Recently, Chairman Thomas introduced the American Jobs Creation Bill in the House of Representatives for passage. Similar to the recently passed Senate Jumpstart Our Business Strength (JOBS) Act, the bill includes various provisions that may affect hedge funds and their managers. However, certain provisions contained in the Senate JOBS Act are not included in the House version. As the legislative process moves forward, it remains questionable whether a tax bill will emerge from joint House-Senate conference during this presidential election year and be enacted into law during 2004. An overview of the general legislative proposals included in the House bill that may affect hedge funds and their managers is presented below.
Under the bill, assets set aside directly or indirectly in an offshore trust (or other arrangement designated by the Secretary of the Treasury to be covered by these rules) for the purpose of paying nonqualified deferred compensation are treated as currently includible in gross income to the extent that they are not subject to substantial risk of forfeiture and at the time set aside or transferred outside of the United States. The phrase “other arrangement” in the proposed language is not clarified.
If the requirements of the bill are not satisfied, then in addition to current income inclusion, interest at the underpayment rate plus one percentage point will be imposed on the underpayments that would have occurred had the compensation been includible in income when first deferred or, if later, when not subject to a substantial risk of forfeiture. Any increases in the value or earnings with respect to such assets are treated as additional transfers of property. Moreover, a nonqualified deferred compensation plan may not allow distribution events and may not permit acceleration of distributions.
Offshore fund deferred compensation arrangements that do not involve offshore trusts are not subject to the rule requiring current taxation until such time as the arrangement is identified as such by the Internal Revenue Service.
Of particular significance, absent from the bill is the JOBS Act provision that would require investment options that a participant may elect under a nonqualified deferred compensation plan to be comparable to those that may be elected by participants of the qualified plan that has the fewest investment options. In addition, the 10% “penalty tax” contained in the Senate JOBS Act is not included in the bill.
If enacted into law as drafted, the deferred compensation provisions of the bill would be effective for amounts deferred after June 3, 2004, unless deferred prior to 2005 pursuant to an irrevocable election made on or before June 3, 2004.
Reportable Transaction Disclosures and Penalties
The bill contemplates penalties ranging from US$10,000 to US$200,000 per transaction for failure to disclose reportable transactions. The penalty is US$10,000 in the case of an individual and US$50,000 in any other case. The amount is increased to US$100,000 and US$200,000 respectively, in the case of a “listed transaction,” or one that is “substantially similar” to a listed transaction. The penalties are strict liability penalties to be imposed on any person who fails to include with any return or tax statement any required information with respect to a “reportable transaction.” This proposal would be effective for returns and statements the due date for which comes after the date of enactment.
Moreover, the bill replaces existing rules applicable to tax shelters with a new accuracy-related penalty that applies to listed and reportable transactions with a significant tax avoidance purpose. The penalty rate (ranging between 20% and 30%) and defenses available to avoid the penalty vary, depending on whether the relevant transaction has been adequately disclosed.
Significant penalties included in the Senate JOBS Act as well as the House bill, if enacted, will place increased pressure on hedge funds and their service providers to accurately track and determine which items should be reported. Additionally, California recently has enacted similar legislation imposing significant nondisclosure penalties, and other states, including New York, are preparing their own similar legislation. Recently, anti-tax shelter legislation has gained momentum in the United States and abroad as a result of the current business, political and budgetary environments.
Limited Mandatory 754 Basis Adjustments
Instead of the mandatory section 754 basis adjustments proposed in the JOBS Act, the bill would limit that provision to instances of losses such as where a partner contributes built-in loss property to a partnership or to certain transfers of partnership interests when the partnership property has a built-in loss. The bill would require adjustments to the basis of partnership property in the case of contributions of built-in loss property to a partnership. The built-in loss may be used only by the contributing partner and not by the other partners in the partnership.
For transfers of partnership interests with “substantial built-in losses” (i.e., greater than US$250,000), the bill provides for mandatory basis adjustments to the transferee partner’s basis in the partnership assets. The provision contains new alternative rules for “electing investment partnerships” to be treated as not having a substantial built-in loss while the election is in effect. Additionally, the election provides for loss deferral for transfers of partnership interests, with a special transition rule for investment partnerships in existence on June 4, 2004. However, hedge funds characterized as trading partnerships may not be considered eligible to be considered “electing investment partnerships.”
U.S. Virgin Islands Residency Test
Some U.S. citizens have claimed the benefit of residency in the U.S. Virgin Islands and accordingly a reduced rate of tax. Currently, qualification for this benefit is determined by a mostly subjective U.S. Virgin Islands residency test.
Although the Senate JOBS Act directed Treasury to replace this subjective test with a more objective test based on days resident, the House bill is silent in this area. The IRS and Treasury reportedly already are working on regulations that would address the U.S. Virgin Islands residency test.
The bill would repeal the foreign personal holding company rules and foreign investment company rules. Those provisions essentially overlap the controlled foreign corporation rules and passive foreign investment company rules, so the main effect of the repeal is a reduction in administrative burdens rather than a significant change in taxes. In addition, the bill adds a new category of Subpart F income: income from certain personal service contracts performed by an offshore corporation in which the individual designated to provide services owns 25% or more. These provisions would be effective for taxable years of foreign corporations beginning after 2004.
The bill replaces the nine Foreign Tax Credit “baskets” with a two-basket system for “passive category income” and “general category income.” Financial services income is treated as “general category” income in the case of a member of a financial services group or firms predominantly engaged in the active conduct of a banking, insurance, financing or similar business. The provision is effective for tax years beginning after Dec. 31, 2006 (two years later than provided for in H.R. 2896).
Other Financial Instruments Changes
The bill would make various changes to the straddle rules, including repealing the stock exception to the definition of personal property. In addition, the bill would allow the designation of certain offsetting positions as a straddle to prevent the IRS from matching one of those positions with an undesignated position and would make other changes to the amount and timing of recognition of deferred losses. Unlike the JOBS Act, the bill does not propose to repeal the qualified covered call exception for OTC options. The changes would be effective for positions established on or after the date of enactment.
Hedge fund managers will need to continue to be aware of ongoing legislative initiatives that may affect the industry. As the legislative process moves forward it will be important to follow which provisions if any survive. Moreover, structures, agreements and plans also may need to be revisited should tax legislation affecting the industry be enacted.
Howard Leventhal, co-national director of Ernst & Young’s Asset Management Tax Practice, is a partner in Ernst & Young’s Global Hedge Fund Practice and is based in the firm’s New York financial services office. Alan Munro, is a partner in the National Tax Department leading Ernst & Young’s Lake Michigan area Asset Management Tax Practice.
Contact Robert F. Keane with questions or comments at: