The Deferred Compensation Rules for Non-Residents

A Deferred Compensation by Nonresident Aliens Tax Overview

Deferred Compensation by Nonresident Aliens

Deferred compensation is one of the primary benefits provided to employees, directors, and other corporate members in order to entice them to work for the company. Whether it is an established company or a new company, deferred compensation provides employees with the motivation to make a company great  — with the ability able to financially benefit from the outcome, once the vesting or other related period is met. While deferred compensation for US persons is already complicated, when it involves non-resident aliens it becomes much more complex due to the withholding requirements and other ancillary issues such as what happens when a resident alien becomes a nonresident alien – usually because they no longer meet the Substantial Presence Test or relinquished/pronounced their US status. Let’s take a brief walk through the practice unit provided by the Internal Revenue Service on the issue of deferred compensation received by non-resident alien individuals.

Who do these Rules Apply To?

The purpose of this specific practice unit is to identify taxpayers who are non-resident aliens but performed work for a US company that offered deferred compensation benefits — and the deferred compensation benefits were ‘qualified’ (the rules for qualified versus nonqualified deferred compensation differ).

As provided by the IRS:

1. 1. • Has the NRA ever performed services in the United States? ? An NRA is only taxed on deferred compensation to the extent it is compensation from personal services performed in the United States under IRC 861(a)(3). If the NRA did not perform services in the United States, the income is considered foreign-source and likely exempt from U.S. taxation. If the NRA performed services both inside and outside the United States, compensation will be allocated between U.S. and foreign-source on the basis that most correctly reflects the proper source of income under the facts and circumstances of the particular case. Commonly, allocation is done on a time basis between U.S. and non-U.S. workdays in order to determine the portion of income that is U.S. source.

      • Is the NRA a resident of a treaty country? ? Many tax treaties reduce or eliminate any U.S. tax that would otherwise be imposed under the Code on certain items of income. Therefore, it is critical to determine if the taxpayer is a resident of a treaty country and if so, carefully review the applicable treaty article(s).

      • What are the U.S. withholding tax rules? ? The withholding tax rules governing the payment of deferred compensation and pensions to NRAs are complex. If the determination of the NRA recipient’s liability for U.S. income tax on the payment is not clear, withholding agents may be conservative and withhold in order to avoid potential liability as a withholding agent. If the agent withholds and the NRA’s taxable income is lower or exempt from U.S. tax, the NRA will have to file a U.S. Nonresident Alien Income Tax Return and claim a refund for any amount of over withheld tax.

Why are these 3 Factors Important?

The reason why these three factors above are crucial is that there will impact whether there is any tax requirement for the nonresident alien and if so what is the withholding.

Has the NRA ever performed services in the United States

The first question involves whether or not the services were performed in the United States. More specifically, if the services were not performed in the United States then a non-resident alien is not subject to tax on the income. While the United States follows a worldwide income tax model, it is only for US persons — and non-resident aliens are not considered US persons.

Is the NRA a resident of a treaty country?

the United States has entered into nearly 60 tax treaties with foreign countries. The tax treaties identify certain sources of income that may be exempt from taxes based on the specific verbiage in the treaty. In addition, even if the income is taxable – it may be taxed at a reduced rate.

What are the U.S. withholding tax rules?

In general, the withholding rules for non-US persons are more complicated than the withholding for US persons. Taxpayers who are non-resident aliens do not want more money withheld than absolutely necessary. Depending on the specific tax treaty, there may be a reduced amount of withholding or even a complete elimination of the withholding if the treaty examines the specific type of income from taxation in the United States. It also helps determine whether a withholding agent has the right to reduce or eliminate the amount of withholding.

How to Determine Sources of Income?

Income sourcing rules are crucial, because of the income is not considered sourced in the United States then the United States would (usually) not have the opportunity to tax the income to a non-resident alien.

As provided by the IRS:

• • • Source of Income

      • The sourcing of income rules is important to determine if the United States can tax-deferred compensation. Compensation for personal services is generally sourced to the location where the services are performed. The general sourcing principles for deferred compensation are described below, though the treatment may differ based on several factors (including if the compensation is a distribution from a U.S. tax-qualified defined benefit plan, described in later slides).

        • Compensation for personal services performed by an individual is generally sourced on a time basis. This is usually computed as the number of U.S. and non-U.S. workdays during the calendar year.

        • Multi-year compensation arrangements are sourced according to U.S. and non-U.S. workdays within the multi-year period. These include arrangements in which an employee is taxed on compensation in one taxable year that is attributable to services performed in more than one taxable year.

        • Fringe benefits are sourced to the country of the employee’s “principal place of work.” These include employer-provided housing, local transportation, hazardous/hardship duty pay, reimbursements of taxes, dependent tuition, and moving expenses.

Distributions from a Tax-Qualified Retirement Plan of a U.S. Company

The Code covers two types of tax-qualified retirement plans: 

Defined Benefit Plans

• • • These are employer-sponsored plans where the benefits paid to employees are computed using a formula that considers multiple factors, such as salary history and length of employment. A pension plan, for the purpose of IRC 401(a), is “established and maintained by an employer primarily to provide systematically for the payment of definitely determinable benefits to his employees over a period of years, usually for life, after retirement.” 

