UK government proposes reform of taxation of LLC members

The US LLC is a popular business vehicle, particularly in the private capital sector. However, its current UK tax treatment can give rise to effective double taxation for members who are UK resident individuals. In a welcome move, on Wednesday, the UK government launched a consultation on measures to tackle this issue, including a proposal for US LLCs (and other "reverse hybrids") to be treated as transparent for the purposes of UK tax on individuals.

        
            Key points
        
Effective double taxation can arise for UK resident members of entities (such as most US LLCs) that are treated as tax transparent in their own jurisdictions but opaque in the UK.

To tackle this problem HMRC is consulting on proposals to treat these "reverse hybrid" entities as transparent from the perspective of their members who are UK tax resident individuals.  Such treatment would be mandatory rather than by election.

The transparency route would solve the double taxation concern and provide certainty but would potentially give rise to complex technical issues. In addition, mandatory transparency would remove the current flexibility for businesses to effectively choose whether their US LLCs should be transparent or opaque from a UK perspective.

The reforms will only apply to LLC members who are individuals. This is good news for pension funds, as opacity prevents them from being treated as directly undertaking any trading activities of the LLC (the profits of which would be taxable in their hands). For corporation taxpayers, the retention of opacity should preserve the likely availability of the dividend exemption and not disturb their grouping analysis.

The proposals are by no means set in stone. HMRC is seeking views on all aspects of the transparency option (including whether it be mandatory), considering alternative routes (relief by credit or deduction) and asking for other ideas.

The consultation closes on 31 July. No date has been given for the implementation of any reforms.

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Background

Tax mismatches often arise where an entity is treated, for tax purposes, as transparent (so "look through") in its jurisdiction of establishment but opaque in a jurisdiction where one of its investors is resident. Such an entity is commonly referred to as a reverse hybrid.

The US limited liability company (LLC) is a popular business vehicle, providing limited liability and operational flexibility. It is commonly used in private capital investment structures, for example, as an asset holding vehicle. For US federal income tax purposes, its default status is that it is transparent (either as a partnership or, if it only has one member, as a disregarded entity), but a "check the box" election can be made for it to be treated as opaque. Typically, businesses will not make this election, so most US LLCs we come across are transparent for US tax purposes.

Whether any given non-UK entity is treated as opaque or transparent for UK tax purposes will depend on the circumstances of the entity. However, HMRC does, in its guidance, set out its general view of the position of various different entity types - but this is subject to the particular facts in any given case (and so may be overridden). HMRC considers that US LLCs will typically be opaque for UK tax purposes.

The problem

The mismatch between the typical US tax classification of a US LLC (transparent) and HMRC's view of the typical US LLC (opaque) can give rise to effective double taxation. This is because, in the US, UK resident members will be subject to tax on their share of the profits of the US LLC as they arise, but not on distributions of those (post-US tax) profits. However, in the UK, those members will not be taxed on the profits as they arise in the US LLC, but will be taxed on distributions of those (post-US tax) profits.

In addition, the current conditions for double tax relief will not be met (either under a double tax treaty or under domestic rules) because the tax charges do not arise on the same profits or income – in the US the tax is on profits whereas in the UK the tax is on distributions. This can give an effective tax rate of over 70%.

The consultation

There are two elements to the consultation. The first is a fact-finding exercise, under which HMRC is looking for information on the difficulties that come up in practice in relation to reverse hybrids and how businesses address them, as well as detail as to how other jurisdictions deal with similar challenges. The second element looks for views on how the UK should address the problems arising from the taxation of reverse hybrids and proposes potential solutions.

Transparency

The main proposal in the consultation is that reverse hybrids be treated as tax transparent from the perspective of its members who are UK resident individuals. This treatment would not apply to UK resident reverse hybrids or those trading in the UK through a permanent establishment.

Notably, it appears that this treatment would be automatic rather than by election. However, in line with the overall flavour of the consultation as a whole, HMRC seems to have an open mind on the point, with one of the specific questions it asks being whether respondents see any advantages or disadvantages to transparent treatment applying automatically, rather than by irrevocable election.

Individual members of a reverse hybrid within the new regime would treat it as though it were a partnership unless they were the sole member, in which case, they would be treated as carrying on the business of the entity themselves. In either case, members would be subject to tax on the entity's profits as those arose.

In addition, HMRC is proposing that the transparency apply for capital gains purposes, with partnership tax principles applying.

Alternative forms of relief

As well as transparency, the consultation also seeks views on two other forms of relief – deduction or credit for foreign tax.

Deduction: the proposal here is that any foreign tax would be deductible in calculating the individual member's UK tax liability. HMRC give the example of distributions from the reverse hybrid and say that the UK tax on this would be calculated on the distributions net of foreign tax already paid by the individual on the distributed profits.

Credit: the proposal here is that a credit for foreign tax on underlying profits would be available against the individual member's UK income tax liability on distributions. This form of relief typically gives a better result for taxpayers than relief by deduction, as credit relief allows the full amount of the foreign tax to offset the UK tax liability, whereas under deduction relief that foreign tax only reduces taxable income.

Anything else?

HMRC are also asking for any other ideas for reforming the taxation of individual members of reverse hybrids.

Timing

The consultation closes on 31 July. No date has been given for the implementation of any reforms.

If the transparency proposal were introduced, the consultation confirms that it would apply prospectively for tax years following the date of introduction of new legislation.

Comment

HMRC has framed the consultation as a pro-growth measure, with the proposals designed to enhance the UK's attractiveness to talented globally mobile individuals. The UK's appeal to that community has been dented, in particular, with last year's removal of the non-dom regime and, for private capital managers, the recent reform of carried interest taxation, so the consultation is potentially a welcome change of direction from the government.

There is room for improvement in relation to the current UK tax treatment of foreign reverse hybrids. This is particularly the case for US LLCs, where, in addition to the effective double taxation problem, there has been long-standing uncertainty as to whether they should be considered transparent or opaque for UK tax purposes. In this regard, HMRC stands by its view that they are likely to be opaque, despite a finding of transparency by the Supreme Court in its 2015 decision in Anson.

The proposed transparency treatment would address both these issues, eliminating double taxation and providing certainty as to the entity's status. A further advantage would be that distributions from reverse hybrids to individual members would be ignored for tax purposes, removing the need to engage in (often difficult) analysis about how such returns should be classified from a UK tax perspective.

The fact that the reforms will only apply to individuals is likely to be good news for other members of reverse hybrids. For those whose tax exemption does not extend to trading profits (such as pension funds), transparency would potentially expose them to unwelcome tax liabilities if the reverse hybrid carries on a trade. For corporation taxpayers, the retention of opacity should preserve the likely availability of the dividend exemption and not disturb their grouping analysis.

However, the proposed transparency is not a straightforward measure, and its introduction would potentially give rise to some additional complexities. The consultation appears to recognise this, asking a wide range of questions on possible consequences (for example, in relation to what happens when an entity joins the regime or ceases to be transparent for foreign tax purposes). In addition, mandatory transparency would remove the current flexibility for businesses to choose whether their US LLCs should be transparent or opaque from a UK perspective (by adopting appropriate provisions in the US LLC's constitutional documents).

Helpfully, it looks like HMRC is very much in listening mode, as it will be important that any reform is carefully worked through before implementation, and industry's views taken into account.

The Travers Smith Tax Policy Team will respond to the consultation. Please get in contact if there are any points that you would like us to raise with HMRC.

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