To the extent that U.S. investment advisors are willing to forgo favorable capital gains treatment, they may be able to defer recognition of incentive compensation fees in respect of foreign capital under management. However, the arrangement must comply with the complex rules of Code Section 409A, and take into account potential changes to those rules.
The basic tax structure for most private equity and hedge funds is the same although there are many variations. The assets of the fund are held in an investment vehicle that is classified as a partnership for U.S. income tax purposes. The investment vehicle is typically formed under the laws of a foreign tax haven jurisdiction and it checks the box to attain U.S. partnership classification. Generally speaking, two streams of investment capital flow into the investment vehicle – from investors that are ultimately fully taxable in the U.S. (“taxable investors”) and from investors that are exempt from U.S. income tax (“tax-exempt investors”). The latter group includes foreign persons that are not subject to U.S. tax jurisdiction and U.S. entities exempt from income tax under Code Section 501. For U.S. income tax purposes, the taxable investors are direct or indirect partners in the investment vehicle, meaning that any income they recognize retains the character as determined at the investment vehicle level (e.g., if the investment vehicle earns long-term capital gain, the taxable investors’ share is taxable to them as capital gain). Tax-exempt investors may have the opposite goal – they do not want partnership income that retains its character and carries with it dreaded U.S. tax reporting requirements. Thus the tax exempt investors will hold their interest through a foreign entity that is classified as a corporation for U.S. income tax purposes. This foreign corporation is called a “blocker” because it blocks the income (and concomitant reporting obligations) from passing through to the investor.
The “2 and 20” Formula
The most familiar formula for compensating the investment manager in private equity and hedge funds has two components. The first is an annual cash payment equal to two percent of the value of the fund assets under management. It is intended to compensate the manager for operating costs, and typically does not generate significant taxable income because the fee income is generally fully offset by ordinary deductions.
The second component is 20 percent of the aggregate net gain realized by the fund (the “carried interest”), often after some preferred return to the investors. The investment manager is usually required to refund amounts distributed pursuant to the carried interest if, for example, gains on an early investment are offset by smaller gains (or even losses) on a later investment (called “claw-back provisions”). The carried interest generally applies on an investor-by-investor basis, and the structure of the carried interest can vary depending on whether the investors are taxable or tax-exempt investors as well as on the nature of the fund’s investment activities. For taxable investors, the carried interest is usually structured as a partnership interest in the fund because there is no effective way to earn a tax-free return on a deferred carried interest attributable to taxable investors.
For the carried interest associated with tax-exempt investors investing in the fund through a foreign corporation, the investment manager can defer all or part of the carried interest and attain a tax-free investment return on the carried interest, subject to two conditions. The first condition is that any deferred carried interest will be taxed as ordinary income. Thus, the advisor must first determine whether the benefit of deferral outweighs immediate tax at lower capital gains rates. For this reason, this deferred carried interest structure is more often adopted by hedge funds, which typically generate ordinary income anyway, as opposed to private equity funds, which generate large amounts of capital gains Under the typical deferral strategy, a carried interest that is “earned” by the investment advisor will be payable at the end of the deferral period along with a “notional” investment return calculated over the deferral period. The investment return is measured as if the carried interest were invested in the fund. Deferral of U.S. tax is achieved on this notional investment return because the return is allocated to a foreign corporation that is not subject to U.S. income tax. The second condition is that the deferral arrangement must comply with Code Section 409A.
The American Jobs Creation Act of 2004 enacted Code Section 409A to combat perceived abuses with nonqualified deferred compensation arrangements for executives. In general terms, executives were able to obtain significant security for future payments of deferred compensation, while retaining significant control over the investment of the deferred compensation during the deferral period, by relying on authorities governing income recognition by taxpayers using the cash method of accounting. Code Section 409A requires a service provider to recognize income attributable to services rendered unless the plan satisfies certain requirements throughout the deferral period. If the plan fails to satisfy the Code Section 409A requirements the service provider is subject to a special 20 percent tax on the deferred income as well as an interest charge reflecting the deferral of regular tax on such income.
The service provider must generally elect to defer compensation for services provided in a year before the year begins (the election for performance based compensation may be made up to six months prior to the end of the year in which services were rendered). The deferral election must specify when and how the deferred compensation will be paid. The plan must bar distribution of the deferred compensation to the service provider prior to the date specified in the deferral election, except in the case of a change in control of the service recipient or in the event of certain extraordinary events occurring to the service provider, such as (i) loss of job; (ii) disability; (iii) death; and (iv) unforeseeable emergency. In other limited circumstances, the deferred compensation may be accelerated.
The service provider is able to choose how the investment return on the deferred compensation will be measured. However it is uncertain how often the service provider can change investment decisions during the deferral period. Moreover, the investment return on the deferred compensation is not a real return on an amount that is actually invested; rather it is a notional investment used to determine the payment amount at the close of the deferral period. The service recipient is free to hedge or reserve against its obligation to make the future payment in any way it wishes. Where the investment return is based on a hypothetical investment of the deferred compensation in the fund, the fund simply sets up a reserve to track the contingent future liability (the reserve enables the fund to properly account for net asset value).
The reserve must simply be an accounting device and not a trust or the functional equivalent of a trust because, under Code Section 409A(b), a service provider is taxed on any deferred compensation funded by foreign trusts and arrangements that effectively shield assets from claims of creditors. Congress was particularly concerned about the use of foreign trusts to hold nonqualified deferred compensation.
Under current law, U.S. income tax can be deferred on all or part of the carried interest, assuming the Code Section 409A requirements are satisfied. The greatest area of uncertainty concerns the degree to which the service provider can change the means for measuring an investment return on the deferred carried interest. The proposed regulations under Code Section 409A have reserved on the provisions that govern funding the deferred compensation. While the IRS could determine that a notional investment in a fund managed by the service provider gives the service provider a degree of control that is inconsistent with deferral, we believe such a development is unlikely in light of the prevalence of these arrangements. Nonetheless, taxpayers should keep a close watch on developments in this area.