Using a foreign corporation or other entity to manage an offshore investment fund created a popular tax deferral opportunity for any United States individual managers who were employed by the foreign entity. The funds were structured so that the foreign entity managing it was not subject to United States income taxes on its earnings from the fund. These management entities were formed in low tax (or no tax) jurisdictions. This enabled them to hold and invest on a pre-tax basis, amounts that would ultimately be paid to the United States individual managers down the road. The United States individuals benefited from years of tax free accumulation of investment returns. The Emergency Economic Stabilization Act of 2008 (Pub. L. 110-343 10/3/08) added Section 457A to the Code to end this deferral opportunity.
Section 457A will preclude the deferral of U.S. federal income tax on compensation received for services performed after 2008 for foreign corporations or partnerships located in tax haven jurisdictions, unless the deferred compensation is subject to a substantial risk of forfeiture. Section 457A will also require fund managers to pay tax on deferred compensation earned for services performed in or prior to 2008 by the later of (i) the last taxable year beginning before 2018, or (ii) the taxable year in which the deferred compensation ceases to be subject to a substantial risk of forfeiture.
Under a limited short-term deferral exception, compensation would not be treated as deferred (and current income inclusion would not be required) under Section 457A if the service provider receives payment of the compensation no later than 12 months following the end of the foreign entity’s taxable year during which the right to payment of such compensation is no longer subject to a substantial risk of forfeiture.
Under Section 457A, compensation is subject to a “substantial risk of forfeiture” only if (1) the service provider’s right to the compensation is conditioned on the performance of substantial future services and (2) the possibility of forfeiture is substantial. A notable consequence of this restrictive definition is that a condition related to a purpose of the compensation (other than future performance of services), such as a performance-based condition, or a condition related to the attainment of specified earnings targets, does not create a substantial risk of forfeiture.
When deferred compensation is required to be included in income under Section 457A, the compensation amount will be increased by the sum of (i) an interest charge computed at the underpayment rate plus 1% on the underpayments that would have occurred had the deferred compensation been includible in gross income for the taxable year in which it was first deferred or, if later, the first taxable year in which the deferred compensation is not subject to a substantial risk of forfeiture, and (ii) an amount equal to 20% of the amount of the compensation.
Deferred compensation arrangements which may be subject to Section 457A should be reviewed and revised during 2008 to avoid the worst-case scenario of the current recognition of compensation income without the contractual entitlement to the current payment of that compensation.