HMRC provides guidance on the implications of the recent case Anson v Revenue and Customs Commissioners

Delaware limited liability companies (LLCs) are regularly seen in many international corporate groups, including in advisory firms and as hedge and other investment funds. The treatment of LLCs is somewhat flexible for US tax purposes, as by default they are treated in the same way as partnerships (although they are able to elect to be treated as a corporation for US tax purposes). No such elective regime exists in the United Kingdom, and the tax treatment of LLCs and their members turns on whether the LLC is opaque or transparent for UK tax purposes. Until now, HM Revenue and Customs’ (HMRC’s) practice—which was widely accepted as being correct—has been that LLCs should usually be treated as opaque.

In the case Anson v Revenue and Customs Commissioners ([2015] UKSC 44), Mr. Anson, a UK resident taxpayer, was a member of a Delaware LLC (treated as a partnership for US tax purposes) and was subject to US tax on his share of the LLC’s profits as they arose. For UK tax purposes, however, HMRC denied Mr. Anson a credit against his UK tax liability for the US tax on the basis that the LLC was not transparent and therefore Mr. Anson’s income consisted of the LLC distributions and not the underlying profits themselves, with the result being that the US tax was not imposed on the “same income”. As a result, Mr. Anson was liable to pay UK income tax on the income distributed (net of the US tax paid) with no credit for the US tax already paid, which produced an effective rate of taxation of around 67%. On 1 July 2015, the Supreme Court of England & Wales (Supreme Court) gave its judgment in Anson, a landmark ruling that allowed Mr. Anson a credit for his US tax against his UK income tax liability.   

The decision came as a surprise to many, as it represented a departure from HMRC’s previous view that Delaware LLCs should be treated as opaque for UK tax purposes. The Supreme Court agreed with the decision of the court of first instance (the First Tier Tribunal or FTT) that Mr. Anson was in fact entitled to the profits as they arose (in other words, that the LLC was transparent for income tax purposes). This decision has created some uncertainty about how Delaware LLCs should be treated from a UK tax perspective, including whether all LLCs should be treated in the same way.

HMRC’s Historical Practice of Entity Classification

HMRC has a long and well-established practice (set out in, among other places, HMRC’s manuals) of entity classification for the purposes of working out whether a non-UK company should be treated as opaque (like a UK company) or transparent (like an English partnership). There are several limbs to the test (developed following the decision in Memec v IRC [1998] STC 754), including

  1. whether the entity has a separate legal personality,
  2. whether it issues share capital or something equivalent,
  3. whether the business is carried on by the entity or its members,
  4. whether members are entitled to the profits of the business as they arise or only following distribution,
  5. who is responsible for the debts of the business, and
  6. to whom do the assets used in the business belong.

HMRC’s view has always been that no one factor should be determinative.

HMRC’s Views on Anson

On 25 September, HMRC released it views on the case, and its implications for UK companies and individuals with interests in Delaware LLCs.[1] HMRC’s brief contains no comment on the continuing applicability of the published entity classification tests, but the implication is that HMRC will continue to apply them as before. With respect to Delaware LLCs in particular, while this is not expressly set out, our interpretation is that HMRC has taken the view that the deciding factor in Anson was the LLC agreement and not the Delaware law itself, and as a result the case does not necessarily have wide relevance to other LLCs. With respect to companies, HMRC has said that they will continue to treat as companies those LLCs that have historically been treated as companies within a corporate group. It is not clear how HMRC will treat UK companies that have LLC interest outside a corporate group, such as a holding. For individuals, however, a case-by-case approach is to be adopted.

The First Tier Tribunal’s Decision

The FTT focussed on whether the taxpayer’s UK income tax liability had been computed “by reference to the same profits or income” as the US tax within the meaning of the relevant provisions of the treaty between the United Kingdom and the United States. To assess this, rather than considering the entire entity classification test referred to above, the FTT focussed on whether Mr. Anson (or the LLC) was entitled to the profits as they arose. It relied on evidence provided by Delaware law experts regarding the relevant provisions of the Delaware statute and the LLC agreement. Emphasis was placed on both the LLC agreement and the provisions of Delaware law, including section 18-101, which defines an LLC interest as including the “member’s share of profits or losses” of the LLC; section 18-503, which provides that “profits and losses shall be allocated among the members. . . in the manner provided in the LLC agreement”; and section 18-601, which provides that “to the extent and at the times or upon the happening of the events specified in the LLC agreement, a member is entitled to receive from an LLC distributions before the member’s resignation from the LLC”. In Anson, the relevant LLC agreement provided for gross income and losses to be credited and debited to the members’ capital accounts according to their sharing ratios. The fact that the LLC was not required to distribute profits immediately, but rather allocated them to the members’ accounts, did not necessarily mean that the profits belonged to the LLC in the meantime.

