A recent decision of the UK’s First Tier Tax Tribunal in Mr Swift v The Commissioners has raised doubts in relation to the UK tax treatment of US limited liability companies (LLCs) and members’ interests in such entities. Similar issues were discussed and ruled on by the Tax Court of Canada in TD Securities (USA) LLC v The Queen last month. In each case the court had to decide whether the appellant was entitled to double tax treaty relief.
For both UK and Canadian tax purposes US LLCs have commonly been considered to be opaque, which contrasts with the US tax position under which (in the absence of an election to the contrary under the “check-the-box” regulations) such entities enjoy tax transparency. Why is the distinction important for tax purposes? The profits of an opaque entity, for example a company, are treated as its own and the company itself is taxed thereon. Members (i.e. shareholders) are then generally only taxed in relation to any profits actually distributed by way of dividend. On the other hand, the profits of a transparent entity, such as a partnership, are treated as profits of the members (i.e. partners) themselves who are taxed on those profits as entitlement to them arises, irrespective of whether such profits are actually distributed or retained. In addition, HM Revenue and Customs (“HMRC”) and the Canadian Revenue Agency (“CRA”) have traditionally regarded US LLCs as capable of having share capital which has its own implications for cross border tax planning.
In summary, it is questionable if the judgment in either case stands up to technical scrutiny, whilst clearly justice was done. However, in relation to the TD LLC case, the deadline for the CRA to file an appeal has passed so the ruling of the Tax Court will stand and taxpayers may wish to consider claiming refunds of overpaid Canadian taxes where treaty benefits were denied in circumstances similar to those of TD LLC. In contrast, it is hard to advise what action should be taken in reliance on the Swift decision as HMRC is appealing the Tribunal’s decision and will be maintaining its existing view of the LLP as opaque and as having ordinary share capital pending the result of its appeal. In the meantime, however, in line with HMRC guidance published last week (accessible here), any member of a US LLC who feels that the UK treatment of a particular LLC should be reviewed in light of the Tribunal’s decision is invited to write to Stan Surgin, Business International, Yorke House, Castle Meadow Road, Nottingham, NG2 1BG providing full details of the basis of their application.
One thing that is clear is that even closer scrutiny should be made by non-US resident taxpayers of structures whether in bound or outbound USA as some surprising results can accrue whichever way the final decision goes. If opaque, then UK residents will continue to suffer double tax on US source profits of the LLC. If transparent, then group structure will be broken and relief such as substantial shareholding put at risk.
It is also essential not merely to accept standard LLC documentation. Much can turn on the manner in which the statutes are worded in deciding whether the LLC is akin to a partnership or is opaque with an issued share capital.
Finally, taxpayers are well advised to consider other US entities where the treatment is perhaps clearer such as S Corps or Delaware partnerships.
Please see below the summaries of the two cases and our comment on their implication.
UK: Mr Swift v The Commissioners
The main question before the Tribunal in this case was whether the profits of a Delaware LLC (“SPLLC”), on which Mr Swift, a UK resident member of the LLC, had paid tax in the US (as for US tax purposes SPLLC was fiscally transparent), were deemed to be his or the LLC’s. If the former, then he would be entitled to double taxation relief for the US tax paid. HMRC argued that he was not entitled to such relief as the LLC was a corporate (opaque) entity that had paid the equivalent of a dividend and so Mr Swift was not being taxed in the UK on the same profits or income as in the US.
In determining whether or not the UK tax was “computed by reference to the same profits or income” i.e. whether or not SPLLC was a transparent entity for tax purposes, the Court claimed to follow the approach adopted in Memec v IRC, considering the characteristics of a UK partnership, a Scottish partnership and a UK company and then deciding where along that spectrum this Delaware LLC fell.
In reaching its decision the Tribunal considered the provisions of the Delaware LLC Act (the “Act”). The Act defines a member’s interest in an LLC as including “a member’s share of the profit and losses” of the LLC, which are to be “allocated among the members…in the manner provided for in a limited liability company agreement”, or if the LLC agreement does not so provide, as prescribed by default rules in the Delaware LLC Act. Accordingly, a member’s entitlement to allocations of an LLC’s profits depends entirely on the wording of the LLC agreement. The Tribunal reviewed SPLLC’s operating agreement, finding that the agreement did not contemplate that profits could belong to the LLC as they must be allocated to the members. The Tribunal therefore concluded that SPLLC stood somewhere between a Scots partnership and a UK company but considered it to be on the partnership side particularly in relation to its income. Accordingly Mr Swift was taxed on the same income in the US and UK and was entitled to double taxation relief.
