provides services when the compensation becomes nonforfeitable. For example, if an individual provides services to a wholly owned subsidiary, the service recipient is the subsidiary, not its parent corporation.7

III. Nonqualified Entities

A. In General

The Notice provides that a service provider may be an individual, corporation or an unincorporated entity, regardless of whether the provider uses the cash or accrual accounting method.8 Services provided to “nonqualified entities” are subject to §457A. A nonqualified entity is:

(1) a foreign corporation unless substantially all of its net income is effectively connected with the conduct of a U.S. trade or business (“effectively connected income”) or is subject to a “comprehensive foreign income tax;” and

(2) a partnership unless substantially all of its income is allocated to persons other than foreign persons not subject to a comprehensive foreign income tax and entities exempt from U.S. income tax under the Code.9

B. Definitions

1. Substantially All

“Substantially all” of a foreign corporation's income is subject to a comprehensive foreign income tax if, for its taxable year ending with or within the service provider's taxable year it:

(1) either (i) is eligible for the benefits of a comprehensive income tax treaty between its country of residence and the U.S., or (ii) can show that it is resident for tax purposes in a foreign country that has a comprehensive income tax; and

(2) enjoys no more favorable corporate income tax treatment in its country of residence than is provided under that country's general corporate income tax law.10

2. Comprehensive Foreign Income Tax

Substantially all of a foreign corporation's income is not subject to a comprehensive foreign income tax, however, if:

(1) its taxable income in its country of residence excludes, in whole or part, foreign source income; and

(2) the amount of foreign source income excluded for the taxable year (the “excluded amount”) exceeds 20% of its gross income.11

3. Excluded Amount

The “excluded amount” includes income shielded from tax by a deduction, exemption, and taxation at less than 50% of the generally applicable rate or by other means. Gross income is determined using the country of residence's definition of the term, plus all foreign source income that falls beyond the reach of that country's tax laws.12

Substantially all of a foreign corporation's income is effectively connected income if, for the corporation's taxable year ending with or within the service provider's relevant taxable year, at least 80% its gross income is effectively connected and is not exempt from U.S. income tax under a U.S. treaty obligation. One example of income that might not be subject to U.S. income tax under a treaty would be income not attributable to a permanent establishment.13

4. Comprehensive Income Tax Treaty

A “comprehensive income tax treaty” is every U.S. income tax treaty other than those with Bermuda and The Netherlands Antilles. To be eligible to benefit under a treaty, a foreign person must be a resident within the meaning of the treaty and satisfy any other treaty requirements, including any provisions limiting treaty benefits.14

5. Partnership Test/U.S. Relevant Partnership

A “relevant partnership” is not a nonqualified entity for a taxable year if substantially all (80%) of its income is allocated to persons other than eligible persons.15

A U.S. partnership is a “relevant partnership” if it either:

(1) must file a partnership income tax return; or

(2) determines the distributive share of income of any partner under §704.

6. Allocation of Gross and Net Income

If a U.S. relevant partnership allocates any net income, gross income is considered to be allocated to the partner who received the related allocation of net income to the extent that such net income is derived from gross income. Gross income of a foreign partnership, or a domestic partnership that is treated under a foreign country's laws as resident in that country for tax purposes, may be treated as allocated to the partnership.16

Gross income of a partnership that is not a U.S. relevant partnership is determined for the partnership's taxable year using any reasonable method that incorporates §61 principles. In general, gross income is deemed allocated to a partner to the extent the partner includes it in its current gross income under the tax laws of the partner's country of residence, regardless of whether such income is distributed to the partner. Gross income of a partnership that is not a U.S. relevant partnership plan may be treated as allocated to the partnership.17

7. Eligible Person

An item of partnership gross income allocated to a partner generally may be treated as income allocated to any single direct or indirect owner of the partner that takes such income into account currently under the laws of its country of residence, regardless of whether the income actually is distributed to the owner (an “eligible person”).18

Gross income is allocated to an eligible person to the extent that:

(1) gross income from an unrelated trade or business is allocated to an organization subject to the unrelated business income tax under §511;

