In the United States, the heads of human resources and their advisors are reviewing and amending all plans, agreements and related documents providing compensation to U.S. taxpayer employees to comply with Section 409A of the U.S. Internal Revenue Code (the “U.S. Code”).  This review should not be limited to compensation plans, programs and arrangements in the United States.  There are a number of compliance areas under Section 409A of the U.S. Code that have taken global employers by surprise.  Section 409A of the U.S. Code includes certain provisions that impact the global compensation plans and programs of multinational employers.  In particular, there are special requirements for multinational employers that are publicly-traded non-U.S. securities exchanges.

Section 409A of the U.S. Code governs deferred compensation for U.S. taxpayers and provides strict rules and requirements on the deferral and payment of deferred compensation.  Deferred compensation is broadly defined to include equity-based compensation, employment agreements, separation agreements, offer letters and all deferred compensation plans and programs.  A failure to comply with Section 409A of the Code results in a 20% excise tax assessed on the employee, plus interest penalties, on the value or payment of the deferred compensation.

This article addresses two main areas that impact the publicly-traded multinational employer under Section 409A of the U.S. Code.   First, global equity plans of publicly-traded multinational employers in which U.S. taxpayer employees participate may require changes to the pricing methodology and amendments to comply with Section 409A of the U.S. Code.  Second, special timing of payment rules apply to the payment of compensation and benefits upon the separation from service of a U.S. taxpayer employee if the foreign parent is publicly-traded and elections under the special timing of payment rules may be helpful to employers in administering these rules.  (Section 409A of the U.S. Code also impacts employers globally with respect to compensation and benefits plans, programs, arrangements and agreements for their U.S. taxpayer employees, expatriates and global employee transfers, which are beyond the scope of this article.) 

 

Global Equity Incentive Plans of Publicly-Traded Employers

Deferred compensation under Section 409A of the U.S. Code is broadly defined to include all types of equity based compensation.  For example, stock options, stock appreciation rights, restricted stock, restricted stock units, phantom stock, share awards and all other types of equity  based compensation are potentially subject to Section 409A of the U.S. Code.  A failure to comply with its requirements will subject U.S. taxpayer employees who receive equity based awards to a potential 20% excise tax on such awards and interest penalties. 

 

Stock Options and Stock Appreciation Rights.

On April 10, 2007, final Treasury Regulations were issued under Section 409A of the U.S. Code (the “Treasury Regulations”).  The Treasury Regulations provided clarification to the rules governing stock options and stock appreciation rights.  Section 1.409A-1(b)(5)(i)(A) & (B) of the Treasury Regulations provide an expansive exemption for stock options and stock appreciation rights granted at an exercise price that may “never be less than the fair market value on the date of grant” and that do not have a feature for the deferral of compensation.  If stock options and stock appreciation rights meet the requirements of this exemption, they will then be exercisable following vesting throughout the term of the award and the grants will be considered exempt under Section 409A of the U.S. Code.

The Treasury Regulations considerably limit the determination of “fair market value” with respect to publicly-traded employers.[1]  Under Section 1.409A-1(b)(5)(iv)(A) of the Treasury Regulations, “fair market value” may be determined based on:  (i) last sale before or first day after the grant date; (ii) closing prices on the trading day before or on the trading day of the grant date; (ii) arithmetic mean of the high and low prices on the trading day before or on the trading day of the grant; or (iv) any other reasonable method using actual transactions in such stock as reported by the market.  “Fair market value” also may be determined based on an average selling price, otherwise known as a weighted average, over a period not to exceed 30 days, provided that the program must irrevocably specify the commitment to use such average selling prices before the beginning of the specified period, unless otherwise required by applicable foreign law.  Section 1.409A-1(b)(5)(vi)(B) of the Treasury Regulations provide that the “date of grant of the option” will not occur until the date in which the minimum exercise price, maximum number of options, the class of underlying stock and the employee to whom the grant is awarded are fixed or determined.  

