U.S. Tax Advisory. Final section 409A regulations What you need to know and do now On April 10, 2007, the U.S. Treasury Department and Internal Revenue Service issued final regulations under section 409A of the U.S. Internal Revenue Code. Section 409A was enacted as part of the American Jobs Creation Act of 2004. While the final regulations do not make dramatic changes to the 2005 proposed regulations, they do clarify and in some instances relax the proposed regulations. The final regulations take effect on January 1, 2008. Until then, the transition relief under the previously issued installments of IRS guidance continues to be available. For reference, at the end of this note are hyperlinks to the relevant prior IRS guidance, as well as to prior Linklaters Tax Advisories on section 409A. This note highlights some of the more noteworthy elements of the final regulations and lists certain action items for consideration. Contents December 31, 2007 amendment deadline 1 Mandatory NQDC plan provisions Short-term deferrals 3 Stock options/stock appreciation rights (SARs) 4 Termination of employment 6 Separation pay (severance) 7 Identifying key employees 8 Plan aggregation rules 9 Permitted delays in payment 9 Split-dollar life insurance arrangements 9 2 Failure to comply with section December 31, 2007 amendment deadline 409A 9 All nonqualified deferred compensation agreements, methods, programs or other arrangements (collectively NQDC plans ) which do not comply with section 409A must be amended by December 31, 2007 in order to avoid the consequences of noncompliance with section 409A (as described more fully below). The final regulations clarify that the amendments are required only to bring the NQDC plans into documentary compliance as of January 1, 2008, and are generally not required to reflect any actions taken under the transition rules (for periods before January 1, 2008). Offshore trusts 10 Prior IRS guidance 11 Prior Linklaters Tax Advisories 11 U.S. Tax and Executive Compensation Contacts 12 April 20, 2007 1
Designate a 409A compliance team consisting of members from the company s tax, legal, benefits, HR and payroll departments. Create a 409A time-action-responsibility checklist for implementing compliance. Inventory all NQDC plans that will require amendment in order to become section 409A compliant. Check each NQDC plan s terms (or, if applicable, the terms of the underlying award agreement) to determine what action is required to make the section 409A amendments, including whether board of directors or committee approval is required, if any participant notification, consent or signature is required, or if (unusually) shareholder approval is required. Consider scheduling constraints and timing implications. Determine what ancillary documents will also require updating, such as plan summaries, tax summaries, S-8 prospectuses, employee handbooks, websites, etc. Determine whether any amended documents should be re-filed under applicable securities laws in the U.S. or elsewhere and whether any amended documents should be re-circulated to participants. Consider whether third-party plan administrators should be involved early in the compliance process and what updating is required for computer systems (such as for tracking key employees who are subject to the sixmonth delay). Notify plan administrators and plan trustees of the NQDC plan amendments. Mandatory NQDC plan provisions The following provisions are considered material and must be included in each NQDC plan: the amount (or the method or formula for determining the amount) of deferred compensation, the time and form of payment, the six-month delay rule for payments to key employees (also referred to as specified employees in section 409A) of public companies, and 2 April 20, 2007
if the plan so permits, the conditions for making initial deferral elections and subsequent deferral elections. The material terms of each NQDC plan must be in writing and may be specified in one or more documents (such as a combination of the general plan and the specific award agreement). It should be noted that a savings clause, providing that a NQDC plan will be interpreted to be consistent with section 409A and that any inconsistent provisions will be disregarded, is not effective. Ensure that the mandatory provisions described above are included in the applicable NQDC plan documents. For U.S. employees of multinational companies, determine if there are provisions in the existing home-country NQDC plan document that do not comply with section 409A. If so, those provisions should be specifically modified with respect to the U.S. employees. Short-term deferrals In general, compensation that is paid within 2½ months after the end of the year in which it vests (a short-term deferral ) is exempt from section 409A. The final regulations clarify that the exemption only applies if the arrangement would not under any circumstances permit a payment to be made after the end of shortterm deferral period. For example, a payment which is conditional on terminating employment would not qualify for the short-term deferral exemption, because a termination of employment (and, therefore, the payment) could potentially occur after the end of the short-term deferral period. Even if the employee actually terminates employment and receives payment within the short-term deferral period, the arrangement would nevertheless be deferred compensation subject to section 409A rather than exempt as a short-term deferral. The final regulations provide that the short-term deferral rule can apply separately to each payment, so long as the entire payment is made during the short-term deferral period. Accordingly, where a payment has been designated as a separate payment, it may qualify as a short-term deferral exempt from section 409A even where the employee has a right to subsequent payments under the same arrangement. In contrast, where a payment (such as a life annuity or a series of installment payments treated as a single payment) has not been designated as a separate payment, any initial payments in the series of U.S. Tax Advisory. 3
payments will not be treated as short-term deferrals, even if they are paid within the short-term deferral period. The final regulations permit the payment of short-term deferral amounts to be delayed where the delay is due to an unforeseeable impracticability, where making the payment would jeopardize the ability of the employer to continue as a going concern, or where the making of the payment would cause the employer s U.S. tax deduction to be not permitted under section 162(m) (which applies to certain non-performance-based compensation over $1 million). Confirm that each NQDC plan that is intended to be exempt from section 409A under the short-term deferral rule is properly drafted to fit within the exemption. If the NQDC plan provides for installment payments, consider whether the plan should be amended to treated each payment as a separate payment. Stock options/stock appreciation rights (SARs) Flexibility to extend exercise periods The final regulations provide employers with the flexibility to extend the exercise period of stock options and SARs, if (i) the extension is not beyond the earlier of the original maximum term of the option or ten years from the original date of grant, or (ii) at the time of the extension, the option is underwater. The final regulations confirm that incentive stock options under section 422 of the U.S. Internal Revenue Code and discounted options under a section 423 employee stock purchase plan are exempt from section 409A. An extension of a section 422/section 423 statutory option s term will cause the statutory option to become subject to section 409A only if the same extension of a nonstatutory stock option would have resulted in such treatment. Employers now have much-needed flexibility to adjust the exercise period of stock options and SARs consistent with business needs and plan terms. This flexibility is particularly useful in the context of stock options and SARs held by terminated employees. 4 April 20, 2007
Modifications to section 422/section 423 statutory options should be done in a manner that ensures that the option continues to be exempt from section 409A. Use of averaging method to determine fair market value of publicly traded stock The final regulations clarify the requirements which must be met when using an averaging method to determine the fair market value of a share. If an employer determines fair market value using an average selling price over a period that is within 30 days before or after the date of grant, the commitment to grant the stock option with an exercise price using the average selling price must be irrevocable before the beginning of the averaging period. Specifically, the recipient of the stock option, the number and class of shares subject to the option, and the method for determining the exercise price (including the period over which the averaging will occur), must be designated before the beginning of the averaging period. However, to the extent that a foreign law requires that the exercise price of a stock option or SAR be based upon a specific price averaging method and period, the exercise price may be set accordingly so long as the averaging period does not exceed 30 days. Under the transition rules, the exercise price of stock options and SARs issued before January 1, 2005 will be treated as set at fair market value if based on a good faith attempt by the issuer to set the exercise price at fair market value. The exercise price of stock options and SARs issued between January 1, 2005 and January 1, 2008 will be treated as set at fair market value if a reasonable valuation method has been used to determine such fair market value. In addition, for stock options and SARs issued before January 1, 2008, taxpayers may rely upon the provisions of the proposed or final regulations for determining fair market value. Determine how the exercise price is required to be set under the stock option/sar plan. If an averaging method is specified, the requirements described above will need to be satisfied for all awards issued after December 31, 2007. For awards being issued before January 1, 2008, consider what method to use to determine fair market value. U.S. Tax Advisory. 5
