The use of U.S. limited liability companies (LLCs) as holding vehicles or operational business entities has become increasingly popular among U.S. taxpayers. Along with a remarkably flexible charter, U.S. LLCs offer the opportunity to shield owners from unlimited liability while retaining flowthrough treatment for tax purposes. A U.S. LLC that has not made an election for corporate treatment—a "transparent" U.S. LLC—is effectively disregarded as an entity separate from its owner or, in the case of multiple owners, treated as a partnership for federal income tax purposes.
However, when it comes to cross-border structuring, transparent U.S. LLCs should be used with great caution. This item explores some common issues encountered by foreign taxpayers adopting transparent U.S. LLCs to invest or operate in the United States. Unless otherwise noted, any reference to an LLC is to a U.S. LLC that has not elected to be treated as a corporation for U.S. tax purposes.
Classification of an LLC for Foreign Tax Purposes
The crux of the issue is the potential mismatch in how an LLC is classified under U.S. tax law and the laws of a foreign jurisdiction. In many instances, the transparent treatment accorded under federal law is not relevant in determining how the LLC is classified for the tax purposes of another country. If the LLC is regarded as a nontransparent entity by the jurisdiction of its foreign owner, a mismatch will arise as to the identity and residency of the taxpayer who recognizes revenues and expenses, as well as the timing of income recognition.
A recent case before the U.K. Supreme Court is helpful in illustrating this scenario and its potential consequences, Anson v. Commissioners for Her Majesty's Revenue and Customs, UKSC 44. George Anson was a U.K. resident who ran his investment management business in the United States through a Delaware LLC. In the United States, he was taxed on his share of the LLC's profits regardless of actual distributions and was personally liable for federal and state income taxes. As the profits were distributed to the LLC's members, Anson was then taxed in the United Kingdom on the distributions. Problems arose when Anson attempted to claim a foreign tax credit in the United Kingdom for the U.S. taxes he paid, arguing that the profits subject to tax were the same, and under the United States-United Kingdom treaty, they could not be taxed twice (i.e., by the United States when earned and by the United Kingdom when distributed).
The U.K. tax authorities denied Anson's claim, finding the LLC was indeed a separate corporate entity for U.K. tax purposes and that the income from the distribution was not the same as the income from the profits recognized by the LLC. Hence, no double taxation had occurred, and no credit was permitted. The U.K. Supreme Court disagreed and allowed foreign tax credit relief. In light of the specific terms of the LLC agreement and applicable Delaware law, the court found that for U.K. tax purposes, the LLC members were effectively viewed as recognizing their share of the profits as they were earned by the LLC and not upon the actual distribution.
This case is emblematic of the uncertainty foreign taxpayers may face when using LLCs. The present decision conflicts with the U.K. tax authorities' historical view that most LLCs should be regarded as nontransparent entities; however, many commentators have noted that its scope is narrow, and for purposes of U.K. tax law, the classification of an LLC remains a determination based on the specific facts. Many U.K. members of LLCs are left wondering (1) whether they should recognize their share of profits for U.K. tax purposes when earned by the LLCs or when distributed to them, and (2) whether the income from the LLC is eligible for a foreign tax credit or should rather be classified as a dividend, possibly exempt in the hands of a U.K. corporate entity (under a regulatory scheme referred to as "participation exemption"). As of this writing, the U.K. tax authorities had not made any official comment in response to the Anson decision.
Loss of Treaty Benefits With Respect to U.S. Income
If an LLC is effectively treated as a hybrid entity (i.e., a company regarded as fiscally transparent by the United States and nontransparent by the other jurisdiction), foreign taxpayers should also be concerned about the potential loss of treaty benefits with respect to U.S.-source income earned by the LLC.