(2) U.S. effectively connected income is allocated to a person subject to U.S. income tax and is not exempt therefrom by a U.S. treaty;

(3) gross income is allocated to a U.S. person other than (i) a tax-exempt entity; (ii) a U.S. domestic partnership; or (iii) a trust or estate, except to the extent it is subject to U.S. income tax on such income and the income is neither included in the beneficiary's gross income nor paid or permanently set aside for a charitable purpose; or

(4) gross income that is not effectively connected is allocated to a foreign person, who is subject to a comprehensive foreign income tax on such income.19

8. Comprehensive Foreign Income Tax

A foreign person is subject to a “comprehensive foreign income tax” with respect to a partnership item of income only:

(1) if the person generally takes such income into account currently under the tax laws of the person's country of residence, regardless of whether the income actually is distributed to such foreign person; and

(2) (i) if the foreign person is other than a nonresident alien individual (a) such person is an entity that is not fiscally transparent under the laws of its country of residence with respect to such income; (b) such person qualifies as a “foreign corporation;” and (c) such income is not excluded from the foreign person's income by an exemption, exclusion, dividends paid or dividends received deduction (or similar provision), taxation at less than 50% of the generally applicable rate or by other means; or (ii) if the foreign person is a nonresident alien individual (a) such person is eligible for the benefits of a comprehensive income tax treaty with the U.S., or is subject to a comprehensive foreign income tax, and (b) such income is not excluded from the person's taxable income by any exemption, exclusion, deduction (including a dividends paid deduction or dividends received deduction (or similar provision), taxation at less than 50% of the generally applicable rate or by other means.20

9. U.S. Effectively Connected Income

If a foreign corporation has income taxable under §882 (U.S. effectively connected income), §457A does not apply to compensation that, had it been paid in cash when it became nonforfeitable, would have been deductible under §882 principles by the foreign corporation against such income. If the compensation expense would not have been part of the corporation's cost of goods sold, it is considered to be deductible against such income only to the extent that it would be properly allocated and apportioned to such income. If the compensation expense would have been part of the corporation's cost of goods sold, it is considered to be deductible by the corporation against such income using any reasonable method based on the surrounding facts and circumstances.21

10. Determination Date of Entity

Whether an entity is a nonqualified entity is determined as of the last day of each of the service provider's taxable year in which the NQDC becomes nonforfeitable and remains deferred. If an entity becomes a nonqualified entity during a service provider's taxable year and remains a nonqualified entity as of the last day of such taxable year, NQDC is subject to §457A for such taxable year and NQDC is taxable to the extent it has not previously been taxed. If an entity ceases to be a nonqualified entity during a service provider's taxable year and is not a nonqualified entity as of the last day of that taxable year, NQDC is not subject to §457A for that taxable year of the service provider.22

Whether a partnership is a nonqualified entity as of the last day of the service provider's taxable year is determined based on the allocations or deemed allocations of gross income by the partnership for the partnership's taxable year ending with or within the service provider's taxable year. If a partnership does not yet have a taxable year that has ended or has one that ends on the last day of the service provider's taxable year, a good faith estimate of such allocation of the partnership for its current taxable year is used to determine if it is a nonqualified entity.23

The determination of whether NQDC is provided by a nonqualified entity is made as of the last day of the service provider's relevant taxable year. For any amount deferred, the service recipient is any entity or entities which, had it paid the NQDC in cash to the service provider in the relevant taxable year, could take a compensation deduction for it under U.S. tax principles.24

IV. Taxable Amount

A. In General

Under §457A, NQDC includes actual or notional income attributable to such compensation. The Notice provides that when the right to earnings is specified, the earnings become nonforfeitable when the related compensation becomes nonforfeitable. Rights to reasonable earnings credited on at least an annual basis therefore are taxable when the right thereto vests. Earnings other than reasonable earnings or earnings that are not credited at least annually are treated in part or whole as currently deferred amounts. The amount of income is determined by applying the analogous §409A rules.25

To the extent that NQDC is taxable under §457A before it is paid (i.e., previously taxed income) it will not be not taxed when paid. Section 457A, however, may still apply to the right to future reasonable earnings on previously taxed amounts. In determining the amount that is not taxable at the time of payment, taxpayers again are to apply §409A principles.26