The Tribunal warned that due to the wide freedom to contract the terms of an LLC under Delaware law their findings may not be of general application. However it is not clear if, and/or to what extent, it is possible to contract so as to amend the position, though it would be advisable to review LLC operating agreements and related agreements to minimize the risk of unintended consequences.
In determining the categorisation of SPLLC, the Tribunal also considered whether the members’ interests in the LLC constituted “share capital or something which serve[d] the same function as share capital”, which would be indicative of company status. Again looking to the specific terms of SPLLC’s operating agreement, the Tribunal held that the membership interests in SPLLC were not similar to share capital but rather more similar to partnership interests, the legal transfer of which requires the consent of all partners, whilst the economic benefits may be transferred without such consent and without the transferee becoming a partner.
Although the Tribunal reached its decision without reference to HMRC’s guidance in its Tax Bulletins, their ruling is consistent with HMRC’s current approach whereby, if members’ interests in a Delaware LLC are evidenced by a certificate issued by the LLC, HMRC will accept that the LLC has “ordinary share capital”. Here there was no indication that SPLLC had issued such certificates.
Such a finding is of crucial significance from a tax perspective as an opaque entity without share capital cannot be a member of a group for UK tax purposes and so would break a group structure for companies held beneath such entity, consequently also failing to be classifiable as a “75% subsidiary” or qualify for any group calculation or relief purposes. Additionally the availability of reliefs conditional upon levels of shareholding, such as the substantial shareholders exemption for corporation tax purposes, would seemingly disappear for its members.
Unfortunately, the scope of the decision is not clear. As well as the Tribunal’s warning that their findings in this case were heavily influenced by the specific terms of SPLLC’s operating agreement, some commentators have highlighted that the Tribunal did not find that SPLLC should be characterized as transparent for all UK tax purposes; their decision being restricted to how its profits should be treated in respect of its members. It therefore leaves open the possibility that the LLC should still be characterised and treated as opaque for other aspects of UK tax law.
Further, the decision is not a binding precedent and HMRC are appealing it. Therefore, at least until the outcome of the appeal is known, HMRC’s existing practice of treating Delaware LLCs as opaque entities will be maintained. At this stage however, the findings of the Tribunal are worth keeping in mind where a UK resident taxpayer has an interest in a US LLC or a US LLC forms part of a group with UK resident members. HMRC guidance published last week advises that any member of a US LLC who feels that the UK tax treatment of a particular LLC should be reviewed in light of the Tribunal’s decision in Swift, should write to Stan Surgin, Business International, Yorke House, Castle Meadow Road, Nottingham, NG2 1BG setting out full details of why they believe that to be the case.
Canada: TD Securities (USA) LLC v The Queen
The long-standing approach of the CRA had been to deny double taxation treaty benefits to payments made to U.S. LLCs, on the basis that from a Canadian tax perspective, the LLC is the taxpayer as it is a corporation (opaque entity), the profits of which belong to it and are directly taxable in its (not its members’) hands; whist in the US it is fiscally transparent (in the absence of an election to the contrary) and so is not taxed directly on its profits.
In this case, the US LLC (“TD LLC”) was wholly owned by a U.S. corporation and had a permanent establishment in Canada. The main issue before the Court was whether TD LLC was entitled to enjoy the benefits of the Canada-US double tax treaty (“US Treaty” or “Treaty”) in respect of its Canadian-sourced income during its 2005 and 2006 taxation years, and accordingly pay branch tax at the reduced rate of 5% applicable under the Treaty for those years. The CRA had denied TD LLC the benefit of the reduced rate, assessing its liability for branch tax at 25%.
The US Treaty applies to “persons who are residents of” Canada and/or the US. It was not disputed that TD LLC qualified as a “person” as defined in the US Treaty but the question before the Court was whether TD LLC was a “resident” of the US for these purposes. The US Treaty provides “the term ‘resident’ of a Contracting State means any person that, under the laws of that State, is liable to tax therein by reason of that person’s domicile, residence, citizenship, place of management, place of incorporation or any other criterion of similar nature”.
The CRA defended its denial of Treaty benefits on the basis that the evidence clearly demonstrated that TD LLC itself was not liable to tax in the US where its income was taxed in the hands of its sole member. The CRA further maintained that even if TD LLC were considered to be liable to tax by virtue of its income being taxed at member level, the tax would not be “by reason of that person’s domicile, residence, citizenship, place of management, place of incorporation or any other criterion of similar nature”.
TD LLC’s position was that, following the provisions of the US Treaty, as the phrase “liable to tax in” the US is not defined in the US Treaty it falls on the Court to define it by reference to Canadian law. In addition, TD LLC proposed that the phrase “liable to tax in” the US has a different meaning from the determination whether a person is required to pay tax on its income in the US. Its alternative argument was that, consistent with the commentaries to the Organisation for Economic Co-operation and Development (“OECD”) Model Tax Treaty (“OECD Model Treaty Commentaries”), on which the US Treaty is based, and to which commentaries neither Canada nor the US made any reservations or material observations, a liberal interpretation and application of the US Treaty designed to achieve its purpose must give meaning to the phrase “resident of a Contracting State” that includes a US LLC such as TD LLC.
The Court decided in TD LLC’s favour and commented that the CRA’s treatment to-date of US LLCs was an “anomaly” particularly in light of its position in relation to:
- Trusts – These are dealt with specifically in the US Treaty and are deemed “resident” for Treaty purposes to the extent that their income is taxed either at entity or at beneficiary level;
- Not-for-profit organisations, pension funds and government entities – Again dealt with expressly in the Treaty, these are recognised as “resident” even though they do not generally pay income tax in the US because they are exempt from tax;
- Foreign partnerships – Whilst, strictly speaking, such entities are not themselves liable to tax and so may not on a strict interpretation be considered resident for US Treaty purposes, the benefits of the Treaty are extended to them in the following way: Income earned by such entities can qualify for Treaty benefits on the basis that the members (in this case, partners) are persons liable to tax and entitled to claim the benefit of the Treaty; and
- US “S Corps” – US corporations that elect under Chapter S of the US Internal Revenue Code (the “US Code”) qualify as being “resident” in the US for Treaty purposes, even though they are treated under the US Code as fiscally transparent entities with their income being taxed in the hands of shareholders.
The Court regarded the OECD Model Treaty Commentaries and the OECD Partnership Report on the appropriate treatment of partnerships as instructive and considered that there was no reason for the Treaty not to be interpreted to apply in the same way to both partnerships and fiscally transparent LLCs. This, in the Court’s view was consistent with the object and purpose of the US Treaty and the US’ intentions since signing in 1980, though Canada (and the CRA) had not adopted the same approach. The Court therefore concluded that TD LLC was “resident” in the US for Treaty purposes and accordingly entitled to double taxation treaty protection and to pay branch tax at the reduced rate by virtue of:
- its worldwide income being subject to US tax, although not at entity level, at member level; and
- the place of incorporation of its member (i.e. the US), being the very reason that TD LLC’s income was subject to full and comprehensive taxation in the US.
As part of its case, the CRA raised its concern that a finding for TD LLC in this instance would result in future LLCs being able to choose between having the US Treaty apply in accordance with the Court’s reasoning here or, alternatively, on the basis of the Fifth Protocol Amendments (“Amendments”).
The Amendments were agreed between Canada and the US in 2007. They are not retroactive and therefore could not be applied to TD LLC’s 2005 and 2006 Canadian branch profits. In effect, they make the benefits of the US Treaty available to US LLCs (amongst other fiscally transparent entities) to the extent that the members of the LLC are US Treaty residents. However, income of the LLC attributable to non-US residents is not entitled to Treaty protection, even if these members reside in another country which has a tax treaty with Canada.
The Court was not persuaded by the CRA’s arguments. In summing up, the Court did recognise that there was some irony in the fact that its decision in this case had been, on a prospective basis, statutorily overridden prior to it having been decided, as TD LLC and its sole member would have satisfied the requirements of the Amendments and been entitled to the protection of the US Treaty, had the Amendments been applicable to the years in question. In view of this the Court did not believe that it was affording “a materially different gate to access the US Treaty, much less a potential flood gate” and dismissed the CRA’s concerns. In light of this it is interesting to consider whether the decision in this case would have been different if TD LLC were owned by multiple members with mixed US and non-US residency.
As regards the availability of double taxation relief in respect of US taxes paid by a Canadian-resident individual member of a tax transparent US LLC, the CRA already allows limited credits and deductions on the understanding that such taxes are paid in respect of the taxpayer’s membership interest in the LLC.
The deadline for filing an appeal of the Tax Court’s ruling was 10 May 2010 but the Crown has chosen not to appeal so the decision will stand. Nevertheless it may still be wise to review existing group structures to optimise tax efficiencies where you have US-incorporated LLCs operating in Canada, particularly if the circumstances are not similar to those of TD LLC as the full scope of the decision is not clear. US LLCs may also wish to consider filing amended returns and/or claims for refunds of excess tax that may have been paid to the CRA due to the denial of treaty protections in the past. Applications for refunds must be made no later than two years after the calendar year in which the amount was withheld and remitted.
(With many thanks to co-contributor, Maya Sandhu)
