Ongoing Uncertainty Regarding Entity Classification for UK Tax Purposes

Transcription

1 Ongoing Uncertainty Regarding Entity Classification for UK Tax Purposes Swift v HMRC is a Delaware LLC tax transparent? SUMMARY The question as to whether a non-uk entity such as a Delaware limited liability company ( LLC ) should be treated as transparent or opaque for UK tax purposes can make a significant difference to the amount and timing of tax incurred by a UK taxpayer investing in it. The UK tax tribunal in this recent first instance decision came to the conclusion that a Delaware LLC should be treated as transparent for UK foreign tax credit purposes. In so doing, it avoided economic double taxation. However, this decision is surprising because it had previously been thought that in most cases a LLC would be treated as opaque. The LLC in this case does not seem to have had any particularly unusual features. The decision itself may be appealed but it illustrates the uncertain tax treatment that a UK investor in a LLC will face and provides a discussion of the issues that need to be considered in resolving that uncertainty. There is also a longstanding question as to whether a LLC can disrupt a UK tax group and the decision is relevant to this. This memorandum sets out some of the issues that a UK taxpayer considering an investment in a LLC will need to consider by reference to the decision in this case. UK taxpayers face similar issues when considering investment in other non-uk entities that are not clearly equivalent to English companies. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 SWIFT v HMRC 1 A recent decision in the UK tax courts has underlined the uncertain UK tax treatment that will be faced by a UK investor in a Delaware limited liability company, even though the court found in favour of the taxpayer. The basic difficulty is that the UK does not have clear rules as to whether to treat an investment in a LLC as equivalent to an investment in a partnership (tax transparent) or in a company (tax opaque) for tax purposes. The published guidance 2 of the UK tax authority, HMRC, while recognising that the individual facts must be considered in each case, indicates that the default position is that a LLC should be treated as opaque. The outcome of the case (which may be appealed) was that the LLC in question was transparent. However, it does not appear that that LLC had any particularly unusual features. The UK tax treatment may be determined by fairly subtle changes in the drafting of the LLC operating agreement. The difference in treatment can significantly affect the amount of tax payable, as the facts of the case illustrate. Mr. Swift was a venture capitalist who, together with his US colleagues, set up Sandpiper Partners LLC ( SPLLC ), which acted as an investment manager to various venture capital funds, receiving fee income. All profits were distributed to the members. The question at issue in the case was whether Mr Swift was able to credit US tax paid on the LLC s activities against his UK tax liability on the distributions. If, as the First Tier Tribunal (the Tribunal ) decided, he was entitled to a credit, out of a profit share of 100, he would have suffered roughly 45 of US tax on distributed or undistributed profits, but would have no UK tax to pay. If, as HMRC contended, he was not entitled to a credit he would be liable for further UK tax of 22, on top of the US tax of 45, as and when profits were distributed to him. A UK credit was available if the UK tax was computed by reference to the same profits by reference to which the United States tax is computed 3. The Tribunal found that Mr Swift was charged to tax in the US on his share of the profits of the LLC (distributed or undistributed) on the basis that SPLLC was a partnership for US Federal and state tax purposes. If the LLC was opaque for UK tax purposes, the UK tax would have been on the equivalent of a dividend, which would not constitute the same profits subject to US tax. Therefore no foreign tax credit would have been available for a UK-resident non-corporate taxpayer. ENTITY CLASSIFICATION The essential question for UK tax purposes was whether to treat the UK taxpayer as being taxable on his share of the LLC s income (whether or not distributed) or whether to recognize the LLC as a separate corporate entity and treat the UK taxpayer as receiving some form of distribution from the LLC (only taxable if distributions are actually received). In the former case the UK would give credit for the US tax TC00399 HMRC International Manual ( INTM Article 24(4) of the UK/US Double Tax Convention of 24 July 2001 (SI 2002/2848) (the Treaty ) -2-

