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House Takes Another Swing at Deferred Compensation

Tax Alert

Author: Steven D. Bortnick

6/12/2008

In the October 2007 issue of the Pepper Hamilton Tax Update, we wrote about certain legislative attacks on investment fund managers. (See “Proposal Targets Offshore Deferred Compensation and Carried Interests.”) At that time, 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 by Chairman Rangel 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.

Recent Congressional actions give investment fund managers affected by the deferred compensation proposal (i.e., primarily hedge fund managers who manage offshore investment vehicles) cause for concern.

On May 21, 2008, the House passed H.R. 6049, the Renewable Energy and Job Creation Act of 2008. The bill seeks to extend a number of the credits that expired at the end of 2007 or are scheduled to expire at the end of 2008. The bill was received in the Senate on June 4, 2008, and on June 10, Senate Democrats moved to limit the time for debating the bill before a vote. The motion failed, however, to receive the requisite votes. On the same day, Senate Finance Committee Chairman Max Baucus (D-Mont.) unveiled a substitute amendment to H.R. 6049 that contains the provision discussed herein and provides for a new AMT patch.

Until June 11, it was generally believed that private equity fund and hedge fund managers could enjoy 2008 without worrying about Congressional proposals to tax carried interests at ordinary income rates. On June 11, however, Chairman Rangel burst everyone’s bubble by announcing that he will introduce legislation providing for an AMT patch offset by the carried interest proposal. This announcement comes on the heels of, and is likely in reaction to, Chairman Baucus’ announcement that he will introduce legislation providing for an AMT patch without offsets.

To pay for the extension of expiring credits, H.R. 6049 includes a modified version of the proposal to currently tax-deferred compensation from certain tax-indifferent parties. This article discusses some of the implications of the proposed legislation and compares the current proposal with last year’s version.

Review of Proposed Section 457A

Proposed 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.

Proposed 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, proposed 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 tax payer’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. 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, proposed 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 initial October proposal, 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.

In addition, depending on the meaning of “determinable,” which is not clear from the language of the statute, many investment fund managers may be subject to the 20 percent additional tax and interest charge under Section 457A. Investment fund deferred compensation arrangements providing for reinvestment of deferred amounts may cause such deferred compensation to have no ascertainable value until the end of the deferral period. Accordingly, at the end of the deferral period, the investment fund manager would be subject to the interest charge and the additional 20 percent tax.

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 in Section 409A.

Changes to Proposed 457A

The legislation that was passed by the House on May 21, is largely similar to the proposal in H.R. 3996, as summarized above. H.R. 6049, however, includes the following noteworthy changes:

  1. Under the new proposal, compensation determined solely by reference to the amount of gain recognized on the disposition of an “investment asset” would be considered subject to a substantial risk of forfeiture until the date of disposition. For purposes of Section 457A, an investment asset is defined as any single asset that is (i) acquired directly by an investment fund or similar entity, (ii) with respect to which such entity does not (nor does any person related to such entity) participate in the active management of such asset, and (iii) substantially all of any gain on the disposition of which (other than deferred compensation) is allocated to investors in such entity. Accordingly, compensation determined by reference to gain on the disposition of an investment asset would be includible income at the time of disposition and would not be subject to the penalties for amounts that are not determinable.
  2. The new proposal provides that compensation will not be treated as deferred (and, thus, will not be subject to Section 457A) if paid within 12 months after the end of the taxable year of the service recipient during which the right to payment of such compensation is no longer subject to a substantial risk of forfeiture. This exception, however, is not available to the extent the compensation is based on the amount of gain from the disposition of an investment asset that is treated as subject to a substantial risk of forfeiture, as described above. Compensation based on gain from the disposition of an investment asset, therefore, must be included in the service provider’s income during the year in which the disposition occurs.
  3. The new proposal would exempt deferral arrangements maintained by foreign corporations if payment of the compensation in cash on the date the income is not subject to a substantial risk of forfeiture would have resulted in a deduction to the foreign corporation against its effectively connected income. This provision replaces a provision in the prior proposal that required that a foreign country’s tax system must have rules regarding the deductibility of deferred compensation similar to ours in order for the country to be considered to have a comprehensive tax system.
  4. Under the new proposal, taxpayers would be permitted 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. Such contributions must be paid in cash to public charities during the year in which the accelerated amounts are includible in income.
  5. The new proposal expands the mandate for service guidance regarding acceleration of payments for amounts attributable to pre-2009 services to certain “back-to-back arrangements.” A back-to-back arrangement involves a situation under which an entity receives services from a service provider such as an employee, and the entity in turn provides services to a client and the fees payable by the client are deferred at both the entity level and the employee level.
  6. New Section 457A generally would apply to deferred income for services performed after December 31, 2009. However, if the income would be deferred beyond tax years beginning before 2018, such deferred income would be includable in income in the last taxable year beginning before 2018. The proposal does require Treasury to come up with rules that would permit, for some limited time, the acceleration of income from services performed before 2009 to pre-2018 periods without violating Section 409A.

Pepper Perspective

In October, it seemed that Congress was more amenable to passing proposed Section 457A than the carried interest provision. The passage of H.R. 6049 by the House, together with the June 10 vote and Chairman Baucus’ retention of the deferred compensation provision in his amendment to H.R. 6049, indicate that the House and the Senate Democrats support the deferred compensation provisions. However, the Senate Republicans’ failure to support the June 10 motion indicates their resistance to this legislation, even in the absence of the carried interest proposals. It remains to be seen whether the Democrats will leverage their majority in the Senate to pass this legislation in connection with the much-needed extender provisions.

It also remains to be seen whether Senate Democrats will extend their support to a House bill containing the carried interest proposal. Acknowledging likely resistance in the Senate, Chairman Rangel noted that “the Senate isn’t thinking of paying for [the AMT]. The Senate isn’t thinking of paying for anything.”

We are keeping a close watch on Congress, as some predict Congress will move on the proposals before the summer recess in August. We will provide you with alerts as the proposals move through Congress, so continue watching your inbox for our updates.

Steven D. Bortnick and Michelle Parten

The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.