Are Compensatory Options on Offshore Hedge Fund Shares Subject to the Anti-Deferral Provisions of Internal Revenue Code Section 457A?

For years, hedge fund managers and investors have discussed the possibility of structuring the performance allocation payable by an offshore fund to its manager as an option on or appreciation right with respect to shares of the offshore fund.  The benefits of structuring the performance allocation as an option or appreciation right include tax deferral, an implicit clawback and a multi-year measurement period.  See “Hedge Fund Managers Considering Fund Appreciation Rights Compensation Structures to Defer Tax on Performance Compensation and to Better Align Manager and Investor Incentives,” Hedge Fund Law Report, Vol. 2, No. 45 (Nov. 11, 2009).  However, implementation of such structures has been held up by tax risk: The IRS had not opined on whether options or appreciation rights in this context are subject to the anti-deferral provisions of Internal Revenue Code (IRC) Section 457A.  That ambiguity was resolved, in large measure, by a recent IRS revenue ruling.  This article identifies the specific issue addressed by the revenue ruling; summarizes relevant IRC provisions and Treasury Regulations; details the IRS’ analysis in the revenue ruling; and restates the revenue ruling’s conclusion.  Subsequent articles in the HFLR will delve into the consequences of the revenue ruling for structuring hedge fund performance compensation.

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