3 paid by Mr. Swift; in the latter it would not. In the handful of decided cases, the UK courts have approached this question on an ad hoc basis by asking whether non-uk entities are sufficiently similar to UK partnerships to be treated as partnerships for the purposes of UK tax. UK partnerships include both partnerships where some partners have limited liability 4 and partnerships with legal personality 5. Hence, despite uncertainties in the past, the fact that an entity has legal personality is not invariably a conclusive factor for UK entity classification purposes. Confusingly, a UK limited liability partnership is a form of UK body corporate, not a partnership as such, under the statute creating UK limited liability partnerships. However, such an entity is expressly deemed to be treated as a partnership for UK tax purposes. It will not be one of the UK partnerships to which the courts will have regard in making the comparison mentioned in the previous paragraph. HMRC has published a list of relevant factors for the purposes of classifying non-uk entities 6. These factors have no statutory force but represent HMRC s distillation of the limited guidance provided by the courts as well as the Tribunal. The HMRC list seems to have influenced counsel s submissions in the Swift case. The factors mentioned in that list, none of which is conclusive, are, in summary: a) whether the entity has a legal existence separate from that of the persons that have an interest in it (in other words does it have legal personality); b) whether members of the entity are entitled to profits as they arise; c) whether the entity carries on business on its own behalf or via its members; d) whether the entity issues share capital or something similar; e) whether business assets belong beneficially to the entity or to its members; and f) whether the entity or its members is responsible for the debts of the business. HMRC attaches particular importance to (b) and (c). The Tribunal in Swift concluded: SPLLC stands somewhere between a Scots partnership and a UK company, having the partnership characteristics of the members being entitled to profits as they arise and owning an interest comparable to that of a partnership interest, and the corporate characteristics of carrying on its own business without liability on the members and there being some separation between Managing Members and other members falling short of the distinction between members and directors. Since we have to put it on one side of that dividing line we consider that it is on the partnership side particularly in relation to its income Partnerships under the Limited Partnership Act 1907 Scottish partnerships, although these are rarer than English partnerships, which typically lack legal personality INTM

4 This finely-balanced conclusion was only reached after a lengthy discussion as to whether the members of SPLLC have an interest in the profits of SPLLC as they arise (the Tribunal concluded that they do). This was a matter of disagreement between the experts in Delaware company law and was only resolved by reference to the detailed analysis of the LLC operating agreement. However, the Tribunal seems to have been strongly influenced by s of the Delaware LLC Act (the Act ) which provides that the profits and losses of a limited liability company shall be allocated among the members, and among classes or groups of members, in the manner provided in a limited liability company agreement. According to the Tribunal, this section does not contemplate that profits can belong to the LLC as they must always be allocated to the members. Consequently it was irrelevant that the LLC operating agreement only provided for allocation to be carried out at each year end and distribution even later. If this reasoning is correct, it seems that in practice it may be difficult to draft an LLC operating agreement which has the effect that members will not be regarded by a UK tax court as having an interest in the profits as they arise. In particular, the provisions of the LLC operating agreement, which the Tribunal regarded as fixing the allocation, were the provisions governing the members capital accounts, which are typically in standard form for US tax purposes. The Tribunal s reasoning raises some intriguing questions. As the Tribunal seemed to accept, a UK-style private limited company could be formed on the basis that dividends of all its profits are automatically declared in favour of its shareholders as the profits arise. Would the Tribunal then regard those profits as not belonging to that company because they are allocated automatically to its members, with the result that the company is transparent for UK tax purposes? If so, this would be a very unexpected outcome. We do not think the Tribunal would take that view but it illustrates the problems with applying the criterion as to whether members are entitled to profits as they arise, especially where the entity in question is a separate legal person. The other factor that pointed to transparent treatment in Swift was that a member owns an interest comparable to that of a partnership interest, not least because of the requirement for consent from other members before that interest could be transferred. This was a less significant factor in the context of the case. However, it is a factor that can more easily be varied in the establishment of the LLC. It is also relevant to another UK tax problem that can be encountered with LLCs, as discussed below. TAX GROUPING This other problem is that in order to be part of a group for most UK tax purposes (including capital gains, group relief and stamp duty), an entity must be a body corporate having ordinary share capital 7. Not only will an entity without ordinary share capital not form part of the group but HMRC may also take the 7 Defined in Section 1119 Corporation Tax Act 2010 to include all share capital other than fixed-rate preference shares -4-

