The restrictions of Internal Revenue Code Section 409A were not enough—the Emergency Economic Stabilization Act of 2008, popularly referred to as the financial “bail out bill” (the “Act”), enacted on October 3, 2008, includes a provision that has eliminated the ability of certain taxpayers (primarily, but not exclusively, offshore hedge fund and private equity fund managers) to defer fees earned after this year, unless they are willing to make changes to how most current fee arrangements are structured. The provision does not attempt to define hedge funds and private equity funds but, rather, defines the taxpayers subject to the provision (called “nonqualified entities”) in such a way to apply to current typical fund structures.
This provision of the Act is premised on the idea that certain types of taxpayers, including investment funds, take advantage of foreign tax laws in a way that is not possible in the case of U.S. companies. U.S. corporations are denied a deduction for deferred compensation until the compensation is paid; therefore, there is a balance with respect to the timing of income recognition and tax deduction. This balance is not present in the case of a foreign payor that is subject to little or no tax. Congressional policy makers view this as a gap in the law that makes foreign companies indifferent to paying compensation currently or deferring payment. This provision of the Act is designed to close that perceived gap.
The Act applies generally to amounts deferred that are attributable to services performed on or after January 1, 2009. In the case of amounts attributable to services performed before January 1, 2009, the Act provides a limited “grandfather” exemption, described below.
The provisions of the Act do not apply to partnership carried interests that typically comprise part of fund manager compensation1 or other property subject to tax under Code Section 83.2 Legislation that would change the taxation of partnership carried interests was considered by Congress this year. While that proposal has not gained sufficient support in Congress so far, given increasing budget pressures, it may emerge again in the new Congress next year.
This advisory summarizes key aspects of the legislation, and also describes what fund managers still need to do in 2008 to comply with Section 409A and what options are still available with respect to existing deferrals.
Background – Section 409A
Since the enactment of Section 409A, deferred compensation arrangements have been required to meet specific requirements in order to avoid the imposition of significant tax penalties. Section 409A generally applies to compensation deferred and vesting on or after January 1, 2005. Section 409A imposes restrictions on the time and form of payment of deferred compensation, and limitations on the timing of initial and subsequent deferral elections. Section 409A also generally prohibits accelerated payments of deferred compensation.
The Act – Further Restrictions on Deferral Opportunities
“Nonqualified Entities” – Who is subject to the Act?
The provisions of the Act apply to compensation paid by two types of entities. A “nonqualified entity” includes
- foreign corporations, unless substantially all of the corporation’s income is either (a) effectively connected to the conduct of a trade or business in the U.S. or (b) subject to a comprehensive income tax, and
- partnerships, unless substantially all of the partnership’s income is allocated to persons other than
(a) foreign persons not subject to a comprehensive foreign income tax and (b) tax-exempt entities.
A comprehensive income tax is considered to exist if the relevant foreign country has a comprehensive income tax treaty with the United States or the IRS makes a determination that the country has a comprehensive income tax.
These definitions were crafted specifically to cover typical funds that are designed to minimize both U.S. and foreign tax. Offshore funds are typically organized in countries, such as the Cayman Islands, which have little or no income taxes (and which are not parties to a tax treaty with the United States). Such funds are also not subject to U.S. tax (because the income is not effectively connected to the conduct of a trade or business in the United States).
The provision does not apply to the deferred compensation arrangements of corporations or partnerships in countries that are U.S. tax treaty partners. In such cases, Section 409A will continue to apply to deferred compensation arrangements of employees who are U.S. citizens or residents and subject to U.S. tax. Countries that have comprehensive income tax treaties with the United States include, among many others, major U.S. trading partners such as Canada, the People’s Republic of China,3 France, Germany, Mexico, India, Ireland, Israel, Japan and the United Kingdom.
If a foreign corporation or partnership in a country without a tax treaty with the United States employs individuals subject to U.S. tax, then whether the provision applies will be subject to a determination by the IRS of whether the country has a comprehensive income tax.
Another exception may be available in the case of a foreign corporation that is a nonqualified entity but has some income that is effectively connected to a U.S. trade or business and is taxable in the United States. In such cases, the compensation may still be deferred if the compensation would have been deductible by the corporation against its U.S. tax.
In theory, the rationale behind the provision—i.e., that the payor is not subject to tax and therefore is indifferent to whether compensation is paid currently or deferred—could be applied to U.S. governmental and tax-exempt employers. However, the provision does not apply to deferred compensation arrangements of such employers. Such arrangements continue to be governed by the laws in effect before the Act (e.g., Code Section 409A and Section 457). Note, however, a partnership consisting of tax-exempt entities is a nonqualified entity under the Act.
The End of Deferral – When is deferred compensation earned after 2008 includible in income?
Under the Act, deferred compensation from nonqualified entities is subject to tax when the compensation is no longer subject to a substantial risk of forfeiture—i.e., when the compensation is vested. Compensation is subject to a substantial risk of forfeiture if the fund manager (or other person providing services) must continue to perform services for a stated period of time before having a right to payment of the compensation. In such cases, the compensation is includible in income when the required period of service (i.e., the vesting period) ends. While vesting periods are common in many corporate executive compensation arrangements, most current fund manager fee arrangements are not structured to include a vesting period.
