Paying for the Bailout by Currently Taxing Offshore Deferrals

October 20, 2008

Effective January 1, 2009, the ability of U.S. taxpayers to defer taxation on income earned from certain offshore entities will be severely restricted. New Section 457A of the Internal Revenue Code of 1986, as amended, is part of the Emergency Economic Stabilization Act of 2008 (H.R. 1424, commonly referred to as the “bailout” bill), and Congress/Treasury is counting on the projected increase in tax revenues generated from the immediate taxation of income earned from the covered offshore entities to “pay” part of the cost of the financial package. The purpose of Section 457A is to limit the ability of hedge fund and private equity fund managers to defer tax on compensation that is payable from certain “tax indifferent” offshore entities.

Under Section 457A, any compensation deferred under a nonqualified deferred compensation plan of a “nonqualified entity” is includable in gross income and taxable when there is no substantial risk of forfeiture to the rights to the compensation. A “nonqualified entity” includes (i) a foreign corporation where substantially all of its income is not effectively connected with the conduct of a trade or business in the United States or where it is not subject to a comprehensive foreign income tax, and (ii) any partnership where substantially all of its income is allocated to foreign persons who are not subject to a comprehensive foreign income tax or to organizations that are exempt from United States income tax. In short, the compensation payable by entities in tax-haven jurisdictions and partnerships with foreign or tax-exempt partners will be taxed upon vesting, even if it has not been paid to the service provider, unless those entities (or partners of those entities) are otherwise subject to tax.

The immediate taxation rule will not apply, however, if the service provider receives the compensation within 12 months after the end of the taxable year in which the right to the compensation vests, or if the deferred compensation is determined solely by reference to the amount of gain recognized on the disposition of an “investment asset” and such compensation is paid (and taxable) in the year of disposition. For deferred compensation that cannot be determined at the time of the deferral, the amount becomes includible in the service provider’s income at the time such compensation becomes determinable, and the income is subject to a 20% penalty tax and an interest charge, calculated back to the date of deferral.

Section 457A is generally effective only for deferred compensation attributable to services performed after December 31, 2008. However, existing deferrals must be included in the service provider’s gross income by the end of 2017 (or the taxable year in which the rights to such compensation vests, if later). The Act requires Treasury to provide guidance on modifying existing nonqualified deferral plans to permit compliance with Section 457A without violating the general deferred compensation rules of Section 409A.

In light of the new Section 457A, hedge fund and private equity fund managers that have offshore deferral arrangements should immediately address the changes mandated for 2009, and consider the planning opportunities that are available under the transition relief provided in Section 457A.

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