Introduction

Many multinationals have adopted the view that the harsh income inclusion rules of Code section 457A are essentially irrelevant. Basically, this attitude stems from the belief that that the company's US employees providing services abroad to related foreign entities are doing so as employees of a US-based company pursuant to the terms and conditions of a secondment agreement. This article points out that while a secondment agreement, that is properly worded and implemented, may act as an effective shield against Code section 457A, it may also inflict a detrimental blow to the US company's subpart F income. Accordingly, any US company that seconds its employees to related foreign-based entities should re-evaluate that arrangement to assure that it is obtaining the desired tax outcome.

More specifically, this article looks at how two unrelated and relatively recent federal income tax provisions may be applied in the case of a common business arrangement involving the loan-out or secondment by a U.S. company or one or more of its workers to a foreign subsidiary. These income tax provisions are (i) Code section 457A which applies certain gross income inclusion rules to deferred compensation from certain tax indifferent parties and (ii) Treas. Reg. § 1.954-3(a)(4)(iv) which expands the manufacturing exception to foreign base company sales income (FBCSI) by adding a "substantial contribution test" to that exception. As discussed below, it would appear that, at least in form, the structure of many secondment arrangements should insulate the seconded employees and the parties to the arrangement from the adverse tax consequences of Code section 457A. On the other hand, such arrangements generally would prevent the parties from obtaining the tax benefits of Treas. Reg. § 1.954-3(a)(4)(iv). Depending on the particular situation, this set of tax consequences might or might not reflect the most favorable outcome for the taxpayer. Structuring the secondment arrangement without full consideration of the tax consequences involved could result in the loss of a favorable tax outcome. Accordingly, a U.S. company seconding workers to a foreign subsidiary should understand the tax implications of its secondment arrangements. This requires coordination within the company to ensure that the secondment arrangement provides optimum results, and may require taking actions that align the desired outcome, the provisions of the secondment agreement, and the common-law employment rules.

Secondment Agreements

It is not unusual for a United States based company with international affiliates to temporarily transfer or "second" its U.S. workers to a foreign subsidiary (or other affiliate) pursuant to a secondment agreement. Secondment agreements frequently provide, among other things, that during the secondment period the seconded workers remain on the U.S. company's, or a related U.S. service company's, payroll and remain its employees. The foreign subsidiary generally is obligated to reimburse the U.S. company for an amount at least equal to its payroll and benefits costs attributable to the seconded workers. Thus, consistent with the terms of the agreement, compensation paid to the seconded worker remains subject to U.S. federal employment taxes, the U.S. company continues to act as the worker's common-law employer, and the seconded worker continues to be covered under the U.S. company's benefit plans and under the U.S. social security system during the secondment period.

The way in which Code section 457A and Treas. Reg. § 1.954-3(a)(4)(iv) become pertinent in the context of a secondment arrangement may be illustrated by the following example:

Example: A U.S. corporation (USCo) and its wholly-owned foreign subsidiary (FORCo), which is a controlled foreign corporation (CFC), enter into a secondment agreement. The agreement is entered into because FORCo requires the skills and presence of USCo's workers for a specified period of time in connection with FORCo's activities involving the manufacturing, through a third party contract manufacturer, of certain personal property that it sells to related CFCs. The workers perform their services outside the U.S. and outside the country where FORCo is organized. The secondment agreement provides that the seconded workers will remain the employees of USCo for all federal tax purposes and employee benefit purposes and that FORCo will reimburse USCo for its payroll costs during the secondment period, including its costs of covering the worker under USCo's deferred compensation plan. USCo's deferred compensation plan satisfies the provisions of Code section 409A and defers the payment and taxation of vested amounts until the worker separates from service. FORCo satisfies the definition of a "nonqualified entity" under Code section 457A(b), but does not maintain its own nonqualified deferred compensation plan. The nature of FORCo's activities, if conducted through its own employees, would satisfy the "substantial contribution test" provided by Treas. Reg. § 1.954-3(a)(4)(iv) and, therefore, would exempt such sales income from the definition of FBCSI. If, however, the activities were conducted by workers who were not FORCo's employees, the exemption would not apply. For this purpose, the term "employee" means a common law employee under Treas. Reg. § 31.3121(d)-1(c).

Code Section 457A

In general, Code section 457A provides that any compensation that is deferred under a nonqualified deferred compensation plan of a nonqualified entity is includible in gross income when there is no substantial risk of forfeiture of the employee's rights to such compensation. As noted in the example, FORCo is a "nonqualified entity" that does not maintain its own deferred compensation plan. However, USCo's deferred compensation plan might be treated as if it were also maintained by FORCo if a payment by FORCo of the amount deferred for a seconded worker under USCo's plan would provide FORCo with a compensation deduction under U.S. federal income tax principles. Notice 2009-8, 01/08/2009, Q&A -14. This raises the issue of whether the seconded worker is performing personal services for USCo or for FORCo. See, Treas. Reg. § 1.162-7.

