U.S. LLCs for U.K. Tax Purposes

U.S. limited liability companies (LLCs) have become the preferred business entity in many situations because their members get the best of both worlds: legal liability protection while being taxed in the United States as a partnership. But what are the global tax implications for LLC members who are not U.S. residents?

These issues were discussed in the August 2011 issue of The Tax Adviser1 in light of a 2010 decision by the United Kingdom’s First Tier Tribunal (Tax) that a U.K. resident was entitled to a U.K. income tax credit for U.S. tax paid on distributions from a U.S. LLC of which he was a member.2 As noted in that article, Her Majesty’s Revenue and Customs (HMRC) planned to appeal the decision. In a win for HMRC, the decision has now been overturned in the Upper Tribunal Tax and Chancery Chamber.3

Swift Case Decision

The main issue of the case was whether double-taxation relief was available, i.e., was a U.K. taxpayer, George Anson, liable for U.K. tax based on his share of profits from the U.S. LLC or on the equivalent of a dividend?

Anson, a U.K. resident and ordinarily resident, invested in a Delaware LLC, HarbourVest Partners LLC. The LLC distributed all profits to the members quarterly, withheld appropriate U.S. taxes, and filed U.S. tax returns. Anson reported the income as partnership income on his U.K. personal tax return and claimed foreign tax credits for the U.S. taxes withheld.

HMRC disagreed with the taxpayer’s position and sought to disallow the tax relief for the U.S. tax paid. HMRC’s position was that, under English law, the LLC should be treated as “opaque” (i.e., a corporation) and Anson should not be entitled to double-taxation relief. In effect, when a U.S. LLC distributes cash to a U.K. member, it is deemed a dividend for U.K. tax purposes and taxed accordingly; HMRC deems U.S. tax withheld as a tax paid by the corporation and not creditable on the U.K. taxpayer’s return.4

The First Tier Tribunal stated that it preferred to apply Article 23(2)(a) of the 1975 United Kingdom–United States income tax treaty, “United States tax payable . . . shall be allowed as a credit against any United Kingdom tax computed by reference to the same profits or income by reference to which the United States tax is computed” (emphasis added), as opposed to looking at whether the LLC was transparent versus opaque.

In the First Tier Tribunal, the two parties’ experts analyzed a six-question test from HMRC Tax Bulletin 39 (February 1999), which HMRC uses to help with foreign entity classification. They agreed on four of the questions but disagreed on the answers to two:

1. Does the entity issue share capital or something else that serves the same function as share capital?
2. Are the persons who have an interest in the entity entitled to share in its profits as they arise; or does the amount of profits to which they are entitled depend on a decision of the entity or its members, after the period in which the profits have arisen, to make a distribution of its profits?5

With respect to the “share capital” issue, the tribunal found:

Our findings of fact in the light of this evidence in relationship to the membership interest in [the LLC] is that it is not similar to share capital but something more similar to partnership capital of an English partnership, the transfer of which requires the consent of all the partners but the economic benefits can be transferred without consent and without the transferee becoming a partner (s. 31 of the Partnership Act 1890).

This conclusion would imply that the LLC was more transparent than opaque.

With respect to the “profits arising” issue, the First Tier Tribunal indicated that it preferred the taxpayer’s argument that the LLC operating agreement allocated profit to the members as it arose, and it rejected an argument by HRMC that “profits did not belong to the members.” The tribunal concluded that “our finding of fact in the light of the terms of the LLC Operating Agreement and the views of the experts is that the members of [the LLC] have an interest in the profits as they arise.”

HMRC did argue that the “source of the income” should be examined, but the First Tier Tribunal preferred to concentrate on “whether the income belongs to the Appellant [Anson] as it arises, that is to say does the Appellant have a right to that income immediately it arises?” It concluded that he did and that Anson was entitled to double-tax relief.

The tribunal summed up its decision as follows:

[The LLC] stands somewhere between a Scots partnership and a UK company, having the partnership characteristics of the members being entitled to profits as they arise and owning an interest comparable to that of a partnership interest, and the corporate characteristics of carrying on its own business without liability on the members and there being some separation between Managing Members and other members falling short of the distinction between members and directors. Since we have to put it on one side of that dividing line we consider that it is on the partnership side particularly in relation to its income.

The factor we are mainly concerned with in relation to the Treaty is whether the profits belong to the members as they arise. We have concluded that this is the effect of the LLC Operating Agreement and the [Delaware LLC] Act. Accordingly the Appellant is taxed on the same income in both countries and is entitled to double taxation relief under the Treaty for the Federal tax.

