Deferred Compensation Trusts

March 2000

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There are a number of deferred compensation arrangements that have been developed to help senior executives to defer or avoid both national and local taxes on their remuneration packages whilst working at home and abroad.

The term "deferred compensation" may be applied to any payment for services not made at the time the services were rendered. These arrangements typically rely upon the trustees of a Jersey discretionary trust to hold the deferred remuneration assets. As a professional trust company, Volaw Trust Company is regularly instructed to establish and administer such trusts.

This briefing note explains some of the benefits that might be gained from establishing deferred compensation arrangements using Jersey trusts; it also explains how Volaw Trust Company is able to help in establishing such trusts and in providing trustee services.

WHO MIGHT BENEFIT FROM THESE PACKAGES?

It is customary for an employer to reflect regional variations in the cost of living, housing and income tax in the remuneration packages of its expatriate executives. In addition, such executives habitually receive bonus awards intended to compensate them for the inconvenience of living abroad. The income tax associated with the remuneration is frequently a significant part of the assignment cost. Therefore, any reduction in this tax cost is desirable, especially when the benefit accrues to both employer and employee. It is commonplace for employees to view their bonus awards as a source of savings. Accordingly, if the employer offers to provide an attractive savings vehicle, whilst reducing the tax liability, it is possible to improve the expatriate remuneration package whilst at the same time achieving significant reductions in the cost of assigning the executive abroad.

WHEN WILL TAX BE PAYABLE?

Once an employer has established a deferred compensation plan for the benefit of its expatriate employees, the employees do not become liable to tax (either in their home or in their host country) on the income contributions that the employer makes to the plan, until such time as they receive distributions from the plan. Such distributions will be taxable in the year that they are paid. Hence, tax is deferred until the employee receives the distribution. Until distributed to the employee, the trust fund is invested and, because the contributions made to the trust are without deduction of tax, the investment returns are likely to be substantially greater notwithstanding the eventual charge to tax. This provides an additional benefit to the employee.

WHAT ARE THE POSSIBLE ADVANTAGES TO THE EMPLOYER?

From an employer’s perspective, the establishment of a deferred compensation plan may lead to the following possible advantages:

• the reduction or eradication of the host country’s social security and income tax levies;
• the reduction of tax equalisation payments and the overall cost of all foreign assignees participating in the plan;
• the deferral of cash outlay. The employer may offer attractive interest rates to the employee and thereby retain cash liquidity for longer;
• the provision of a major incentive to those employees assigned to join the overseas-based work force;
• the motivation of existing overseas assignees to remain diligent and loyal to their foreign assignments.

WHAT ARE THE POSSIBLE ADVANTAGES TO THE EMPLOYEE?

From an employee’s perspective, the main criteria influencing his decision to participate in the deferred compensation plan will be:

• The deferral of taxation on his remuneration/bonus payments until such time as funds are actually distributed to him, at which point income tax and not capital gains nor gift taxes will be applied;
• Once the employer has contributed funds to the trust, he may not reclaim them. Therefore, the funds will be available to the employee subject to any essential terms and conditions stipulated in plan rules.
• The employee may direct the manner in which the funds are invested. Should the employer offer to provide an attractive rate of interest, the employee will receive an 'increased' real rate of interest due to the capital accumulation over time, on which interest has rolled-up gross as a consequence of the pre-tax shelter afforded by the deferred compensation plan;
• Alternatively, the employee may choose to direct investment of the trust funds, in which case the trustees, who are at liberty to act independently and autonomously of the employer, will respectfully consider the employee’s wishes. It is unusual for the trustees to object to an employee’s recommendations, unless evidence of any legal, ethical or commercial considerations become apparent, in which case such findings will be discussed with the employee in advance of taking any further action.
• Eventually, the employee may find himself in a lower domestic tax bracket at the time of distribution. Perhaps, this will be as a consequence of having reached the age of retirement. Further, it is entirely possible that income tax levied by the host country may be avoided altogether if distributions from the trust fund are made after the employee has ceased to be resident in that jurisdiction.

WHAT POSSIBLE DISADVANTAGES ARE THERE FOR THE EMPLOYEE?

The possible disadvantages to the employee of subscribing to the plan are as follows:

• An election to defer a portion of an employee’s remuneration/bonus payments must be made prior to the commencement of the period during which the amounts concerned will be settled into the trust fund. Ideally, this election should be made by the assignee prior to his departure date from his country of origin when taking up an overseas assignment.
• The funds awarded to the trust by the employer must not be subjected to any security arrangements. For the plan to be effective in certain specific jurisdictions, the funds must be made available to the creditors of the employer in the unlikely event that the employer becomes insolvent and goes into liquidation.
• Furthermore, the employee may face a substantial risk of forfeiting the accumulated funds should he fail to meet any stringent stipulations as stated in the plan rules. For example, the employee may not join a competitor firm before a specified period of time has elapsed since termination of the employment, to which the plan rules apply.
• Finally, the employee may be obliged to disclose fully the contingent asset that the deferred compensation plan represents on his domestic tax returns to the tax authorities in his country of origin. This requirement will apply for so long as the employee retains a contingent interest in the trust fund.

HOW CAN VOLAW TRUST COMPANY HELP WITH DEFERRED COMPENSATION TRUSTS?

A deferred compensation trust may provide a versatile vehicle with which to seal the mutually beneficial relationship between employer and employee. Volaw Trust Company, as a leading independent Jersey trust company, will be pleased to advise on how best to apply the principles set out in this briefing note to your specific circumstances. Volaw Trust Company is closely associated with Voisin, one of Jersey’s best known and longest established law firms. Together, the two firms are able to provide all of the advice that may be required in Jersey in relation to the establishment and administration of these trusts. The experience accumulated by Volaw Trust’s directors and staff during many years of service in the legal, accounting, tax and banking sectors will be applied to the formation and administration of these tax efficient structures, which potentially offer tremendous added-value.

This note is intended to provide a brief rather than a comprehensive guide to the subject under consideration. It does not purport to give legal or financial advice that may be acted or relied upon. Specific professional advice should always be taken in respect of any individual matter.