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 US-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 Way and Means Committee, HR 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.