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by Edward Tanenbaum, Esq.
Alston & Bird LLP
New York, New York
Well, first it was §409A. Now it's new §457A. As a part of the Emergency Economic Stabilization Act of 2008 (P.L. 110-343), signed into law by President Bush on October 3, 2008 (“Act”), Act §801 added new §457A entitled “Nonqualified Deferred Compensation from Certain Tax Indifferent Parties.” The new statute specifically targets hedge fund managers but is much broader. And, on January 8, 2009, the IRS issued Notice 2009-8, in the form of a Q&A with examples, providing interim guidance on the application of §457A to nonqualified deferred compensation plans of nonqualified entities.
Nonqualified deferred compensation (more precisely, deferred payment) plans have long been, and continue to be, a perfectly acceptable mode of compensation. The bottom line thinking is that if the compensation simply represents a bare promise to pay and is not in any way securitized, and various election timing rules are met, deferral of an income inclusion should be permitted until payment is actually made. After all, goes the theory, the payor will not receive a deduction until the income is reported by the service provider, i.e., the Treasury is not the worse for it. It's all nice and balanced.
Nonetheless, the area of nonqualified deferred compensation has been under attack in recent years. In the olden days (as my kids would say), defined as pre-§409A, the ability of persons to defer income and at the same time to have a degree of control over that income, and to have income events accelerated and somewhat securitized, was more prevalent than Congress apparently had intended. As a result, §409A was enacted, generally calling for many changes to the required timing of elections, changes to allowable acceleration of income, as well as prohibitions on the tax-favored receipt of deferred compensation from certain offshore vehicles, e.g., certain trusts.
Coming on the heels of §409A, and the massive regulations issued thereunder, §457A (which is the key revenue raiser in the Act) attacks deferred compensation arrangements of hedge fund managers who, together with their counterparts, the private equity guys (more in the context of “carried interests” but also in the context of deferred compensation), were thought to have been achieving windfalls with respect to their “management fee” and “incentive fee” compensation arrangements.
These perceived abuses are more commonplace with hedge fund managers who, unlike their private equity counterparts, typically receive ordinary income or short-term capital gains which, if structured as deferred compensation, would give them both deferral of income and a tax-free return on the deferred amount for payments made to them by the offshore corporate hedge fund.
But §409A apparently did not go far enough. Under traditional matching principles, the benefit of deferral of compensation comes at the cost of the postponement of a tax deduction for the compensation paid until such time as the compensation is taken into income by the service provider. What became apparent to those who watch the hedge fund industry very closely was that hedge fund managers were reaping huge tax benefits in the form of deferral while the Treasury was not gaining anything in the form of a postponed tax deduction for the compensation paid since the foreign corporate entity paying the compensation typically pays no U.S. tax anyway. In a clear sense, payment is being made by an entity that is “tax indifferent.”
Enter §457A. Under this section, any compensation to a service provider, including individuals, corporations, partnerships, but not including independent contractors with multiple clients unless such independent contractors perform management services (involving a promise to pay but deferral of payment) under a “nonqualified deferred compensation plan” of a “nonqualified entity” is included in income when there is “no substantial risk of forfeiture” of the right to payment. Thus, the benefit of deferral is lost and the service provider has immediate income inclusion (assuming no substantial risk of forfeiture) when the compensation (the promise) is undertaken by a tax indifferent party known as a nonqualified entity.
A nonqualified deferred compensation plan is defined in the same manner as set forth in §409A and includes earnings on previously deferred amounts as well as any arrangement under which compensation is based on the increase in value of a specified number of equity units of the service recipient, e.g., stock appreciation rights. However, compensation is not regarded as deferred if it is paid within 12 months after the end of the taxable year of the service provider during which the right to payment is not subject to a substantial risk of forfeiture.
If the amount of the compensation is not determinable at the time it would otherwise be included in income under §457A, the compensation will be includible in income when it is so determinable but the tax due is increased by an interest factor plus an amount equal to 20% of the compensation.