A multinational publicly-traded employer with shares trading on a non-U.S. stock exchange may use a methodology to allocate the numbers of options or stock appreciations rights and determine their exercise price that does not meet these new requirements for U.S. taxpayer employees.  The practical issues arise when the publicly-traded employer determines allocations based on an average selling price that exceeds 30 calendar days[2] or allocates the shares based on an exercise price determined prior to the date the number of shares subject to the option are fixed and determinable.  In such event, the options or stock appreciation rights so granted will be viewed as being granted at a discount below fair market value for U.S. tax purposes.  If the awards allow for exercise in tax years following vesting (understanding that a long exercise period generally is a desirable feature of stock options and stock appreciation rights), the awards would by their terms violate Section 409A of the U.S. Code and subject the U.S. taxpayer employees to tax penalties.  Although there is an exception to providing the averaging period be irrevocable if the averaging period is required under applicable foreign law, this exception would appear to be limited to a legally required pricing methodology (as opposed to a permissible pricing methodology that results in the desired tax treatment for the non-U.S. employees) and is expressly limited to a 30 day averaging period.

Another example is where an allocation depends on a multiple of cash compensation prior to an averaging period.  For example, 20% of an individual’s base salary will be granted as stock options based on a 10 day selling average, the number of stock options is determined by dividing the portion of the base salary by the average selling price on the last day of the averaging period.  In such case, there is an argument that the exercise price, the number of shares and the individual is fixed and determinable on the same date of grant because there is no real discretion. 

If the pricing methodology needs to be adjusted to comply with Section 409A of the U.S. Code, the employer will need to make a decision as to whether a new pricing methodology should be used for all grants or whether the current pricing methodology be used for grants to non-U.S. taxpayer employees and a new methodology for equity grants to U.S. taxpayer employees.[3] If a separate pricing methodology is used for U.S. taxpayer employees, the existing plan could be amended by providing an Appendix applicable to U.S. taxpayer employees or by creating a sub-plan for U.S. taxpayer employees, subject to applicable foreign law.

The Treasury Regulations also specify that the exemption for stock options and stock appreciation rights only apply if the rights were granted with respect to “service recipient stock.”  “Service recipient stock” is defined under Section 1.409A-1(b)(5)(iii) of the Treasury Regulations to mean common stock for purposes of Section 305 of the U.S. Code.  This definition also excludes stock that has any preference as to distributions (other than distributions in liquidation of the issuer).  Any type of stock that has a preference and is publicly traded may not qualify as “service recipient stock,” however, that determination will depend on whether the features of the stock are similar to the features of common stock under Section 305 of the U.S. Code, of which there is little guidance.  Section 1.305-5 of the Treasury Regulations defines “preferred stock” to mean stock where the facts and circumstances show the stock in relation to other classes of stock enjoys limited rights and privileges as to dividends and liquidation priorities, but does not participate in corporate growth to any significant extent.  This implies that “common stock” must mean stock where the holder is likely to participate in the current and anticipated earnings and growth of the issuer.  Factors to consider include whether the stock participates in current and anticipated earnings, the rights of the stock upon liquidation, participation in cash dividends, the book value of the stock, the extent of preference and participation of each class of stock.

American depositary receipts (“ADRs”) also specifically qualify as “service recipient stock.”   Financial depositary receipts and other types of publicly traded equity similar to ADRs should qualify as “service recipient stock,” however, there is no guidance on point.  The features attendant to the shares of publicly-traded multinational employers will need to be considered by analogy to U.S. common stock, which does not give multinational employers the certainty they desire. 

Section 1.409A-1(b)(5)(v)(D) & (H) of the Treasury Regulations provide that extensions, modifications and adjustments to stock options and stock appreciation rights in connection with corporate transactions must comply with certain U.S. tax rules.  These rules specifically reference certain detailed adjustment rules under Section 424 of the U.S. Code.   Where adjustments are made to stock options and stock appreciation rights pursuant to applicable law of the non-U.S. jurisdiction in which the shares are traded, in many cases, those equitable adjustments do not comply with the Section 424 Treasury Regulations.  Accordingly, multinational employers could be put in the difficult position of being required by law to make equitable adjustments that do not technically fall into one of the permitted adjustments.  Again, the equitable adjustment provisions may be considered by analogy, however, multinational employers are left with a great deal of uncertainty and potential additional tax costs. 

 

Restricted Stock Awards.