Upper Tribunal Appeal

The appeal in the Upper Tribunal Tax and Chancery Chamber was heard in front of Mr. Justice Mann, who specifically stated that he was going to consider and rule only on the double-taxation point. Mann stated, “The question in this case is whether or not income on which the two sets of tax has been charged falls within those words [from Article 23(2)(a), ‘any United Kingdom tax computed by reference to the same profits or income by reference to which the United States tax is computed’]. The question is whether UK tax is computed by reference to the same profits or income as the US tax.”

Opposing Arguments on Appeal

HMRC argued that the First Tier Tribunal had misanalyzed the effect of the LLC agreement. The tribunal had found that Anson was entitled to the profits in a proprietary sense, which was conceptually wrong, as it was the LLC that owned all the assets of the business. HMRC argued that the only thing owned by Anson was a contractual right to an equivalent of the profits. Therefore, in no meaningful sense (proprietary or otherwise) was Anson entitled to profits as they arose. HMRC argued that “the profits were at all times owned by LLC.”

The issue to be determined was the source of the taxed income. For U.S. tax purposes, the source was the trade of the LLC, which under U.S. tax law is attributed to the members of the LLC for tax purposes. For U.K. tax purposes, the source of the income was the LLC agreement, with the effect that U.K. and U.S. tax were not computed by reference to the same profits and income.

Anson countered that the tribunal had found a contractual, not proprietary, entitlement to profits. Thus, the First Tier Tribunal had been right to conclude that the entitlement to profits arose as profits arose, as no third-party act was required to give rise to that entitlement (as compared with when a dividend is declared). Thus Anson was entitled to profits as they arose, which meant that he was taxed on the same profits or income in the United Kingdom and the United States and thus was eligible for double-tax relief.

In light of that argument, HMRC proposed another argument that would prevent Anson from claiming double-tax relief. HMRC argued that Anson’s rights to have part of the profits credited to his capital account were not such as to trigger a charge to U.K. tax. U.K. tax was only payable on a distribution, not a crediting, and it followed that he would be taxed on different profits or income in the United Kingdom, compared with in the United States. The mere allocation would not be a taxable event in the United Kingdom, and thus the source of the U.K. income would be different, i.e., it would be the LLC agreement.

Was the Right to the Profits Proprietary or Contractual?

Mann highlighted that determining whether the right to the profits was proprietary or contractual was crucial to determining whether double-tax relief was available to Anson. The First Tier Tribunal had found that a “limited liability company interest” is defined by Delaware statute as “a member’s share of the profits and losses of a limited liability company and a member’s right to receive distributions of the limited liability company’s assets.” The First Tier Tribunal had said, “This implies that the members have a share in the profits.” Mann stated that this “suggests a move into proprietorship territory.”

Leaning further toward the proprietorship territory, the First Tier Tribunal had observed, “The fact that the book profit is allocated (and the reallocations are made) ‘at least as often as annually’ might indicate that the profits must belong to the LLC until the allocation is carried out. We do not consider that this is the case in the light of s.18-503 of the [Delaware LLC] Act which does not contemplate the possibility.”

Mann commented that on the face of it, this observation is wrong. Delaware Code Section 18-503 provides that “[t]he profits and losses of a limited liability company shall be allocated among the members, and among classes or groups of members, in the manner provided in a limited liability agreement.” Section 18-503 does not speak to ownership of profits; it talks about allocation. Mann also noted that the tribunal had used the word “belong,” which would imply that it had meant ownership in some form.

Both parties disagreed about the meaning of the distribution policy in the LLC agreement, but Mann stated that their dispute went more to the mechanism or timing of the profits, as opposed to whether Anson or the LLC owned them. Mann noted that the tribunal had observed that HMRC’s expert’s “reason for saying that the profits did not belong to the members was that the profits allocated to the capital accounts remain subject to the risks of the business and constitute part of the assets of the LLC,” which would seem to indicate that the LLC owned the profits.

However, the First Tier Tribunal had further noted that if the profits belonged to the LLC, there was no mechanism to transfer them from the LLC to Anson, as there would be in the corporation/dividend scenario. So the tribunal found that the profits did belong to the members. Although the tribunal had acknowledged that the assets belonged to the LLC until a distribution was actually made, “we do not consider that this means that the profits do not belong to the members.”

Was the First Tier Tribunal’s Finding Correct?

Mann stated that he believed the First Tier Tribunal considered that the profits belonged to the members in a proprietary sense. He stated that there was nothing in the First Tier Tribunal’s findings that would justify its conclusion that Anson had any form of proprietary entitlement to the profits. Mann went on to say that, pursuant to the six-factor test, the LLC had its own identity, conducted its own business, owned its own assets, etc. Therefore, if the tribunal based its reasoning on these findings, the proprietary-interest theory that the profits belonged to the members was flawed.

Mann further asked, if the members did not have a proprietary interest in the assets and liabilities of the LLC, how could they have a proprietary interest in its profits, which are not something that one can own as an asset? How can someone own the profits if he or she does not own the assets? Therefore, he expounded, the profits could not “belong” to Anson as the tribunal had implied, and its decision had to be reconsidered.

