(The article featured
below is a selection from Hedge
Funds and Private Equity: Risk Management and Regulatory Update, which is
available to subscribers of that publication.)
Hedge Fund Group Opposes Deferred Compensation Provisions in Energy and Tax
Extenders Bill
A bill temporarily extending many expiring tax provisions of the Internal
Revenue Code would wrongly pay for those extenders by increasing the tax
obligations of the hedge fund industry, in the view of the Managed Funds
Association. In a letter
to Senate Republicans, the group said these provisions would adversely affect
the competitiveness of U.S.- based hedge fund managers. The House recently
passed (H.R. 6049) the Energy and Tax Extenders Act of 2008. The bill is now
stalled in the Senate, primarily over these and other revenue raisers.
To be competitive with non-U.S. based hedge fund managers and to meet the
demands of foreign and U.S. tax-exempt investors, explained the association,
U.S.-based hedge fund managers have established investment funds offshore.
Currently, the Code makes it necessary from a practical standpoint for U.S.
tax-exempt entities and non-U.S. investors to invest directly in those offshore
funds. The investors in these offshore funds expect the managers of the fund to
invest in the foreign fund in order to align their interests. U.S.-based hedge
fund managers establish offshore funds to meet the needs of these investors,
even though the managing of offshore funds can have negative tax consequences
for the manager and its employees.
Hedge fund managers therefore utilize both qualified and non-qualified deferred
compensation to attract and retain key personnel. Further, investors in offshore
funds frequently expect managers to make such deferrals because the deferred
amounts remain as general assets of the foreign fund, which continues to subject
them to risk of loss, thereby continuing the alignment of interests between the
manager and the investors. Ultimately, any deferred compensation is repatriated
and then generally taxed at the top ordinary income tax rate.
The proposal to eliminate the ability of hedge fund managers to defer taxation
on their compensation could affect existing contracts between hedge funds and
their managers and employees in a way that acts as a retroactive change in
settled law. The proposal would also have the effect of disrupting compensation
programs that have been legitimately established. The MFA argued that such a
retroactive change could disrupt the management of offshore funds at a time when
the U.S. capital markets need the liquidity provided by such funds.
According to House Speaker Nancy Pelosi, the bill would stop hedge fund managers
and corporate executives from escaping income taxes by using offshore tax havens
by immediately taxing the deferred compensation of executives and employees of
U.S. corporations that are offshore in a tax haven.
As explained by the House Ways and Means Committee, H.R. 6049 would tax
individuals on a current basis if they receive deferred compensation from a tax
indifferent party. Current law allows executives and other employees to defer
paying tax on compensation until the compensation is paid. This deferral is made
possible by rules requiring the entity paying the deferred compensation to defer
the deduction that relates to this compensation until the compensation is paid.
Matching the timing of the deduction with the income inclusion ensures that the
executive is not able to achieve the tax benefits of deferred compensation at
the expense of the Treasury. Instead, the entity paying the compensation bears
the expense of paying deferred compensation as a result of the deferred
deduction.
Where an individual is paid deferred compensation by a tax indifferent party,
such as an offshore fund, there is no offsetting deduction that can be deferred.
As a result, individuals receiving deferred compensation from a tax indifferent
party are able to achieve the tax benefits of deferred compensation at the
expense of the Treasury.
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