There is a general exemption for restricted stock.  Section 1.409A-1(b)(6) of the Treasury Regulations provide that there is no deferral of compensation if the value of the compensation is not included in income by being substantially nonvested under Section 83 of the U.S. Code.  Though not explicit, by excluding the transfer of property under Section 83 of the Code from the definition of “deferred compensation,” restricted stock is in effect exempt under Section 409A of the U.S. Code (unless it otherwise provides for a feature of deferral).

 

Restricted Stock Units, Performance Units and Phantom Stock.

There is no specific exemption under Section 409A of the U.S. Code for restricted stock units, performance units, phantom stock and other similar equity based awards.  These awards are subject to Section 409A of the U.S. Code and will need to be designed to comply with the requirements of Section 409A of the U.S. Code.

 

Critical Items for Review.

·      Pricing methodology of stock options and stock appreciation rights and the date of grant (number of shares and price must be fixed as of the date of grant)

·      Features of underlying stock

·      Equity adjustment provisions

·      Additional deferral features

·      Awards that are not exempt under Section 409A of the U.S. Code

 

Specified Employee Six Month Delay Rule

Publicly-traded multinational employers will need to pay attention to post-termination pay and benefits, including severance payments, to certain key U.S. taxpayer employees upon their separation from service.  Section 409A of the U.S. Code requires that, in the case of a “specified or key employee” of a “public company,” a distribution of deferred compensation upon a separation from service may not be made before the date that is six months after the date of separation from service (or if earlier the date of death).  This rule is referred to in this article as the “six month delay rule.”  This rule was enacted to address the Enron circumstances where certain executives were able to obtain distributions of their deferred compensation benefits in the period leading up to Enron’s bankruptcy.  By requiring executives to wait six months following their separation from service of a publicly-traded employer, the executive’s deferred compensation will be at risk in the event of bankruptcy or insolvency of the employer within the six month period following their departure.

The six month delay rule applies to publicly-traded companies on a controlled group basis and therefore particularly impacts multinational employers that are publicly-traded on a non-U.S. stock exchange with U.S.-based subsidiaries and affiliates.  The identification of key employees to whom the six month delay rule applies also is determined on a controlled group basis.[4]  Key employees may include non-U.S. taxpayer employees and U.S. taxpayer employees and care should be taken to identify the U.S. taxpayer employees who will be implicated.

Section 409A of the U.S. Code defines “specified or key employee” under Section 416 of the U.S. Code, which provides certain discrimination testing rules applicable to U.S. tax-qualified retirement plans.  Under Section 416 of the U.S. Code, a “specified or key employee” is defined as any employee who meets one of the following tests at any time during a plan year:

(i) an officer of the employer having an annual compensation greater than $150,000;

(ii) a 5-percent owner of the employer; or

(iii) a 1-percent owner of the employer having an annual compensation from the employer of more than $150,000. 

No more than 50 employees (or if lesser, the greater of 3 or 10 percent of the employees) will be treated as officers.  Under Section 1.416-1, Q&A T13 of the Treasury Regulations, the determination of whether an employee is an officer depends upon all available facts, including the source of his or her authority, the term for which elected or appointed and the extent of the employee’s duties.[5]   In general, specified or key employees will be considered to be the top 50 officers with the highest annual compensation during the determination period.   Compensation for this purpose is defined under Section 415 of the U.S. Code (which provide complex rules applicable to U.S. tax-qualified retirement plans).

To identify the top 50 officers based on compensation, the multinational employer will need to look across the entire controlled group, comparing compensation levels for the entire organization.  This leads to some difficult practical issues, particularly as to how to obtain global compensation data, how to determine whether compensation of non-U.S. taxpayer employees meets the definition of compensation for U.S. taxpayer employees, and how to assess the impact on U.S. taxpayer employees.

In this regard, the Section 409A Treasury Regulations help employers by providing certain elections that are intended to simplify the identification process of specified or key employees.  Section 1.415(c)(2) of the Treasury Regulations permit the employer to make simplified elections as to the definition of compensation, provided that the elected definition is applied consistently to all employees for purposes of identifying specified or key employees.  Most helpful to multinational employers is that the employer may elect to exclude certain (non-U.S.) foreign compensation earned by non-resident aliens.  This exclusion, if elected, would in most instances limit the category of specified or key employees to U.S. taxpayer employees.  This exclusion is useful where it is difficult to obtain global compensation data or where data privacy rules restrict the dissemination of compensation information.  However, if the (non-U.S.) foreign compensation exclusion is applied, there will be a greater number of U.S. taxpayer employees who fall within the top 50 officers than if compensation was taken into account for the global employee population.  In other words, the exclusion would increase the number of U.S. taxpayer employees subject to the six month delay rule upon their separation from service.   