Additional issuers and classes of stock The final regulations expand the potential number of entities within a group and the classes of stock that may issued under stock option and SAR awards. Broadly, the final regulations (i) increase an employer s flexibility in determining which entity s shares may be used for awards, so that, in addition to stock of the participant s direct employer, awards may be made over the stock of any other corporation that is upstream from the employer using a 50 percent (and in some cases a 20 percent) ownership test and (ii) permit any class of stock that would qualify as common stock under section 305 of the Internal Revenue Code to be used, subject to certain limitations relating to preferences and buyback rights. Dividend equivalents The final regulations provide that a right to a payment of accumulated dividend equivalents at the time of the exercise of a fair market value stock option or SAR generally will be treated as a reduction in the exercise price of the stock option/sar (which would generally cause the option/sar to become a discount option/sar and lose its exemption from section 409A). However, if the right to receive the dividend equivalent is not contingent on exercise of the stock option or SAR, it will not be treated as a reduction in the exercise price. Termination of employment (leavers) An employee separates from service with the employer if the employee dies, retires or otherwise has a termination of employment with the employer. The final regulations provide a rebuttable presumption that an employee has terminated employment if it is expected either that no further services will be performed or that the employee s level of services will be reduced to no more than 20 percent of the average level of services performed over the previous 36 months. An employee is presumed not to have separated from service if the expected level of services will exceed 50 percent of the average level of services performed over the previous 36 months. In the context of an asset sale, the buyer and seller have flexibility to determine, before the closing date, whether the seller s employees have experienced a separation from service as a result of the transaction. 6 April 20, 2007
To avoid inadvertently triggering a payment event, consider whether agreements that provide for garden leave should be amended to specifically state that an employee is not considered to have experienced a separation from service for section 409A purposes during the garden leave period. For employees who are in phased retirement, consider whether the reduced level of services warrants treatment as a separation from service for section 409A purposes and if the applicable plan should be amended accordingly. Separation pay (severance) The final regulations provide additional flexibility to employers in structuring their severance arrangements. To the extent that a severance arrangement provides for the payment of severance only upon an involuntary termination (or due to participation in a window program ), an amount of severance equal to the lesser of two times the employee s annual compensation or two times the limit under section 401(a)(17) of the Internal Revenue Code (currently, this amount is $225,000) is exempted from section 409A, provided this amount is paid to the employee within two years following the termination of employment. To the extent the actual amount of the severance exceeds this limit, the amount in excess of the limit remains subject to section 409A (including the six-month delay for key employees). The final regulations also recognize that certain voluntary terminations for good reason are tantamount to involuntary terminations and should be accorded the same treatment as described in the preceding paragraph. The final regulations provide a safe harbor good reason definition. Review the good reason definition in existing severance arrangements and determine whether it would meet the standard for an involuntary termination. Consider whether the good reason definition should be amended to conform to the safe harbor definition in the final regulations. U.S. Tax Advisory. 7
Identifying key employees for purposes of the six-month delay In general, a payment of nonqualified deferred compensation to a key employee of a public company on account of separation from service may not occur before the date that is six months after the date of separation from service (or, if earlier, the date of death). In the ordinary course, the maximum number of employees within a controlled group of companies who will be key employees for section 409A purposes is determined under section 416(i) of the Internal Revenue Code and is capped at 50 employees. The final regulations provide certain defaults in order to make it easier for employers to identify their section 409A key employees. Under the default rule, key employees are identified based on a twelve-month period ending on December 31 and the effective period for the designation is the twelve-month period commencing the following April 1. Employers, however, are given some flexibility to select other determination dates but, if they do so, they must specify such dates in the plan itself or in a separate document applicable to all plans. In response to comments that employers may wish to be over-inclusive in identifying their key employees, the final regulations provide an alternative identification method under which up to 200 employees may be designated as key employees. The final regulations also provide guidance on how to determine which employees are key employees following a corporate transaction, such as a merger, spin-off, or initial public offering. Ensure that the NQDC plan provides for the six-month payment delay for key employees on account of a separation from service. Employers who wish to designate determination dates for identifying key employees (that are different from the prescribed default dates) must take the necessary action to do so. Employers who wish to use the alternative identification method must take the necessary action to do so. Notify plan administrators and plan trustees which participants are key employees. Have a communications approach regarding key employees. 8 April 20, 2007