With an important exception, compensation is subject to a substantial risk of forfeiture if the right to payment is conditioned upon the future performance of substantial services. However, to the extent provided in regulations, if the compensation is determined solely by reference to an amount of gain recognized on the disposition of an “investment asset,” then compensation will be treated as subject to a substantial risk of forfeiture until the date of disposition. An “investment asset” is defined as any single asset (other than an investment fund or similar entity): (1) which is acquired directly by an investment fund; (2) with respect to which such entity (or any related person) does not participate in the active management of such asset (or if the asset is an interest in an entity, in the active management of the activities of such entity); and (3) substantially all of the gain on the disposition of which is allocated to investors in such entity.
The key to §457A is the promise of payment by a tax indifferent party, i.e., a nonqualified entity. The term “nonqualified entity” means either: (1) a foreign corporation (a corporation defined in §7701(a)(3) that is not domestic under §7701(a)(4)), unless “substantially” all of its income is effectively connected with a U.S. trade or business or unless substantially all of its income is subject to a “comprehensive foreign income tax;” or (2) any partnership (domestic or foreign, as defined in §7702(a)(2)), unless “substantially” all of its income is allocated to persons other than foreign persons with respect to whom the income is not subject to a comprehensive foreign income tax and other than organizations which are exempt from tax under the Code. For this purpose, substantially all of the income of a partnership is allocated to eligible persons if at least 80% of the gross income of the partnership is allocated to eligible persons. For purposes of the partnership rules, a foreign person is subject to a comprehensive income tax with respect to an item of income of the partnership only if the partner takes the income into account on a current basis under the laws of the country in which the foreign person is a resident (unless included only by reason of an anti-deferral regime) and certain other conditions are met.
In the case of a foreign corporation with effectively-connected income taxable under §882, §457A does not apply to any compensation which, had it been paid in cash at a time when the compensation was not subject to a substantial risk of forfeiture, would have been deductible by the foreign corporation against that income but only to the extent the compensation would be properly allocated and apportioned to such income under the principles of §1.861-8. If the compensation would be a part of the corporation's cost of goods sold, the compensation would be considered deductible using a reasonable method satisfactory to the IRS based on all of the facts and circumstances. Substantially all of a foreign corporation's income will be treated as effectively connected with a U.S. trade or business if at least 80% of its gross income is effectively connected and not exempt by treaty.
The statute and Notice 2009-8 define “comprehensive foreign income tax” to mean, with respect to a foreign person, the income tax of a foreign country provided that either: (1) the foreign person is eligible for the benefits of a comprehensive income tax treaty between that foreign country and the United States; or (2) the foreign person can demonstrate to the satisfaction of the IRS that the country of its residence has a comprehensive foreign income tax and (3) the foreign corporation is not taxed by its country of residence under a regime that is more favorable than the corporate income tax otherwise imposed in that country. However, the rule would not be met if the corporation's taxable income under the laws of its country excludes (whether by exemption, exclusion, deduction or by means of taxation of such income at a rate less than 50% of the generally applicable rate) nonresident source income and such income exceeds 20% of its gross income. However, such income is not considered excluded if it is effectively connected income and not exempt under a treaty, or it is a dividend from a domestic corporation, or it is a dividend from a corporation substantially all the income of which is subject to a comprehensive foreign income tax.
A foreign person is eligible for the benefits of a comprehensive income tax treaty if the treaty is one entered into by the U.S., with the exception of Bermuda and the Netherlands Antilles, and the foreign person is a resident within the meaning of the treaty and satisfies the limitation on benefits provision. Notice 2009-8 requests comments on whether and to what extent a limitation on benefits provision or exchange of information program is relevant to the determination of what is a “comprehensive income tax treaty.”
Section 457A is effective with respect to amounts deferred which are attributable to services performed after December 31, 2008, as well as amounts attributable to services performed on or before December 31, 2008, unless such latter amounts are includible in income before 2018.
Section 457A is a provision that appears to have successfully targeted the hedge fund industry, in particular. Next up: carried interests?
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