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PwC alternatives alert, October 10, 2008
A changing landscape: Analyzing hedge fund compensation after the elimination of fee deferral
On October 3, 2008, President Bush signed into law the Emergency Economic Stabilization Act of 2008. The primary purpose of this bill is to provide a plan for the Treasury Department to purchase troubled assets held by certain financial institutions and pension plans. The largest revenue raiser in this bill is a mechanism to currently tax deferred fees earned by hedge fund managers. New Section 457A may reduce the term of current deferrals and effectively ends the ability for hedge fund managers to defer fees in the future.
Description of Section 457A
Under Section 457A, fees that are deferred by investment managers of certain off-shore hedge funds are taxable to the manager at the time when there is no substantial risk of forfeiture on such compensation. The law is focused on plans held by "nonqualified entities" which include foreign corporations organized in jurisdictions typically viewed as "tax havens," and partnerships that are substantially owned by tax-exempt organizations and foreign entities that are not themselves subject to local tax. Note that Section 457A does not apply to compensation that is received within 12 months after the end of the year that the services are provided.
Once services have been performed, a substantial risk of forfeiture will not exist if the deferred fees are subject to risk of loss attributable to the performance of the underlying assets of an investment fund. If the amount of income is not determinable after services are rendered, Section 457A will subject such income to an additional 20% tax plus an interest charge in the future when the income is fixed.
A substantial risk of forfeiture will exist only if the recipient's rights to such compensation are contingent upon future performance of the recipient. An exception exists if the deferred compensation is determined solely by reference to the amount of gain recognized on the disposition of an investment asset. An investment asset does not include an investment fund or similar entity but rather refers generally to a single asset. As a result, the exclusion does not apply where losses on the disposition of one asset can be offset against gains on the disposition of a separate asset. In addition, this exclusion is not available if the fund manager participates in the active management of the asset.
This provision will be effective for compensation that is attributable to services rendered after December 31, 2008. In the case of deferrals that fall within this section but relate to services rendered prior to January 1, 2009, such deferred compensation needs to be taken into income as of the later of (i) a taxable year that begins before 2018 or (ii) the taxable year in which there is no substantial risk of forfeiture, in order to avoid interest and penalties.
Observations
Many hedge funds and alternative investment funds that are organized as master-feeders or other hybrid structures currently pay an incentive fee from the offshore feeder to the management company. In many cases, this incentive fee is deferred as a liability and is indexed to the performance of a fund or funds managed by the investment manager for a number of years. Until the time that the fee is fully vested, the fee grows on a pre-tax basis indexed to performance of the fund which is typically based on the trading value of the assets in the portfolio.
Under this new legislation, because a hedge fund's fee deferral plan would be held by a "nonqualified entity," such deferred compensation would fall under Section 457A and thus fees would not be permitted to be deferred in future years without being subject to interest and penalties. Prior amounts deferred under typical plan arrangements would also need to be taken into account for income tax purposes before 2018 in order to avoid interest and penalties.
- Restructuring Compensation Arrangements
Without the benefits of deferral and pre-tax basis growth, many funds might be faced with the recognition of ordinary fee income which not only is subject to the highest marginal tax rates but could also be subject to additional taxes, such as the self employment tax imposed on individuals or the 4% Unincorporated Business Tax (UBT) imposed on flow-through entities in New York City. In order to avoid negative tax consequences, funds may consider restructuring their funds before January 1, 2009, in order for foreign feeder funds to co-invest with the general partner who could then receive an incentive allocation from the co-investment vehicle rather than a fee.
For example, if a hedge fund is set up as a master-feeder structure with a foreign master partnership that holds investment assets, a US feeder fund that is a partnership, and a foreign feeder fund that is a corporation, the hedge fund could create a partnership to hold the foreign feeder's interest in the master, and that intermediate fund would be jointly owned by the general partner and the foreign feeder fund. In this type of structure, the general partner would receive an incentive allocation from the intermediate partnership. Such an allocation, if comprised of interest, dividends and other types of investment income, would likely not trigger self-employment tax, or the UBT if services are provided in New York City and would also allow the recipients to receive the benefit of flow through treatment on the income. Other potential structures exist, depending on the nature of income generated and the business needs of the fund principals, which may include creating mini-master funds or having the general partner own an interest directly in the master fund. If a fund contemplates restructuring the investment manager's compensation as a response to these new rules, it should consider the business purpose for such change, in addition to simply avoiding future penalties on deferred income. For example, Section 409A also covers deferred compensation plans, and could impose penalties if a deferred compensation plan is changed.
- Impact of Proposed Carry Legislation
A profits or incentive allocation, such as that typically made to a general partner in a US feeder fund, is not currently treated as "compensation" for tax purposes and is thus exempt from Section 457A. That is why restructuring a fund as a mini-master or use of an intermediate partnership is an effective strategy for tax purposes. In 2007, there were several proposals in the House and Senate that would change the treatment of income received pursuant to an incentive allocation. Referred to as "carry" in the proposed legislation, if enacted, would treat incentive and profits allocations generally as compensation subject to the highest marginal tax rates, self employment tax, etc. Whether or not this legislation is enacted depends on the president that is elected in November 2008 and whether the government seeks to regulate and impose higher taxes on hedge funds and alternative investment funds.
