Attorney Comments on International Aspects of Deferred Compensation Plan Rules

Our firm has several clients, unrelated to one another, who are US citizens residing outside the United States and working for foreign employers. These clients have received unsecured unfunded promises of future compensation from their foreign employers pursuant to nonqualified deferred compensation plans (the "Foreign Plans"). Pursuant to the Foreign Plans, the clients are beneficiaries of foreign trusts (the "Foreign Trusts") that are intended to pay the deferred compensation. The Foreign Trusts provide that certain amounts otherwise payable to the employee at a specified future date would instead be paid to the employer if the employer becomes insolvent and are intended to be so-called "Rabbi trusts" that are treated as grantor trusts owned by the foreign employer for US federal income tax purposes. In some cases the employer creates a separate trust for each employee to whom a promise has been made. In other cases, the employer has made promises to multiple employees and a single trust is used to hold the assets that are intended to be paid to the employees.

Prior to the enactment of GOZA, the Foreign Trusts were not subject to Code Section 409A(b) because no contributions were made on or after January 1, 2005. GOZA amends the effective date provision for Code Section 409A(b) such that the provision now applies as of January 1, 2005 regardless of when contributions were made to the trust or arrangement. The Foreign Trusts are now subject to, and presumably in violation of, Code Section 409A(b). As you know, this would result in each employee being subject to (i) income tax on the value of their interest in the Foreign Trust, (ii) an addition to tax equal to 20 percent of the amount of income recognized, and (iii) an interest charge to reflect the deferral obtained prior to January 1, 2005. Quite harsh consequences to be imposed retroactively.

Presumably in recognition of how unreasonable it would be to impose such harsh consequences retroactively, Section 403(hh)(3)(B) of GOZA instructs the Secretary to issue guidance (the "Guidance") within 90 days of the enactment of GOZA under which a plan shall be treated as not having violated Section 409A(b) of the Code if such plan comes into conformance with such requirements during such limited period as the Secretary may specify in such guidance. We hope that the Guidance will address the following issues:

In addition, although the Foreign Trusts were drafted in large part based on the model Rabbi trust published by the Internal Revenue Service ("IRS"), in most cases there are provisions which vary from the model to address local requirements in the jurisdictions where the Foreign Trusts were organized. Some of these provisions would need to be amended before a US institution would agree to serve as successor trustee. Additional language may be needed to address risk management concerns raised by the US financial institution. And some language changes will obviously need to be made to conform the Foreign Trusts to the requirements of the Guidance. We have found that negotiating with US financial institutions over language changes to trust documents is a time consuming process. Often multiple layers of approvals must be obtained within the financial institution before it can accept a trusteeship under a document not drafted by the institution itself.

Furthermore, in the current climate with respect to money laundering and anti-terrorism, US financial institutions are properly careful before taking on accounts on behalf of foreign persons. The due diligence and "know your customer" background checks required in these situations can take months to complete. Where the foreign employer is organized or operates outside the OECD, the checks can take even longer.

For these reasons, the "limited period" during which plans can come into compliance with Code Section 409A needs to be sufficiently long, in our view at least 6 months and preferably a year, so that plans will have sufficient time to find a US financial institution willing to take on the trust or other arrangement, to negotiate whatever amendments to the governing documents might be required under the Guidance, and to satisfy the US financial institution's risk management concerns.

If the Guidance is not issues in a timely manner, or if the Guidance does not provide definitive rules and a fixed time period for coming into compliance, a scheduled distribution date under an existing trust or arrangement may occur prior to the plan and the trust or arrangement being able to come into compliance with Code Section 409A(b). If the required distribution consists of the entire balance in the trust or arrangement, it may not be possible for the plan subsequently to come into compliance with Code Section 409A(b). The Guidance should provide that violations of Code Section 409A(b) that existed on the date of enactment of GOZA will be treated as not being violations if (i) distributions are made pursuant to the terms of the trust or other arrangement, (ii) the plan and the trust or other arrangement were not materially modified after the enactment of GOZA, (iii) the service provider reports the receipt of the distribution on a timely filed (including extensions) US federal income tax return and pays the tax due, if any, with respect to such distribution, and (iv) the distribution is scheduled to be and is in fact made on or before the date 180 days after issuance of substantive guidance explaining how to comply with Code Section 409A(b).

As for the location of assets, we suggest that publicly traded securities held in a custodial account with a US financial institution (at an US office) should be deemed located within the United States regardless of the jurisdiction in which (i) the issuer of such securities is organized or operates or (ii) the securities are primarily traded. We understand that the funding rules were intended to insure that, should the service recipient eventually prove insolvent, creditors of the service provider could obtain recourse against the assets by filing suit in US court and having the court take jurisdiction over the assets. We believe that the rules set forth above provide adequate security that assets held in a trust or other arrangement would be subject to the jurisdiction of an appropriate US court.

Providing an open ended window of opportunity at some indefinite time in the future is not an adequate replacement for a currently effective safe harbor. As discussed above, the statutory waiver of existing violations under Section 403(hh) of GOZA requires that the plan come into compliance during the "limited period provided by the Secretary". If the Guidance is delayed for an extended period, plans may be required to distribute assets to service providers prior to the commencement of the limited period. It may be impossible for such plans to qualify for the GOZA waiver of violation.

Furthermore, the absence of substantive guidance has a chilling effect on the ability of foreign employers to provide nonqualified deferred compensation to US persons. Currently, there is no way to be absolutely sure that any nonqualified deferred compensation plan sponsored by a foreign employer satisfies Code Section 409A(b). We have several clients who have refrained from agreeing to nonqualified deferred compensation arrangements offered by their foreign employers precisely because they cannot be sure how to comply with Code Section 409A(b). This puts US persons at a disadvantage when competing for positions against non-US service providers, who can agree to permit the employer to defer compensation without risking tax penalties and an interest charge. While it is true that there is an exception where the services are performed in the jurisdiction where the assets are located, it is often the case that qualifying for this exception would be disadvantageous to the foreign employer -- whereas locating the assets in the United States would be acceptable if the parties could be confident that the addition to tax and interest charge under Section 409A(b) does not apply.

Finally, while we find the issue of allocating violations among multiple US service providers to be intellectually stimulating, we do not think that resolving that problem justifies delaying the issuance of substantive rules for locating trusts and assets within the United States. We believe that any US person who is aware of an existing or future violation of Section 409A(b) is overwhelmingly likely to comply within the limited period provided under the Guidance. The rate of tax applicable to violations (currently 35% tax plus 20% addition to tax plus interest charge which will typically bring the aggregate rate over 60% and often above 70% or even 80%) makes non- compliance unacceptable. Moreover, we suspect that any US person who becomes aware of a violation outside the compliance period is going to hesitate before reporting the violation. Therefore, violations likely are only going to be unearthed by examination. It is likely to be several years before any such violations are discovered, providing the Secretary more than enough time to deliberate in a less hurried manner prior to issuing regulations allocating violations among multiple US persons. The need for time to resolve points that are unlikely to arise for years should not delay the issuance of guidance as to pressing issues that affect the careers and compensation of US persons working outside the United States today.

Thank you very much for your consideration of these comments.