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Tax Bulletin (November 2008)

Offshore Deferred Compensation to be
Taxable at Time of Vesting




By Clare Stoudt and Nicholeen DePersis, tax associates in the Washington, D.C. and Northern Virgina offices, respectively, of Pillsbury Winthrop Shaw Pittman LLP.

See Material Available On-Line for links to relevant legislative material.

If you have or can obtain the Acrobat Reader, or have an Acrobat-enabled web browser, you may wish to download or view our November 2008 Tax Bulletin (a 212K pdf file), containing a printed version of this article and also available via ftp at:

    ftp.pmstax.com/gen/bull0811.pdf.

This bulletin concerning tax matters is part of the Tax Page, a World Wide Web demonstration project, no portion of which is intended and cannot be construed as legal or tax advice. Comments are welcome on the design or content of this material.

On October 3, 2008, the economic rescue act[fn. 1] was enacted with the hope of restoring the viability of the nation's credit markets. Division C of this act, entitled the Tax Extenders and Alternative Minimum Tax Relief Act of 2008, contains a revenue-raiser requiring the current income inclusion upon vesting of nonqualified deferred compensation paid by certain "tax indifferent" entities, effective for services performed beginning January 1, 2009.

Deferred compensation attributable to services provided prior to January 1, 2009, is entitled to up to a ten-year grandfather provision; thus deferred compensation that would be payable in 2018 or later may be deferred only through 2017 (or until no longer subject to a substantial risk of forfeiture, if later). The new provision "is tougher than tax provisions for nonqualified deferred compensation under tax code section 409A," according to an Internal Revenue Service official.[fn. 2] Under the new provision, offshore nonqualified deferred compensation will be taxed when it becomes vested, "even if it is only an unfunded, unsecured promise to pay."[fn. 3]

Background

The tax treatment of nonqualified deferred compensation is currently governed by section 409A of the Internal Revenue Code (the "Code"). Generally, if certain requirements are met, deferred compensation is not taxed until actually or constructively received. The service recipient is not permitted a deduction for the nonqualified deferred compensation until the taxable year in which the deferred compensation is includible in the service provider's income. The deduction deferral creates a "tension" between a service provider and a taxable service recipient, potentially limiting the amount of compensation the service recipient is willing to permit the service provider to defer.

If, however, the service recipient is indifferent to the timing of the deduction, (as in the case of a service recipient not subject to U.S. taxation) "the cost of allowing service providers to defer under a nonqualified deferred compensation arrangement is not borne by the service recipient. Instead, this cost is borne by the Treasury."[fn. 4]

Though only recently passed, legislation to remedy the issue of using tax-indifferent parties for deferred compensation plans was originally introduced in 2007, the Offshore Deferred Compensation Reform Act of 2007.[fn. 5] When the Offshore Deferred Compensation Reform Act did not pass, the legislation continued to be proposed as part of other reform efforts, most recently in the Energy Improvement and Extension Act of 2008.[fn. 6]

New Code Section 457A

New Code section 457A requires the current inclusion of amounts deferred under a nonqualified deferred compensation plan of a "nonqualified entity," when such amount is no longer subject to a substantial risk of forfeiture. Compensation is not treated as deferred if it is received by the service provider within 12 months after the end of the service recipient's taxable year in which the compensation is no longer subject to a substantial risk of forfeiture. For purposes of the provision, a nonqualified entity is any foreign corporation unless substantially all its income is effectively connected with the conduct of a trade or business in the United States or its income is subject to a comprehensive foreign income tax.[fn. 7] A nonqualified entity is also a partnership unless substantially all of its income is allocated to persons other than foreign persons or tax-exempt persons.

Under Code section 457A, a nonqualified deferred compensation plan is defined by reference to Code section 409A. However, plans that provide a right to compensation based on the appreciation in value of a specified number of equity units of the service recipient are also nonqualified deferred compensation plans for purposes of the new Code section 457A. Thus, the new provisions may not apply to equity interests in a fund (such as carried interests, restricted stock and options) but would apply to stock appreciation rights and other types of awards based on the appreciation in the value of the fund or its equity units.

If the amount of the compensation is not determinable, that amount will be includible at the time it becomes determinable, but will be subject to interest computed back to the year in which the compensation was earned or released from a substantial risk of forfeiture, if later, along with a 20 percent penalty at the time of income inclusion.

Compensation determined solely by reference to the gain recognized on disposition of an investment asset is excepted from the rule. In such cases, the nonqualified deferred compensation is treated as subject to substantial risk of forfeiture until the time of the disposition of the asset, and therefore is not includible until the time of disposition.

Who Is Affected By 457A?

Code section 457A impacts any person deferring compensation under the nonqualified plan of a "nonqualified entity," as defined above. The provision was specifically designed to reach U.S. managers of offshore hedge funds, including those with side pocket investments or foreign and tax-exempt investors. Typically, fund managers may elect to defer the fees they earn from providing investment advice to funds, and because the offshore funds are not subject to U.S. taxation (and therefore indifferent to the timing of the deduction for the payment of compensation), there is no incentive for the fund to restrict the amount of that deferral. New section 457A makes that compensation taxable to U.S. fund managers as soon as it is no longer subject to substantial risk of forfeiture.

Further, the carried interest in hedge funds and equity funds could be subject to the new provision to the extent that the carry represents a right to compensation. Whether the carry would be treated as compensation is not clear; however, the terms and structural assumptions of fund agreements should be reviewed in light of the new law.

Although the target of new Code section 457A is deferred compensation paid by offshore hedge funds, any partnerships with foreign partners or tax-exempt investors could potentially be subject to the provision. Accordingly, such partnerships should review any plan that allows for the deferral of compensation to determine whether the new law applies.

The statute focuses on deferred compensation maintained by a foreign corporation in countries with minimal income tax, such as Bermuda or the Cayman Islands, or by a foreign or U.S. partnership in which the partners are not subject to U.S. or foreign income tax or where a significant equity interest is held by a tax exempt entity. Issues are raised where a U.S. taxpayer works for a nonqualified entity both within and without a covered jurisdiction, or works in a tax treaty jurisdiction but is covered by a plan maintained in a covered jurisdiction. Taxpayers should consider what compensation alternatives are available in light of new section 457A.

Material Available On-Line

The following material is available with the indicated file sizes:

Notes

  1. H.R. 1424. [return to text]

  2. Alan Tawshunsky, Deputy Division Counsel and Deputy Associate Chief Counsel in the Internal Revenue Service's Tax Exempt and Government Entities Division, speaking at an October 3, 2008 American Law Institute-American Bar Association Conference. [return to text]

  3. Id. [return to text]

  4. H.Rpt. 110-658, 110th Cong., 2nd Sess. (accompanying H.R. 6049), p. 195 [return to text]

  5. S. 2199. [return to text]

  6. H.R. 6049. [return to text]

  7. Code § 457A(b)(1)(A), (B). [return to text]


This material is not intended to constitute a complete analysis of all tax considerations. Internal Revenue Service regulations generally provide that, for the purpose of avoiding United States federal tax penalties, a taxpayer may rely only on formal written opinions meeting specific regulatory requirements. This material does not meet those requirements. Accordingly, this material was not intended or written to be used, and a taxpayer cannot use it, for the purpose of avoiding United States federal or other tax penalties or of promoting, marketing or recommending to another party any tax-related matters.


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