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New Restrictions on Offshore Interests: An Examination of IRC § 457A

By Magda Bonutti Szabo, MAFIS, LL.M., Tax Director for Konowitz, Kahn & Company, P.C.

This article is reprinted with permission from the November 16, 2009, Vol. 35, No. 46 issue of the Connecticut Law Tribune. © Copyright 2009. Incisive Media US Properties, LLC. All rights reserved. duplication without permission is prohibited. All rights reserved.

On October 3, 2008, President Bush signed into law the Emergency Economic Stabilization Act of 2008, colloquially referred to as the Financial Bailout Bill. This Act’s provisions primarily addressed the $700 billion financial rescue with a number of extensions for popular expiring tax cuts included. Neatly slipped between these provisions was a brand new Tax Code Section, 457A (§ 801 of the Act), aimed particularly at U.S. service providers receiving income from offshore funds. Since this provision was under consideration prior to the market meltdown, it was included with the thinking that it would ultimately defray some of the bailout costs. The financial markets are now showing signs of rebounding, giving heightened importance to this provision.

BACKGROUND
The genesis behind this new provision was concern over income deferrals for service providers of offshore investment (hedge funds). Such funds are generally set up in no-tax jurisdictions such as the Cayman Islands or Bermuda. Per the provisions of IRC § 864(b)(2), fund income can be sitused to these tax haven offshore locations even though underlying services are technically being performed in the United States.

IRC § 409A requires that an election to defer income generally can be made as long as it is executed prior to the year in which the income is earned. The focus of § 409A is preventing a service provider from being able to control the receipt of the income. Hence, payments of deferred income per a set date, fixed schedule, change of control, disability, or death are acceptable. The service recipient (e.g., domestic corporation or partnership) must pay tax on any income generated by the deferred amount until the income is actually or constructively received by the service provider.

On the other hand, in a no-tax jurisdiction, the deferral on funds set aside does not cause the service recipient (foreign corporation or partnership) to incur any tax liability. Growth on the income sitused offshore is greater as it is not subject to taxation, increasing returns. Congress concluded that U.S. service providers receiving deferred compensation from such entities in tax haven jurisdictions have achieved the tax benefits of, in effect, qualified deferred compensation, without any of its restrictions, simply by their choice of jurisdiction.

New Code § 457A targets “nonqualified deferred compensation plans” of “nonqualified entities” where there is no “substantial risk of forfeiture,” mandating current inclusion in service provider income.

PLANS OR ARRANGEMENTS IN THE SCOPE OF IRC § 457A
Nonqualified deferred compensation plans are defined by reference to Code § 409A(d) which addresses plans or arrangements that provide for a deferral of income in general. Certain plans are exempt. These are the various qualified employer plans such as defined benefit and contribution plans and qualified benefit plans. Restricted stock, qualified incentive stock options or employee stock option plans are excluded.

There is a short-term deferral exception to § 457A. Compensation will not be treated as deferred if payment is received within 12 months of the end of the service recipient’s taxable year during which the substantial risk of forfeiture lapses. Hence, if the service recipient is on a fiscal year, and the service provider is on a calendar year, a significant deferral can be achieved.

SUBSTANTIAL RISK OF FORFEITURE
Generally, substantial risk of forfeiture lapses when no future substantial services are required to be rendered by the service provider in order for the service provider to obtain a right to income. The risk must be consequential. Risk will not be substantial if the service provider owns a significant amount of the total voting power or value of the service recipient.

Under § 457A, once the substantial risk of forfeiture on income lapses, it becomes taxable to the service provider. There are limited exceptions. If the service provider is actually paid within twelve months after the end of the taxable year in which the risk of forfeiture dissolves, recognition is deferred. Further elective deferrals are allowed only where the present value of the right that is being received on lapse is materially greater than what the service recipient could otherwise have elected to receive. For example, if a plan provides that the service recipient chooses to receive cash or shares that continue to be restricted for a period of years, deferral will continue.

There is an exception for deferred amounts tied to passive investment assets.
This involves compensation that is hinged on the sale of a passive investment asset (not including an investment fund or similar vehicle) where substantially all the gain is allocated to the entity’s investors. For example, if an investment fund provides that the fund manager receives a fixed percent of the gain from the disposition of an operating company, the carve-out can apply as long as the fund manager does not actively participate in the management of the operating company.

A major trap in § 457A triggering severe penalties involves deferred amounts that are not determinable when the risk of forfeiture lapses. In such cases, § 457A requires that the service recipient pay, in addition to income tax owed at forfeiture lapse, 20% of the deferred amount plus interest. These are typically arrangements calculated based on a formula. For example a year-end bonus based on a formula hinged off variables involving annual profits is not determinable at year-end when risk of forfeiture lapses.

NONQUALIFIED ENTITIES
IRC § 457A targets “nonqualified entities.” These are (1) “foreign corporations” or (2) “partnerships that are not otherwise exempt from 457A.” Foreign corporations are defined as offshore entities classified as corporations for U.S. tax purposes unless (1) at least 80% of a corporation’s income is “U.S. effectively connected income” per § 882; or (2) is income subject to “comprehensive foreign income tax” (generally, an eligible tax under a comprehensive U.S. tax treaty as long as no more than 20% of the foreign corporation’s income is non-resident sourced or the foreign tax rate is not materially lower).

Any partnerships, regardless of whether they are domestic or offshore, are “nonqualified entities” unless at least 80% of partnership income is directly or indirectly, allocated to (1) U.S. persons paying taxes on the income; (2) foreign persons with respect to whom such income is subject to a comprehensive foreign income tax; (3) foreign persons where the income is effectively connected with the conduct of a U. S. trade or business and a U.S. withholding tax is paid on the income; or (4) tax-exempt organizations where the income is unrelated taxable business income.

EFFECTIVE DATE
The new provision generally applies only to deferred compensation attributable to services rendered after December 31, 2008. Amounts deferred on account of services performed before January 1, 2009 may continue to be deferred under existing arrangements, but must be included in income on or before December 31, 2017, or later in the improbable event that a substantial risk of forfeiture still exists at such time. The requirements of § 457A that must be met are in addition to the existing deferred compensation rules of § 409A.

CONCLUSION
Code § 457A changes the deferred compensation rules for all “nonqualified entities.” We expect further guidance to be issued from the Treasury that will limit the definition so that only the intended entities, offshore investment funds, will be subject to § 457A. Meanwhile, taxpayers with offshore interests should be mindful of this provision.

The Author
Magda Bonutti Szabo is Tax Director at Konowitz, Kahn & Company, P.C., a CPA firm with offices in North Haven and Middlebury. She holds a B.A. and Master of Accountancy and Financial Information Systems from Cleveland State University, a Juris Doctor (J.D.) from Cleveland-Marshall College of Law, and a Master of Laws (LL.M.) in Taxation from Case Western Reserve University School of Law. She is admitted to practice in Connecticut, New York, Pennsylvania, Ohio, and Federal and U.S. Tax Courts, and holds a license as a certified public accountant.

Magda has been involved in planning, formation and reporting issues for domestic & foreign entities. She is an experienced advisor to clients on domestic and offshore tax matters involving corporations, partnerships, REITS, funds, investments, trusts, tax exempt organizations, start-up ventures, mergers, acquisitions, and divestitures. She is also skilled in domestic and foreign personal tax matters involving estate & succession planning, foundations, public charities and asset protection.