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November 13 2008
Employers Beware: Under New Law, U.S.
Employees of Many Partnerships and Foreign Corporations May No Longer Be Able to
Beginning on January 1, 2009, commonly used nonqualified deferred compensation
arrangements may no longer be available to U.S. employees of certain
partnerships and foreign corporations (referred to herein as “Covered
Employers”). Legislation enacted on October 3, 2008 has added Section 457A to
the Internal Revenue Code (the “Code”). Section 409A of the Code (“Section
409A”) (enacted in 2004) already imposes many requirements and limitations on
nonqualified deferred compensation arrangements. However, new Section 457A of
the Code (“Section 457A”) may spell the end of U.S. federal income tax deferral
for compensation paid to U.S. employees by Covered Employers.
Hedge funds, whose U.S. managers are the primary target of Section 457A, will
naturally want to review the effect of the new rules on their deferred fee
arrangements and to monitor for upcoming regulations or other guidance that will
presumably address some of the uncertainties created by the new statute
(including, in particular, the uncertainties illustrated by the examples below).
However, all Covered Employers who may pay deferred compensation should also
carefully examine the potential application of the new statutory rules to their
employees subject to U.S. taxes, including U.S. citizens and U.S. residents, and
monitor for any new guidance with respect to these rules.
The New Law Ends Deferral or Imposes a Punitive Tax on Deferred Compensation
The new law introduces two basic rules for “deferred compensation” (i.e.,
compensation deferred for a period of more than 12 months following the year in
which it is earned) received from a Covered Employer. First, deferred
compensation is taxable once it is “vested.” Deferred compensation is vested
when it is no longer subject to a substantial risk of forfeiture (generally,
once the right to compensation is no longer contingent upon the performance of
“substantial” future services). Second, if at the time of vesting the amount of
deferred compensation is not determinable, it is included in income when it
becomes determinable. However, at the time the amount becomes determinable, it
is also subject to an additional 20% tax plus interest.
The New Law Targets Hedge Fund Managers, But…
Section 457A targets a structure commonly used to defer fee income received by
managers of offshore hedge funds. In a typical offshore hedge fund structure, a
fund manager (generally organized as either a foreign corporation or
partnership) earns fee income from the funds it manages and, in turn, pays
compensation to the individuals who provide the management services on its
behalf. The compensation arrangements also frequently include non-qualified
deferred compensation plans that allow the individuals to defer all or a portion
of their compensation, subject to the limitations of Section 409A. Under Section
457A, this deferral opportunity will be substantially eliminated.
The Broad Reach of the New Law Extends to Many Other Types of Employers
The scope of Section 457A is much broader than just hedge fund managers, in
large part as a result of the statutory definition of “Covered Employers” whose
compensation arrangements are subject to the new rules. Under Section 457A,
Covered Employers include, with limited exceptions, all non-U.S. corporations
unless substantially all of their income is subject to a “comprehensive foreign
income tax.” It therefore generally includes, among others, all corporations
organized in offshore jurisdictions like the Cayman Islands, Bermuda or the
British Virgin Islands. It also includes any partnership, whether domestic or
foreign, any meaningful amount of whose income is allocated to partners who are
either U.S. tax-exempt organizations or non-U.S. persons not subject to a
“comprehensive foreign income tax” with respect to such income.
“Side Pocket” Arrangements
Section 457A authorizes regulations that would treat deferred fees with respect
to certain single-investment “side pocket” arrangements as being unvested until
the side pocket’s sole investment is sold (which would prevent the application
of the additional 20% tax and interest charge). However, no such regulations
have been issued so far. Furthermore, it remains unclear how this special rule
will interact with the rules of Section 409A. Treatment of side pocket
arrangements will remain uncertain until the Treasury Department issues guidance
that activates the special rule and addresses the interrelation between Sections
409A and 457A with respect to single-investment side pocket compensatory
To better understand what the new rules mean as a practical matter, consider the
following common scenarios:
1. Deferred Hedge Fund Fees:
Andrew is a U.S. citizen employed by Investco. Investco is a foreign hedge fund
manager and is a Covered Employer. Investco agrees to pay Andrew annual
compensation in an amount equal to a specified percentage of the fund’s net
income (his “Fees”). Andrew is entitled to (and does) defer this compensation
under an arrangement that complies with Section 409A. Deferred Fees accrue
earnings at a rate that reflects the rate of appreciation of the fund’s assets.