If an amount becomes taxable under §457A before it is paid but is forfeited before payment, the service provider can deduct the loss.27

B. Undeterminable NQDC Amounts

A vested NQDC amount is not determinable if it would be calculated as a formula amount under the §409A regulations. This generally occurs where the amount of the payment (rather than its timing) is unknown at the end of the taxable year because it is based on factors that remain variable at that time. An amount that is treated as not determinable when it otherwise would be taxable under §457A becomes taxable when it becomes determinable.28 The Notice provides the following example: a bonus based on annual profits as of December 31, 2010 is a formula amount at all times prior to December 31, 2010. The amount, however, becomes determinable as of December 31, 2010 because the information necessary to calculate the bonus exists, even if the calculation of the annual profits is not readily available.29

When an amount that is treated as not determinable when it otherwise would be taxable under §457A becomes determinable, the tax for the year it becomes taxable is increased by (i) 20% of the taxable amount, plus a “premium interest tax” equal to the IRS underpayment rate plus 1 percentage point on the amount that would have been taxable in the taxable year in which it first was deferred or, if later, the first year in which it is becomes nonforfeitable.30

V. Coordination with Section 409A

Sections 457A and 409A may both apply to the same NQDC. In applying §409A to NQDC covered by §457A, taxability under §457A is considered a payment for purposes of both sections' short-term deferral rules. In addition, until IRS issues further guidance, the taxability of earnings on NQDC under §457A is considered a payment pursuant to a fixed schedule if the earnings are reasonable, credited at least annually and are taxable under §457A in the later of the taxable year in which they are credited or in which they otherwise would be taxable under §457A.31

For NQDC attributable to services performed before 2009, a change in the time and form of payment to conform to the date the NQDC becomes taxable under §457A is not a prohibited acceleration of payment32 provided the change is in writing and becomes effective before 2012. Similarly, to the extent that NQDC attributable to services performed before 2009 was earned and nonforfeitable before 2005 and is not otherwise subject to §409A under the §409A effective date rules, a change in the time and form of payment solely to conform to the date the NQDC becomes taxable under §457A is not a “material modification” provided the change is in writing and becomes effective before 2012.33

In general, a right NQDC subject to §457A is not NQDC under §409A solely because it is “paid” for purposes of the §409A short-term deferral rule by the time it t becomes nonforfeitable. Therefore, a plan provision stating that NQDC will be payable in cash when it becomes taxable under §457A is not necessary because the payment is not subject to §409A. Payment timing issues under §409A, however, may arise if the right to NQDC becomes, or ceases to be, subject to §457A in a future year. Payment timing issues also can arise if earnings become taxable under §457A, to the extent that they otherwise would have been accumulated and paid at a deferred date. Until IRS issues further guidance, the payment of NQDC during the service provider's taxable year in which it becomes taxable under §457A is not an impermissible acceleration under §409A. The NQDC plan's provisions, however, still must include the §457A short-term deferral rule.34

VI. Intermediate Service Recipients and Back-to-Back Plans

If the service provider is also an intermediate service recipient and provides NQDC subject to §457A to its service providers that is attributable, in part or whole, to services performed before 2009, a change in the time and form of payment solely to conform to the date the amount becomes taxable is not an impermissible acceleration if the change is made in writing and becomes effective before 2012. Furthermore, to the extent NQDC subject to §457A was earned and became nonforfeitable before 2005 and is not otherwise subject to §409A under the §409A effective date rules, a change in the time and form of payment solely to conform to the payment date the NQDC becomes taxable under §457A is not as a material modification under §409A if the change is made in writing and becomes effective before 2012.35

In a “back-to-back” arrangement under which a service provider provides services to an intermediate service recipient (e.g., a hedge fund manager) that, in turn, provides services to the ultimate service recipient (e.g., the hedge fund itself), to the extent the arrangement is covered by §409A, all potential times and forms of payment under which the service provider may be paid by the intermediate service recipient must be constitute a permissible payment event, which may include separation from service. Where the service provider is paid when the intermediate service recipient separates from the ultimate service recipient, however, is not considered to be to a permissible payment event.36

