Most Canadian employers with executives who are subject to US taxation are generally aware that non-qualified deferred compensation plans for these employees must be reviewed to ensure compliance with or exemption from Code section 409A, enacted in 2004. Employers generally have until the end of 2007 to formally amend their plans (IRS Notice 2006-79), which in the interim must be operated in good faith compliance with section 409A.

Section 409A dramatically changed the rules governing non-qualified deferred compensation, eliminating much of the flexibility that had been a hallmark of deferred compensation. (Some deferrals are grandfathered.) Significant new restrictions are imposed on benefit deferrals and distributions, and changes are made to the form and time of payment. Penalties for non-compliance are steep (immediate taxation of all vested amounts, interest, and a 20 percent excise tax), underscoring the need for careful attention to the new rules. Compliance has been complicated by the delay in the issuance of final regulations. Proposed regulations were issued on September 29, 2005 (Reg-158080-04); final regulations promised for the spring of 2006 have not materialized, leaving employers to cope with interim guidance and many unanswered questions.

Most employers have focused their reviews on traditional non-qualified deferred compensation plans, such as supplemental executive retirement plans (SERPs) and excess benefit plans. But the definition of deferred compensation under section 409A is extremely broad and covers a wide range of plans and arrangements that may have as yet escaped an employer's review. Employers need to expand the scope of their reviews to include many non-traditional compensation arrangements or else risk inadvertent violations of section 409A.

Most non-qualified stock options , for example, are explicitly exempt, but only if they are not discounted: the exercise price must equal or exceed the underlying shares' FMV at the date of grant. Discounted options must comply with section 409A or be subject to tax and penalties at vesting. Similar rules apply to stock appreciation rights. Practically speaking, recipients may be required to exercise discounted options at a time identified when they were originally granted. Much of the benefit is lost because the recipient no longer has the flexibility to choose the tax year of the options' exercise and thus the income inclusion. Privately held companies also face the burden of demonstrating that their options are issued at FMV to escape the clutches of section 409A.

Full-value stock options (including incentive stock options) are initially exempt, but may inadvertently attract the new rules if they are impermissibly modified to effectively result in a new grant for section 409A purposes. If the exercise price is below FMV at the date of the new grant, the previously exempt options are now tainted. Some modifications--such as acceleration of vesting--are permitted, but changes to the terms of existing options should be made cautiously. For example, employers commonly extend the exercise period for employees who are terminating employment. Such an extension is permissible if it does not surpass the later of the end of the calendar year after, and two and a half months after, the former option's expiry date. Longer extensions result in the option's generally being subject to, and in violation of, section 409A from the date of the original grant, regardless of the exercise price.

Severance arrangements should also be examined carefully. Severance provided on involuntary termination may be exempt if it does not exceed two times the lesser of the compensation and the qualified plan limitation ($225,000 for 2007), and it is fully paid by the end of the second calendar year following the termination year. A payment that fails to meet the severance exception may nevertheless meet another exception. For example, severance paid on involuntary termination meets the short-term deferral exception if all payments are made within two and a half months after the end of the termination year. However, severance agreements often provide for benefits on voluntary termination by the executive with "good reason," and current guidance excludes severance payments made under such an agreement from both the severance and the short-term deferral exceptions, even if the actual event that triggers payment is involuntary termination.

Non-exempt severance payments must comply with section 409A. Generally, the time and form of payment must be specified from the outset in the employment agreement or severance plan, and timing changes are strictly limited. For example, accelerating payments from instalments to a lump sum is not permitted. Severance payable to certain key employees of publicly traded companies may require a six-month delay in payment.

A wide variety of other plans and arrangements have a deferred compensation element, including severance policies, deferred bonus plans, and phantom stock plans. Affected benefits are commonly found wrapped into other agreements, such as individual employment, consulting, and change-of-control agreements. Any arrangement or agreement should be examined if a payment to a service provider for a right to compensation that became legally binding in a year is deferred to a later year. Offending agreements may cover a single person or non-employees, such as directors, independent contractors, and partners who provide services in return for compensation.

Anita Costello Greer