Employee Benefits Alert
The Emergency Economic Stabilization Act of 2008 (the “Act” or “EESA”), which was signed into law on October 3, 2008, makes a number of changes to the federal income taxation of deferred compensation arrangements, provides new federal tax rules for executive compensation of financial institutions participating in the new relief programs authorized by such legislation, and adopts a new Mental Health Parity rule. The following is a summary of those provisions.
Foreign and Other Deferred Compensation Arrangements Affected by EESA
Section 801 of the Act adds new section 457A to the Code, relating to the taxation of service providers on deferred compensation from certain foreign corporations or tax-indifferent parties. Under the provision, compensation deferred under a nonqualified deferred compensation plan of a nonqualified entity is includible in gross income as soon as there is no substantial risk of forfeiture of the rights to such compensation. The new provision applies in addition to the requirement of section 409A (or any other provision of the Code or general tax law principle) with respect to nonqualified deferred compensation. Thus, compensation that is deferred under a plan that satisfies the deferral requirements of section 409A of the Code might, nevertheless, have to be taken into income currently under new section 457A.
In general, the new provision, if applicable, will either completely eliminate the tax deferral of compensation beyond a twelve-month short-term deferral period, impose an interest charge and additional 20 percent tax in a situation where deferral of taxation beyond the twelve-month period is permitted. In addition, existing deferral periods may have to be shortened for amounts deferred with respect to services performed prior to December 31, 2008.
Deferred Compensation Covered by the Act. Subject to certain exceptions, a “nonqualified deferred compensation plan” under section 457A has the same meaning given to that term under Code section 409A (d). Unlike the definition under section 409A (d), however, a nonqualified deferred compensation plan under section 457A includes any plan that provides a right to compensation based on the appreciation in value of a specified number of equity units of the service recipient. Thus, stock appreciation rights (SARs) are treated as nonqualified deferred compensation under section 457A, regardless of the exercise price of the SAR. Also, under section 457A, a special exception provides that compensation shall not be treated as deferred if the service provider receives payment of such compensation not later than twelve months after the end of the taxable year of the service recipient during which the right to the payment of such compensation is no longer subject to a substantial risk of forfeiture.
Foreign Entities Covered by the Act. Section 457A applies to a nonqualified deferred compensation plan of a “nonqualified entity.” A nonqualified entity is (1) any foreign corporation unless substantially all of its income is (a) effectively connected with the conduct of a trade or business within the United States, or (b) subject to a comprehensive foreign income tax, and (2) any partnership unless substantially all of its income is allocated to persons other than (a) foreign persons with respect to whom such income is not subject to a comprehensive foreign income tax, (b) organizations which are exempt from United States federal tax. The term “comprehensive foreign income tax” means, with respect to any foreign person, the income tax of a foreign country if (1) such person is eligible for the benefits of a comprehensive income tax treaty between such foreign country and the United States, or (2) such person demonstrates to the satisfaction of the Internal Revenue Service that such foreign country has a comprehensive income tax. The legislative history of the Act indicates that the Secretary may provide guidance concerning the case of a corporation resident in a country that has an income tax treaty with the United States but that does not generally tax the foreign-source income of its residents (a “territorial country”). Based on the foregoing, it appears that without clear guidance from Treasury, there may be difficulties in determining with certainty whether section 457A applies if the foreign corporation operates in a country that does not have an income tax treaty with the United States, or if the foreign corporation operates in a country that is a territorial country.
Substantial Risk of Forfeiture. For purposes of section 457A, the rights of a person to compensation generally are treated as subject to a substantial risk of forfeiture only if such person’s rights to such compensation are conditioned upon the future performance of substantial services by any individual. As noted in the legislative history, the term “substantial risk of forfeiture” does not include a condition related to a purpose of the compensation (other than future performance of substantial services) regardless of whether the possibility of forfeiture is substantial. Thus, for example, amounts payable under long-term performance plans may constitute deferred compensation for these purposes regardless of any applicable performance condition.
In addition to the general definition of substantial risk of forfeiture, to the extent provided in Treasury regulations, if compensation is determined solely by reference to the amount of gain recognized on the disposition of a certain type of investment asset, such compensation shall be treated as subject to a substantial risk of forfeiture until the date of such disposition. For this purpose, the term “investment asset” means any single asset (other than an investment fund or similar entity) (1) acquired directly by an investment fund or similar entity, (2) with respect to which such entity does not participate in the active management of such asset, and (3) substantially all of the gain on the disposition of which (other than such deferred compensation) is allocated to investors in such entity.
