In a June 2008 Tax Alert, we wrote about certain proposed legislative attacks on investment fund managers. Today, October 3, 2008, the House passed and President Bush signed H.R. 1424, the Emergency Economic Stabilization Act of 2008, more colloquially known as the bailout package, which was passed by the Senate on October 1. In an effort to make the bailout package more palatable for reluctant House Republicans, on October 1, 2008, the Senate added provisions that would extend a number of the credits that expired at the end of 2007 or are scheduled to expire at the end of 2008. In addition to these so-called sweeteners, the Senate included the proposal to currently tax the deferred compensation from certain tax indifferent parties.
History of Section 457A
During 2007, Congress was considering two revenue-raising proposals. The first proposal provided for the taxation of carried interests at ordinary income rates. The second proposal provided for the current taxation of deferred compensation from certain tax indifferent parties. Both proposals were included in H.R. 3996, as revenue-raising offsets to the AMT patch in an attempt to comply with the House’s policy of offsetting tax savings provisions with revenue-raising provisions, known as the pay-go policy. Due to the Senate’s opposition to the proposals and the compelling need to pass the AMT patch, H.R. 3996 was passed on December 6, 2007, without the deferred compensation or carried interest provisions. Then again during June, the House included proposed Section 457A to the Internal Revenue Code, which would currently tax the deferred compensation from tax-indifferent parties, in H.R. 6049, the Renewable Energy and Job Creation Act of 2008. The bill, however, met opposition in the Senate and was not passed.
H.R. 1424 includes a slightly modified version of Section 457A of the proposed Section 457A included in H.R. 3996 and H.R. 6049. This article discusses some of the implications of the new provision and compares the version passed into law today with some of the previous versions.
Review of Section 457A
Section 457A is intended to prevent the deferral of compensation income where the service recipient does not give up a tax deduction as a result of such deferral. While Section 409A (which imposes a 20 percent excise tax on certain income deferral arrangements that do not satisfy specific requirements) aims to deter such deferral, Congress believes that its effectiveness as a deterrent to deferral depends on the service recipient desiring a U.S. tax deduction for the compensation sooner rather than later. Section 457A recognizes that certain foreign entities are indifferent with respect to whether a deduction for compensation is deferred. Accordingly, in an effort to prevent facilitation of deferral by tax-indifferent service recipients, Section 457A restricts the ability to defer tax on compensation paid to a service provider by a nonqualified foreign entity pursuant to a nonqualified deferred compensation plan. Where applicable, the service provider would be required to include in income all deferred compensation at the time that the right to such compensation is not subject to a substantial risk of forfeiture. A taxpayer’s right to the compensation is subject to a substantial risk of forfeiture if such right is conditioned upon the performance of substantial services in the future.
For purposes of this provision, nonqualified foreign entities are defined as (1) foreign corporations, unless substantially all of their income is subject to tax in the U.S. because it is effectively connected with a trade or business in the U.S. or subject to a comprehensive foreign income tax; and (2) any partnership, unless substantially all of its income is allocable to persons other than foreign persons not subject to a comprehensive foreign income tax and tax-exempt organizations. In short, a foreign entity will be a nonqualified foreign entity unless it (or, in the case of a partnership, its partners) are subject to U.S. taxes or comprehensive foreign income taxes. A foreign person would be considered to be subject to a comprehensive foreign income tax only if the person is eligible for the benefits of a comprehensive income tax treaty with the United States or demonstrates to the Treasury that the foreign country has a comprehensive income tax.
If a taxpayer receives deferred compensation under a nonqualified deferred compensation plan from a nonqualified entity and such amount cannot be reasonably determined at the time awarded, Section 457A imposes an interest charge on the amount ultimately determined through the date such amount is determined, plus an additional tax equal to 20 percent of the amount of the compensation. Both the interest charge and the 20 percent tax must be paid in addition to the taxpayer’s ordinary income tax rate of 35 percent. As in the prior drafts of this provision, it still is unclear whether this provision is intended to reach the portion of the deferred fees that are considered to be reinvested in the fund, or just those considered reinvested in illiquid assets of a fund. In either case, these provisions appear to treat a fund manager who defers fees from offshore funds worse than had the manager been paid the fees in cash and reinvested the proceeds.
Section 457A also requires the acceleration of any deferred compensation attributable to pre-2009 services for compensation covered by Section 457A but for its effective date. Such existing deferred amounts must be included in the service provider’s income by the later of the last taxable year beginning before 2018 or the taxable year in which there is not substantial risk of forfeiture to the rights to such compensation. The proposal requires Treasury to provide rules that would permit, for a limited time, the acceleration of income from services performed before 2009 to pre-2018 periods without violating the requirements Section 409A.
Changes to Section 457A
The only difference between 457A as included in H.R. 1424, passed today, and the prior version included in H.R. 6049 is the removal of a provision included in H.R. 6049 that would have permitted taxpayers to make deductible charitable contributions, without regard to the percentage limitations otherwise imposed by Section 170, to offset amounts includible in income due to the acceleration under Section 457A of deferred compensation for pre-2009 services. It is unclear what was troubling with that provision, other than a desire to ensure that any amounts included in income as a result of Section 457A went to help pay for the bailout.
After more than a year of hearings, debates and multiple drafts of proposed legislation directly aimed at fund managers, these managers have fallen victim to the need to pass bailout legislation quickly. Though fund managers may rest easy for the moment that the proposals to tax carry as ordinary income were not included, these proposals will not disappear quietly, and we should expect to see further proposals after the presidential election.
Steven D. Bortnick, Leonard Schneidman and Michelle Parten