United States: Recent Legislation May Impact Offshore Hedge Fund Deferral Arrangements
(A periodic update on trends and developments affecting the industry)

By Elizabeth Shea Fries, Marian A. Tse and Robert G. Kester
Karen F. Turk contributed to the preparation of this article.

Congress enacted Section 409A of the Internal Revenue Code as part of the American Jobs Creation Act of 2004 to restrict certain deferred compensation arrangements. The IRS recently issued Notice 2005-1, 2005-2 IRB 274, clarifying certain aspects of the statute, and additional guidance is expected throughout 2005. Although the new statute does not specifically target offshore hedge fund management and incentive fee deferral arrangements, the broad scope of the statute appears to render it applicable to many such arrangements, and the onerous consequences of non-compliance make it critical for hedge fund managers to examine their deferral arrangements to assess whether changes should be made to conform with the new law.

Section 409A generally requires certain deferred amounts to be included in current income (and therefore subject to current tax), and imposes a penalty equal to 20% of the compensation required to be included in gross income (together with an interest charge), unless certain technical requirements (discussed below) are satisfied. The term "nonqualified deferred compensation plan" is expansively defined to include any plan or arrangement that provides for the deferral of compensation, subject to limited exceptions not generally applicable to most offshore hedge fund deferral arrangements.

To avoid current inclusion of deferred amounts (and attendant interest and penalties) under Section 409A, a deferral arrangement must satisfy certain technical requirements relating to the timing of distributions, acceleration of payments and mechanics of making deferral elections. In general, compensation deferred under a plan may not be distributed earlier than (i) separation from service (or six months following the date of separation from service for certain key employees), (ii) the date the provider becomes disabled, (iii) death, (iv) a specified time or fixed schedule specified under the plan at the time of the deferral, (v) a change of control of the service recipient, or (vi) an unforeseeable emergency. Moreover, the plan may not permit the acceleration of the time or schedule of any payment except pursuant to regulations that have yet to be promulgated. Finally, a service provider generally may only defer compensation for services performed during a year if the election to defer is made before the end of the previous year. In the case of an election to defer performance-based compensation based on services performed over a period of at least 12 months (e.g., incentive fees), the election may be made no later than six months before the end of the service period.

Section 409A is not limited to deferral arrangements with individuals. Section 409A specifically applies to deferral arrangements with personal service corporations (including similar entities organized in non-corporate form). Many investment managers are closely held firms where services are substantially performed by owner-employees, thereby falling within the definition of personal service corporations or similar entities. In that event, unless the investment manager provides advisory services to at least two "unrelated" funds, deferral arrangements between a hedge fund and a closely-held investment manager would be subject to Section 409A.

Very often, the investment manager who has entered into a fee deferral arrangement with the hedge fund will also enter into a mirror "back-to-back" deferral arrangement with its employees whereby the employees become entitled to payment when the manager receives its deferred fees from the hedge fund. However, a number of the distributable events permissible under Section 409A do not appear applicable to entity service providers. Given the limitations imposed by Section 409A on the timing of distribution of deferred amounts, back-to-back deferral arrangements may no longer be feasible and may have to be restructured to meet the requirements of the new statute.

Section 409A also prohibits the funding of deferral arrangements through trusts (or other arrangements determined by the Secretary of the Treasury) located outside the United States. The intent behind the statute is to target offshore rabbi trusts that are not subject to claims of U.S. creditors, but the statutory language is broad enough to include offshore hedge fund deferral arrangements. The amounts deferred in hedge fund deferral arrangements are typically held directly by the offshore hedge fund and are subject to claims of creditors. So far, no guidance has been issued as to what constitutes an "other arrangement" for these purposes. Accordingly, the application of these rules to most offshore hedge fund deferral arrangements remains uncertain. Practitioners are hopeful that future guidance, expected to be issued during 2005, will clarify this issue.

Section 409A generally applies to amounts deferred after December 31, 2004. An amount is "deferred" for this purpose only if the right to be paid is both legally binding and "earned and vested" (i.e., the amount is not subject to a substantial risk of forfeiture or a requirement to perform future services). Deferral arrangements in effect before January 1, 2005 are generally not subject to the new rules unless the plan or arrangement under which the deferral is made is materially modified after October 3, 2004.

The extent to which Section 409A ultimately restricts hedge fund management and incentive fee deferral arrangements remains subject to additional guidance that is expected to be issued in 2005. However, the current guidance permits plan sponsors of existing plans to amend or terminate the plans in 2005 without tax penalties. Hedge fund managers are encouraged to consult their tax advisors as to the application of Section 409A to their specific deferral arrangements and should consider whether to modify or replace their offshore deferral arrangements in light of the changes effected by Section 409A and the expected additional guidance.

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