Contribution Plans

• • • These are plans in which employees have a separate account that reflects employee and employer contributions, trust income and expenses, and gains or losses. The account balance is the basis for determining the employee’s benefits. Examples include 401(k) and 403(b) plans, employee stock ownership plans (ESOPs), profit-sharing plans, simplified employee pensions (SEPs), and simple retirement accounts (SIMPLEs).

      • Both defined benefit plans and defined contribution plans can be designed to accept beforetax contributions (aka employer contributions, including elective contributions to a qualified cash or deferred arrangement under IRC 401(k)) and after-tax contributions (aka employee contributions).

    • Distributions from a U.S. tax-qualified retirement plan to an NRA have three components:

      • The portion attributable to pre-tax contributions for services rendered within the United States: Distributions with respect to contributions for services rendered by the employee on or:

        • IRC 871(a)

        • IRC 871(b)

        • IRC 864(c)(6) before December 31,1986, are taxed as U.S.-source FDAP at 30% under IRC 871(a)(1)(A).

        • Distributions with respect to contributions for services rendered by the employee after December 31,1986, are taxed as ECI at graduated rates under IRC 871(b) and 864(c)(6). 

    • The portion attributable to pre-tax contributions for services rendered outside the United States: Considered foreign-source distributions and therefore not subject to U.S. tax. See the sourcing rules discussed above to determine how to allocate contributions between U.S. and non-U.S. workdays. 

    • The portion attributable to earnings and accretions of the plan: So long as the plan is a U.S. trust, these distributions are treated as U.S.-source FDAP and taxed at 30% under IRC 871(a)(1)(A). Note: Distributions from a U.S. tax-qualified defined benefit plan are sourced under a computation method set out in Rev. Proc. 2004-37.

Equity-Based Compensation – U.S. Stock Option Plans

• • • Employee stock options offer an employee the right to purchase a set number of shares at a specified price for a fixed period. IRC 83 governs nonstatutory stock options (NSOs) (also known as nonqualified stock option plans) and states that a taxpayer who receives property in exchange for services must recognize ordinary income equal to the excess of the fair market value (FMV) of the property once it vests over any amount paid for such property. It contains two rules affecting all NSO transactions:

• • • If the option has a readily ascertainable FMV on the date of grant and is substantially vested, the taxpayer includes in gross income the “spread” on the grant date. The “spread” is the excess of the FMV of the option over any amount paid for the option. § If the option does not have a readily ascertainable FMV on the grant date and is substantially vested, the taxpayer includes in gross income the “spread” on the exercise date. The “spread” is the excess of the FMV of the option over the exercise price. Note that the restricted property rules apply, so if the option is not substantially vested at the time the option is granted or exercised, then there is no taxable event in either of the two situations discussed above.

• • • An NRA may be subject to U.S. tax on part or all of the “spread” to the extent he or she worked in the United States during the vesting period. A stock option plan is generally treated as a “multi-year” arrangement and should be sourced based on workdays between the date the option was granted and the date it became vested. The U.S. source portion of the “spread” is subject to wage withholding under IRC 3402, taxed as ECI at graduated rates and subject to FICA and FUTA taxes either at the date of grant if it has a readily ascertainable FMV or at the date of exercise of the option if not. Any subsequent sale of the stock after the exercise of the option would be subject to the capital gain/loss rules for NRAs. For statutory stock option plans (also known as incentive stock options (ISOs) or qualified stock option plans), there is no recognition of income on either the grant or the exercise of the option as long as the stock received from the exercise of the option is held for at least two years from the grant date or one year from the exercise date. However, the exercise of an ISO will result in an item of adjustment for alternative minimum tax (AMT) purposes. Any subsequent sale of the stock received through the exercise of the option is subject to the capital gain/loss rules for NRAs. If the holding requirements are not met, the option is treated as an NSO and subject to the NSO rules.

Equity-Based Compensation – Restricted Stock Plans

• • • A restricted stock plan is an arrangement in which the employer transfers company stock to an employee at the beginning of the vesting period, subject to the condition that the employee remains employed with the company until the end of the vesting period. If not, the employee must forfeit the stock back to the employer. These plans are generally considered “multi-year” arrangements and are sourced over the entire vesting period. The U.S.-source portion of the spread is treated as compensation in the year that the participant’s rights in the shares vest and is taxed as ECI at graduated rates. The employee would be subject to wage withholding under IRC 3402 as well as FICA and FUTA taxes.

