© Copyright 2006 Rogers Publishing Ltd. The following article first appeared in the January 2006 edition of BENEFITS CANADA magazine.
Don’t defer
New U.S. laws on taxation of deferred compensation that apply to Canadian employers have already kicked in.
By Sandra Wieder Cohen

Canadian employers are evaluating their compensation arrangements covering U.S. citizens, regardless of residency, for compliance with sweeping new legislation governing the operation and design of deferred compensation.

On Jan. 1, 2005, new legislation(Section 409A to the U.S. Internal Revenue Code)was enacted to govern the operation and design of deferred compensation payable to employees. The new law is controversial because the rules affect any employer who employs even a single United States taxpayer anywhere in the world.

Unfortunately, the meaning of “deferred compensation” within the regulation is extremely broad yet unclear. Deferred compensation is compensation which employees but also directors and certain independent contractors have a legally binding right to receive in a future year.

The new law also affects many plans that are not ordinarily associated with traditional deferred compensation. For example, bonus plans, discount stock options, and even severance and employment agreements are all covered under the “deferred compensation” umbrella.

Employers and plan sponsors could find that consequences of noncompliance with the new law are severe. Compensation under the non-compliant arrangement, and any similar arrangements that are required to be aggregated with it, can be included in gross income and will incur interest at the underpayment rate plus 1% along with a 20% additional tax.

The regulations affect compensation retroactively. If compensation was deferred or a bonus awarded but the deferred compensation was not “earned and vested” prior to the Jan. 1, 2005 effective date, the plan must comply with the new rules.

Some plans may be exempt from Section 409A. For example, if the compensation is paid within two and a half months after the end of the taxable year in which it is earned and vested, it is not “deferred compensation.” Generally, the new law restricts the circumstances that may trigger a distribution of deferred compensation and prescribes rules for the election to defer compensation.

Take steps to identify all of the arrangements that may provide deferred compensation. In particular, deferred share unit plans, retirement compensation arrangements, bonuses and severance arrangements should be reviewed for compliance. It’s also important to identify any stock option and stock appreciation rights that were granted with a below fair market value exercise price.

Voluntary deferral elections, if any, should be made before the end of the calendar year preceding the year in which services are rendered(in other words, before Dec. 31, 2005 to defer compensation for services that will be rendered in 2006). Elections to defer 2006 bonuses may occur on a later date(six months prior to the end of the bonus performance period)provided the bonus meets the requirement for “performance- based compensation” and the performance period is at least one year. Payments that result from termination of employment must be delayed for six months if the employee is a “key employee”(generally, officers who earn more than $140,000 and certain other shareholders).

Before March 15, 2006:
Short-term bonuses for the calendar year ended Dec. 31, 2005 (or for a fiscal-year that ended during 2005)should be paid in full by March 15.

Before Dec. 31, 2006:
Participants may change the time and form of payments from deferred compensation plans until Dec. 31, 2006. However, any election made in 2006 cannot apply to payments that an individual would otherwise receive in 2006, so it would be prudent to institute a default form of payout that would apply to payments in 2006.

The deadline to amend plans to conform to the new law is Dec. 31, 2006. If possible, allow the current guidance to be digested into “best practices” before amending plan documents.

Although the regulations under Section 409A are still in proposed form, Canadian employers are actively responding to the new requirements in order to avoid causing severe tax penalties to their U.S. executives.

Sandra Wieder Cohen is a partner in Osler, Hoskin & Harcourt’s New York office. Sandra.cohen@osler.com.