Plan aggregation rules The proposed regulations classified plans in four broad categories. All the plans within each category are aggregated and treated as a single plan. One major consequence of aggregation is that one non-compliant plan will taint all the other plans in that category even if all these other plans are section 409A compliant. The final regulations helpfully expand the number of categories to nine, thereby reducing potential cross-tainting within a particular category. The nine categories are (i) elective account balance plans; (ii) non-elective account balance plans; (iii) non-account balance plans; (iv) involuntary separation pay plans; (v) split-dollar life insurance; (vi) reimbursement plans; (vii) stock options and SARs; (viii) foreign plans; and (ix) a catchall for any other plans. Each NQDC plan should be categorized into the applicable category and tracked accordingly. Permitted delays in payment The final regulations modify the provisions in the proposed regulations permitting delays in payment. The final regulations provide that a payment of deferred compensation may be delayed, so long as all payments to similarlysituated employees are treated consistently, to the extent that the making of the payment would: (i) cause the employer s U.S. tax deduction to be not permitted under section 162(m), (ii) violate the securities laws or other applicable law, or (iii) jeopardize the ability of the employer to continue as a going concern. Split-dollar life insurance arrangements Concurrent with the release of the final regulations, the IRS also issued Notice 2007-34 relating to the application of section 409A to split-dollar life insurance arrangements. The notice generally clarifies that these arrangements may be subject to section 409A and addresses, among other things, the application of the section 409A grandfather rules to split-dollar arrangements. Failure to comply with section 409A If a NQDC plan does not comply with section 409A, the employee receiving the deferred compensation will be subject to immediate taxation of all vested U.S. Tax Advisory. 9
deferred compensation of the same type, an interest charge based on underpayment of Federal income tax, and a 20 percent additional tax on the amount included in income. While employers are not directly subject to penalties for section 409A violations, they may face associated tax reporting and withholding penalties and employee relations issues. The final regulations do not address the calculation and timing of amounts required to be included in income or the reporting and withholding requirements applicable to employers providing nonqualified deferred compensation covered by section 409A, but indicate that further guidance on these requirements will be issued. Offshore trusts The final regulations do not address the application of section 409A(b). This generally prohibits the use of offshore trusts associated with nonqualified deferred compensation plans and the use of triggers where amounts held in a trust become restricted to be used to pay nonqualified deferred compensation on an event related to the financial health of the employer. Taxpayers may continue to rely upon the transition guidance provided under Notice 2006-33 relating to the application of section 409A(b) to certain outstanding arrangements until further guidance is issued. 10 April 20, 2007
Prior IRS guidance (click on hyperlinks) Internal Revenue Bulletin 2005-43 (Section 409A proposed regulations) Notice 2005-1 (Initial guidance under section 409A) Notice 2006-4 (Stock rights) Notice 2006-33 (Transition relief for offshore trusts) Notice 2006-64 (Federal conflict of interest) Notice 2006-79 (Additional transition relief under section 409A) Notice 2006-100 (Reporting and withholding) Announcement 2007-18 (Compliance program for misdated options) Notice 2007-34 (Split-dollar life insurance) Prior Linklaters Tax Advisories relating to section 409A (click on hyperlinks) U.S. overhauls deferred compensation, November 5, 2004 IRS clarifies restrictions on deferred compensation, December 22, 2004 IRS provides critical guidance on deferred compensation, September 30, 2005 IRS provides transition relief for deferred compensation trusts, March 24, 2006 U.S. Tax Advisory. 11
U.S. Tax and Executive Compensation Contacts For further information, please contact: Stephen Land 212 903 9018 stephen.land@linklaters.com Robert Thornton Smith 212 903 9019 bob.smith@linklaters.com Bindu Culas 212 903 9155 bindu.culas@linklaters.com Valerie Leipheimer +44 207 456 5508 valerie.leipheimer@linklaters.com Heidi Schmid 212 903 9042 heidi.schmid@linklaters.com Francisco Duque 212 903 9084 francisco.duque@linklaters.com Matthew Welsh 212 903 9061 matthew.welsh@linklaters.com Karen Slotsky 212 903 9202 karen.slotsky@linklaters.com New York 1345 Avenue of the Americas New York, NY 10105 Tel: (1) 212 903 9000 Fax: (1) 212 903 9100 This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts at Linklaters, or contact the editors. Linklaters. All rights reserved 2007 Please refer to www.linklaters.com/regulation for important information on the regulatory position of the firm. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by emailing us at marketing.database@linklaters.com 12