Amount of Compensation Not Determinable. If the amount of any compensation is not determinable at the time when there is no substantial risk of forfeiture of the rights to such compensation, e.g., the employee’s right to the compensation is subject only to a performance condition, the amount will not be includible in gross income until the time the amount is determinable. In such case, however, the amount of income tax for the taxable year in which such amount is includible in gross income (i.e., the taxable year in which the amount is determinable) is increased by the sum of (1) an amount of interest (based on the underpayment rate plus one percent) plus (2) an amount equal to 20 percent of the amount of such compensation. The legislative history provides that it is intended that Treasury regulations be issued describing when an amount is not determinable for purposes of the provision.
Effective Dates. Section 457A is effective generally for deferred amounts which are attributable to services performed after December 31, 2008. In addition to this general effective date, a special rule applies to deferred amounts attributable to services performed before January 1, 2009 (“pre-2009 deferrals”). If under present law, pre-2009 deferrals would not otherwise be includible in gross income in a taxable year beginning before 2018, then, under the Act, such amounts will be includible in gross income in the later of (1) the last taxable year beginning before 2018, or (2) the taxable year in which there is no substantial risk of forfeiture of the rights to such compensation.
Treasury Guidance on Amending Plans. Not later than 120 days after the date of enactment of the Act (October 3, 2008), the Secretary of the Treasury is required to issue guidance providing a limited period of time during which a nonqualified deferred compensation arrangement attributable to services performed on or before December 31, 2008, may, without violating the requirements of section 409A of the Code, be amended to conform the date of distribution to the accelerated date the amounts are required to be included in income.
Observations. An employer that (1) is a foreign corporation or a partnership with tax exempt entities or foreign corporations as partners, and (2) provides compensation to service providers who are subject to U.S. federal income tax, should determine the potential impact section 457A might have on its compensation arrangements. Moreover, U.S. corporations with U.S. expatiates working for foreign subsidiaries will also want to consider the possible application of such legislation. It may be possible that the deferred compensation plans of a U.S. parent that also cover employees of foreign subsidiaries may be covered by this provision, particularly if the deduction for such compensation is sourced to the subsidiary. In addition, because of the difference in federal tax treatment between expatiates working for U.S. corporations and those working for foreign corporations, the new rules may lead the IRS to scrutinize seconding arrangements involving U.S. expatriates who are carried on the payroll of a domestic service corporation but assigned to work at foreign subsidiaries.
New Tax and Executive Compensation Rules for Certain Financial Institutions
The Act also modifies certain federal tax rules for financial institutions participating in the new assistance programs sponsored by Treasury. The financial assistance provided by Treasury may take several forms: the Troubled Asset Auction Program (“TAAP”) under which the Treasury will purchase, via auction, troubled mortgage-related assets; the Capital Purchase Program (“CPP”) under which Treasury will acquire a debt or equity position in the financial institutions; and the Program for Systemically Significant Failing Institutions (“PSSFI”) under which Treasury will provide direct assistance to certain failing firms on terms negotiated on a case-by-case basis. Recently, the Treasury Department released related guidance on these programs in the form of Notices 2008-94, 2008-TAAP, and 2008-PSSFI, together with certain interim rules published in 31 CFR Part 30.
Financial institutions participating in these assistance programs will be affected by certain changes made by the Act to the tax rules in section 162(m) relating to limitations on deductions of executive compensation, and the tax rules in section 280G limiting deductions for so-called parachute payments. Institutions participating in the TAAP selling more than $300 million in troubled assets (“applicable employers”) generally will be subject to these new tax rules directly, as well as a prohibition on entering new employment contracts with certain parachute agreements. Institutions participating in the CPP and PSSFI programs will have to agree as a condition of participation to follow the section 162(m) changes and will also be subject to certain non-tax restrictions on parachute payments, as well as other limitations on executive compensation. Employers that are not subject to these rules may nevertheless wish to be aware of them inasmuch as it is possible that the changes by the Act to these tax rules may be precursors of changes that future legislation will extend to all employers.
Amendments to Code Section 162(m). With respect to applicable employers (which may include private employers and non-corporate entities), new Code section 162(m)(5) lowers the general deduction limitation from $1,000,000 to $500,000, and expands its scope in several respects. The new provision restricts the deduction for remuneration, with no exception for performance-based compensation, commissions, or amounts payable under existing binding contracts. The limitation applies to the applicable employer’s CEO and CFO (or relevant counterparts), as well as the three highest-paid other officers.
The new limit applies to compensation attributable to services performed in an “applicable taxable year,” regardless of when it is actually paid. (For these purposes, an applicable taxable year is a taxable year which includes any portion of the period established by the Act for the Treasury to maintain the troubled asset relief program.) Thus, unlike the current section 162(m) rules, a covered executive’s compensation attributable to an applicable taxable year will continue to be limited by section 162(m)(5) in future taxable years in which the compensation is paid.
