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:
A “nonqualified entity” means:
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:
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):
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.
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 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, [email protected])
Charles F. Feldman (212-351-3908, [email protected])
Arthur D. Pasternak (202-955-8582, [email protected])
David I. Schiller (214-698-3205, [email protected])
Michael J. Collins (202-887-3551, [email protected])
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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