The Act imposes a penalty if the amount of compensation is not determinable when vested. The legislative history of the Act provides that an amount is not determinable if it varies based on the satisfaction of objective conditions. For example, if an incentive fee is structured so that the amount varies based on the satisfaction of certain performance targets (e.g., $X is paid if one target is reached, and $2X is paid if a higher target is reached), the fee is considered “not determinable” until it is known which target has been met, if any. In such cases, the amount of the fee is includible in gross income when it is determinable, but there is also a 20% additional tax, plus interest. Treasury officials have already indicated their interest in enforcing this rule and collecting the penalty.
There is a way to avoid the penalty—compensation is not considered deferred under the Act if it is payable by the end of the taxable year after the year in which it is vested. This means that if fees vary based on targets, as is typically the case, funds have until the end of the following year to determine whether the targets have been met and to pay the fee.
Example: Under a management contract with Offshore Fund OF (a nonqualified entity), fund manager FM is entitled to an incentive fee for 2009 at the end of 2009, provided that certain financial targets are reached and FM is still performing services under the contract on December 31, 2009. The incentive fee is $X if a first-tier target is met, $2X if a second target is met, and $2.5X if a third target is met.
Under this contract, the fee for 2009 vests on December 31, 2009. The amount of the fee is not determinable at that time. However, as long as the fee is determined and paid by the end of 2010, the fee is not considered to be deferred under the Act. The amount paid is includible in income in 2010, but the additional 20% tax and interest do not apply.
A special rule may be available for determining vesting in the case of compensation that is earned as a result of the disposition of a single investment asset. Under this rule, compensation is not considered vested if it is attributable to the sale of a single investment asset, provided that the manager is not actively involved in the day-to-day management of the investment asset. The legislative history includes as an example an arrangement in which an investment fund acquires an operating company and the fund manager (who does not actively participate in the management of the operating company) will receive 20% of the gain from the sale. There are a number of restrictions on this rule. For example, it does not apply if the fund holds two or more operating companies and the manager’s compensation is based on the net gain from the disposition of the companies. Also, this special rule cannot be relied upon until Treasury issues guidance.
One more thing to watch out for: The Act generally defines deferred compensation as under Section 409A, including any exceptions adopted by the IRS in the final 409A regulations. However, the Act takes a significant departure from the Section 409A rules by including as deferred compensation any compensation that is based on the appreciation in value of a specified number of equity units of the investment fund or other service recipient. Thus, for example, stock appreciation rights are generally not subject to Section 409A, but are deferred compensation for purposes of the Act. The legislative history indicates this rule is intended to prevent avoidance of the provision, for example, through the use of instruments the value of which is determined by reference to profits or value.
Transition Rule – What happens to compensation earned before 2009?
The Act provides a limited “grandfather” provision for amounts earned before 2009. Under this provision, existing fee deferral elections that provide for payment before 2018 will remain in effect for any amounts attributable to services performed before December 31, 2008. The Act does not require that such amounts also be vested by the end of 2008 in order to be grandfathered; however, it is possible that Treasury will address this in guidance.
If payment is due to occur after 2017, the Act provides that income inclusion occurs in 2017. The Act directs the Secretary of the Treasury to issue guidance permitting existing deferral elections to be amended without violating the rules of Section 409A to provide for payment of such deferred amounts at the same time of income inclusion (i.e., in 2017). In some cases, fund managers may also have deferred compensation arrangements with their employees (i.e., “back-to-back arrangements”); the Treasury is also directed to allow modification of such back-to-back arrangements during a transition period without violating Section 409A.
Example: Fund manager FM has previously elected (in accordance with Section 409A) to defer the incentive fee earned from a nonqualified entity for 2007. Under the deferral election, the fee is due to be paid in 2015. In addition, FM elected (in accordance with Section 409A) to defer the fee earned for 2008. Under this election, the 2008 incentive fee is due to be paid in 2018.
Under the Act, the election with respect to the 2007 fee remains in force, and the deferred fee will be includible in gross income in 2015, when paid in accordance with the deferral election. However, under the Act, the deferred fee for 2008 will be includible in gross income in 2017. Under guidance to be issued by Treasury, the arrangement can be amended (during a transition period to be determined) to provide for payment in 2017 (rather than 2018) without violating Section 409A.
Continuing Application of Section 409A to Existing Deferrals – What still needs to be done in 2008?
Code Section 409A continues to apply to any existing deferrals of compensation earned and vesting on or after January 1, 2005. This means that, if a fund manager has any outstanding deferrals (or has a deferral election in place for 2008 fees), the deferral plan must be brought into written compliance with Section 409A before December 31, 2008. Failure to do so will result in significant tax penalties.
While it’s too late now to make a “last chance” deferral election with respect to 2008 fees (such elections generally must have been made by December 31, 2007), there is one last opportunity to change the time and form of payment of any amount due to be paid in 2009 or later, without running afoul of the anti-acceleration rules of Section 409A and without complying with the Section 409A restrictions on subsequent deferral elections. Any such election must be made by December 31, 2008.
Example: If a deferred fee is currently scheduled to be paid in 2011, but the manager no longer wants to defer, or wants to defer to a different year, he can elect by December 31, 2008, to have the fee paid in 2009 (or any later specified year or years up through 2017). After December 31, 2008, any such change in time and form of payment can only be made if the change does not take effect for 12 months, and only if the change defers payment for at least an additional five years.