New IRS Ruling Permits Deferred Compensation Opportunities for U.S. Fund Managers of Offshore Hedge Funds

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By Chris M. Kang, Esq., Susan A. Wetzel, Esq., Charles F. Plenge,
Esq., Kenneth K. Bezozo, Esq., and  Vicki L. Martin-Odette, Esq.

Haynes and Boone, LLP, Dallas TX

The Internal Revenue Service ("IRS") recently issued Rev. Rul.
2014-18 (the "Ruling") allowing the deferral of compensation from
offshore hedge funds through the use of stock options ("Options")
and stock-settled stock appreciation rights ("SARs") without
running afoul of §457A.


Since the enactment of §457A in 2008, U.S. hedge fund managers
generally have not been able to defer fee-based incentive
compensation paid from offshore hedge funds. Section 457A generally
provides that deferred compensation from a "nonqualified entity"
(such as an offshore hedge fund) is includable in income at the
time the compensation is no longer subject to a substantial risk of
forfeiture. As a result, U.S. hedge fund managers have been
required to receive incentive fees or an incentive allocation on an
annual basis. These current payments also had the potential effect
of misaligning the interests of the fund's investors with those of
the fund manager. Because fund managers were paid on an annual
basis, in highly profitable years the fund manager could receive
the full incentive compensation, with little risk of a clawback of
such compensation in any subsequent poorly performing years.

Section 457A generally covers the same "non-qualified deferred
compensation plans" as those covered under §409A, except it also
includes "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." Section 409A generally excludes from
"non-qualified deferred compensation plan" Options and SARs with an
exercise price that is no less than the fair market value at the
time of grant. The legislative history to §457A and Notice 2009-8
state that Options and SARs that are otherwise excluded from
deferred compensation under §409A should not be treated as deferred
compensation under §457A. However, prior to the issuance of the
Ruling, many hedge fund managers expressed concern that the
exception for Options and SARs under §457A would not apply to
offshore hedge funds and their managers.

The Ruling

The Ruling amplifies previous guidance issued by the IRS in
Notice 2009-8 and confirms that Options and SARs, when properly
structured, should be exempt from Section 457A. In the Ruling, the
compensation arrangement between the service provider (i.e., the
fund manager) and the service recipient (i.e., the fund) was an
Option or SAR that could only be settled in stock and that
otherwise met the requirements to be exempt from §409A. In
addition, the fund manager in the Ruling had the same redemption
rights with respect to any shares received upon exercise as any
other shareholders of the fund (i.e., third party investors).

The service recipient in the Ruling was an entity organized and
taxed as a foreign corporation and the service provider was a
limited liability company taxed as a partnership with allocations
to U.S. taxpayers. Based on these facts, the Ruling should apply to
many common hedge fund structures as the parties described in the
Ruling reasonably resemble typical structures used by fund managers
in connection with offshore hedge funds (or offshore feeders in
master-feeder arrangements). Because the Options or SARs described
in the Ruling were not treated as deferred compensation
arrangements under §457A, any inherent gains would be realized and
included in income only upon the exercise of the Option or SAR.

Future Impact

The Ruling provides U.S. hedge fund managers with flexibility in
structuring their compensation arrangements with offshore vehicles.
For example, Options and SARs can be structured to lock a fund
manager's incentive compensation into the value of the fund itself
for a fixed number of years or upon the occurrence of certain
events (e.g., the exiting of the investor) by agreeing in advance
when the Options or SARs will be exercisable. By effectively
allowing multi-year fee deferrals, the Ruling permits investors to
better align their interests with the fund managers, without
investors asking for a clawback of fees.

Although the Ruling clears the way for possible deferred
compensation arrangements, there are tax tradeoffs. For instance,
the value of the compensation realized when the Options or SARs are
exercised will be recognized as ordinary income by the fund
manager. In addition, the Ruling does not address other tax issues
arising in connection with multi-year incentive compensation
structures, such as those arising under the "passive foreign
investment company" (PFIC) rules.

For more information, in the Tax Management Portfolios, see
Brisendine, Drigotas and Pevarnik, 385 T.M.
, Deferred
Compensation Arrangements,  and in Tax Practice Series,
see ¶5715, Taxation of Nonqualified Deferred Compensation Plans -
Sections 409A and 457A.

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