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Proposal Targets Offshore Deferred Compensation and Carried Interests

Tax Update

Author: Steven D. Bortnick

11/13/2007

The latest attack on investment fund managers’ carried interests came on November 2, 2007, when the House Ways and Means Committee approved An Amendment in the Nature of a Substitute to the Temporary Tax Relief Act introduced by Chairman Charles Rangel (D-NY.). The bill is targeted at patching the Alternative Minimum Tax (AMT), which in its current iteration is anticipated to hit 23 million U.S. households. Members of the House have stated that they will only pass a fix to the AMT, on a pay-go basis, i.e., by including revenue raisers sufficient to cover the $50 billion of revenue lost by patching the AMT. Accordingly, Chairman Rangel’s bill includes two significant revenue raisers that would impact investment fund managers.

The first revenue raiser, which is nearly identical to the legislation introduced by Senator John Kerry (D-Mass.) and Representative Rahm Emanuel (D-Ill.) on October 18, 2007, would add new section 475A to the Internal Revenue Code. Broadly, this provision would require the current taxation of deferred compensation from certain tax indifferent parties. The second revenue raiser provides for the taxation of carried interests at ordinary income rates. It is essentially a modified version of the bill introduced Representative Sander Levin (D-Mich.) on June 22 and discussed in our June 25, 2007 Tax Alert.

Carried Interests

Carried interests can come in a variety of forms. The carried interest in the form of a partnership profits interest, or the right to a share of the appreciation in the partnership assets, has been the subject of most of the publicity and legislative proposals. Fund managers who hold these carried interests generally count on the flow-through nature of a partnership to generate income that is taxed largely at long-term capital gain rates. Where the fund is a corporation for U.S. tax purposes, capital gains derived by the fund would not flow through as capital gains. In the case of an offshore fund classified as a corporation for U.S. tax purposes, the carry generally is in the form of an incentive fee that may be deferred by the manager. Generally, these funds are formed in tax haven jurisdictions, such as the Cayman Islands. Subject to certain restrictions, the manager can expect significant tax savings as a result of this deferral.

Even under current law, the fund manager has to navigate special rules in order to defer management fees. The manager cannot be in constructive receipt of the fee. Accordingly, the manager and the fund have to agree to the deferral before the period for which the services are performed. Once deferred, the manager generally cannot have the right to accelerate payment of the fee. Additionally, the fee generally cannot be set aside in an account protected from the funds creditors. Moreover, Section 409A provides other restrictions that, if not followed, may result in acceleration of income and the imposition of an excise tax.

Proposed Section 475A

Proposed Section 475A 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 manager’s right to the compensation is only subject to a substantial risk of forfeiture if such right is conditioned upon the performance of substantial services in the future.

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. This requires further explanation. 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 U.S. or demonstrates to the Treasury that the foreign country has a comprehensive income tax. In each case, the foreign country’s tax must have rules regarding the deductibility of deferred compensation similar to those in the Internal Revenue Code.

If a taxpayer receives deferred compensation under a nonqualified deferred compensation plan from a nonqualified entity and such amount cannot be reasonably ascertained at the time awarded, proposed Section 475A imposes an interest charge on the amount ultimately ascertained through the date such amount is ascertained, 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. It 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 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.

Proposed Section 475A generally applies to deferred income for services performed after December 31, 2007. However, if the income would be deferred beyond tax years beginning before 2017, such deferred income would be includable in income in the last taxable year beginning before 2017. 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 2008 to pre-2017 periods without violating Section 409A.

Depending on the meaning of “ascertainable”, 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 475A. Investment fund deferred compensation arrangements providing for reinvestment of deferred amounts or subjecting deferred compensation to the attainment of certain performance criteria 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.

Modifications of the Proposals to Tax Carry as Ordinary Income

As mentioned above, the proposals in the latest bill to tax carry as ordinary income from the performance of services are very similar to the earlier proposals. There are some very important modifications worth mentioning here. The latest proposal would preclude avoidance of their reach by having investors or the partnership make or guarantee loans to the manager to purchase an interest in the partnership. They also would preclude avoidance by having the investors make loans instead of capital contributions to the partnership. Additionally, gain on options, derivatives and convertible and contingent debt the value of which is substantially related to the amount of income or gain from assets with respect to which the manager provides investment management services will be treated as ordinary income for the performance of services. Finally, the new proposal modifies the penalty provisions, including increasing to 40 percent the penalty for any understatement relating to the rules on convertibles and derivatives or the regulations implemented to prevent avoidance of these provisions and making the exception for understatements as a result of reasonable cause unavailable to such understatements. Moreover, the proposal would be retroactive to tax years ending (or certain events occurring) after November 1, 2007.

Pepper Perspective

A big question is whether the AMT patch can be implemented without the revenue from the provisions described above. On November 1, Senator Charles Grassley said that he expected that the House will pass the bill, but that the measure will have to be amended to remove changes to carried interest taxation and the proposed Section 475A. Whether the carried interest and deferred compensation provisions will be passed as part of the patch to the AMT should be decided in the very near future, because Treasury Secretary Henry Paulson requested that Congress pass any change to the AMT by early November, to allow the IRS sufficient time to create and make available the necessary tax return forms for the 2008 filing season.

Even if the Senate prevails and the provisions are not included as part of the AMT patch, these provisions still may be enacted as part of legislation during 2008. It is our understanding that the deferred compensation provision has even more support than the carried interest provisions. We will continue to monitor the proposed legislation and its political support, so continue watching for updates in Pepper Tax Alerts.

Steven D. Bortnick and Michelle Parten

This article is informational only and should not be construed as legal advice or legal opinion on specific facts.