Bailout Bill to End Use of Tax Deferred Compensation Programs by Offshore Fund Managers

October 20, 2008

The recently passed Emergency Economic Stabilization Act of 2008 (“EESA”) contains a provision which significantly limits the ability of investment advisory firms to defer fees earned under investment management arrangements with offshore funds for services performed after December 31, 2008. 

The new law supersedes current section 409A of the Internal Revenue Code (the “Code”).  Generally, section 409A allows the taxation of compensation received under non-qualified plans to be deferred until actual receipt provided certain requirements are met.  This generally allowed investment advisory firms to defer paying tax on offshore investment fund advisory fees by deferring the receipt of those fees.  EESA adds new section 457A to the Code, which requires any fees deferred under a deferral agreement with a “nonqualified entity” to be included in gross income as soon as the compensation is not subject to a “substantial risk of forfeiture.”

For purposes of section 457A, a “nonqualified entity” is any foreign corporation unless substantially all of its income is effectively connected with the conduct of a U.S. business or is subject to a comprehensive foreign income tax, and any partnership unless substantially all of its income is allocated to persons other than foreign persons who are not subject to a comprehensive foreign income tax.  Under this definition most offshore investment funds would be “nonqualified entities.”

A “substantial risk of forfeiture” exists only if payment of the deferred fee is subject to the taxpayer’s continued performance of substantial services.  The typical fee deferral arrangement is not conditioned on the continued performance of substantial services.  Thus, most existing fee deferral arrangements would not permit income recognition deferral under the new law.

Under EESA, existing deferrals and earnings on existing deferrals for services performed prior to January 1, 2009 may be deferred until 2018.  Transition relief will be issued within the next 120 days providing a limited period of time to allow existing deferral arrangements to comply with the new law without violating the section 409A prohibition against accelerating payments.

Compensation that is not determinable at the time of vesting is subject to a 20% penalty plus interest when it becomes determinable.  This provision is specifically aimed at hedge fund side pocket performance fees unless those fee arrangements meet certain conditions.  Side pocket performance fees are a profits interest that a hedge fund manager earns in a fund’s side investments in illiquid assets such as real estate or distressed securities.  Such amounts are generally not known until the hedge fund liquidates its position in these side investments. 

Under Treasury Regulations to be issued in the future, compensation determined solely by reference to the amount of gain recognized from the disposition of an investment asset (other than an investment fund or similar entity) will be treated as subject to a substantial risk of forfeiture until the date of such disposition.  For this purpose an investment asset is any single asset acquired by an investment fund or similar entity with respect to which the entity does not participate in the active management of such asset (or if such asset is an interest in an entity, in the active management of the activities of such entity), and substantially all of the gain on the disposition of which is allocated to investors in such entity.  This provision will permit performance fees tied to assets with long-term holding periods, but generally will not provide any benefits to most hedge funds, which have actively managed portfolios.

For additional information on this topic, you may contact Howard A. Neuman or Carol Spawn Desmond.