On June 10, 2014, the Internal Revenue Service (“IRS”) issued Revenue Ruling 2014-18 (the “Ruling”), which addresses the issue of multi-year performance measurement periods in offshore hedge funds of U.S. based hedge fund managers by clarifying an uncertainty under existing statutory U.S. federal tax law.
Since the enactment of Section 457A1 in 2008, U.S. based hedge fund managers have generally needed to be paid incentive fees from offshore hedge funds on an annual basis or opt for an incentive allocation made on an annual basis to avoid adverse tax consequences of deferring income recognition. Section 457A provides for (1) an acceleration of the inclusion of otherwise deferred incentive compensation into taxable income, (2) an interest charge to recapture any tax deferral benefit obtained previously in violation of the principles of Section 457A, and (3) a 20% penalty tax on top of the regular income tax on the incentive compensation deferred in violation of the principles of Section 457A.
Section 457A is applicable only if compensation of a U.S. taxpayer is deferred under a “nonqualifying deferred compensation plan” of a nonqualified entity (such as an offshore hedge fund) for which there is no substantial risk of forfeiture of the rights to receive such compensation. Section 457A defines “nonqualifying deferred compensation plan” by reference to the definition of such term under Section 409A, but also includes “any plan that provides a right to compensation based on the appreciation in value of a specified number of equity units of the service recipient.” The Treasury regulations under Section 409A provide that nonqualified stock options (or “NSOs”) and stock appreciation rights (or “SARs”) which have been issued in exchange for services with a strike price at least equal to the fair market value of the underlying stock of the issuing service recipient at the time of grant (and that satisfy certain additional requirements), are exempt from the definition of “nonqualified deferred compensation plan” under Section 409A (together the “Section 409A Stock Option Exceptions”). Because the Section 457A definition expressly included SARs, it was not clear whether, or under what circumstances, the Section 409A Stock Option Exceptions would also apply to Section 457A.
The Ruling addresses a situation in which a U.S. partnership owned by U.S. taxpayers (U.S. hedge fund manager) provides services to a non-U.S. entity that is a nonqualified entity (offshore fund) and is compensated through stock settled NSOs or SARs. The Ruling concludes that, given the legislative history and the statutory language, the Section 409A Stock Option Exceptions also apply in the Section 457A context, provided, in the case of SARs, that the SARs by their terms must be settled in stock of the offshore fund. Thus, the NSO or SAR would not need to meet the annual payment rule of Section 457A but could be exercisable after a multi-year performance period.
We have the following initial observations on the Ruling:
- The Ruling may afford hedge fund managers much greater flexibility in structuring carried interests in offshore funds. One consequence of the ruling is that it will help hedge fund managers and investors (including numerous U.S. public pension plans) in connection with their attempts to strike the right economic bargain without undue interference from U.S. tax laws. The key problem that had emerged under Section 457A was that an arrangement pursuant to which the incentive compensation of the U.S. hedge fund manager was measured in respect of the offshore hedge fund’s investment performance over multiple years (rather than on a year-by-year basis) would have to be treated as a “nonqualified deferred compensation plan,” thereby triggering the draconian consequences of Section 457A for the U.S. hedge fund managers. Investors, particularly as a result of the recent financial crisis, have repeatedly asked for such type of arrangements on the ground that such arrangements may, in certain circumstances, result in a better alignment of the interests of the investors and the hedge fund manager. The Ruling removes this Section 457A tax obstacle to such sought after arrangements by confirming that the Section 409A Stock Option Exceptions apply to Section 457A in the context of a typical offshore hedge fund. By using the Section 409A Stock Option Exceptions, it appears now to be possible, if structured correctly, to implement an incentive compensation arrangement based on a measurement of performance over multiple years without triggering Section 457A.
- While the Ruling appears to allow a hedge fund manager to use NSOs or SARs to defer its income from a carried interest in an offshore fund beyond the time when income is recognized by the fund, an arrangement will have to be structured very carefully and will involve tax trade-offs. In particular, the value of a carried interest will have to be recognized as ordinary income at the time of exercise of an NSO or a SAR.
- Moreover, the use of an NSO or SAR may produce different economics to a fund manager than an annual incentive fee or an incentive allocation, depending on the circumstances and the economic arrangement with investors.
- The Ruling does not address ancillary tax issues in connection with such incentive compensation structures based on multi-year measurement periods, such as issues under the “passive foreign investment company” (or “PFIC”) rules. These ancillary issues will have to be dealt with carefully.