Under the provisions of the secondment agreement in the example, USCo would appear to be entitled to the compensation deduction because the seconded worker is treated as USCo's employee. Thus, FORCo's payment to USCo that is measured by USCo's payroll costs presumably would not be treated as a payment of compensation by FORCo, unless the seconded worker were classified as FORCo's common-law employee. This could occur where the facts underlying the working relationships among a seconded worker, USCO, and FORCo result in the seconded worker being treated as the common-law employee of FORCo rather than of USCo., notwithstanding the provisions of the secondment agreement. Under such facts, FORCo likely would be entitled to the compensation deduction under U.S. federal income tax principles and the provisions of Code section 457A would be applied to deferred compensation accumulated under USCo's deferred compensation plan for the benefit of a seconded worker as if FORCo sponsored the plan. Thus, under Code section 457A, such deferred amount would be included in the seconded worker's gross income in the year such amount vested, rather than when paid out upon termination of employment, pursuant to the terms of the deferred compensation plan and the provisions of Code section 409A.

It may be noted that in Notice 2009-8, the Treasury and the IRS specifically requested comments regarding the extent to which a reimbursement arrangement with respect to a domestic taxpayer service recipient and a nonqualified entity that has agreed to share or reimburse the domestic taxpayer service recipient's compensation costs should result in the domestic taxpayer service recipient also being treated as a section 457A nonqualified entity.

Treas. Reg. § 1.954-3(a)(4)(iv) and the Substantial Contribution Test

As noted in the example, if FORCo satisfies the substantial contribution test provided by Treas. Reg. 1.954-3(a)(4)(iv), income from the sales to the related CFCs would be excluded from being characterized as FBCSI. Under the example, FORCo would satisfy the substantial contribution test through the activities of the workers seconded from USCo, if the seconded workers were classified as FORCo's employees under the common-law test of Treas. Reg. § 31.3121(d)-1(c). The preamble to Treasury Decision 9438 , 01/05/2009, which added the substantial contribution test to the regulations, provides that the term "employee" may encompass certain seconded workers…whose activities are directed and controlled by [FORCo's] employees, so long as those individuals are deemed to be employees of [FORCo] under sec. § 31.3121(d)-1(c).

Discussion

Although it is possible that the IRS and Treasury might issue future guidance regarding the application of Code section 457A to secondment arrangements, under existing guidance, and under the secondment arrangement discussed above, USCo's nonqualified deferred compensation plan would not appear to come within the scope of Code section 457A unless a determination was made that (i) the common-law relationship of employer and employee does not exist between USCo and the seconded workers, and (ii) such a relationship does exist between FORCo and the seconded workers. On the other hand, the benefits of satisfying the substantial contribution test under Treas. Reg. § 1.954-3(a)(4)(iv) would be denied to the parties unless a determination was made that the seconded workers were properly treated as the common-law employees of FORCo.

In some situations, benefits derived from the avoidance of Code section 457A will outweigh the loss of the benefits that could be derived from satisfying the substantial contribution test. This may not be the case in other situations. Moreover, even where overall tax benefits could be maximized by satisfying the substantial contribution test, which would require FORCo to become the common-law employer of the seconded workers, other considerations, such as continued coverage under the U.S. social security system and continued participation in USCo's benefit programs by the seconded workers, may be more important than such increased tax benefits. In any case, these important issues merit the attention of those persons within USCo who have the responsibility for monitoring the tax consequences and trade-offs that are at stake.

If, after considering all of the competing issues, it is determined that maximum benefits are achieved by having the seconded workers treated as the common-law employees of FORCo, perhaps in order to satisfy the substantial contribution test, changes to the secondment agreement, consistent with that determination, would be required. Of course, establishing the requisite common-law employment relationship is not solely a question of contract language, but involves the facts underlying the employment relationship. Thus, the facts pertaining to the right to control the activities of the seconded workers may have to be revised to ensure that FORCo retains or acquires that right in a manner that satisfies the regulations and other IRS determinations on this issue. In this regard, Rev. Rul. 87-41, 1987-1 CB 296, describes 20 factors designed as guides for determining whether the person or persons for whom services are performed exercise sufficient control over the individual for the individual to be classified as an employee. More recent IRS guidance and training materials provide that facts evidencing worker control fall into three categories: behavioral control, financial control, and the relationship between the parties. See, for example, Publication 15-A, Employer's Supplemental Tax Guide (2010).

If USCo determined that maximum benefits are achieved by having the seconded workers treated as the common-law employees of USCo, it is possible that no material changes to the provisions of the secondment agreement would be required. However, in light of the interest shown by Treasury and the IRS in the application of Code section 457A to arrangements such as the secondment arrangement discussed herein, and the overriding importance of the common-law employment rules in applying the income tax rules, taxpayers may wish to review both their secondment agreements and the facts underlying the employment relationships involving USCo, FORCo, and the seconded workers so that, if necessary, appropriate actions may be taken to avoid the adverse affects of Code section 457A and to secure the other benefits of retaining USCo as the common-law employer.

For more information, please contact:

Layla Asali, lasali@milchev.com, 202-626-5866

Gary Quintiere*

Fred Oliphant*

Adrian Morchower*

Joel Weiss*

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