Deferred Compensation Received by Covered Expatriates

• • • A special tax regime applies to certain eligible deferred compensation items paid to a covered expatriate (CE). CEs are former U.S. citizens or long term lawful permanent residents (green card holders who did not take treaty positions to be treated as a nonresident alien for at least § IRC 877A(d)(3) § Notice 2009-85 8 out of the 15 years prior to expatriation) who expatriated. An eligible deferred compensation item is any deferred compensation item with respect to which: § The payor is either a U.S. person or a non-U.S. person who elects to be treated as a U.S. person, § The CE notifies the payor of his or her status as a covered expatriate, and 

    • The CE irrevocably waives right to claim any withholding reduction under any U.S. treaty. For eligible deferred compensation items, the payor must deduct and withhold a tax equal to 30% of any taxable payment to a CE with respect to such an item. A taxable payment is any payment to the extent it would be includible in gross income of the CE if such person continued to be subject to tax as a citizen or resident of the United States. In the case of any deferred compensation item, the amount of a taxable payment will not include the portion of such item that is attributable to services performed outside the United States before or after the expatriation date while the CE was not a citizen or resident of the United States.

Examples Provided by the IRS

Here are some IRS examples to illustrate the concept:

Source of Income – Single-Year and Multi-Year Arrangements

• • • Example 1: In Year 1, NRA taxpayer works 125 days in the United States, 125 days in his country of residence, and defers $50,000 of his compensation until Year 3. In Year 2, he works zero days in the United States, 250 days in his country of residence, and defers $100,000 of his compensation until Year 3. If these were considered single-year arrangements, $25,000 of his deferred compensation from Year 1 would be considered U.S.- source ($50,000 multiplied by 125 days divided by 250 days) and the remaining $25,000 would be considered foreign-source in Year 3. For the deferred compensation earned in Year 2, zero would be U.S.-source ($100,000 multiplied by 0 days divided by 250 days) and $100,000 ($100,000 multiplied by 250 days divided by 250 days) would be foreign-source in Year 3.

    • Example 2: In Year 1, an employer promises to pay NRA employee, in addition to his annual salary, $100,000 as an incentive for the employee to work from the beginning of Year 1 until the end of Year 2. If the employee does not work until the end of Year 2, the full $100,000 of the deferred compensation will be forfeited. The employee fulfills this requirement and works until the end of Year 2, and the incentive is paid in Year 3. In Year 1, the employee worked 250 days in the United States and zero days abroad. In Year 2, the employee worked zero days in the United States and 250 days abroad. This arrangement is considered a multi-year arrangement and therefore the deferred compensation is allocated based on U.S. and foreign workdays throughout the two-year period. Therefore, 50% ($50,000) of the deferred compensation is allocated to U.S. sources and 50% ($50,000) is allocated to foreign sources in Year 3. 

Distributions from a Tax-Qualified Pension Plan Example

• • • An NRA taxpayer retires this year and begins receiving pension payments from his former U.S. employer’s tax-qualified pension plan. The taxpayer worked for this U.S. employer in the United States for 10 years prior to retiring. Under IRC 864(c)(6), the portion of pension payments attributable to pre-tax contributions to the pension fund while the taxpayer worked in the United States would be considered ECI, even though the NRA taxpayer is not engaged in a U.S. trade or business at the time he receives the payments. The portion of the pension payment attributable to the earnings and accretions of the plan would be FDAP income subject to tax at 30% under IRC 871(a)(1)(A). Even though a portion of the payments will be taxed as ECI, the entire payment would be subject to 30% withholding under IRC 1441. Assuming no treaty applies to exclude the distributions from U.S. taxation, if the amount of withholding exceeds the amount of tax due, the NRA taxpayer may be eligible for a refund by filing a Form 1040-NR return. The taxpayer is required to pay additional amounts should the withholding on the payment not satisfy the taxpayer’s full tax liability.

Stock Options- Source of Income

• • • Example: On January 1, 2006, Company Q compensates employee J with a grant of nonstatutory stock options that do not have a readily ascertainable fair market value when granted. The stock options permit J to purchase 100 shares of Company Q stock for $5 per share. The stock options do not become exercisable unless and until J performs services for Company Q for 5 years. J works for Company Q for the 5 years required by the stock option grant. In years 2006-2008, J performs all of his services for Company Q within the United States. In 2009, J performs half of his services for Company Q within the United States and half of his services for Company Q without the United States. In year 2010, J performs his services entirely without the United States. On December 31, 2012, J exercises the options when the stock is worth $10 per share. J recognizes $500 in taxable compensation ($10 minus $5 multiplied by 100) in 2012. Pursuant to Treas. Reg. 1.861-4(b)(2)(ii)(A) and (E), compensation for personal services performed by an individual is sourced on a time basis.

    • Under the facts and circumstances, the applicable period is the 5-year period between the date of grant (January 1, 2006) and the date the stock options become exercisable (December 31, 2010). On the date the stock options become exercisable, J performs all services necessary to obtain the compensation from Company Q. Accordingly, the services performed after the date the stock options become exercisable are not taken into account in sourcing the compensation from the stock options. Since J performs 3.5 years of services for Company Q within the United States and 1.5 years of services for Company Q without the United States during the 5-year period, 7/10 of the $500 of compensation (or $350) recognized in 2012 is income from sources within the United States and the remaining 3/10 of the compensation (or $150) is income from sources without the United States.

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist that specializes exclusively in these types of offshore disclosure matters.

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