The Emergency Economic Stabilization Act of 2008, signed into law on October 3, 2008, requires that compensation deferred under an arrangement with a “nonqualified entity” be included in taxable income when earned, regardless of when it is paid.
The new law, effective for services rendered on or after January 1, 2009, defines “nonqualified entity” to include any foreign corporation unless substantially all of that corporation‘s income is (i) effectively connected with the conduct of a trade or business in the United States or (ii) subject to a comprehensive foreign income tax. This means that Cayman Islands and BVI corporations, as well as corporations organized in other low-tax countries typically used for offshore hedge funds, would be nonqualified entities. If the amount of compensation is not determinable in the current year, it is includible in income when it becomes determinable. At that point, the law imposes both a significant interest charge and an additional tax of 20% of the amount of compensation.
The new law does not apply to deferred compensation that remains subject to a “substantial risk of forfeiture.” However, the “substantial risk of forfeiture” exception includes only compensation that is (i) conditioned on the performance of future services or (ii) determined solely by reference to gain recognized on the performance of certain investment assets (in which case the compensation becomes taxable on the disposition of those assets).
For deferrals of compensation attributable to services performed before 2009, the law requires the recognition of taxable income for the last tax year beginning before 2018 (meaning the 2017 tax year for most individuals) or, if later, the first year in which there is no “substantial risk of forfeiture” of the rights to the compensation. Taxpayers will be permitted to amend existing deferred compensation arrangements to comply with that timetable without violating Internal Revenue Code section 409A restrictions. The U.S. Treasury Department will be issuing guidance on that process within the next four months, at which point we will have a better idea of the appropriate course of action.