As part of the Emergency Economic Stabilization Act of 2008 (H.R. 1424) (the "Act"), Congress added new § 457A to the Internal Revenue Code of 1986, as amended (the "Code"). Section 457A was prompted by a perceived need to curb deferral of income inclusion for popular fee arrangements currently used by offshore hedge funds. When a service recipient is not tax indifferent, a tension typically will exist between a service provider's interest in deferring income and a service recipient's need for a current deduction for that income payment. This tension not only serves to limit abuses in the deferral of income but provides somewhat offsetting tax revenue in the form of a deferred deduction matching a deferred inclusion. Section 457A was enacted to prevent certain deferrals of inclusion when service recipients, like offshore hedge funds, are tax indifferent, eliminating the offsetting need for a current deduction.1
Section 457A is effective for amounts deferred which are attributable to services performed after December 31, 2008. A special rule applies for deferred amounts attributable to services performed before January 1, 2009. The deferred amounts are not included in gross income until the last taxable year beginning before 2018, or until the taxable year in which such amounts are no longer subject to a substantial risk of forfeiture, if later.
Section 457A provides that any compensation that is deferred under a "nonqualified deferred compensation plan" of a "nonqualified entity" will be included in gross income when there is no "substantial risk of forfeiture" of the rights to such compensation. A prior version of the Act made explicit § 457A's reach to encompass service providers who were accrual method taxpayers as well as cash method taxpayers. The reference to accrual method taxpayers was removed from the Act, leaving ambiguous whether accrual method taxpayers are covered. The language of § 457A also leaves doubt as to whether it reaches taxpayers other than individuals. The language of § 409A applies to an "individual" but was expanded to other persons in the Treasury Regulations; § 457A, however, refers to the performance of services by a "person". Section 457A would apply to consultants as well as employees, but does not apply to a partnership interest. Accordingly, carried interests in partnerships are not subject to § 457A.
Nonqualified Deferred Compensation Plans
For this purpose, a "nonqualified deferred compensation plan" is generally defined by crossreference to § 409A, except that a plan that provides rights to compensation based on appreciation in value of a specified number of equity units of the service recipient, such as a stock appreciation rights plan, is a nonqualified deferred compensation plan under § 457A, but not § 409A.
- Nonqualified Entities
Included in the § 457A definition of a "nonqualified entity" are (i) a foreign corporation unless substantially all of its income is effectively connected with the conduct of a U.S. trade or business or subject to a comprehensive foreign income tax; and (ii) any partnership unless substantially all of its income is allocated to persons other than foreign persons who are not subject to a comprehensive foreign income tax on the allocable income or taxexempt organizations. No standard for "substantially all" is set out in § 457A. A person will be considered subject to a comprehensive foreign income tax if such person is eligible for the benefits of a comprehensive income tax treaty between the United States and the foreign country. If the applicable foreign country does not have a comprehensive income tax treaty with the United States or the service recipient is not eligible for treaty benefits, the foreign corporation or foreign partner, as the case may be, must demonstrate to the satisfaction of the Secretary, presumably pursuant to the Treasury Regulations directed to be issued, that the applicable foreign country has a comprehensive income tax. Absent some carve out in future Treasury Regulations, a partnership will be a nonqualified entity if substantially all of its income is allocated to tax-exempt partners even if those tax-exempt partners are not tax-indifferent with respect to the income at issue, for example, because they are subject to withholding tax under § 1446 or to unrelated business income tax.
Carried interests in partnerships will not necessarily be affected by § 457A.
- Substantial Risk of Forfeiture
The concept of "substantial risk of forfeiture" under § 457A is different than substantial risk of forfeiture used elsewhere in the Code. For purposes of § 457A, "the rights of a person to compensation shall be treated as subject to a substantial risk of forfeiture only if such person's rights to such compensation are conditioned upon the future performance of substantial services by any individual". Accordingly, other conditions which might be required to receive the compensation, such as a requirement of a certain level of profitability being achieved by the service recipient or some other economic threshold being met prior to the service provider having an absolute right to the compensation, would not constitute a substantial risk of forfeiture. Section 409A contains the same definition of "substantial risk of forfeiture" as § 457A, with the exception of the word "only". The Treasury Regulations under § 409A, however, expanded the definition: "Compensation is subject to a substantial risk of forfeiture if entitlement to the amount is conditioned on the performance of substantial future services by any person or the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial." Treas. Reg. § 1.409A-1(d)(1). Based on the legislative history and the inclusion of "only", the Treasury Regulations to be issued under § 457A are not expected to expand the conditions which would constitute a substantial risk of forfeiture for purposes of § 457A.
An exception to this substantial risk of forfeiture limitation for compensation based on gain recognized on an investment asset is to be set forth in future Treasury Regulations. Section 457A provides that "to the extent provided in regulations prescribed by the Secretary", compensation determined solely by reference to the amount of gain recognized on disposition of an investment asset will be treated as subject to a substantial risk of forfeiture until the investment asset is disposed of. An investment asset is any single asset (other than an investment fund or similar entity) that is acquired by an investment fund or similar entity if the entity (or a related person) does not participate in the active management of the asset and if substantially all the gain on disposition of the asset is allocated to investors in such entity. Active management includes participation in the day-to-day activities of the asset but does not include the election of a director or other voting rights exercised by shareholders.
- Interest Charge and 20% Penalty
Although, under § 457A, the amount of deferred compensation is included in gross income at the time the income is no longer subject to a substantial risk of forfeiture, an exception exists if the amount of compensation is not determinable at that time, for example, if the amount of compensation is based on a percentage of future earnings. If the amount of compensation is not determinable when it is no longer subject to a substantial risk of forfeiture, the amount of compensation will be included in gross income when determinable and the service provider will be subject to an interest charge and a penalty. The amount of the interest charge is calculated at an interest rate equal to the underpayment rate plus one percent and is applied to the underpayment that would have occurred had the deferred compensation been included in gross income for the taxable year in which it was first deferred or, if later, the first taxable year in which such deferred compensation was no longer subject to a substantial risk of forfeiture. The penalty amount is 20% of the amount of compensation, mirroring the penalty rule of § 409A. This interest and penalty charge eliminate the attractiveness to accrual based taxpayers of taking the position that an amount should not be included in income because it could not be determined with reasonable accuracy.
- Short-term Deferral Exception
Compensation is not considered deferred for purposes of § 457A if the service provider receives the compensation no later than 12 months after the end of the taxable year of the service recipient during which the right to the payment of such compensation is no longer subject to a substantial risk of forfeiture. This short-term deferral exception is much longer than the 2˝ month short-term deferral used in § 409A and elsewhere in the Code. The short-term deferral exception, however, does not extend to compensation determined solely by reference to the amount of gain recognized on the disposition of an investment asset. Thus, once the investment asset has been sold and the deemed substantial risk of forfeiture removed, the 12 month period would not apply.
In compliance with U.S. Treasury Department Circular 230, you are hereby notified that any discussion of U.S. federal tax issues contained herein is not intended nor written to be relied upon, and cannot be relied upon, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
1 Compensation paid by state and local governments, which are also tax indifferent service recipients, is addressed in § 457.
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