Executive Summary New Section 457A (Nonqualified Deferred Compensation) New York November 3, 2008 On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (H.R. 1424) was signed into law. The Act adds new section 457A to the Internal Revenue Code of 1986, as amended. Section 457A requires any nonqualified deferred compensation paid by a nonqualified entity to be included in income when the compensation is no longer subject to a substantial risk of forfeiture. Amounts that are not determinable at the time there is no substantial risk of forfeiture are includable in income when they are determinable, subject to an interest charge (computed back to the year in which the compensation was deferred or was released from a substantial risk of forfeiture) plus a penalty tax equal to 20% of the amount of such compensation. Section 457A generally eliminates the ability to defer, without penalty, compensation payable from nonqualified entities very generally (under the statute without benefit of guidance that may clarify various uncertainties), foreign corporations incorporated in non-tax treaty jurisdictions and not subject to U.S. net income tax, or pass-through entities unless substantially all of the partners are subject to U.S. tax or are foreign persons resident in tax treaty jurisdictions. For section 457A, a substantial risk of forfeiture is only related to performance of substantial services and does not include other contingencies, even if they are significant and related to performance goals of the service recipient. While section 457A is targeted primarily at the typical fee deferral arrangements of offshore hedge funds, it is likely to have an impact beyond the hedge fund area. Cleary Gottlieb Steen & Hamilton LLP, 2008. All rights reserved. This memorandum was prepared as a service to clients and other friends of Cleary Gottlieb to report on recent developments that may be of interest to them. The information in it is therefore general, and should not be considered or relied on as legal advice.
In fact, the potential application of section 457A may be of concern to all individual employees subject to U.S. income tax (including U.S. citizens or residents who are working abroad, or foreign individuals subject to U.S. taxation with respect to services performed in the United States) who are working for foreign corporations or for many U.S. or foreign partnerships. Section 457A may also be of potential concern for a variety of other U.S. service providers that are receiving compensation from a partnership or from a foreign corporation. Although section 457A applies only to services provided to nonqualified entities, it will apply to a broader class of service providers than section 409A does. 1 For example, section 457A appears to apply to accrual method taxpayers. Consequently, corporations with deferred fee income will need to determine whether section 457A will require them to accelerate their income inclusion or potentially subject them to a 20% penalty tax (if the deferred compensation is not determinable at the time it is no longer subject to a substantial risk of forfeiture). Similarly, unlike section 409A, section 457A does not currently contain an exclusion for independent contractors. Consequently, professional service firms whose fee payment arrangements are based on contingencies (aside from the obligation to continue to perform services) may be subject to section 457A. Section 457A will apply to deferred compensation attributable to services performed starting January 1, 2009. Deferred compensation attributable to services performed prior to that benefit from a transition rule and can be deferred until the later of the last taxable year of the service provider beginning before 2018, or the taxable year in which the compensation is no longer subject to a substantial risk of forfeiture (as defined in new section 457A). 1 Section 409A, which generally requires that deferred compensation be included in income either on one of several specified permissible payment dates or events or once the amount is no longer subject to a substantial risk of forfeiture (under a broader definition of substantial risk of forfeiture), continues to apply in addition to section 457A. While section 457A borrows a number of concepts from section 409A of the Code, there are a number of key differences between these two provisions. 2