For these purposes, there are special rules for assigning compensation to particular years. If the deferred compensation plan provides for benefit payments under a formula that allocates benefits to a specific period of service, the compensation will generally be allocable to that period. In addition, compensation will not be allocable to a period prior to the date the employee is employed by an employer and acquires a legally binding right to the compensation. To the extent that the compensation is subject to a substantial risk of forfeiture, under which the executive must perform future substantial services, the compensation will generally be allocated pro rata over the period of the required future services.
Amendments to Code Section 280G. With respect to applicable employers, the Act adds new section 280G(e), which broadens the definition of a section 280G “parachute payment” to pick up payments on account of the severance from employment by an executive who would be a covered executive under section 162(m)(5). The new provision applies to severance (1) by involuntary termination, or (2) in connection with the applicable employer’s bankruptcy, liquidation or receivership. Notice 2008-94 defines “involuntary termination” to include “terminations for good reason,” within the meaning of Code section 409A, and certain types of “voluntary” terminations. A “parachute payment” for purposes of section 280G(e) will mean payment to a covered executive during an applicable taxable year on account of a covered severance if the aggregate present value of the payment equals or exceed an amount equal to 3x the individual’s base amount under section 280G. It should be noted that for these purposes, certain exclusions under section 280G do not apply, including specifically the exclusion for payment of amounts determined to be reasonable compensation.
Mental Health Parity Act
The Act also includes the Paul Wellstone and Pete Domenici Mental Health Parity and Addiction Equity Act of 2008 (the “Mental Health Parity Act”). The new provisions expand the 1996 federal Mental Health Parity Act. The old rule prohibited employers from imposing lower lifetime or annual limits on mental health benefits than on medical/ surgical benefits. The new rule significantly expands the parity requirements for plan years beginning on or after October 3, 2009. The following are a few of key requirements:
Substance Use Disorder Benefits. While the old rule only applied to mental health benefits, the new rule also applies to substance use disorder benefits. Note that the Act does not require a plan to cover either substance use or mental health benefits, but if the plan does cover such benefits it must comply with the parity requirements.
Financial Limitations. Financial requirements, such as deductibles, co-payments, co-insurance, and out-of-pocket limits, may not be more restrictive for mental health or substance use disorder benefits than the predominant requirements that apply to substantially all medical and surgical benefits covered under the plan. In addition, plans may not have separate cost-sharing arrangements that only apply to mental health or substance use disorder benefits.
Treatment Limitations. Treatment limitations, such as limits on the number of visits or days of coverage, that apply to mental health or substance use disorder benefits may not be more restrictive than the predominant requirements that apply to substantially all medical and surgical benefits covered under the plan. Furthermore, plans may not have separate treatment limitations that apply only to mental health or substance use disorder benefits, which is a common practice today.
Medical Necessity Determinations. Plans may still make determinations regarding the medical necessity of a certain treatment. However, the Act requires the criteria that will be used for such determinations, and the reasons for any denial, to be made available upon request.
Out-of-Network Providers. If a plan provides coverage for out-of-network medical/ surgical benefits, then coverage must also be provided for out-of-network mental health or substance use disorder benefits in a manner that is consistent with the parity requirements.
Application of State Law. The new Mental Health Parity Act includes a preemption rule similar to that imposed by the HIPAA Privacy Rule. The federal rules set minimum requirements; insured plans must also comply with state laws that are more restrictive than the federal rules. (Note that for self-funded plans, ERISA preempts the application of state law, so self-funded plans would have to comply with the federal Mental Health Parity Act but not any state law
Cost exemption. Similar to the 1996 rule, the Act includes an exemption for plans that can demonstrate that implementing the parity requirements would cause them to incur increased cost in excess of a certain amount. However, this exemption is not likely to be helpful for most employers because the plan must comply with the parity requirements for six months before applying for the exemption. From a practical standpoint, most employers did not take advantage of the 1996 cost exemption because they were unwilling to implement a benefit in one year and take it away in the next. The same is likely to be true for employers today.
Observations. The Departments of Labor, Treasury, and Health and Human Services information as employers seek to comply with the new rules. Note that these new requirements are much more extensive than the current parity law. Employers should carefully review their current plan designs and most will probably need to amend their plans in order to company with the new rules.
For more information, please contact any of the following lawyers:
Fred Oliphant, email@example.com, 202-626-5834
Anthony Provenzano, firstname.lastname@example.org, 202-626-1463
Gary Quintiere, email@example.com, 202-626-1491
Garrett Fenton, firstname.lastname@example.org, 202-626-5562