One of the key differences between nonqualified deferred compensation arrangements and qualified deferred compensation plans is that strict limits are imposed on the amount of compensation that can be deferred annually in a qualified plan (e.g., up to $15,000 — or up to $20,500, including a $5,000 catch-up contribution for certain participants age 50 and older — in a 401(k) plan and an additional $4,000 in an IRA) and the amount that a person (generally, highly-compensated) can defer in a nonqualified arrangement is generally unlimited. US corporations however, are only entitled to a deduction for amounts deferred by an executive under a nonqualified arrangement at the time the compensation is no longer subject to forfeiture and paid out to the employee, typically years later. Offshore companies that are located in no-tax jurisdictions may provide nonqualified deferred-compensation to their US-based employees without any adverse effect since tax deductions to such companies are not relevant.
On October 18, 2007, Senator John Kerry (D-MA)and Representative Rahm Emanuel (D-IL) introduced legislation in the Senate and the House of Representatives called "The Offshore Deferred Compensation Reform Act of 2007," which is designed to restrict the ability of high-income earners, such as US-based hedge fund managers operating foreign corporations, from deferring the tax liability with respect to deferred compensation payable by the offshore corporation. The legislation seems to have been motivated at least in part by an April 17, 2007 New York Times article describing the perceived ability of US hedge fund managers to defer large amounts of money offshore. The reach of the proposed legislation is not limited to hedge funds.
The proposed legislation would create a new Section 457A of the Internal Revenue Code of 1986, as amended (the "Code") that would generally eliminate the ability of US taxpayers to defer nonqualified deferred compensation (as defined in Section 409A(d) of the Code) in offshore tax havens. Offshore nonqualified deferred compensation paid by a foreign corporation would be taxable income when there is no substantial risk of forfeiture to the compensation. The proposed legislation does not apply to onshore nonqualified deferred compensation mainly because onshore arrangements are viewed as having less of a potential for abuse since an onshore employer must forgo a deduction until such time as the deferred compensation is taken into income by the service provider, providing a disincentive (of the employer) for offering these arrangements. As a general matter, the current practice of hedge fund managers is to defer amounts that are not subject to a substantial risk of forfeiture and thus, the effect of the proposed legislation would likely be profound to such managers. For purposes of the proposed legislation, a foreign corporation is defined as any foreign corporation unless "substantially all" of the income of the corporation meets the following exemptions: (i) the income is effectively connected with the conduct of a trade or business in the United States (since such businesses are generally subject to US income taxation on such income); or (ii)(A) the income is subject to an income tax imposed by a foreign country that has a comprehensive income tax treaty with the United States, (B) the corporation is eligible for benefits of the treaty, and (C) a deduction is allowed for compensation under rules that are substantially similar to the way in which the US provides deductions for compensation.
If enacted, the legislation will apply to amounts deferred in taxable years beginning after December 31, 2007. Existing deferrals and earnings on existing deferrals would not be subject to the new rules.
The proposed legislation reflects a trend in Congress to consider restrictive legislation, including possible proposals relating to (i) limiting the amount of nonqualified deferred compensation that can be deferred generally under US tax rules, (ii) the taxation of carried interests and (iii) the reexamination of the ability to use offshore entities to address "unrelated business income tax" issues affecting tax-exempt investors.