The Emergency Economic Stabilization Act imposes substantial new restrictions on deferral of investment management fees, incentive fees and other compensation payable by hedge funds, private equity funds and certain foreign corporations and partnerships.
The Emergency Economic Stabilization Act ("EESA") added new restrictions on the ability of the investment managers of hedge funds and private equity funds to defer taxes on their investment management and incentive fees payable by such funds. In general, EESA makes deferred compensation payable by certain partnerships and foreign corporations to employees, directors and other persons who perform services (such as a fund's investment manager) taxable when the compensation vests (i.e., when it is no longer subject to a substantial risk of forfeiture).
How These Restrictions Affect Fund Managers: The new restrictions will affect the compensation arrangements for most fund managers as follows:
- Fund investment managers (and other service providers) generally may not elect to defer their investment management fees, incentive fees or other compensation beyond the year following the year in which the compensation vests.
- Fees or other compensation that is contingent on the sale of an investment asset of the fund (if neither the fund nor any of its affiliates participates in the management of that asset) will be taxable in the year in which the sale of the asset occurs.
- The new restrictions do not apply to the award of equity interests in the fund (such as carried interests, restricted stock and most options). However, compensation that is based on the appreciation in the value of the fund or its equity units is subject to the new restrictions.
- Forms of compensation that are difficult to value when vesting occurs (including springing partnership or equity interests and compensation based on the appreciation in the value of illiquid assets managed by the fund or its affiliates) will be taxable when the amount of compensation becomes determinable, but additional tax penalties (described below) will apply.
The new restrictions are described in greater detail below.
What Compensation is Subject to the New Restrictions: The new restrictions apply to compensation if the following two conditions are met:
- The compensation is paid under an arrangement maintained by a "tax disinterested person" (generally, a corporation or partnership if a significant portion of its income is not subject to substantial U.S. or foreign income tax); and
- The payment of the compensation is deferred beyond the end of the year following the year in which it vests.
Thus, the new restrictions do not apply to arrangements maintained by any domestic corporation, or by any foreign corporation if substantially all of the foreign corporation's income is subject to either U.S. or substantial foreign income tax. Similarly, the new restrictions do not apply to any arrangement maintained by a partnership if substantially all of the income of the partnership is allocable to persons who are subject to either U.S. or substantial foreign income tax. The new restrictions will apply to compensation arrangements maintained by a foreign corporation in countries with little or no income tax, such as Bermuda or the Cayman Islands, or by a foreign or U.S. partnership in which any significant equity interest is held by tax-exempt and/or foreign investors that are not subject to U.S. or foreign income tax.
Additional Tax Penalties Apply if Compensation is not Determinable When Vesting Occurs: If the amount of the compensation is not determinable when it vests (for instance, if the amount of compensation is subject to future contingencies such as the sale of certain illiquid assets), the compensation will not be taxable until the amount becomes determinable, but then the fund manager (or other service provider) will be subject to an additional 20 percent tax penalty plus the interest on underpayment of taxes charged back to the year in which the deferred compensation vested.
Special Rules for "Investment Assets": If the compensation is contingent on the sale of an "investment asset," the compensation will be taxable when the asset is sold unless the compensation is paid no later than two-and-a-half months after the end of the tax year in which the asset is sold, in which case the compensation will be taxed when paid. An "investment asset" is any single asset acquired directly by an investment fund if:
(i) neither the fund nor any person related to the fund, such as an investment manager for the fund, participates in the active management of the asset (or if the asset is an equity interest in an entity, in the active management of the activities of that entity); and
(ii) substantially all of the gain on the sale of the asset (other than the deferred compensation) is allocated to the investors of the investment fund.
Equity Units: The new restrictions also apply to compensation based on the appreciation in the value of a specific number of equity units (such as stock appreciation rights). Accordingly, the compensation under any "appreciation rights" arrangement will be taxable when it vests, unless the compensation is paid by the end of the year following the year in which it vests, in which case it is taxed when paid. The legislative history, however, indicates that transfers of property rights such as carried interests, restricted stock and options with an exercise price not less than the fair market value of the underlying equity units as of the date of grant are not subject to the new restrictions.
Vesting: Compensation will generally be treated as vested (i.e., no longer subject to a substantial risk of forfeiture) for purposes of the new restrictions when the right to the compensation is no longer conditioned on future performance of substantial services. Non-service-related conditions or contingencies are generally not treated as vesting conditions. Thus, for example, if a fund manager is entitled to compensation based on the appreciation in the value of equity units above a stated level, that compensation will be treated as vested on grant unless the fund manager's right to the appreciation is forfeitable upon termination of the management services agreement.
Compensation that is determined solely by reference to the gain recognized on the sale of an "investment asset" (as defined above), however, does not vest (and thus is not taxable) until the investment asset is sold. This exception to the requirement that only service-related conditions can create a substantial risk of forfeiture does not apply to equity interests in an investment fund. It also does not apply to any asset if the fund or its affiliates participate in the active management of the asset.
Effective Date: The new restrictions apply to deferred compensation that is attributable to services performed after December 31, 2008. In addition, to the extent that deferred compensation attributable to services performed prior to January 1, 2009, is not otherwise taxable to the fund manager (or other service provider) before 2018, it will become taxable on the later of (i) the last day of the last tax year beginning before 2018 or (ii) the year in which the deferred compensation vests.
Coordination with Section 409A: The Department of Treasury is directed to issue guidance within 120 days after the date of enactment of EESA to permit deferred compensation arrangements relating to services performed before January 1, 2009, to be amended to change the timing of any deferred compensation payments to comply with the new deferred compensation restrictions without violating the requirements of Section 409A. The guidance is to allow the amendment of back-to-back deferred compensation arrangements. Back-to-back deferred compensation arrangements are frequently used by fund managers to provide for the payment of deferred compensation by the fund manager to its employees and consultants at the same time that the fund manager receives deferred compensation from the fund.