VII. Effective Dates

Section 457A applies to NQDC attributable to services performed after December 31, 2008. If §457A would not apply to an amount of NQDC solely because it is attributable to services performed before January 1, 2009, to the extent it is not taxable in a taxable year beginning before 2018, it becomes taxable in the later of (i) the last taxable year beginning before January 1, 2018, or (ii) the first taxable year in which it becomes nonforfeitable.37

If a service provider obtains a nonforfeitable right to NQDC before January, 2009 and, as of December 31, 2008 the NQDC plan provides for payments under a formula that relates to a specified period of service within a taxable year (e.g., compensation paid during a particular quarter) NQDC generally is attributable to that period. To the extent that under the plan as of December 31, 2008, NQDC is not attributable to services performed in a specified period, it is generally attributed to services performed during the year in which the service provider obtains a nonforfeitable right. If a service provider is entitled to NQDC only upon an involuntary separation from service, the amount attributable to services performed before January 1, 2009, is the amount to which the service provider would be entitled based on service and compensation earned as of December 31, 2008. Any requirement to perform further services is disregarded for this purpose. Any additional amount to which the service provider becomes entitled on or after January 1, 2009, which relates solely to services performed after December 31, 2008, is attributable to service performed on or after January 1, 2009.

The Notice treats a right to reasonable earnings on amounts attributable to services performed before January 1, 2009 as attributable to services performed before January 1, 2009, but only to the extent further services were not required on or after January 1, 2009 in order to retain the earnings.

A service provider does not have a nonforfeitable right to the extent that NQDC can be reduced unilaterally or eliminated by the service recipient or other person after the services are performed. If the surrounding facts and circumstances indicate that the discretion to reduce or eliminate NQDC is available or exercisable only upon a condition, or the discretion lacks substantive significance, however, the Notice treats the NQDC as nonforfeitable. NQDC is not considered to be subject to unilateral reduction or elimination, however, solely because it may be reduced or eliminated pursuant to the plan's objective terms, such as applying a nondiscretionary, objective provision that creates a forfeiture risk.

To the extent that under a NQDC plan as of December 31, 2008, a service provider must perform substantial future services, the NQDC generally is attributed to services performed over the future period. If the forfeiture risk lapses after 2008, but before it would otherwise lapse as of December 31, 2008, had the service provider continued providing services (e.g., due to death, disability or an acceleration of vesting), the allocation is pro rated over the period in which the service provider obtained a nonforfeitable right to the date that the forfeiture risk otherwise would have lapsed under the plan's terms as they stood on December 31, 2008 had the service provider continued to provide services.38

For this purpose, a plan's terms as of December 31, 2008, are the terms that were in effect on December 31, 2008, and do not include any post-2008 amendments, even if made effective retroactively. A plan, however, can be amended retroactively to provide that a forfeiture risk that otherwise would lapse after 2008 will be treated as lapsing before January 1, 2009, provided the amendment is in writing and becomes effective before July 1, 2009, and the service recipient applies any shortening of the period during which a NQDC is forfeitable to every service provider participating in that NQDC arrangement or under a substantially similar arrangement.39

VIII. Conclusion

Section 457A dramatically changes the U.S. income taxation of offshore persons' NQDC. Despite the transition rules, it constitutes a remarkable reversal of tax policy in a very short time frame. As such, the very unpredictability of this change is likely to have a destabilizing and adverse effect on markets already stretched to their breaking point.

