U.S. Bailout Bill Significantly Impacts Deferred Compensation For Fund Managers, Raising New Tax Issues

The Emergency Economic Stabilization Act of 2008 - commonly known in the U.S. as the 'bailout bill' - will have a major impact on many fund managers and their taxable compensation. The bill, which was signed into law (P.L. 110-343) by President Bush on October 3, 2008 to stabilize the shaky American financial system, adds a Section 457A to the Internal Revenue Code (the 'Code'). This new section will significantly limit the ability of fund managers or service providers of certain hedge funds and private equity funds to defer management or incentive fees.

Under prior law, many fund managers or service providers of offshore funds in tax haven jurisdictions such as the Cayman Islands and Bermuda deferred their compensation income through deferred annual bonuses, stock appreciation rights, side pockets, or other deferral arrangements. Since these offshore funds are indifferent to the timing of deduction for compensation, there is no incentive for the funds to limit the deferral amounts.

Section 457A is aimed at eliminating such deferrals from tax-indifferent offshore funds. Under Section 457A, fund managers and service providers must include the compensation in income when it vests (i.e., when its receipt is not conditioned upon future performance of substantial services). It applies in addition to any other Code provisions governing the taxation of deferred compensation, including Section 409A.

Although Section 457A primarily targets deferrals from offshore funds, its statutory scope is broader. More specifically, Section 457A applies generally to compensation under any deferred compensation arrangement (other than certain employer provided benefits plans) of a 'nonqualified entity' that is paid later than 12 months after the end of the taxable year during which the right to the payment vests. Any foreign corporation is a nonqualified entity unless substantially all of its income is subject to U.S. income tax or to a comprehensive foreign income tax. In addition, any partnership (whether foreign or not) is also a nonqualified entity unless it allocates substantially all of its income to persons other than tax exempt organizations and foreign persons who are not subject to a comprehensive foreign income tax on such income.

Generally, foreign persons are considered to be subject to comprehensive foreign income tax if they are subject to income tax in a foreign country that has a comprehensive income tax treaty with the U.S. and are eligible for the benefits provided under that treaty.

If the amount that must be included in income cannot be determined when the property first becomes vested (e.g., if the amount payable will vary depending on the satisfying of certain objective thresholds), the deferred compensation will be subject to income tax, plus an interest charge and a 20-percent penalty, when the amount becomes determinable. This will particularly impact performance-based or side pocket arrangements. However, in some cases compensation may be contingent on the disposition of a single asset held as a long-term investment and the service provider does not actively manage the asset other than by making the decision to buy or sell the investment. To the extent provided in future regulations by the U.S. Department of Treasury, such compensation may be non-taxable until the disposition date.

Section 457A applies to deferred compensation attributable to services performed on or after January 1, 2009. For deferred compensation attributable to services performed before January 1, 2009, to the extent such amount is not included in income in a taxable year beginning before 2018, the income is included in the later of the last taxable year of the service provider beginning before 2018 or the taxable year of vesting.

The Treasury will provide a limited time period during which a nonqualified deferred compensation arrangement attributable to services performed on or before December 31, 2008 may be amended to conform their distribution dates to the date upon which such amounts must be included in income.

Individuals and entities should consult their tax advisers on how the new Section 457A affects their situation and whether plan amendments should be made to reflect the requirements of Section 457A.