Following their consideration of the joint effect of the law and the LLC agreement, the FTT concluded that Mr. Anson was entitled to the profits as they arose, not dependent on the timing of a distribution. While the FTT did not specify if it was the Delaware law or the LLC agreement that carried more weight, they did acknowledge that the Delaware law allows “wide freedom to contract the terms of a Delaware LLC” and therefore their conclusions may not be of “general application”—implying that the agreement itself was the final determining factor.

The Supreme Court Decision

On appeal from the FTT decisions, the Upper Tribunal and Court of Appeal both felt that the proper test was actually whether the LLC members had a proprietary right to the LLC’s assets and business, which the parties agreed was not the case. This lead those courts to conclude that the profits could not belong to Mr. Anson as they arose and therefore he was not entitled to a tax credit (as the UK and US taxes were not computed by reference to the same profits).

The Supreme Court reversed the Upper Tribunal and Court of Appeal decisions and found that the income on which the taxpayer was liable to UK tax had the same source as the income on which he was liable to US tax, because Mr. Anson was indeed entitled to his share of the profits of the LLC as they arose. The Supreme Court determined that the FTT was entitled to make the finding (as a matter of fact, based on the expert witnesses’ evidence) that the profits did not belong to the LLC in the first instance (with the members only becoming entitled to those profits on a subsequent distribution of those profits), but rather that the profits belonged to the members of the LLC as they arose.

It is well established in UK tax law that the UK tax treatment depends on the local non-tax law of the facts (see, e.g., Baker v Archer-Shee [1927] AC 844 and Archer-Shee v Garland [1931] AC 212), although it may sometimes be challenging to determine the local law analysis. The Supreme Court commented that the FTT’s “conclusion. . .was that, under the law of Delaware, the member automatically became entitled to their share of the profits generated by the business carried on by the LLC as they arose, prior to, and independently of, any subsequent distribution”. They also acknowledged that the factual outcome was a combined question of Delaware law and the LLC agreement, but it was not clear whether the law or the LLC agreement had more relevance. 

The Supreme Court’s decision did not specifically consider whether the LLC was opaque or transparent for UK tax purposes (which had historically been a focus of HMRC) because it was not necessary to reach a decision on this for foreign tax credit purposes, but only to determine whether Mr. Anson was entitled to the profits as they arose. Indeed, it is no longer entirely clear whether HMRC will still need to apply the same tests to determine opacity or transparency in many cases, or whether the entitlement to profits will now “trump” the other features.

Practical Implications for Taxpayers

The decision, together with HMRC’s announcement, creates some uncertainty about the way Delaware LLCs—and potentially other non-UK entities—should be treated for UK tax purposes. For UK companies with Delaware LLC interests that have previously relied on the UK corporation tax exemption for dividends with respect to distributions received from Delaware LLCs (the availability of which is predicated on HMRC’s previous treatment of Delaware LLCs as opaque), it seems that this treatment continues to be available, which implies that no changes from the historic treatment are required for UK companies with interests in LLCs within their corporate group.

However, it may be necessary for individual members of an LLC to examine the exact terms of the LLC agreement to ascertain whether or not the LLC should be treated as transparent. It is not clear on what basis HMRC draws this distinction between individual members and corporate members, and it raises a number of questions. For example, will a corporate member of a suitable LLC be able to have it treated as a transparent entity? And what would be the tax treatment where a UK company and a UK individual have interests in the same LLC? It would be illogical to apply different treatment to each, as the treaty test is the same for both. Furthermore, it is still not clear whether HMRC will approach transparency in the case of other non-UK entities in the same way or will focus more or less exclusively (for foreign tax credit purposes) on the question of who is entitled to the profits as they arise. Furthermore, the Anson case analysed the UK–US tax treaty provisions; UK domestic law is substantially similar, so will HMRC apply this decision to cases that do not involve the UK–US treaty?

Before HMRC released its announcement in response to the Supreme Court’s decision, the decision potentially cast doubt on UK tax corporate groupings due to a perception that HMRC would likely change its existing practice on the treatment of membership interests in Delaware LLCs as share capital, even though the Supreme Court did not specifically address this point. HMRC has now confirmed that it will continue its existing approach to determining whether a US LLC should be regarded as having share capital—that is to say, an LLC will continue to be regarded as having share capital if it issues membership certificates.

What is now clear is that planning for use of a US LLC where UK members are involved requires careful attention to the terms of the document with a view either to conforming as closely as possible to the salient terms of the operating agreement in Anson where tax transparent treatment is desired, or to departing where necessary where non-flow-through treatment in the United Kingdom is preferable. Care will need to be taken to recognise that there is a distinction between entitlement to profits as they arise and an entitlement to call on an immediate distribution of available cash.

Where tax transparent treatment in the United Kingdom is required, the safest path may still be to use a limited partnership—the accepted practice before the Supreme Court’s decision in the Anson case.