- Side Pockets
Some trading partnerships may also have investments in illiquid assets that are owned by investors in a side pocket arrangement. These illiquid investments are similar to private equity investments and a partner's income as well as the general partner's incentive allocation from such assets is typically not realized until the underlying asset is sold. Thus, if a partner redeems out of a partnership, such partner may retain an interest with respect to the side-pocket investment. While there is a carve out in Section 457A for deferred compensation that is based on gain recognized on an investment asset, it is not clear whether such exception could apply in typical side-pocket arrangements. Specifically, Section 457A(d)(1) provides that if compensation is determined solely by reference to the amount of gain recognized on the disposition of an investment asset, such compensation will be considered to be subject to a risk of forfeiture until the underlying asset is disposed.
This exception does not appear to apply if the compensation relating to this asset is netted against the disposition of any other investment assets in a fund. Guidance regarding the government's intent with respect to this exception can be found in the Joint Committee of Taxation's (JCT) description of H.R. 6049 which was one of the bills that preceded the Emergence Economic Stabilization Act of 2008. This bill also included a proposed Section 457A, which contained the same exception for substantial risk of forfeiture upon disposition of a single asset. As there is presently no JCT description of the current law, one can look to the prior JCT description for a possible interpretation. In its description, the JCT specifically provides that this substantial risk of forfeiture exception is not intended to apply if a fund holds two or more operating corporations and the fund manager's compensation is based on the net gain resulting from the disposition of both corporations. Thus, depending on a specific fund manager's compensation agreement, this exception may have limited applicability to typical side pocket investments in illiquid assets.
Note also that the single asset exception does not apply to an asset that is actively managed by a hedge fund investment manager. While no guidance can be found in the current Section 457A, the JCT report of H.R. 6049 provides that,"[a]ctive management is intended to include participation in the day-to-day activities of the asset, but does not include the election of a director or other voting rights exercised by shareholders." In addition, a portfolio manager's decision to buy or sell the investment is also not considered in this report to be active management. However, since there is no bright-line test, investment managers may have difficulty relying on this exception for targeted investments in illiquid assets where compensation is delayed until future disposition. Tax planning and structuring should be considered if active management in subsidiaries is intended by a fund manager.
Even if the investment asset exception is not satisfied, just because a fund has a side pocket investment does not mean that the income from such investment will be subject to interest and penalties under Section 457A. For example, if the income from an investment is held by a US fund that has substantially all US investors that are subject to tax, such compensation would not be deemed to be received from a "nonqualified entity." This may be common for US-based investments that generate US effectively connected income, even if owned through a blocker entity. In addition, if income is received pursuant to an allocation and not as compensation, such arrangement would likely not trigger Section 457A.
- Treatment of deferred fees prior to January 1, 2009
Prior and current deferred incentive fees need to be taken into income generally by a tax year beginning before 2018. For deferrals that vest prior to 2018, an election can be made (if compliant with Section 409A) to re-defer such amounts as long as the income recognized by December 31, 2017. If deferred fees are accelerated into income, it is intended that the acceleration not be deemed to be a violation of Section 409A, which if applicable, could result in additional penalties. Note that in a prior version of Section 457A sponsored by the House, there was an incentive for charitable donations of prior deferred fees; this is not part of the final legislation.
- Compliance with Section 409A
Despite the elimination of future incentive fee deferrals, Section 409A compliance is still important for hedge funds regardless of whether such funds have incentive fee deferrals in place. Section 409A has a broader application and impacts many forms of deferred employee compensation, not just the nonqualified compensation plans described above. As noted in the PwC Alternatives newsletter dated September 5, 2008, Treasury regulations recently promulgated under Section 409A contain numerous requirements that must be satisfied in order to avoid penalties as well as current taxation of deferred income. Taxpayers have until the end of 2008 to make sure that deferred compensation plans are up to date with these new rules. If deferred compensation plans are not in compliance with the new Section 409A rules as of January 1, 2009, the participants must recognize income on all deferrals made or vested after December 31, 2004 and an additional 20% tax penalty plus interest charges will apply. Taxpayers who maintain pre-2005 deferral plans should also take steps to ensure that such grandfathered plans are not co-mingled with plans subject to Section 409A or the grandfathered status of older plans may be lost.
Given the impact that this legislation may have on a number of hedge funds and alternative investment funds that currently have deferred fee arrangements in place, it is recommended that clients review the particular attributes of such plans in order to determine whether proactive restructuring should occur before December 31, 2008, in addition to developing a plan for taking prior deferred fees into account before 2018.
Specific advice and assistance may be sought from your PwC engagement team or from any of the partners in our Alternative Investment Funds Group.
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