As Notice 2009-8 demonstrates, the intricacies of §457A compliance run as deep as or deeper than the requirements of §409A, with the difference that the transitional rules of §409A gave domestic NQDC plan sponsors and beneficiaries sufficient time to restructure their arrangements and to thoroughly examine and digest the details before taking action. The suddenness with which these changes came about will make §457A compliance much more costly in the short run than §409A compliance has proved to be, despite any synergies that may be derived by overlaying large portions of the §409A regulatory regime upon §457A. Persons subject to U.S. income tax that sponsor or benefit under offshore NQDC arrangements should immediately consult their advisors to determine the optimal course of action in response to these developments. Advisors and clients will need to factor into their decision-making process, among other things, their level of risk tolerance and their willingness to pay increased compliance costs. Notice 2009-8 provides ample evidence that the process will be an exacting one so long as markets remain unstable and that, for clients and their advisors, the compliance requirements of §457A are not so much a set of rules, but rather, are a constantly moving target. As such, even someone who supports the basic principles underlying §457A may be inclined to question the timing of the enactment of a new complex regulatory regime in the midst of an economic crisis. The issue of how offshore deferred compensation should be taxed has been around for many years. In light of that, was there really an imperative to pull the trigger at this particular point in time?

For more information, in the Tax Management Portfolios, see Brisendine and Drigotas, 385 T.M., Deferred Compensation Arrangements, and in Tax Practice Series, see ¶5710, Nonqualified Deferred Compensation.


1 All section references herein are to the Internal Revenue Code of 1986 as amended and the Treasury regulations thereunder unless otherwise specified. Section 457A was enacted by the Tax Extenders and Alternative Minimum Tax Relief Act of 2008, P.L. 110-343 (TEAMTRA), enacted Oct. 3, 2008.

2 Notice 2009-8, Q&A-12. Nonforfeitability is determined under the “legally binding right” standard of §409A. See Regs. §§1.409A-1(b)(1) and 31.3121(v)(2)-1(b)(3)(i).

3 Corresponding to §457A's enactment date.

4 See Notice 2009-8, Q&A-2.

5 Regs. §1.409A-1(b)(5)(i)(B).

6 See Regs. §1.409A-1(b)(5)(i)(A).

7 §457A(d)(3)(B); Notice 2009-8, Q&A 4. The definition in Regs. §1.409A-1(b)(4) applies for this purpose, using the definitions of “deferred compensation” and “substantial risk of forfeiture” provided in §457A.

8 Notice 2009-8, Q&A-5. Independent contractors, however, are not service providers if they have multiple independent clients and do not provide management services. See Q&A-5, citing Regs. §1.409A-1(f)(2).

9 Notice 2009-8, Q&A-6. “Foreign corporation” is defined in §7701(a)(3)-(4). “Partnership” is defined in §7701(a)(2). Id. at Q&A-7.

10 Notice 2009-8, Q&A-8(a).

11 Notice 2009-8, Q&A-8(b).

12 Notice 2009-8, Q&A-8(c).

13 Notice 2009-8, Q&A-9.

14 Notice 2009-8, Q&A-10.

15 §457A(b)(2).

16 Notice 2009-8, Q&A-11(b).

17 Notice 2009-8, Q&A-11(c).

18 Notice 2009-8, Q&A-11(e).

19 Notice 2009-8, Q&A-11(e).

20 Notice 2009-8, Q&A-11(f).

21 Notice 2009-8, Q&A-12.

22 Notice 2009-8, Q&A-13(a).

23 Notice 2009-8, Q&A-13(b).

24 Notice 2009-8, Q&A-14.

25 Notice 2009-8, Q&A-15, 16.

26 Notice 2009-8, Q&A-17, citingProp. Treas. Reg. §§1.409A-4(f)

27 Notice 2009-8, Q&A-18, citing Prop. Regs. §1.409A-4(g).

28 Notice 2009-8, Q&A-20.

29 Notice 2009-8, Q&A-19(a), citing Prop. Regs. §1.409A-4(b)(2)(iv).

30 Notice 2009-8, Q&A-21.

31 Notice 2009-8, Q&A-24, citing Regs. §1.409A-1(b)(4).

32 Under §409A(a)(3) and Regs. §1.409A-3(j)(1).

33 Notice 2009-8, Q&A-25.

34 Notice 2009-8, Q&A-26.

35 Notice 2009-8, Q&A-27(a).

36 Notice 2009-8, Q&A-27(b).

37 Notice 2009-8, Q&A-22.

38 Notice 2009-8, Q&A-23(b)(3).

39 Notice 2009-8, Q&A-23(b)(4).