Certain aspects of the scope of the statute are currently unclear and require clarification in future regulations and guidance. Below is a summary of some of the key uncertainties that exist in the absence of further guidance. 2 KEY UNCERTAINTIES It is currently uncertain when the status of a service recipient as a nonqualified entity is tested - that is, whether it is at the time the nonqualified deferred compensation plan is entered into or at the time the compensation is no longer subject to a substantial risk of forfeiture. Consequently, a service provider may not know whether its deferred compensation will be subject to section 457A. The treatment of foreign persons as being subject to a comprehensive foreign income tax is also uncertain; future guidance will be necessary to clarify when a corporation that is resident in a tax-treaty jurisdiction is treated as not being subject to a comprehensive foreign income tax, or when a corporation resident in a nontax treaty jurisdiction is treated as being subject to a comprehensive foreign income tax. Section 457A raises several compliance issues. The determination of whether a service recipient constitutes a nonqualified entity depends on facts that may not be available to a service provider. In the case of partnerships, these facts include the identity and tax status of partners and the allocation of income among the partners (including similar information about upper-tier pass-through entities) and in the case of foreign corporations, the details of its home country tax status and whether it is entitled to qualify for benefits under a comprehensive income tax treaty. Deferred compensation that is not determinable at the time there is no substantial risk of forfeiture is includable in income when it becomes determinable, plus a 20% penalty tax and an interest charge. The statute does not define the term determinable, although upcoming regulations are expected to provide guidance. Given the penalty / no penalty result that hinges on determinability, there may be considerable pressure to avoid arrangements where determinability is in doubt. 2 For a more detailed discussion of the scope and implications of section 457A, see our Alert Memorandum Thoughts on the Scope and Implications of New Section 457A (Nonqualified Deferred Compensation), dated November 3, 2008. 3
Section 457A contains a very limited exception that treats deferred compensation as subject to a substantial risk of forfeiture (and therefore not subject to current accrual) if determined solely by reference to gains on the disposition of an investment asset. While this exception probably is intended to cover typical hedge fund side pocket arrangements, the utility of the exception is likely to be limited due to its restrictive and somewhat unclear conditions. NEXT STEPS Existing nonqualified deferred compensation plans should be reviewed to determine whether: they are of a type that may be subject to section 457A (e.g., fee income, SARs, RSUs, certain partnership guaranteed payments); the service recipient under the plan is or may become a nonqualified entity; the deferred compensation is subject to contingencies that are considered to constitute a substantial risk of forfeiture for purposes of section 457A that is, the future performance of substantial services by any individual; the deferred compensation payable under such plan is determinable at the time it is no longer subject to a substantial risk of forfeiture; and to the extent covered by section 457A, the plan qualifies for one of the few exceptions from section 457A (i.e., short-term deferral, the investment asset exception, or deductibility against effectively connected income of a foreign corporate service recipient). The statute indicates that there will be only a limited time period during which plans can be amended to comply with section 457A without violating section 409A. Consequently, any pre-2009 deferral arrangements that are subject to section 457A will need to be amended in the near future to provide for payment by the last taxable year of the service provider beginning on or before 12/31/2017 or the date upon which there is no longer a substantial risk of forfeiture, if later. The description of the permitted amendment in H.R. 1424 is narrow (it only applies to an acceleration of the timing of distributions to match section 457A income inclusions) and does not necessarily cover amendments more broadly. Accordingly, any broader 4
changes (e.g., conforming the compensation plan to the narrower definition of substantial risk of forfeiture, amending the compensation to be determinable ) should be implemented before the end of 2008, so as not to violate section 409A. Hedge fund side pocket arrangements will need to be reviewed to confirm that the receipt of fees is subject to a substantial risk of forfeiture within the meaning of section 457A. Alternatively, they must be restructured to either qualify under the investment asset exception or to be replaced with a partnership carried interest (i.e., a mini-master fund structure in which investment assets are held in a partnership and the hedge fund manager receives a partnership distributive share of income or gain from such investment). Deferred compensation attributable to services performed in 2009 and afterwards for nonqualified entities cannot be deferred for more than twelve months from the end of the taxable year of the service recipient in which there is no longer a substantial risk of forfeiture. Questions regarding this memorandum or the application of section 457A may be directed to Bob Raymond, Jason Factor or any of our other partners or counsel in New York listed under Tax or Employee Benefits in the "Practices Areas of Law" section of our website (http://www.clearygottlieb.com). * * * * * CLEARY GOTTLIEB STEEN & HAMILTON LLP 5
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