For Offshore Fund Managers, It’s Time to Rethink Everything
March 25, 2009
The managers of offshore investment funds have been taking it on the chin lately, not only from the markets but also from the U.S. government. First, there was the enactment late last year of Section 457A of the Internal Revenue Code, which applies a new tax regime to deferred compensation paid to persons providing services to offshore corporations and certain partnerships. Now come two new (but uncoordinated) tax initiatives. One, contained in the Administration’s budget proposal, would tax managers’ “carried interests” at ordinary income tax rates, rather than capital gains. The other, contained in the Stop Tax Haven Abuse Act, proposed legislation that has received Administration support, would treat offshore corporations, including hedge funds, as domestic corporations if they are managed and controlled in the U.S.
Under IRS interim guidance (IRS Notice 2009-8) on Section 457A:
- The “service providers” affected by this provision include not only hedge fund managers, the specific target of Section 457A, but nearly any person (not just individuals) rendering services to a “nonqualified entity.”
- “Nonqualified entities” include (a) any foreign corporation, unless (i) substantially all of its income is effectively connected with the conduct of a U.S. trade or business (and, therefore, taxable under U.S. law), or (ii) it is subject to a “comprehensive foreign income tax” (defined somewhat restrictively) and (b) any partnership (U.S. or foreign), unless substantially all (generally, at least 80%) its income is allocable to persons other than U.S. tax-exempt organizations and foreign persons with respect to whom such income is not subject to a “comprehensive foreign income tax.”
Under Section 457A, deferred compensation attributable to services performed after 2008 is taxable as soon as the service provider no longer is required to perform future services for the nonqualified entity in order to receive it (that is, the compensation is “vested” or “nonforfeitable”), unless the compensation will be paid within 12 months of the end of that tax year (i.e., a short-term deferral).
Example: Before the end of 2009, the manager of an offshore hedge fund elects to defer receipt of some of the fees it will earn in 2010, until January 1, 2013. Payment will be made in 2013 whether or not the manager is then providing services to the fund. Result: The manager’s 2009 fees are taxable in 2010, even though they will not be paid until 2013.
The existence of a condition to payment, even if related to the purpose of the compensation, such as the achievement of a performance goal, will not defer the taxable event. If, however, the amount of the deferred compensation cannot be determined as of the date it becomes nonforfeitable, the compensation will be taxed when it is determinable, but at a higher rate equal to: (i) the sum of the taxpayer’s ordinary income tax rate increased by 20%, plus (ii) interest on the resulting underpayment of taxes, accruing generally from the date the compensation is vested using the standard rate applicable to the underpayment of taxes increased by 1%.
Example: An offshore hedge fund manager offers his traders participation in a bonus pool in which they will share 1% of the fund’s average profits for the period 2010-2014 (the “bonus period”). To qualify to receive a share of the pool, a trader must be employed for at least 3 years during the bonus period, and if he terminates employment with fewer than 60 months of service during the bonus period, his share of the bonus will be based on the number of months he worked divided by 60 months. The bonus is payable January 15, 2015. Result: Under Notice 2009-8, the fund’s profits and, therefore, a trader’s bonus, are not determinable until December 31, 2014. Consequently, the portion of a trader’s bonus that vests in prior years will be taxable in 2014 at a rate 20% higher than the trader’s ordinary income tax rate (plus a 1% higher underpayment interest charge), although the portion (20%) that vests in 2014 should be exempt from the Section 457A tax rates as a short-term deferral.
It is likely that deferred compensation that is, for purposes of determining the service provider’s return on the deferral, deemed invested in the investment fund itself would be taxable when it vests, i.e., the deemed investment would not make it indeterminable for purposes of Section 457A.
Congress gave the IRS authority to create a limited exception for compensation determinable entirely by reference to gains or losses from the disposition of an investment asset. In such case, the compensation would be considered to be subject to a substantial risk of forfeiture, and, hence, not taxable, until the disposition of the asset. However, the IRS has not yet taken any action to implement this potential exception. In the meantime, many offshore investment funds are treating gains from the sale of an asset as carried interests in lieu of deferred compensation arrangements. (But see below.)
Two transition rules that may benefit service providers have deadlines that sponsors of deferred compensation arrangements should note.
Section 457A applies to deferred amounts that are attributable to services performed after 2008. Under Notice 2009-8, unless the terms of the deferred compensation agreement provide for an earlier payment date, deferred compensation attributable to services performed before 2009 will be taxed in the later of (a) the last taxable year before January 1, 2018, or (b) the first taxable year in which the substantial risk of forfeiture of the compensation lapses. Under recent IRS guidance, service providers may be given an election to change the time and form of payment to accelerate a scheduled payment to correspond to the year the compensation will be taxed. This election must be in writing and effective on or before December 31, 2011. Plans may need to be amended to authorize such elections.
In addition, sponsors of deferred compensation arrangements subject to Section 457A have until June 30, 2009 to amend their plans to vest amounts attributable to pre-2009 services that were not vested as of December 31, 2008, provided they do so for all service providers participating in the arrangement or a substantially similar one. This acceleration of vesting effectively removes such compensation from Section 457A taxation.
Partnership Tax Initiative
The Obama Administration has included in its 2010 budget a proposal to tax partners’ carried interests as ordinary income beginning in 2011. Heretofore, carried interests have been subject to favorable tax rules in that (a) they are not taxable when granted, and (b) the character of the fund’s income (often capital gains) was preserved in the hands of management. There is no detail available regarding the Administration proposal. However, proposals to change the taxation of carried interests are not new. A bill passed by the House of Representatives last year would have applied to carried interests in existing as well as new investment funds. It also included provisions (and penalties) designed to prevent taxpayers from using alternative structures to circumvent the bill's purposes.
Corporations “Managed and Controlled” in the U.S.
The Stop Tax Haven Abuse Act, legislation introduced recently into both Houses of Congress with general support from the Administration, includes a provision that would treat as a domestic corporation (and therefore subject to full U.S. taxation) non-U.S. corporations that are “managed and controlled” primarily in the United States. This rule would apply to publicly traded companies and private companies having at least $50 million of assets (including assets under investment management). The legislation does, however, have a two-year delay in its effectiveness. It is likely that many offshore funds that are now corporations for U.S. tax purposes would reorganize (or “check the box”) to be partnerships for U.S. tax purposes rather than subject themselves to taxation under this rule. To the extent that the effect of the legislation cannot effectively be avoided, it will likely drive the actual investment management business to other jurisdictions (where the foregoing tax rules will be moot).
If you wish assistance in determining the application of Section 457A to an existing deferred compensation arrangement, or if you would like to discuss what impact the proposed initiatives may have on your organization, please contact your CL&M attorney or the following: Howard Barnet
(212-238-8606, email@example.com), Patricia Matzye
(212-238-8730, firstname.lastname@example.org), or Dan Pittman
Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
© 2021 Carter Ledyard & Milburn LLP.
© Copyright 2009