Code Section 457A: Ending Deferral of Compensation for Managers of Offshore Hedge Funds

October 30, 2008

The Emergency Economic Stabilization Act was signed into law by President Bush on October 3, 2008.  Included in the Act is new Internal Revenue Code Section 457A, which is intended to end the deferral of compensation payable to managers of offshore hedge funds under a nonqualified deferred compensation plan.  The following are the keys points of the new legislation, with additional details provided below:

  • General Rule: Compensation payable under a “nonqualified deferred compensation plan” of a “nonqualified entity” is included in gross income at the time when there is no longer a “substantial risk of forfeiture” with respect to such compensation;
  • Who Is Impacted: The term “nonqualified entity” includes the foreign fund entity utilized by hedge funds in the standard compensation deferral structure (though some private equity and hedge fund entities (foreign or domestic) and other foreign operating entities may be swept up in the broad definition);
  • Which Plans Are Impacted: The term “nonqualified deferred compensation plan” under Section 457A includes not only all plans subject to Section 409A but also equity appreciation rights that would not normally be subject to Section 409A;
  • When Deferral is Permitted: Compensation may still be deferred as long as the compensation is subject to a substantial risk of forfeiture, but that term is narrowly defined to include compensation that is conditioned upon the future performance of substantial services by the recipient (there is also a limited exception for compensation determined by the gain recognized on the disposition of an investment asset, such as a “side pocket” investment, which is discussed below);
  • Uncertain Amounts: If the amount of any compensation is not determinable at the time it would otherwise be includible in gross income under Section 457A, taxation will be  deferred until the amount is determinable, but the tax payable on such compensation will be increased by the sum of an interest charge (at a rate equal to the underpayment rate plus 1 percentage point) plus 20% of the amount of the compensation; and
  • Effective Date: Section 457A is effective with respect to compensation attributable to services performed after December 31, 2008 (however, as explained in more detail below, deferred compensation attributable to services performed before January 1, 2009, has a maximum deferral period of approximately 10 years—even if the substantial risk of forfeiture has not yet lapsed).  

Nonqualified Entity

A “nonqualified entity” means:

  • Any foreign corporation unless substantially all of its income is either effectively connected with the conduct of a trade or business in the United States or subject to a “comprehensive foreign income tax” or
  • Any partnership (domestic or foreign) substantially all the income of which is allocated to persons other than foreign persons with respect to whom such income is not subject to a “comprehensive foreign income tax” and organizations which are exempt from U.S. federal income taxes.

A tax is a “comprehensive foreign income tax” with respect to a foreign person if either such person is eligible for the benefits of a comprehensive income tax treaty between such foreign country and the United States or such person demonstrates to the satisfaction of Treasury that such foreign country has a comprehensive income tax.  The term “comprehensive income tax” is not defined, and the statute does not provide guidance as to how one demonstrates to Treasury that a foreign country has a comprehensive income tax.  Presumably such details will be provided in future guidance—until that time, U.S. persons considering deferring income payable by a foreign entity in a jurisdiction without a comprehensive income tax treaty with the United States should proceed with caution.

Nonqualified Deferred Compensation Plan

The term “nonqualified deferred compensation plan” generally has the same meaning given to that term under Section 409A, i.e., any plan providing for deferral of compensation other than a qualified plan or any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan.  Unlike Section 409A, however, Section 457A also applies to any plan that provides a right to compensation based on the appreciation in value of a specified number of equity units of the service recipient (e.g., equity appreciation rights arrangements, such as phantom equity and stock appreciation rights plans).

There are two exceptions for compensation that will not be treated as deferred for purposes of Section 457A even if paid under a nonqualified deferred compensation plan:

  • Payments received not later than 12 months after the end of the taxable year of the service recipient during which the right to the payment of the compensation is no longer subject to a substantial risk of forfeiture.  Note that this exception does not apply to the limited exception for compensation determined by the gain recognized on the disposition of an investment asset.  In that case, the compensation is includible in income in the year of the disposition.  Note also that the short-term deferral exception under Section 409A is only 2 ½ months following the end of the taxable year in which the compensation is no longer subject to a substantial risk of forfeiture, so if a plan is subject to both Sections 409A and 457A, service recipients should pay attention to the shorter time period in which to make the payment.
  • In the case of a foreign corporation that is taxable under Section 882 (meaning a foreign corporation with income effectively connected to a U.S. trade or business), Section 457A will not apply to compensation that, had the compensation been paid in cash at the time the substantial risk of forfeiture lapsed, would have been deductible by the corporation against its effectively connected income.

Substantial Risk of Forfeiture: Investment Asset

The statute calls for Treasury to issue regulations providing that compensation determined solely by reference to the amount of gain recognized on the disposition of an investment asset shall be treated as subject to a substantial risk of forfeiture until the date of such disposition.  The term “investment asset” means any single asset (other than an investment fund or similar entity):

  • acquired directly by an investment fund or similar entity,
  • with respect to which such entity does not (nor does any person related to such entity) 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 any gain on the disposition of which (other than the deferred compensation) is allocated to investors in such entity.

It is unclear whether the Internal Revenue Service will clarify what “active management” and “substantially all” mean, and whether the “single asset” limitation would result in typical side-pocket compensation arrangements being unable to satisfy this exception, since the typical compensation on a side-pocket investment consists of multiple investment assets.

Effective Date and Transition Rules

Section 457A is effective with respect to compensation attributable to services performed after December 31, 2008.  To the extent deferred amounts attributable to services performed before that date are not included in gross income in taxable year beginning before 2018, the deferral of such compensation is limited to the later of the taxable year in which there is no substantial risk of forfeiture with respect to that compensation or the last taxable year beginning before 2018.

The statute requires Treasury to issue guidance no later than January 31, 2009, providing a limited period of time during which a nonqualified deferred compensation arrangement attributable to services performed before January 1, 2009, may be amended to change the date of distribution to  comply with Section 457A without violating the requirements of Section 409A.  In addition, Treasury is to issue guidance for the modification of back-to-back arrangements in which employees of the fund manager have deferred compensation under an arrangement that will be funded by the fund’s plan that is subject to Section 457A.

Bottom Line

Offshore hedge funds and other entities potentially subject to Section 457A should determine whether they are subject to the rules of Section 457A, and, if so, whether any modifications will be needed to their compensation plans in order to comply with Section 457A (keeping in mind that plans also may need to be modified, if they have not already been modified, to comply with Section 409A).

Gibson, Dunn & Crutcher LLP

Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn attorney with whom you work or any of the following: 

Stephen W. Fackler (650-849-5385, sfackler@gibsondunn.com)
Charles F. Feldman (212-351-3908, cfeldman@gibsondunn.com)
Arthur D. Pasternak (202-955-8582, apasternak@gibsondunn.com)
David I. Schiller (214-698-3205, dschiller@gibsondunn.com)
Michael J. Collins (202-887-3551, mcollins@gibsondunn.com)

To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matters addressed herein.

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