In the recently published Revenue Ruling 2014-18, the Internal Revenue Service (IRS) concluded that certain nonqualified stock options (NSOs) or stock appreciation rights (SARs) would not be subject to the anti-deferral rules of Internal Revenue Code section 457A (section 457A). Generally, section 457A prohibits the deferral of income for service providers that perform services for nonqualified entities (i.e., foreign corporations based in offshore tax havens, entities substantially owned by tax-exempt organizations, or other tax-indifferent parties). This ruling unlocked a way for fund managers to defer taxes on incentive fees earned from offshore funds. The ruling also created an opportunity for fund managers to attract investors seeking a better system to align fees with multiyear performance periods.
Prior to the passage of section 457A, fund managers were able to defer taxes on incentive fees earned from offshore funds until they chose to repatriate them. They would typically reinvest profits into funds or simply leave cash to accrue in the offshore funds. In 2008, Congress effectively put an end to this practice by introducing section 457A, which for the most part, forced fund managers to recognize incentive fees in taxable income as soon as they were earned. Thus, all incentive fees owed to the fund manager were recognized into taxable income in the year they were earned whether or not the offshore fund actually paid the fund manager that year. This led most offshore fund managers to distribute their fixed incentive annually from the offshore funds.
An unintended consequence of this change was the decoupling of fund manager and investor interests. Investors feared fund managers would seek short-term returns and not the long-term investment horizons preferred by most investors. Fund managers could have high payouts in good years leaving investors with little chance of clawing back incentive fees in future bad years. Pension funds and other long-term institutional investors pushed fund managers to better align incentive payouts to multi-year performance periods, but due to the anti-deferral provisions in section 457A, fund managers typically refused to budge.
Revenue Ruling 2014-18
In Revenue Ruling 2014-18, a foreign corporation issued NSOs and SARs to a US partnership as consideration for services provided. Each NSO and SAR could be converted to a fixed number of common shares and were issued at the fair market value of each share at the grant date. The ruling stated the rights can only be settled in stock upon exercise. Common shares awarded upon exercise would have the same redemption rights as those of other shareholders. The rights have no other feature of deferred compensation, in order for service providers to avoid running afoul of the section 457A rules.
This ruling provides an avenue for fund managers to defer taxes on incentive compensation earned at offshore funds. Taxable income recognition would be triggered upon the exercise of the rights and would be based on the difference between the fair market value of the shares received and their respective exercise price. A key disadvantage of the use of NSOs or SARs is that taxable income resulting from the exercise of these securities is ordinary and not considered long-term capital gains. As such, the use of these instruments to defer taxes is efficient in only some situations, particularly for managers of mark-to-market funds or other funds with short-term and heavy trading strategies. Managers with substantial long-term capital gains might still prefer to use a mini master structure with an incentive reallocation instead of a fee.
Revenue Ruling 2014-18 paves the way for fund managers to adhere to investor demands and align their incentive compensation to their investor’s multiyear investment time horizons. Fund managers in turn can defer taxes on incentive compensation earned from offshore funds until they exercise the stock rights or options awarded to them. The tax deferral mechanisms described in this article may not be appropriate in all situations, but they can certainly help many fund managers attract investors and defer taxes on profits held abroad.
Adopting a stock option or stock appreciation rights plan has many tax complications. Fund managers should assess the applicability of deferred compensation rules and the passive foreign investment company tax regime. As with any new revenue ruling, there are tax planning opportunities to consider.
For more information on this topic, or to learn how Baker Tilly asset management industry specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.