Section 457A of the Internal Revenue Code (the Code) generally restricts the ability of offshore funds and other entities domiciled in tax-indifferent jurisdictions to offer tax-advantaged deferred compensation to U.S. persons. Revenue Ruling 2014-18 holds that stock options and stock-settled stock appreciation rights (SARs) granted by these entities can be structured to avoid Section 457A. Among other things, this ruling allows an offshore fund to compensate its managers with stock rights that will only be subject to U.S. tax upon exercise, so long as the stock right is exempt from Section 409A and the manager has the same redemption rights with respect to acquired shares as other shareholders of the hedge fund.
Section 457A Restrictions on Nonqualified Deferred Compensation
Section 457A restricts the ability of so-called nonqualified entities to defer compensation on a tax-deferred basis to persons subject to tax in the United States. A “nonqualified entity” for this purpose includes foreign corporations domiciled in tax-indifferent jurisdictions and foreign partnerships whose partners are at least in part not subject to tax. If applicable, Section 457A will treat deferred compensation as taxable income when there is no longer a substantial risk of forfeiture. The scope of what constitutes a “substantial risk of forfeiture” under Section 457A is much narrower than under other provides of the Code. Generally, a substantial risk of forfeiture is limited to conditions that relate to the continued performance of services, as opposed to meeting bona fide performance goals. As a result, it is difficult for nonqualified entities to provide incentive compensation on a tax-deferred basis when the only risk of forfeiture is tied to performance objectives.
Section 457A was primarily aimed at fee arrangements between fund managers and offshore funds, and its impact was immediate and profound. Offshore private equity and hedge funds had regularly deferred the payment of incentive fees to fund managers. The amount of fees could be based on fund performance during a single year or over several years. These type of fee arrangements largely disappeared for new service periods after the enactment of Section 457A. In particular, it was important for funds not to defer fees when the payout could not be determined on vesting. Payouts that varied due to future performance fund performance trigger an additional 20-percent tax and interest charges under Section 457A, similar to the penalties imposed under Section 409A of the Code. (Note that Section 457A impacted only fee arrangements and not management incentives structured as carry/partnership interests.)
Relief for Certain Stock Rights under Revenue Ruling 2014-18
The ruling describes a situation in which a nonqualified entity that is a foreign corporation grants stock rights that are exempt from Section 409A to a U.S. limited liability company taxable as a partnership for U.S. income tax purposes (the U.S. service provider). Among other things, the stock rights arrangement does not include any feature for the deferral of compensation, the stock right exercise price is not less than the fair market value of the underlying stock on the date the option is granted, and the awards are for a fixed number of common shares of the nonqualified entity. In addition, the U.S. service provider has the same redemption rights with respect to common shares acquired upon exercise of the stock rights as other shareholders have with respect to their common shares of the nonqualified entity. Revenue Ruling 2014-18 holds that stock rights subject to these restrictions will not to be treated as nonqualified deferred compensation under Section 457A. As a result, a U.S. service provider receiving stock rights that are structured to avoid Section 457A will only be taxable upon exercise.
Set forth below is a chart illustrating how this ruling may be useful to a fund (that is a nonqualified entity) in structuring incentive compensation for its fund managers. In addition to receive a 2-percent management fee on a current basis, the fund manager will receive stock-settled SARs that allow the fund manager to participate in 20 percent of the appreciation of the fund’s appreciation above $100 million. The stock-settled appreciation rights are not subject to a continued service requirement after the date of grant. There is no income tax to the fund manager upon grant when the compensation is considered vested under Revenue Ruling 2014-18. In 2017, the fund appreciates to $300 million, at which point the fund manager decides to exercise the stock-settled SAR. It is only then that the service provider is subject to U.S. income tax on the $40 million gain ($300 million–$100 million * 20 percent) from settlement of the stock-settled SARs.
Section 457A and Revenue Ruling 2014-18 also apply to U.S. persons providing services to employers that are nonqualified entities. Thus, for example, employees working for an employer in Bermuda may be granted a stock-settled SAR as a form of tax-deferred compensation, despite the fact that the employer is a nonqualified entity.
Revenue Ruling 2014-18 does not explicitly state when equity interests received by a manager can be transferred to a third party or redeemed for cash consistent with the stock rights being exempt from Section 457A. In other words, are there circumstances in which an option or a stock-settled SAR would be recharacterized as being cash settled and, therefore, outside the scope of the Section 457A exemption? The only limitation stated in Revenue Ruling 2014-18 is that the service provider has “the same redemption rights with respect to common shares acquired upon exercise of the stock rights as other shareholders have with respect to their common shares.”
Revenue Ruling 2014-18 also does not address the application of these principles when the nonqualified entity is a partnership, limited liability company or other form of non-corporate entity. Presumably, the concepts set forth in the Revenue Ruling 2014-18 are to be applied “by analogy” with respect to “an equity interest in a non-corporate entity (meaning a right to purchase actual equity in such entity, and not a mere right to an amount equal to the appreciation in such equity),” consistent with earlier Section 457A guidance under Notice 2009-8.
This new guidance should be welcome news to fund managers. This ruling provides comfort for fund managers to receive incentive compensation on a tax-advantaged basis in the form of stock rights in a manner that aligns their interests with those of the fund investors. Care must be exercised in structuring stock rights to both meet the conditions under Revenue Ruling 2014-18 and the fund managers’ expectations as to the value of those rights.