Other compensation elections available to employers include adopting definitions of compensation that are easier to identify and administer for U.S. taxpayer employees, including:

(i) Simplified compensation, including wages, commissions, tips, bonuses, fringe benefits, etc. and earned income, and excluding deferred compensation, option gains, premiums, and similar items; or

(ii) Section 3401(a) wages (Form W-2 compensation), including amounts that would be included in wages but for a certain pre-tax elections.

If the foreign exclusion is applied, simplified elections for determining the compensation taken into account could ease the identification and administration of the list of specified or key employees.

The employer also is permitted to select the “identification date” and the “effective date” for determining the list of specified or key employee subject to the six month delay rule.  An “identification date” means the date as of which the key employees are determined, typically December 31.  Once the Key Employees are identified, the list will be effective for a 12-month period following the Key Employee “effective date,” which may be no later than the first day of the 4^th month following the specified employee identification date (i.e., April 1 for an identification date of December 31).[6]  For example, the employer could establish a list of 50 specified or key employees effective as of December 31, 2009, which will be effective if an employee has a separation from service during the period beginning April 1, 2010 through March 31, 2011.

An alternative method may be used to identify specified employees, provided that the method is reasonably designed to include all specified employees (without regard to any elections), is an objectively determinable standard providing no direct or indirect election and results in all employees or no more than 200 employees being subject to the six month delay rule.  For example, a multinational employer could elect to consider global executives of a certain classification level or above as specified or key employees.   As long as the category is reasonably designed to apply to all U.S. taxpayer employees who would be in the top 50 officers using the default rules, such a category should work.

Section 1.409A-1(i)(8) of the Treasury Regulations requires that elections will be effective when all necessary corporate action has been taken to bind all affected deferred compensation plans.  Necessary corporate action is not defined, and it could mean the approval by the employer’s board of directors, compensation committee or any delegate thereof.   In a practical sense, once a list of specified or key employees is developed, when any individual on that list has a separation from service, all post-employment payments, benefits, severance and any other type of compensation will need to be reviewed as to the application of the six month delay rule.  Accordingly, the elections will be effective for all deferred compensation plans under which specified or key employees participate.

If the employer does not make any of the elections described above, the following default elections will apply:

(i) Compensation will be as defined under Treas. Reg. § 1.415(c)(2), including all wages, commissions, tips, bonuses, fringe benefits, medical expenses moving expenses, statutory stock option gains, restricted stock, constructive receipt, but excluding contributions for deferred compensation if not included in gross income, certain stock option gains, sale of stock, group-term life insurance or other similar items. 

(ii) Foreign compensation will be included in calculating compensation. 

(iii) The specified employee identification date will be December 31. 

(iv) The specified employee effective date will be April 1.

Finally, retroactive elections may be made for separations from service occurring prior to January 1, 2008, however, changes to elections on and after January 1, 2008 generally may not be effective for a period of 12 months. 

 

Critical Items for Review.

·      Coordinating the list of specified or key employees globally and with one or more U.S. subsidiaries

·      Availability of global data on compensation

·      Whether to make compensation elections, including an election to exclude foreign compensation

·      Explore whether an alternative method would be appropriate

 

Conclusion

Multinational employers that are publicly-traded on a non-U.S. stock exchange should be aware of how the rules under Section 409A of the U.S. Code may impact them and their U.S. taxpayer employees.  Given the adverse financial impact to U.S. taxpayer employees, as well as potentially to the U.S. employing entity that may bear the costs of the excise tax penalties and interest, multinational employers that consider these rules in advance and plan ahead will be able to limit their exposure to tax penalties affecting their U.S. workforce.  Once the plan design and administrative structures are in place on a global level, there should be fewer surprises. 

 

Gretchen Harders[7]

Epstein Becker & Green, P.C.