The IRS has recently issued a ruling confirming that offshore funds can, in certain circumstances, defer incentive fees payable to U.S. asset managers. Revenue Ruling 2014-18, released by the IRS on June 10, 2014, (the “Ruling”) opens a deferred compensation pathway that has been closed since 2008. Moreover, the ruling paves the way to better align manager compensation with investors by providing a multi-year payment calculation period.
In 2008, Congress effectively shut down deferred incentive fees (and other forms of deferred compensation) from offshore funds to U.S. managers. That year Congress enacted Section 457A which acts to accelerate income taxation to the year of deferral and apply interest and penalties, when the section is applicable. Section 457A applies when a tax indifferent party (a “nonqualified entity”, e.g., offshore fund or company) defers compensation to a service provider that is, or passes through to, a U.S. taxpayer. In order to avoid the adverse effects of Section 457A, funds have been paying incentive compensation from offshore funds to U.S. managers in annually determined amounts.
Under the annually determined scenario the U.S. manager has no ability to defer taxation other than the use of a carried interest which may or may not be helpful depending on the fund. Perhaps more importantly, the annually determined incentive fee causes a fundamental misalignment of risk / reward between the investor and the asset manager. For example, if the manager has a great year in year one, a 20% incentive fee / allocation is paid. But, if year two brings heavy losses there typically is no recoupment of the year one payment. By having a multi-year fee calculation period the time horizon of the investor’s investment can better match the payout to the manager.
There term, “nonqualifying deferred compensation plan” used in Section 457A is defined by reference to Section 409A. The accompanying Treasury regulations (under Section 409A), provide that nonqualified stock options (“NSOs”) and stock appreciation rights (“SARs”) issued in exchange for services with a minimum fair market value strike price at the time of grant (and meet certain other requirements), are exempt from the definition of “nonqualified deferred compensation plan” for purposes of Section 409A. However, the term “nonqualifying deferred compensation plan” is broadened by Section 457A to include, “any plan that provides a right to compensation based on the appreciation in value of a specified number of equity units of the service recipient.” Thus, the fact that Section 457A explicitly included NSOs and SARs caused a serious concern that the Section 409A exemption for fair market value options and SARs did not apply for purposes of Section 457A. This fear persisted even though the IRS stated in Notice 2009-8 (Q&A-2(b)), that stock options and stock-settled SARs otherwise meeting the Section 409A exemption would likewise be exempt for Section 457A purposes.
Many in the industry cautioned that the exemption may not apply between a hedge fund and a manager. As a result, most practitioners and funds took the position that prudence dictated paying offshore incentive fees, or making offshore incentive allocations, at least annually.
The Ruling makes clear that an offshore fund can defer incentive fees to a U.S. manager using stock options or stock-settled SARs. While the Ruling speaks solely in terms of stock, the same analysis would seem to apply to LLC units and LP units.
The Ruling was specific however that the SAR be stock-settled (no cash settlement). Additionally, the Ruling mandated that NSOs and SARs be for a fixed number of shares. The Ruling does not address ancillary tax issues that may arise when using options (e.g., PFIC issues) but is clearly very helpful to mangers and investors alike. However, care must be taken when drafting these instruments such that no other deferral arrangements are present which could run afoul of Section 409A (and thereby null the Section 457A exemption as well).
Also note, there are tax trade-offs for using this deferral mechanic. All deferred fees will be ordinary income when they are received. For some funds this will cause the manager to weigh the pros and cons.
If you have questions regarding the Ruling, fund manager compensation in general or any other tax issues, please contact your regular WithumSmith+Brown partner.