IRS Revenue Ruling Backs Institutions Seeking Changes to Hedge Fund Fees

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By Miles Weiss

June 10 — The Internal Revenue Service issued a ruling that clears the way for institutional investors to seek changes to incentive fees assessed by hedge funds, which may make it cheaper for them to invest in such offerings.

Revenue Ruling 2014-18 clarifies that hedge funds can charge incentive fees cumulatively, rather than annually, without running afoul of a tax law change adopted in 2008.

These fees, typically equaling 15 percent to 20 percent of an investor's profits, comprise a big portion of a hedge fund manager's annual revenue.

Institutions have been pushing managers to charge incentive fees on a cumulative basis, rather than locking in a share of profits annually, to ensure that both sides share the risk of having gains from good years being wiped out later on.

Investors from California Public Employees' Retirement System to the Utah Retirement System to Intel Corp. have urged hedge funds to make the change and have been spurned in the past, said Rick Ehrhart, the chief executive officer of Optcapital LLC, a Charlotte, N.C., consulting firm specializing in incentive compensation payable to money managers.

“The holy grail for them is to divide profits on a cumulative basis,” Ehrhart said in an interview. “There is an inherent clawback” in using this sort of method, Ehrhart said, referring to a private-equity concept that allows investors to take back fees paid to managers if early gains in buyout funds are wiped out by subsequent losses.

In the IRS ruling, the agency says neither the nonstatutory stock option nor the stock-settled stock appreciation right granted to a service provider by a foreign corporation are nonqualified deferred compensation plans subject to tax code Section 457A.

The IRS addressed a scenario in which the service recipient is a foreign corporation and nonqualified entity for purposes of Section 457A(b). The NSO and stock-settled SAR were granted as incentive compensation to the service provider, a limited liability company organized under state law and treated as a partnership for U.S. income tax purposes.

The revenue ruling was meant to provide assurance that both stock options and, more importantly, stock appreciation rights, could be used and would be exempt from Section 457A, Ruth Wimer, a Washington-based partner with McDermott Will & Emery LLP, told Bloomberg BNA June 10.

The revenue ruling is clarifying that stock options as defined in Treasury Regulation Section 1.409A-1(b)(5)(i)(A) are exempt and that SARs defined in Treasury Regulations Section 1.409A-1(b)(5)(i)(B) are also exempt, “but they can't just be stock-settled, they must be only stock-settled,” Wimer said.

In other words, “all stock appreciation rights must provide for settlement only in service recipient stock and furthermore only service recipient stock may be transferred at exercise,” she said.

The guidance is aimed at a company–to-company situation, such as “hedge fund managers managing offshore funds in tax-favored jurisdictions,” she said. The qualifiers in the revenue ruling provide that the SAR must only be settled in stock, the transfer value must be in stock and the redemption rights of the service provider must be the same as any other shareholder, Wimer said.

Rev. Rul. 2014-18 is to be published June 23 in Internal Revenue Bulletin 2014-26.

With assistance from Mary Hughes in Washington.

To contact the reporter on this story: Miles Weiss at mweiss@bloomberg.net

To contact the editor responsible for this story: Christian Baumgaertel at cbaumgaertel@bloomberg.net

Text of Rev. Rul. 2014-18 is in TaxCore.