The “Profits as They Arise” Question

A huge amount of weight was given to the “profits as they arise” question in this case. Anson conceded that if he were not entitled to the profits as they arose, then he would not receive the tax credit. He summarized HMRC’s position as being that if Anson were entitled to the profits as they arose, then Anson would get double-tax relief. The answer to the “profits as they arise” question was thus capable of determining the case because it answered the question, “Are the profits that are taxed in the United Kingdom the same as the profits that are taxed in the United States?”

Whether Anson was entitled to the benefits of double-tax relief under the treaty would have some bearing on whether the LLC was deemed to be transparent or opaque. Anson did not seek to argue that the method of U.S. taxation of LLCs by itself did not render the U.K. tax as “computed by reference to the same profits or income” for the purposes of the treaty. Therefore, determining Anson’s entitlement to the profits of the LLC remained crucial to the final decision.

With respect to the phrase “profits as they arise,” Mann asked, “Whose profits are they?” To find the answer, he analyzed various findings in the Memec plc case6 and concluded that a proprietary right in the underlying property is a very significant factor in determining whether one has a proprietary right to the profits as they arise.

Mann then asked whether Anson had a share in the profits in any relevant sense. Mann referred to the questions, tests, and conclusions in the Memec case and stated, “It is the facts underlying transparency that bring about an equivalence of the profits for the purposes of the double taxation test.”

Upper Tier Tribunal’s Holding

After taking into consideration the proprietary-right arguments and the transparency issue discussed in the Memec case, Mann came to three conclusions:

1. The United States and the United Kingdom taxed different things.

When approached in that way it seems to me to be clear that what Mr. Anson was taxed on was not the same profits that were taxed in the United States. What was taxed in the United States were in law, reality and substance the profits of LLC, albeit attributed to the members for taxation purposes (by election). Although the members were entitled to moneys which could be viewed as the monetary equivalent of the profits of the company (because that would be the result of the calculations and allocations in relation to their capital accounts) what they received was not the same thing. It was a contractual entitlement to money, like plc’s interest in the silent partnership in Memec.

2. Anson had no proprietary right in LLC profits.

[A] proprietary right in the underlying assets seems to me to be a crucial factor in the inquiry, and Mr. Anson had none. I find it difficult to envisage any case of transparency where there is no such right, but whether or not that is possible, the absence in this case is fatal to the taxpayer’s case. LLC owns every­thing; it pays out to its members an aggregate sum of money which can be seen to be the monetary equivalent of its profits. . . . But the profits were the LLC’s and the contractual obligation to credit and distribute did not make them the members’, at least for English tax purposes. The position of the members is nothing like the position of an English partner, and I respectfully disagree with the Tribunal in its finding . . . that the members have interests akin to the interests of a Scottish partner. The interest of the members is not comparable to the interests of Scottish partners because they do not have an interest in the assets of the LLC.

3. The LLC was not transparent.

I therefore find that the LLC is not transparent; the members . . . do not have an interest in the profits of the LLC in any meaningful sense; and that therefore the profits on which tax has been paid in the US are the profits of the LLC. Mr. Anson is taxed [in the United Kingdom] on something different—his distributions from (or entitlement under) the LLC agreement. They are two different sources. . . . The double taxation treaty test is therefore not fulfilled.

Conclusion

This issue is not only between the United Kingdom and United States. Many countries struggle with classifying U.S. LLCs’ profits under their own domestic tax statutes. From a U.K. perspective, a U.K. citizen and resident who invests in a U.S. LLC in his or her personal name is going to be subject to double taxation. It may make sense to invest in the U.S. LLC via a U.S. partnership or some form of corporate entity. But at the end of the day, every situation is unique, and tax advisers will have to evaluate with their clients their particular tax situation to see what works.

Footnotes

¹Whittall, “When Is a U.S. LLC a Partnership for U.S. and U.K. Tax Purposes?” 42 The Tax Adviser 508 (August 2011).

²Swift v. HMRC, [2010] UKFTT 88 (T.C. 2010).

³HMRC v. Anson, [2011] FTC/39/2010 (TCC 2011). The case name was changed because when the First Tier Tribunal’s decision was published, the court did not use the parties’ real names, to protect the LLC’s financial information from its competitors. The appeal uses the parties’ actual names.

⁴ See Inland Revenue Tax Bulletin 29, “UK/US Double Taxation Convention—US Limited Liability Companies (LLCs)” (June 2007).

⁵Inland Revenue Tax Bulletin 39, “Entity Classification,” p. 627 (February 1999).

⁶Memec plc v. Inland Rev. Comm’rs, [1998] BTC 251, [1998] STC 754 (Court of Appeal).