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
 
In association with
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
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). 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 & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd 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 or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Emails

From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

*** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.