Supplemental Retirement Plans

Tax Treatment of Supplemental Retirement Plans

By Nicholas Webb, BNA Tax Management, for the Tax Management International Forum (2008)

The following fact pattern formed the background to the discussion of the second topic.

H Co. is a large, publicly traded (in Host Country) corporation that operates through subsidiaries in over 100 countries (Foreign Countries). Many H Co. executives work in different parts of H Co.’s worldwide operation, often spending several years working for a subsidiary in one Foreign Country and then being transferred either back to H Co. headquarters in Host Country or to the operations of another subsidiary in a different Foreign Country.

H Co. and its subsidiaries provide their employees with standard benefit packages typical of the country in which the operation is located. These usually include retirement benefits, health benefits and various fringe and other welfare benefits. H Co. also allows certain senior executives to participate in a supplemental retirement plan, which is designed to provide the participating executives with retirement benefits in addition to the standard retirement benefits provided to the general employee workforce. The supplemental retirement plan does not satisfy all of the requirements for tax-favored retirement plans under the Host Country’s tax laws.

Against this background, the Forum members were asked to consider the following questions (assuming that their own country was Host Country):

• What are the tax consequences to H Co. and the executives with respect to the retirement benefits provided by the supplemental retirement plan?
• Would the answers to the above question be different if the supplemental retirement benefits attributable to services performed in a Foreign Country are provided under a separate supplemental retirement plan maintained by the subsidiary that operates in the Foreign Country (instead of a single supplemental retirement plan maintained by H Co. for all of its worldwide executives)?
• Would the answers to the above questions be different if the company maintaining the supplemental retirement plan regularly sets aside company assets (whether or not in a trust) to pay the retirement benefits when they become due?

UNITED STATES

Keith Mong of Buchanan Ingersoll & Rooney PC, Washington, D.C., introduced the second topic by remarking on the extent to which companies are having to provide supplemental benefits to increasing numbers of internationally mobile executives as the globalization of the world economy continues. As Mong observed, many countries have tax-favored retirement plans, but because of the limitations invariably imposed on such plans as to the level of benefits they can provide, companies cannot afford executives a sufficient level of retirement benefits though such plans alone. In the United States, abuses involving non-qualifying retirement plans have attracted much attention because of the role they played in the corporate scandals (involving, most notoriously, Enron and Worldcom) of the early 2000s. These scandals provided the final impetus for the 2004 reform of the U.S. rules relating to non-qualifying retirement plans. The pre-2004 U.S. rules, which were in place for roughly 40 years and which Mong characterized as “well-settled and simple,” essentially deferred the taxation (in the hands of an executive) of an unsecured, unfunded promise to pay compensation at a future date until the compensation was actually paid. The company providing the benefit was not entitled to a deduction until the compensation was actually included in the executive? taxable income. One of the perceived abuses to which non-qualifying plans were susceptible under these rules arose from what were known as “haircut provisions.”

These provisions allowed plan participants to elect to receive their deferred compensation at any time provided they agreed to receive a discounted amount. Executives who could foresee that a company was likely to experience economic difficulties could thus cash out their retirement benefits before the company collapsed. Rank and file employees, on the other hand, who only had access to qualifying retirement plans, could not cash them out until after the company collapse and if their retirement benefits were invested entirely in company stock, they lost everything. Another practice that was perceived to be abusive was the setting up of “Rabbi” trusts to hold assets to fund non-qualifying deferred compensation arrangements. Even though assets held by such trusts were technically subject to the claims of general creditors (as was necessary to avoid current income recognition), they were actually invested offshore, where it would be difficult for the creditors to get access to them in the event of the company bankruptcy. Liebman remarked in this context that, at least in certain instances, assets may have been placed in asset protection trusts, where they are not subject to the claims of general creditors, although they may remain accessible to such creditors (under the common law Statute of Elizabeth) if there has been what is known as a “fraudulent conveyance.” Some tax havens, however, have passed laws setting aside the Statute of Elizabeth.

For some years, the IRS had been trying to attack these and other perceived abuses through the courts with little success and, in October 2004, new 9A of the Internal Revenue Code was added by the American Jobs Creation Act of 2004 to address the problem more directly. Mong explained that the new U.S. rules have three main features:

• election restrictions (which impose requirements as to the timing of both initial deferral elections and elections with respect to the form and timing of distributions);
• acceleration restrictions (which provide that deferred compensation generally cannot be accelerated, effectively putting an end to the viability of haircut provisions); and
• distribution restrictions.

The last provide that deferred compensation can only be received on the happening of one of six events:

• separation from service;
• disability;
• death;
• the expiration of a specified time;
• a change in the ownership or control of the corporation concerned; and
• an unforeseeable emergency.

Section 409A also introduces new funding rules the effect of which is to tax immediately in the hands of the executive amounts transferred outside the United States. The consequences of violating the new requirements are severe: current inclusion in income of all deferred income that is not subject to a substantial risk of forfeiture; an interest charge equal to the underpayment rate plus 1% from the date originally deferred; and an additional 20% excise tax.

THE NETHERLANDS

Van den Bruinhorst explained that The Netherlands only allows for deferral of taxation in the case of qualifying pension plans. Where contributions are made to a non-qualifying plan, the annual accrual of pension benefits will be taxable income in the hands of the employee concerned, the annual accrual being determined by the level of the contributions made. Nor will the employee contribution reduce taxable remuneration, but the employer? contribution will be a taxable benefit in kind. On the company side, the deductibility of contributions to non-qualifying plans is subject to a number of limitations.

On the other hand, contributions are deductible when they are paid to a qualifying Dutch plan. Van den Bruinhorst indicated that it is also possible for foreign executives working in The Netherlands and contributing to a plan in their home country to request the approval of the Ministry of Finance (MOF) to have their home country plan treated as a qualifying plan. In deciding whether to grant such approval, the MOF will examine the rules of the home country plan to ascertain whether they are similar to those applying to Dutch qualifying plans.

BELGIUM

Parmentier outlined the various requirements that must be met for contributions to employment-related pension plans to be deductible for Belgian tax purposes. Among those he highlighted were that the capital built up by the contributions may not exceed an amount that would generate annuities amounting to 80% of the final annual salary of the employee concerned and that the contributions must be made to a Belgian insurance company or to the Belgian branch of a foreign insurance company.

This latter requirement is currently the subject of a case before the ECJ, in which the European Commission has claimed that the requirement infringes all four freedoms provided in the EC Treaty. The Attorney General opinion on this case, which was issued on October 3, 2006, supports the view of the European Commission. Retirement benefits paid out by employment-related pension plans are, in principle, subject to tax in an employee hands as employment income at normal progressive rates, but (subject to the fulfilment of certain conditions) may benefit from a favorable tax regime.

SWITZERLAND

Boss explained that all Swiss employers are required either to set up or to join a Swiss occupational pension plan. These compulsory occupational pension plans are the second pillar in Switzerland three-pillar social security system, the first pillar being the state old-age pension insurance scheme and the third, voluntary pension and life insurance schemes. The compulsory occupational pension plan rules provide for a minimum level of benefits (designed, in combination with the state pension scheme, to give retired employees retirement income equal to about 60% of their pre-retirement earnings), but such plans are free to provide benefits in excess of the statutory minimum. Interestingly, all employer contributions under such schemes are deductible as business expenses, provided they are reasonable from a business standpoint. Employees are taxable on their employment income net of their own contributions to such plans and benefits are only taxable in their hands when they are paid out to them.

DENMARK

Emmeluth confirmed that the Danish rules are similar to the Belgian rules in that the deductibility of contributions to a pension plan is conditioned on the plan being established in Denmark or taken out with a Danish insurance company or a Danish branch of a foreign insurance company. Unlike Belgium, Denmark imposes no limit on the amount of contributions to such plans, except in the case of self-employed persons, whose annual contributions are capped at DKK 46,000 (approximately US$7,500). The cap can be avoided where the taxpayer undertakes to keep contributing the same annual amount to the pension plan for at least 10 years. If the taxpayer fails to maintain the contributions for 10 years, his taxable income is recalculated as if he or she had contributed a smaller amount in the years previous to that in which the failure occurs.

Another rule introduced in 2004, allows a self-employed taxpayer to contribute up to 30% of his taxable business profits to a plan with an insurance company or bank, provided the plan meets certain requirements, in particular that it provides for the payment of an annuity for a period of at least 10 years. Denmark also has a special scheme for sportspersons under which they can contribute up to DKK 1,568,200 (approximately US$261,000) per year and may withdraw money from the scheme at an earlier age (46) than is normally permitted (60). There is generally no taxation until retirement benefits are paid out, although there is an annual tax on a pension fund? profits from the investment of the contributions made to it.

FRANCE

French labor law requires employers to withhold from salaries paid to their employees contributions to the French social security system, which are designed to fund the state pension, although according to Gelin the system is “in danger of collapse.” Also mandatory, and also deducted from salaries are payments to complementary retirement schemes managed by qualified joint agencies.

Contributions to both systems are shared between employers and employees, are calculated by reference to the salary earned by the employee concerned, and are deductible for income tax purposes for both employers and employees. Pensions in the form of annuities are taxable as employment income when paid out.

However, Gelin observed that, because of declining returns from these compulsory plans, French companies have increasingly been establishing a “third tier” of supplemental retirement plans for their executives. The rules governing such plans were substantially overhauled as recently as 2003. Under the new rules, these plans benefit from some degree of favorable tax treatment, where certain conditions are met. Gelin pointed in particular to the requirement that to qualify for favorable treatment, a supplemental plan must be made available to a specified group of employees, i.e., it cannot be made available only to specific individuals. Although the case law on this subject is somewhat convoluted, one principle that has emerged is that executives as a group are acceptable as a “specified group” for these purposes. Where the requisite conditions are met contributions will be deductible and, where the plan is a “defined benefits” plan, not taxable as remuneration in the hands of the executive. Where the plan is a “defined contributions” plan, contributions will regarded as remuneration and therefore subject to income tax, but will benefit from a capped deduction for income tax purposes.

Gelin noted in this context that, pursuant to a very recent Ordonnance (n 06-344 of March 23, 2006), and subject to certain conditions, French companies will be able to outsource their supplemental plans to a nonresident dedicated insurance company established in the EU or the European Economic Area without jeopardizing the income tax deduction referred to above. (The Ordonnance will not enter into force until the necessary governmental decrees have been passed.) Pensions, which are generally paid out in the form of annuities, will be subject to income tax when they are received, although executives are likely to pay less tax at this stage because of the effect of France progressive personal income tax rates.

GERMANY

Like the French and Swiss systems, the German pension system has three tiers: the state pension; company pensions; and pensions built up by the voluntary contributions made by individuals out of pre-tax income. While German employees cannot rely on the state pension, Portner suggested that company pensions can be an effective vehicle for providing them with an adequate level of income on retirement. She highlighted two particular tax benefits of company pension plans.

• First, if the company simply makes a promise to pay a pension to an employee on retirement (i.e., the plan is an unfunded plan), such a promise does not give rise to taxable income in the hands of the employee at the time it is made.
• Second, if the company instead makes contributions, for example, to an insurance company, and the employee also contributes, the employer can take a deduction for its contributions for corporate income tax purposes, and the employee can have his or her salary reduced by the amount of his/her contributions and will only be taxed on the reduced amount. Nor is there any limit at all to the level of such contributions, which, in Portner? words, makes it “a rare and very generous German tax break.”

A provision in the German tax code makes it possible for a German resident to deduct contributions even where they are made to an insurance company established outside Germany if the insurance company is established in the EU or the EEA and provided the foreign insurance company is permitted to do business in Germany. The foreign insurance company does not actually have to set up a branch in Germany, which means that the German rules, unlike the Belgian rules (and the French rules, at least until Ordonnance n 06-344 enters into force), are compliant with EC Law.

INTERNATIONAL TAX ASPECTS

Mong noted that, because the United States taxes its citizens and residents on their worldwide income, globally mobile executives who fall into either or both of these categories will be subject to the applicable U.S. rules on deferred compensation, so that careful planning is required when designing such arrangements for U.S. executives, regardless of whether the relevant plan is sponsored in the United States or in a foreign country. Such executives may be eligible for an income tax exclusion with respect to compensation for services or for foreign tax credit relief. Where the executive concerned is a non-resident individual, any compensation relating to services performed in the United States will be regarded as income effectively connected with a U.S trade or business and therefore subject to U.S. taxation.

In this context, Mong emphasized that deferred compensation relating to services performed in the United States will retain its status as effectively connected income, irrespective of whether the executive is engaged in a U.S. business in the year in which it is paid and will be subject to U.S. taxation even if the executive is no longer resident in the United States. It will be important in these circumstances to consider the implications of any applicable U.S. tax treaties, although Mong pointed out that not all U.S. treaties specifically address the taxation of retirement income and those treaties that do, generally limit relief to tax-qualifying plans.

In the European countries, there is considerable variation in the tax treatment of accrued pension rights in the hands of a tax resident of one of these countries who subsequently becomes a nonresident. For example, Portner explained that unlike the U.S. tax rules, the German rules do not provide for any German taxation of retirement benefits accrued in Germany when they are received by an employee who has subsequently become a nonresident of Germany. The position is somewhat more complex when a foreign employee who has been working in The Netherlands and has become a Dutch resident for tax purposes, subsequently becomes a nonresident, although ultimately, according to van den Bruinhorst, it should be possible to ensure that the value of the employee’s accrued pensions rights escapes immediate taxation on his or her departure from The Netherlands.

If the foreign employee continues to participate in his home country pension plan, his or her departure from The Netherlands will trigger the making of a protective or “conserving” assessment with respect to the accrued rights, but the tax under the assessment will not be collected unless and until the employee cashes in his or her rights under the plan. Alternatively, it may be possible, though not easy, to have the foreign plan approved as a Dutch qualifying pension plan, with the same consequences, i.e., that there will be no immediate taxation on the employee becoming a nonresident of The Netherlands. The Belgian approach to this situation is yet again different: where a Belgian resident individual becomes a nonresident, the individual is taxed on the value of his or her accrued pension rights at the time he or she becomes nonresident. Parmentier suggested that this treatment is presumably in conflict with EC law, because it represents a restriction on the free movement of individuals, which is otherwise protected under the EC Treaty.