For many years, both the Canada Revenue Agency (CRA) and Her Majesty’s Revenue and Customs (HMRC) have treated limited liability companies (LLC) formed under Delaware law as hybrid entities, in that a LLC has been “opaque” for the purposes of domestic tax law despite being generally disregarded or treated as a partnership for United States tax purposes.
Hybrid entities, including LLCs, are due to be somewhat of a hot topic next month because, as part of its Base Erosion and Profit Shifting (BEPS) project, the OECD is due to present its recommendations to the G20 Finance Minister in relation to “Action 2: Neutralizing the effects of hybrid mismatch arrangements”. However, over the summer the United Kingdom Supreme Court has stepped into the fray in its decision in Anson v. Commissioners for Her Majesty’s Revenue and Customs ( UKSC 44).
This decision emphasizes that entity classification for international tax purposes is highly dependent on the facts and the governing law applicable to the entity, despite guidance from tax authorities that prefers to apply a “one size fits all” approach. As discussed below, the Anson decision may create renewed interest and support for taking a tax position that diverges from the traditional opaque characterisation of a US LLC.
Anson decision: Background
Mr. Anson was a member of HarbourVest Partners LLC (HV LLC), which carried on an investment management business in Boston, Massachusetts. All of HV LLC’s income, gains and losses were credited and debited to its members’ accounts on a quarterly basis (pursuant to HV LLC’s LLC Agreement) and any profits made in respect to the gains and losses were proportionately distributed to each member of the HV LLC based on their profit share under the LLC Agreement.
As a member of a LLC which carried on a trade or business in the United States, Mr. Anson was liable to United States federal and state income taxes on his share of the profits, as the LLC was treated as a partnership for US tax purposes irrespective of whether he received distributions from the LLC. As a non-UK domiciled UK resident individual, Mr. Anson was liable for UK income tax on foreign income he earned as a member of the LLC to the extent that that income was remitted to the UK.
The Supreme Court was asked to decide whether the profits of the LLC were subject to UK income tax without credit for the underlying United States tax (which would have resulted in an effective tax rate of 67%). Mr. Anson argued that he was entitled to claim double taxation relief under the relevant UK/US Double Taxation Conventions (UK/US Treaties). HMRC disagreed and rejected his claim on the basis that relief was only available where tax is “computed by reference to the same profits or income by reference to which the United States tax is computed” and that income tax was, on the contrary, charged in respect of income derived from rights as a member of the LLC.
The Supreme Court held that Mr. Anson’s entitlement to relief depended upon the construction of the UK/US Treaties and that the correct approach, in accordance with Article 31(1) of the Vienna Convention, was to interpret the a treaty “in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose”. The First-tier Tribunal had found, as a matter of fact, that under Delaware law, HV LLC’s members automatically became entitled to their share of the profits generated by the business carried on by the LLC as those profits arose, prior to, and independently of, any subsequent distribution by virtue of the provisions of its members agreement. The Supreme Court took the view the Tribunal had been entitled to reach this conclusion based on the evidence before it as to the effect of the members agreement which governed the operation of HV LLC under Delaware law. On this basis, the Supreme Court decided that, for UK income tax purposes, the income arising in the US represented Mr. Anson’s share of HV LLC’s profits, thereby allowing Mr. Anson’s appeal.
Tax implications for UK investors in LLCs
The case is interesting for a number of reasons, in a UK tax context, including the following:
- an individual who is resident in the UK may, at least where the documentation governing the operation of a LLC is similar to the HV LLC documentation, be entitled to claim relief under the double taxation treaties between the UK and the US in respect of profits arising from a trade or business carried on in the US. The key question is whether a member is entitled to profits as they arise, rather than whether a LLC has a proprietary interest in assets giving rise to those profits.
- where a company within the charge to UK corporation tax is a member of a LLC, it would seem to be the case that, at least where the documentation governing the operation of the LLC is similar to that in Anson, instead of receiving a tax exempt distribution, it could be treated as receiving taxable income (albeit it with credit for US tax paid on that income).
- a tax-exempt institution, such as a charity or a pension fund, which is a member of a LLC could find itself in receipt of trading income rather than investment income (with all the attendant difficulties this could engender).
- the determination of whether relief is due under a double tax treaty should, in future, be approached as a matter of the correct construction of the relevant treaty provision (rather than, almost as a reflex, by applying the test set out in the Court of Appeal in Memec).
- it may be possible, by means of careful drafting of a LLC’s constitutional documents, to “select” a LLC which is either “transparent” or “opaque” for UK income tax purposes.
- the Supreme Court’s decision does not appear to change the position of a member of a LLC for the purposes of UK tax on capital gains.
- the application of the test in Memec may be confined to whether a UK resident company is entitled to relief from corporation tax in respect of underlying tax paid abroad by a subsidiary where the question is whether that company could be treated as having been paid the dividends from its subsidiaries.
Tax implications for Canadian investors in LLCs
Canadian investors in LLCs have typically been given to understand that a US LLC is not generally considered a tax-efficient vehicle for investment by a Canadian resident individual in a US business. For example, for an Ontario resident individual in the highest marginal tax bracket, the combination of US taxes on an active business carried on by a LLC in the US together with the Canadian taxes on distributions from a LLC (assumed to be opaque) typically results in an overall effective tax rate in excess of 59%. The effective rate can be even higher if income earned by members in a year is not distributed until a later tax year.
Because of these high effective tax rates, a partnership is often a preferred vehicle for Canadian resident individuals to invest in an active business in the US.
Where a Canadian investor who may not have consulted a tax advisor in advance of making a LLC investment (in which case that investor would perhaps have been advised to invest instead in a partnership) and may be surprised by this tax inefficiency when they file their Canadian tax returns, the Anson decision may provide at least an argument for tax relief. While the CRA is likely to disagree with these arguments, in some circumstances it may be worthwhile to challenge the CRA’s approach to the characterisation of LLCs in order to secure a more reasonable effective tax rate.