The deferred Fees, together with earnings thereon, are payable at the earlier of
the time that Andrew terminates his employment with Investco or the time that
the fund is liquidated.
In this example, Andrew’s right to his deferred Fees and any earnings that may
be credited to those deferred Fees is “vested” (that is, not subject to a
substantial risk of forfeiture) at the time he performs the services.
Accordingly, under the first rule of Section 457A, Andrew should be subject to
tax on the amount of his deferred Fees in the year that he performs the services
to which those deferred Fees are attributable. However, the total amount of the
earnings that he will receive is not determinable because they depend on the
performance of the fund. As a result, it is not clear how the Internal Revenue
Service (the “IRS”) will apply the second rule of Section 457A. The IRS most
likely will determine that the amount of the deferred Fees is determinable and
included in Andrew’s income at the time it is earned and credited to his account
each year and that any earnings on the deferred Fees are determinable and
included in his income as they are earned and credited to his account each year.
(Under this scenario, it is not clear how the losses would be treated -- perhaps
Andrew would not be allowed any deduction for losses but would not include
additional earnings in income until after he recoups prior losses through
additional earnings.) Alternatively, the IRS may determine that the amount of
the deferred Fees is determinable and included in his income each year, but the
amount of earnings to be paid to him in the future is not determinable until the
final payment date (because of potential losses and unknown future earnings). In
that case, the amount of earnings would not be taxable until paid to him in the
future. (This treatment would be analogous to the treatment of earnings after
vesting under deferred compensation plans of governmental entities and tax
exempt organizations under Section 457(f) of the Code.) Under this analysis, the
earnings would be subject to the additional tax of 20% plus interest in at the
time of payment. Finally, though not very likely, the IRS may determine that the
total amount of the deferred Fees and earnings thereon is not determinable until
paid. Under that analysis, Andrew would not pay any tax on either the deferred
Fees or the earnings on the deferred Fees until all of the deferred compensation
is paid, but it would all be subject to the additional tax of 20% plus interest
2. Defined Benefit Deferred Compensation:
Employee Betty is a U.S. taxpayer who works for foreign corporation, Caymanco.
Caymanco is organized in the Cayman Islands (one of a number of jurisdictions
that do not have a comprehensive income tax system) and is thus a Covered
Employer. Caymanco provides Betty with a nonqualified supplemental executive
retirement plan (“SERP”). The SERP benefit is based on a percentage of Betty’s
final average pay and years of service. The benefit vests after 5 years of
service. Upon vesting, Betty will not know the amount of her SERP benefit
because she may have future earnings and years of service that will affect the
amount of the benefit.
Because the benefit is not determinable upon vesting, under Section 457A, Betty
does not have taxable income at vesting, but will be taxed at ordinary income
tax rates, incur an additional 20% tax and bear an interest charge when the
amount of her benefit can be determined (i.e., upon her retirement).
3. Elective Deferrals:
Assume the same facts as in Example 2, except Caymanco provides Betty with a
nonqualified deferred compensation plan under which Betty may elect to defer up
to 30% of her salary, payable upon termination of employment. Caymanco will
match her deferrals up to 5% of her salary, subject to a 3-year vesting
requirement. Under this arrangement, Betty’s account balance payable upon
termination will include the aggregate of her deferrals and matching
contributions, adjusted for earnings or losses thereon based on various
investment options chosen by Betty.
Prior to the enactment of Section 457A, Betty generally would have been able to
defer tax on her deferred compensation until termination of her employment.
