The tax treatment of UK tax residents on income from US Limited Liability Companies (LLCs) continues to be a source of concern for many advisers. The short end of the stick is that providing the income always belonged to the LLC members then HMRC will allow a tax credit against UK tax for any US tax suffered. Of course it’s a bit more complicated than that, and set out below is a bit more detail of the UK Supreme Court’s reasoning and judgment. It may help US advisers in reading this commentary to suspend their knowledge of US law, taxation and commercial culture; after all, we are dealing with UK law and taxation, idiosyncratic beasts at the best of times. If you want to skip the history and HMRC arguments go straight to the section ‘Supreme Court Judgement’ and the following section ‘Sour Grapes and going forward.’ More discerning readers will want to understand HMRCs point of view, the history of this case and how a tax rate of almost 85% can arise for some LLC members.
No double tax credit relief.
Prior to the Anson case being heard by the UK Supreme Court (the old House of Lords Court), HMRC took the view that payments to members of LLCs were a distribution of profits and not an allocation of profits, the former being a distribution of the LLCs profits the latter being profits belonging to the member. As a result of this treatment, a UK resident member of an LLC would be taxed in the US but the UK would not give a tax credit for the US tax suffered, despite the requirements of the UK/USA Double Tax Convention.
The effective tax rate.
Anson was a UK tax resident but not domiciled in the UK and as a result of this nondomicile status he was taxed on the income he remitted to the UK from the Delaware incorporated LLC he was a member of. Of every $100 Mr Anson was paid he suffered US tax of $45 and remitted the balance of $55 to the UK where he has taxed at 40% giving rise to UK tax of $22. The total tax he paid was $67 with no credit for US tax paid. For a taxpayer not on the remittance basis but being taxed on the arising basis, which is on the full income arising not on the amount remitted to the UK, the tax is a bit more severe. On every $100 assume a US rate of 39.6% that leaves income of $60.4. The UK will tax the full $100 and assuming a tax rate of 45% with no foreign tax credit relief that leaves $15.4 an eye-watering effective tax rate of 84.6%. At this level of taxation, it is worth making sure the LLC qualifies for UK foreign tax credit relief.
It is helpful in planning post-Anson to understand HMRC’s arguments to the Supreme Court if only to avoid falling into those traps in the future. Effectively, HRMC argued that the members of the LLC had no interest in the specific property of the LLC, and it therefore followed that they had no beneficial interest in the LLCs assets. In that proprietary sense the members were therefore not ‘entitled’ to a share in the profits prior to distribution. In short, HMRC’s view was that the money/profits did not belong to the members but to the LLC which distributed its profits to the members. In opposing, HMRC the Court were made aware that Delaware law drew a distinction between profit/loss on the one side and asset/liability on the other. Money may be held by an LLC and be disclosed in the balance sheet but this does not make it profits of the LLC especially where the income is owed to another person the two entries in the balance sheet would be credit bank and debit creditors (the members). This argument in opposition to HMRC tried to show that the concepts of profit and asset were different and could be treated differently.
Journey through the English courts
A lower court considered whether the profits vested in the members as their property rather than the members had an entitlement to a distribution of the profits. The Judge came to the conclusion that the profits were owned by the LLC and a contractual obligation to credit them to the LLC members accounts and to distribute them did not make them property of the members, at least for English tax purposes. Mr Anson appealed this decision.
The Court of Appeal then heard the case and came to a judgment that many professionals found puzzling. In part, the Appeal Court found that the two jurisdictions were not taxing the same profits. The Court upheld the judgment that Mr Anson was not entitled to a UK tax credit to which Mr Anson appealed to the Supreme Court.
The Supreme Court
Contesting the lower Courts Mr Anson contended;
a) Even though the two jurisdictions treated the income differently they were taxing the same profits and therefore double tax relief credit should be allowed as per the UK/USA Double Tax Convention.
b) The second ground of appeal is that as a matter of UK tax law the lower court were entitled to take the view that Mr Anson was taxable in the UK on his share of the of the profits of the trade carried on by the LLC and that this was the same income that had been taxed in the USA thus a double tax relief credit was applicable – the so-called ‘source’ argument.
The Court rejected the first ground of appeal. The reason for this is that if the UK treatment as a dividend was correct the Double Tax Treaty provisions did not apply to the underlying tax that is the tax that had already been exigible on the distribution.
On second point the Court held that the use of the word ‘source’ has to be given the same meaning as under UK domestic law and therefore this part of the appeal failed.
Supreme Court Judgement
Having dismissed the appeal points, the Supreme Court went on to determine the ‘correct approach to present question.’
First, the Court held that the Double Tax Convention had to be construed in a manner that is ‘international, not exclusively English.’ The Court was predisposed to favour an interpretation which reflected the ordinary meaning of the words and the objective of the Convention.
The Court rejected HMRC’s view that the profits generated by the LLC belong to the LLC. The Court held that HMRC’s view is contradicted by the facts found by a lower court that is the rights of the members are found to arise from the LLC Act combined with the LLC Agreement that the members are party to.
The Court held that the LLC Agreement was not a contract between the members and the LLC; the LLC was not a party to the Agreement but the LLC was brought into being by the agreement. The Court endorsed the lower Court finding of fact that under the law of Delaware, members automatically become entitled to their share of the profits generated by the business carried on by the LLC prior to and independently of any subsequent distribution.
The Court held that Mr Anson was indeed entitled to a share of profits allocated to him rather than receiving a transfer of profits vested in some sense in the LLC. As such Mr Anson was entitled to relief by way of a double tax credit for tax suffered in the USA.
Sour grapes and going forward
HMRC issued a press release following its defeat in the Supreme Court. The Press release noted;
HMRC has after careful consideration concluded that the decision is specific to the facts found in the case. This means that where US LLCs have been treated as companies within a group structure HMRC will continue to treat the US LLCs as companies, and where a US LLC has itself been treated as carrying on a trade or business, HMRC will continue to treat the US LLC as carrying on a trade or business.
HMRC also proposes to continue its existing approach to determining whether a US LLC should be regarded as issuing share capital. Individuals claiming double tax relief and relying on the Anson v HMRC decision will be considered on a case by case basis.
The main points to take from Anson are;
a) There must be an unfettered right to the profits and not a right to the distribution of profits.
b) That a subsequent agreement to distribute profits is not the same as a constitutive document that brings the entity into being in the first place.
c) That group companies may not be treated the same as Anson but each case here will depend on the facts.
d) That the cover of law such as the LLC Act is persuasive although may not be determinative in supporting the claim that there is an individual right to profits and not an allocation of profits.
e) That US citizens who are about to become tax resident in the UK should take advice before arriving to ensure that their membership of an LLC is Anson compliant or that alternative arrangements are considered to ensure the UK give a tax credit on LLC income.