United States: Possible Offshore Deferrals For Hedge Fund Managers – IRS Confirms That Certain Stock Options And Stock Appreciation Rights Are Exempt Under Section 457A

The Internal Revenue Service (the "IRS") has issued Revenue Ruling 2014-18 (the "Ruling")1, which generally confirms that a stock-settled stock option or stock appreciation right that is granted with an exercise/base price of no less than the fair market value of the underlying stock on the date of grant will not be considered "nonqualified deferred compensation" subject to Section 457A of the Internal Revenue Code of 1986, as amended.2  Section 457A effectively ended the practice of offshore hedge fund fee deferrals.

Section 457A

Section 457A generally provides that any compensation that is deferred under a "nonqualified deferred compensation plan" of a "nonqualified entity" is includible in gross income when there is no substantial risk of forfeiture of the rights to such compensation. Under Section 457A, the term "nonqualified deferred compensation plan" generally includes any plan or arrangement pursuant to which a service provider has a legally binding right to compensation during a taxable year that is or may be payable to the service provider in a later taxable year. A "nonqualified entity" is generally defined as (i) any foreign corporation unless substantially all of its income (i.e., at least 80%) is (a) effectively connected with the conduct of a trade or business in the US, or (b) subject to a comprehensive foreign income tax, or (ii) any partnership (domestic or foreign) unless substantially all of its income (i.e., at least 80%) is allocated to persons other than (a) foreign persons with respect to whom such income is not subject to a comprehensive foreign income tax, and (b) tax exempt organizations.

In addition, if the amount of such compensation is "not determinable" at the time that such compensation is required to be includible in income under Section 457A, then such compensation will be includible in income when determinable and will be subject to a 20% additional penalty tax and imputed interest (at the underpayment rate plus 1%) as if such compensation had been includible in income as of the time the income was not subject to a substantial risk of forfeiture.3

Section 457A's enactment effectively ended the practice of offshore hedge fund fee deferral arrangements (other than with respect to certain grandfathered arrangements and arrangements that include service-based risk of forfeiture) as the payors under such arrangements typically qualified as "nonqualified entities" and the arrangements themselves typically qualified as "nonqualified deferred compensation plans."  Further, to the extent these arrangements were structured in a manner so that the amount of compensation includible in income was "not determinable" at the requisite time, Section 457A's punitive tax consequences would apply. Accordingly, most offshore hedge fund managers were forced to receive their performance compensation either in the form of a partnership allocation (since profits interests are generally exempt from Section 457A) or on an annual basis, based on annual performance (as opposed to receiving such fees later in the life of the fund based on a multi-year performance period). 

Of relevance to the Ruling, Section 457A specifically provides that the term "nonqualified deferred compensation plan" includes 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. Such language would clearly include most stock options and stock appreciation rights, as such arrangements typically provide for a right to compensation that is based on the appreciation in value of a set number of shares of the underlying stock in excess of a pre-established exercise/base price.

However, in the Ruling, the IRS confirmed its position that stock options and stock appreciation rights (each, a "stock right") will not constitute "nonqualified deferred compensation" for purposes of Section 457A if structured in the manner described below.

Summary of the Ruling

The Ruling generally provides that a stock right will not constitute "nonqualified deferred compensation" for purposes of Section 457A if:

  • the stock right's terms provide that it must be settled, and it is in fact settled, in "service recipient stock" (i.e., cash-settled stock rights are subject to Section 457A);
  • the exercise/base price of the stock right is at all times not less than the fair market value of the underlying stock on the date of grant of the stock right;
  • the stock right does not otherwise provide any feature for the deferral of compensation (e.g., any right that would allow for the deferral of compensation beyond the date of exercise/settlement);
  • the stock right is granted with respect to a fixed number of shares of service recipient stock; and
  • upon acquiring the service recipient stock pursuant to the exercise/settlement of the stock right, the service provider will have the same redemption rights with respect to such stock as the other shareholders.

What Hedge Fund Managers Need to Know

The important question is how useful will such stock rights really be as a form of deferred compensation for managers of offshore hedge funds. The following are some items to note in regards to the potential utility of stock rights for such purposes (some of which may prove to be non-issues or mere administrative burdens, while others may be non-starters from a tax, legal or business perspective):

  1. A new stock right would need to be granted each time a new or existing investor acquired shares in the fund with respect to a percentage of the shares acquired by the investor at such time.
  2. Each stock right would need to be structured in such a manner so that it is exempt from Section 457A, and the manager's stock rights (collectively) should provide that the manager would not receive a greater amount of compensation (for example, taking into account any hurdle) than it otherwise would receive in the absence of Section 457A restrictions. Upon exercise/settlement of the stock right, this typically would result in the manager having to include as ordinary income the "spread" between the exercise/base price of such stock right and the fair market value of the stock on the date of exercise/settlement.
  3. The manager's compensation would be based on the aggregate performance of the fund during the period from the date of grant through the date of exercise/settlement, rather than being based on annual performance as is currently typical.
  4. Since the exercise/base price of the stock right must at all times be no less than the fair market value of the underlying stock on the date of grant of the stock right, the fund's valuation procedures (which presumably would be used for determining such fair market value) may be subject to increased IRS scrutiny.
  5. Gain from the sale of the underlying shares, as well as distributions with respect to those shares, may be subject to adverse tax treatment under the "passive foreign investment company" ("PFIC") rules, which could negate much of the anticipated tax benefit.

Given the punitive tax consequences that would apply in the case of noncompliance with Section 457A (and the other potential legal, tax and business considerations and restrictions noted above), extreme care should be taken in structuring and implementing any such stock rights. We would be happy to assist and advise you with respect to such matters.

Footnotes

1 The Ruling is available here.

2 Although this confirmation is welcome, the IRS' position in the Ruling is consistent with its position taken in IRS Notice 2009-8, Q/A 2(b), which is available here.

3 For a more detailed summary of Section 457A and IRS Notice 2009-8, please see our prior client alert available here.

Possible Offshore Deferrals For Hedge Fund Managers – IRS Confirms That Certain Stock Options And Stock Appreciation Rights Are Exempt Under Section 457A

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
Shearman & Sterling LLP
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Shearman & Sterling LLP
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions