Consultation on US LLCs

The Chancellor, Rachel Reeves, has announced a consultation on how the UK taxes US Limited Liability Companies (“LLCs”)

This move appears to have been prompted by a belated realisation within H.M. Treasury that the approach to taxing LLCs, as pursued by His Majesty’s Revenue & Customs (“HMRC”), is at variance with the policy of making the UK an attractive location for internationally mobile individuals.

Over the course of the 21st Century, LLCs have become one of the most common ways of structuring project finance in the USA. The default US tax treatment is for a LLC is treated as transparent, in other words as a deemed partnership. That can be varied by the LLC making a ‘check-the-box’ election, which causes it to be taxed as a corporation (i.e., ‘opaque’ in character and separate from its members).

However, such elections are infrequent. In the US domestic context, LLCs are attractive structures because they offer the taxation afforded to a partnership, combined with limited liability for all the members. That provides a distinct edge when compared to using a Limited Partnership. In the latter, at least one general partner has limited liability. Any member of a Limited Partnership who participates in management loses limited liability, whereas there is no such consequence if an LLC member is involved in its management.

HMRC’s current policy on the taxation of US LLCs results in unavoidable double taxation for two categories of individual who are members of an LLC

• Any US citizen or ‘green card’ holder who is resident in the UK and not benefiting from the FIG regime. (This is the case irrespective of where the LLC’s activities are being conducted.)
• Any other UK resident individual who makes a US inward investment by means of membership of an LLC

Based on the Court of Appeal decision in Memec (1) .
• HMRC view the US LLC as a body corporate for UK tax purposes
• Accordingly, for UK purposes, income only arises to the individual member when the LLC makes a distribution
• Such a distribution is generally treated as a dividend for UK purposes, although there may be an argument for an element of employment income if the member is actively involved in management and not being remunerated separately for the provision of those services
• However, any US tax paid by a member on his/her share of LLC income/gains is treated as a payment of the body corporate’s tax liability and therefore not available as a credit against the individual member’s UK tax liability

In Anson (2) , one UK resident individual did contest HMRC’s view, and the matter went as far as the UK Supreme Court. Normally, a decision by the Supreme Court on a tax matter will establish a broadly applicable principle. Although the Court did decide in favour of the taxpayer in this matter, no broad principle on the UK taxation of US LLCs was forthcoming. Rather, in the context of applying the US/UK Tax Treaty, the decision centred on a narrow interpretation of what was meant by, “the same income”. The critical element in answering that question turned on how the Members’ Agreement should be interpreted under Delaware State Law (3) .

HMRC take the view that the Supreme Court’s decision does not impact their historic view of LLCs. (4) The most recent guidance (5) states that, “HMRC continue to believe that the profits of an LLC will generally belong to the LLC in the first instance and that members will generally not be treated as “receiving or entitled to the profits” of an LLC ”

1 Memec plc v CIR 71 TC 77
2 Revenue and Customs Commissioners v Anson [2015] STC 1777
3 The LLC in question was one established under, and subject to, Delaware State Law.
4 Clearly, a case involving the interpretation of a LLC Members’ Agreement governed by Delaware State Law has no direct relevance to how a different Member’s Agreement would be interpreted if the relevant State Law was, for example, that of Wyoming.
5 HMRC international Manual – at INTM180050

When there is double taxation for the LLC member resident in the UK, common sense would indicate recourse to the US/UK Tax Treaty (“the Treaty”) for a resolution. After all. the introductory wording of the Treaty indicates that it is “a new Convention for the avoidance of double taxation”.

However, in the case of any individual resident in the UK who receives income through a US LLC, the Treaty singularly fails to prevent double taxation. Rather, it ensures double taxation.

Article 1, paragraph 8

“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”

The effect of the emphasised wording above was made clear by the then Inland Revenue in the Special Bulletin it published when the Treaty was ratified.

Under the heading, “US LLCs – relief for US tax” is the following,

“The Revenue take the view that for UK tax purposes LLCs should be regarded as taxable entities and not as fiscally transparent. Accordingly, the UK taxes a UK member of an LLC by reference to distributions of profits made by the LLC and not by reference to the income of the LLC as it arises. If tax is paid in the US on the profits of the LLC – and irrespective of by whom that tax is paid – the UK regards that tax as underlying tax. Credit is available for it if, and only if, the member is a UK company which controls, directly or indirectly, at least 10% of the voting power of the LLC.

It follows that relief for underlying tax is not available to an individual UK member of an LLC. This is consistent with the purpose of the elimination of double taxation provisions contained in the previous treaty at Article 23. Article 23(2)(b) provides that, in the case of dividends paid by an ordinary US corporation, relief for underlying tax is only available to a UK company. There is no authority to allow relief for what is underlying tax to a UK individual member of an LLC.

There is no difference in substance between Article 23(2)(b) of the previous treaty and Article 24(4)(b) in the new treaty. Relief for underlying tax will only be available to a UK company which has at least a 10% interest in the US LLC.”

The issue with LLCs issue can be addressed in isolation from broader entity classification issues. Such an approach will avoid the extended time frame involved in a full consultation followed by the necessary legislative drafting for inclusion in a Finance Bill, and the progress of the latter through to Royal Assent.

Some minor alterations to the present US/UK Tax Treaty (“the Treaty”) would achieve the desired result. Making such a suggestion to the US would not necessarily open the door to the US requesting a quid pro quo which The Treasury and HMRC would rather not have to entertain. Rather than asking for something for itself, in this instance the UK would be asking for something which benefited the US and US individuals living in the UK.

The suggestions for amending the Treaty are,

1. Amend paragraph 8 of Article 1 from the present,

“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”

to

“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”

2. Amend paragraph 5 of Article 1 to include paragraph 8 of Article 1 as an exception to the so called, ‘Saving Clause’ rule in paragraph 4 of Article 1
3. Include a ‘grandfathered’ opt out election from these changes for any taxpayer who, in the case of a particular US LLC, has previously been relying on the ‘old’ version of paragraph 8 for opacity
4. Establish an effective date for the implementation of these changes

The practical result of those changes would be,

1. As the LLC is fiscally transparent in one of the Contracting States, both States must adopt that treatment. There is no longer a requirement that fiscal transparency only applies if domestic tax law in the UK, the place of the taxpayer’s residence, already treats the entity as transparent
2. Paragraph 4 of Article 1 (the ‘Saving Clause’) allows a Contracting State, when taxing its residents, to ignore any Treaty provision other than those specified in paragraph 5 of Article 1. Without this addition, the change to paragraph 8 of Article 1 would not eliminate the present double taxation of income derived through a US LLC
3. A means of electing out of the changes would protect from unintended consequences those existing arrangements which rely on operation in its present form

There is a case that the effective date for these changes to the Treaty should have an element of retroactivity.

The present Treaty has been in operation for over 20 years, with the bulk of the negotiations which preceded it having been nearer 25 years ago. Much has changed in that time, including the proliferation of LLCs in the US.

The Treaty negotiators recognised that things change over time and wanted to avoid the issues which arose because of the ‘static’ nature of the predecessor Treaty over its long life. Accordingly, the Exchange of Notes which accompanied the Treaty included a firm commitment to regular reviews.

Exchange of Notes

“In General:
it is understood that the two Governments shall consult together at regular intervals regarding the terms, operation and application of the Convention to ensure that it continues to serve the purposes of avoiding double taxation and preventing fiscal evasion and shall, where they consider it appropriate, conclude Protocols to amend the Convention. The first such consultation shall take place no later than December 31st in the fifth year following the date on which the Convention enters into force in accordance with the provisions of Article 29 (Entry into Force). Further consultations shall take place thereafter at intervals of no more than five years. Notwithstanding the preceding paragraph, either Government may at any time request consultations with the other Government on matters relating to the terms, operation and application of the Convention which it considers require urgent resolution.”

There is anecdotal evidence of a cursory review having taken place as mandated after five years, although nothing was published in either country. Thereafter, none of the mandated reviews appears to have taken place. Had the processes set out in the Exchange of Notes been taking place, the LLC issue might well have been addressed. By way of practical example, when it took a decision by the UK Supreme Court to interpret a sequence of three words in the Treaty, that should have been a signpost that it was time for the two Contracting States to put their heads together. (7)

That Supreme Court decision was handed down on 1st July 2015. Suggested retroactive effective dates for implementation of changes to the Treaty could be:-
• 1 January 2016 for US tax application, and
• 6 April 2017 for UK tax application

7 Revenue and Customs Commissioners v Anson [2015] STC 1777 involved a matter arising under the predecessor US/UK Tax Treaty. However, the three words in question have been been carried over into the Article on Avoidance of Double Taxation in the current Treaty.