Hybrid entities have posed challenges in the tax treaty context. Treaty partners have become increasingly concerned about the use of such structures to obtain unwarranted benefits under the existing treaty networks. As to the United States, the response has been twofold: first, the enactment of Sec. 894 and the regulations thereunder, restricting the availability of treaty benefits in connection with certain U.S.-source passive income earned by hybrid entities, and, second, the introduction of specific treaty language dealing with hybrid entities in the recently signed bilateral treaties and protocols. As a result, non-U.S. taxpayers adopting transparent LLCs in their inbound structures should be wary of potential pitfalls, as shown in the following:
Example 1: A U.K. limited company, a qualified resident of the United Kingdom under the U.S.-U.K. treaty, receives U.S.-source royalties, and its activities in the United States do not rise to the level of a permanent establishment.
Under Article 12 of the U.S.-U.K. treaty, the royalty income is exempt from U.S. federal income tax withholding.
Example 2: Taking the same facts as Example 1, assume further that the U.K. company forms an LLC to insulate the headquarters from liability and streamline the administration of the U.S.-source income, while retaining flowthrough treatment for U.S. tax purposes.
From a merely U.S. tax standpoint nothing has changed. Nonetheless, if the LLC is regarded as a corporate entity under U.K. tax law, the applicability of treaty benefits becomes problematic.
Article 1(8) of the U.S.-U.K. treaty specifically deals with fiscally transparent entities, stating,
An item of income, profit or gain derived through a person that is fiscally transparent under the laws of either Contracting State shall be considered to be derived by a resident of a Contracting State to the extent that the item is treated for the purposes of the taxation law of such Contracting State as the income, profit or gain of a resident.
In other words, the tax law of the residency state determines which taxpayer is regarded as earning the income and, accordingly, whether the residency of the taxpayer warrants access to the treaty benefit.
If one applies the rule to Example 2, the royalty income received by the LLC is not considered derived by the U.K. owner of the LLC, even if under the tax laws of the United States, the LLC is treated as fiscally transparent. Rather, if the LLC is regarded as a corporate entity under U.K. tax laws, the income is treated as derived by the LLC, which is not a resident of the United Kingdom under the treaty. Once a transparent LLC is interposed, the hybrid-entity provision of the U.S.-U.K. treaty effectively denies access to treaty benefits to the U.K. corporate entity.
Most notably, the provision could jeopardize the access to other treaty benefits with respect to U.S.-source income earned through a U.S. LLC, including (1) reduced rates on U.S. withholding on interest and dividends; (2) exemption of business profits not attributable to a U.S. permanent establishment; (3) reduced rates on U.S. branch profit taxes imposed on dividend-equivalent amounts of a U.S. permanent establishment; and (4) exemption of profits from the operation of international transportation.
Thinking Twice Before Using an LLC
Despite the examples above, application of these issues is not limited to U.K. investors. Many foreign jurisdictions, including Canada and several European countries, would normally regard U.S. LLCs as corporate entities distinct from their owners, potentially raising the mismatching scenarios discussed. Notably, the classification of an LLC in a foreign jurisdiction may not be a matter of statutory law; rather, it may require a case-by-case analysis, adding a great deal of uncertainty to the picture.
On the other hand, the treaty approach to hybrid entities varies depending on the treaty partner. Many treaties and protocols signed in the last two decades incorporate provisions similar to the U.S.-U.K. treaty. Other U.S. treaties adopt ad hoc transparent-entity language, such as the treaty with Canada, while older treaty texts might not include hybrid-entity provisions. Nonetheless, all of the treaties should be read in conjunction with the rules of Sec. 894 and its regulations.
Given the complexity and uncertainty surrounding the use of hybrid entities in cross-border tax structuring, transparent LLCs should be handled with care in this context. When flowthrough treatment is desirable in both jurisdictions, the use of more traditional partnership entities, such as limited partnerships, is less likely to result in hybrid mismatches. On the other hand, foreign corporations with a permanent establishment in the United States would often think of a U.S.-incorporated entity as a better option to take advantage of treaty rates on the repatriation of profits to the foreign headquarters. Yet, a foreign investor's choices may be somewhat limited if, for example, a U.S. investment vehicle structured as an LLC is shared with U.S.-based partners. Whenever a U.S. LLC comes into play, the interaction of domestic, foreign, and treaty provisions should be carefully reviewed to prevent unintended tax consequences.
Mark Heroux is a principal with the Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.