On October 3, 2008, President Bush signed the Emergency Economic Stabilization Act of 2008 (the “Act”) into law. The Act adds section 457A to the Internal Revenue Code. Section 457A effectively prohibits the deferral of compensation from offshore investment funds and other “tax indifferent entities” for services performed after 2008, unless the deferred compensation is subject to a “substantial risk of forfeiture”. As a result, for services performed after 2008, fund managers generally will be unable to defer taxation of management fees from offshore funds. In addition, for deferred compensation for services performed in or prior to 2008, fund managers will be required to pay tax on the deferred compensation by the later of (i) the 2017 taxable year, or (ii) the taxable year in which the deferred compensation ceases to be subject to a substantial risk of forfeiture.
The balance of this memorandum describes new section 457A in greater detail.
Section 457A generally provides that compensation that is deferred under a “nonqualified deferred compensation plan” of a “nonqualified entity” is taxable when there is no substantial risk of forfeiture of the rights to such compensation. If, however, the amount of deferred compensation is not determinable at the time when there is no longer a substantial risk of forfeiture, under section 457A, the amount is taxable when the amount becomes determinable and, at that time, is subject to an additional 20% tax and an interest charge (at the underpayment rate plus 1%). This 20% “penalty tax” effectively precludes all deferred compensation that is not subject to a substantial risk of forfeiture.
- Definition of Nonqualified Deferred Compensation Plan. A “nonqualified deferred compensation plan” for purposes of section 457A generally includes any plan, program or arrangement under which a service provider obtains a legally binding right during a taxable year to compensation that is or may be payable in a later taxable year. Deferred compensation also includes any arrangement under which compensation is based on an increase in a specified number of equity units of the service recipient. Thus, stock appreciation rights (SARs) are subject to section 457A, regardless of their exercise price. Compensation is not treated as deferred under section 457A if the service provider receives payment of the compensation within 12 months after the end of the first taxable year during which the right to payment of the compensation is no longer subject to a substantial risk of forfeiture. Accordingly, arrangements that provide for the payment of management fees currently or within 12 months after the taxable year in which the manager’s right to such fees is no longer subject to a substantial risk of forfeiture will be exempt from section 457A, so long as payment is actually made within such period.
- Nonqualified Entities. Section 457A applies only to nonqualified deferred compensation plans of “nonqualified entities.” A nonqualified entity includes a foreign corporation unless (i) substantially all of the foreign corporation’s income is effectively connected with the conduct of a U.S. trade or business, (ii) the foreign corporation is eligible for the benefits of a tax treaty between the foreign country and the United States1, or (iii) the foreign corporation demonstrates to the satisfaction of the Secretary of the Treasury that the foreign country has a comprehensive income tax. (This memorandum refers to a foreign corporation that is a nonqualified entity as a “nonqualified foreign corporation.”) A nonqualified entity also includes any entity that is treated as a partnership for federal income tax purposes unless substantially all of its income is allocated to U.S. taxpayers (i.e., persons that are not tax-exempt organizations or nonqualified foreign corporations).
- Substantial Risk of Forfeiture. Compensation is subject to a substantial risk of forfeiture for purposes of section 457A only if the service provider’s right to the compensation is conditioned on the future performance of substantial services by any individual. For purposes of section 457A, a substantial risk of forfeiture does not include the occurrence of a condition related to a purpose of the compensation (other than future performance of services), regardless of whether the possibility of forfeiture is substantial. Thus, a performance-based condition on compensation, such as the attainment of specified earnings or market value targets, is not sufficient to create a substantial risk of forfeiture.
However, to the extent provided in Treasury regulations, if compensation is determined solely by reference to the amount of gain recognized on the disposition of an “investment asset” (without offset or adjustment for losses on other assets), the compensation will be treated as subject to a substantial risk of forfeiture until the disposition of such asset.2
- Effective Dates. Section 457A generally applies to deferred amounts attributable to services performed after December 31, 2008. In addition, deferred amounts attributable to services performed prior to January 1, 2009 (and which otherwise would be subject to section 457A) are required to be included in income no later than the later of (i) the last taxable year beginning before 2018 or (ii) the taxable year in which a substantial risk of forfeiture no longer exists.
- Additional Guidance. Section 457A authorizes the IRS and the Treasury Department to prescribe such regulations as are necessary or appropriate to carry out its provisions, including regulations disregarding a substantial risk of forfeiture in cases where necessary to carry out the purposes of this section. In addition, the IRS and the Treasury are required to issue guidance no later than May 1, 2009 that provides a limited period of time during which nonqualified deferred compensation arrangements attributable to pre-2009 services may be amended to require distribution on the date the amounts are required to be included in income under Section 457A without violating the requirements of section 409A (which would otherwise generally prohibit the acceleration of payment of deferred compensation). This relief will also apply to “back-to-back” arrangements, where an investment manager defers its fee from the fund it manages and individual employees or partners of the manager correspondingly defer their respective compensation from the manager that is attributable to such fee.