One less loophole

The Emergency Economic Stabilization Act of 2008, which was signed into law on 3 October after weeks of intense debate, included changes to the US tax code that will restrict the ability of private equity and hedge fund managers to use fee deferrals to lessen their tax burden.

Prior to this new rule, a fund manager could reinvest management and incentive fees into a fund on a pre-tax basis, only paying taxes on the fees when they were distributed to the fund manager. This practice has been used almost exclusively by managers of offshore funds where deferral of the compensation deduction by the fund has no tax impact for either the fund or its investors.

The new rule affects deferred compensation schemes of “Nonqualified Entities”. This includes fund managers whose investors are “substantially all” exempt from US tax or a “comprehensive” foreign income tax system; and any partnership unless substantially all of the partnership's income is allocated to taxable investors, including foreign investors who are subject to a comprehensive foreign income tax. Any such compensation will be taxed when that compensation is no longer subject to “a substantial risk of forfeiture”. Under the new rule, a substantial risk of forfeiture exists if the manager's right to receive the compensation is conditional upon the future performance of substantial services.

The rule will eliminate those cases – relatively rare for private equity and hedge funds – where no one has to pay income tax on either fees or the income not shielded by the fee if it is deferred, says Edward Lemanowicz, a partner in Dechert's tax group. In a fund with substantially all taxable LPs, the LPs will pay income tax on the income of the fund not offset by the deferred fee, and in the case where the fee is not deferred, the manager will pay income tax on it. But in the case where the fee is deferred and the LPs are not taxable, then the fee goes untaxed.

“To the extent that no one is subject to tax, in the extreme case, there's no taxable income,” Lemanowicz says. “The act sort of views that as improper tax arbitrage.”

The tricky part of the new rule is determining what portion of a fund's investors must be tax exempt to constitute “substantially all”, and determining how a fund can go about proving the tax status of its investors, he says.

The good news is that the new rule does not affect carried interest. For hedge funds and private equity funds that are formed as partnerships and that provide incentives to fund managers in the form of carried interest, such arrangements will not be treated as deferred compensation subject to the act's new anti-deferral rule.

The act's effective prohibition on deferrals applies to compensation for services rendered after 31 December, 2008. Existing deferrals attributable to services performed prior to 1 January, 2009 are grandfathered under the act, provided any such amounts deferred are distributed and taxed before the last taxable year beginning prior to 2018 (or when such compensation becomes vested, if later).