However, Section 457A significantly alters this result. Since Betty is always
vested in her elective deferrals, such amounts should be taxable immediately
under Section 457A in the year that she earns the salary (thus defeating the
purpose of the deferral arrangement). With respect to the matching
contributions, Betty should first become taxable on the accumulated matching
contributions when she becomes vested in year 3 under the first rule of Section
457A, and each matching contribution after vesting should be taxable at the time
it is credited to her account. However, the precise amount of all or a portion
of Betty’s ultimate deferred compensation benefit may be viewed as not
determinable until paid due to the continuing adjustment for earnings and losses
as discussed with respect to Andrew’s deferred Fees in Example 1. Forthcoming
regulations will likely explain which of the three alternatives described in
Example 1 will apply for determining the timing of the taxation of Betty’s
deferred compensation. However, we expect the most likely result is that (1) her
own deferrals will be taxed as they are earned and credited to her account each
year, (2) the amount of accumulated matching contributions through the vesting
date, together with earnings thereon, will be taxed at the vesting date and
subsequent matching contributions will be taxed as they are credited to her
account, (3) earnings on her own deferrals will be taxed as they are credited to
her account, (4) earnings on the matching contributions after the vesting date
will be taxed as they are credited to her account and (5) special rules will
address how to deal with losses.
The rules of Section 457A generally apply only to compensation for services
performed on or after January 1, 2009. However, deferred compensation amounts
relating to services performed prior to that date do not escape Section 457A.
Rather, such amounts will be includible in income no later than 2017 (or, if not
yet vested by that point, upon vesting).
This memorandum is a summary for general information and discussion only and may
be considered an advertisement for certain purposes. It is not a full analysis
of the matters presented, may not be relied upon as legal advice, and does not
purport to represent the views of our clients or the Firm. Linda Griffey, Luc
Moritz, Summer Conley, and Bryan Kelly contributed to the content of this
newsletter. The views expressed in this newsletter are the views of the authors
except as otherwise noted.
Portions of this communication may contain attorney advertising. Prior results
do not guarantee a similar outcome. Please direct all inquiries regarding our
conduct under New York's Code of Professional Responsibility to O’Melveny &
Myers LLP, Times Square Tower, 7 Times Square, New York, NY, 10036,
Phone:+1-212-326-2000. © 2008 O'Melveny & Myers LLP. All Rights Reserved.
IRS Circular 230 Disclosure
To ensure compliance with requirements imposed by the IRS, we inform you that
any U.S. tax advice contained in this communication (including any attachments)
is not intended or written to be used, and cannot be used, for the purpose of (i)
avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing
or recommending to another party any matters addressed herein.
June 11 2008
Social Security is pleased to announce
that the enrollment period for the Consent Based Social Security Number (SSN)
Verification (CBSV) service has been extended through June 30, 2008.
As you know, CBSV is a fee-based SSN verification service that will permit
private businesses, Federal, State, and local governments to verify an
individual’s SSN once a valid and signed consent form is obtained from the SSN
holder. This letter is being sent to you because you and/or your affiliates may
have an interest in enrolling in this service. Service will begin October 2008.
If you are interested in more information about CBSV, click on, http://www.socialsecurity.gov/bso/cbsvMarketing.html
If you have any questions you may write to SSA.CBSV@ssa.gov.
We hope you will find this service useful and look forward to the opportunity to
discuss this exciting new project with you.
Associate Commissioner for External Affairs
June 11 2008
ATTENTION ALL Hawaii QHTB'S - Tax
Filing Deadline for N-317 June 30th
The deadline for filing the new on-line N-317 is June 30th. Two critical reasons
for filing on time:
1. The penalty for not filing is $1,000 per month up to $6,000.
2. The data DoTax receives from industry will be critical in the discussion on
the renewal of Act 221/215.
Visit the DoTax site home page http://hawaii.gov/tax/ and look for "E-File
Login" for instructions.