5 view that it is not possible to trace a wider group through it, with the possible exception of where all the members of such entity are also part of the group. The inclusion of an entity without ordinary share capital can therefore cause the unexpected loss of the various group reliefs which would otherwise be available. Indeed, avoiding the creation of groups by inserting companies limited by guarantee is a standard taxplanning technique. The UK approaches this question by asking whether a member s interest is analogous to a holding of ordinary share capital in an English company. Again this is not a brightline test but a question of fact and degree to be determined by reference to the relevant non-uk corporate law and a number of factors set out in HMRC guidance 8. Since 2007, HMRC has taken the view that it is not necessary for a member to have availed itself of the possibility provided under s c of the Act (which allows for a member s interest to be evidenced by a certificate issued by the LLC) in order for the LLC to be regarded as having ordinary share capital. This is to some extent supported by the Tribunal s decision, as the absence of such a certificate in this case was one of the factors considered rather than being determinative. The factor that seems to have most influenced the Tribunal is the restriction on transfer of a membership interest in this case. This appears to be solely a function of the provisions of the LLC operating agreement. It is also a potentially inconsistent factor because UK private limited companies shares are routinely subject to major transfer restrictions. Nonetheless, it is considered that a LLC which issues certificates and has transfer provisions similar to those of an English company, where transfers are registered and not subject to approval by the other members, is likely to be considered as having ordinary share capital. However, this does not mean it will necessarily be treated as opaque for tax purposes, as this is only one of several factors to be considered in determining questions of tax transparency. PRACTICAL IMPLICATIONS Although the Tribunal reached a fair and pragmatic conclusion, it is possible to criticize the Tribunal for the weight placed on certain factors. In particular the case was decided on the basis of only two factors pointing to transparency, both of which were the subject of conflicting expert opinion and both of which are inherently problematic. In addition, the Tribunal may have been influenced to some degree by the treatment of SPLLC for US tax purposes, in spite of authority that classification for non-uk tax purposes is not relevant: The US tax returns for 2000 (and we infer all other years) show that the whole of the book profits are allocated to the members capital accounts. This means that the profits do not belong to the LLC in the 8 HMRC Business Brief 54/07: this is another non-statutory distillation of the few relevant judicial decisions -5-

6 first instance and then become the property of the members because there is no mechanism for any such change in ownership, analogous to the declaration of a dividend. It is unclear what precisely the last sentence means bearing in mind that a LLC has legal personality and therefore beneficially owns its income and assets. These matters illustrate the unsatisfactory nature of UK tax law in its approach to entity classification as, in the absence of all factors pointing in the same direction, there is always going to be some scope for argument and therefore some uncertainty for the taxpayer. That uncertainty is compounded by the need for detailed review of non-uk legal documents (often not in English) and the need to obtain expert evidence on non-uk legal questions. By the time the case came to court, SPLLC, presumably as a result of Mr. Swift having become aware of his uncertain and potentially costly UK tax position, had restructured to become a limited partnership. HMRC has historically tended to accept that a Delaware limited partnership is transparent even though it has legal personality. In many cases, in order to obtain a greater degree of certainty, the first option in advising a UK investor may be to see if a different entity, whose classification is clearer either on these principles or at least as per HMRC guidance, can be used instead. Of course, in many cases, this option will not be available. Taxpayers and their advisers have difficult choices to make as uncertainty may be the price of potentially beneficial tax treatment. If the taxpayer had lost in this case it appears that no credit for underlying tax would have been available under the Treaty because the Treaty only gives credit for underlying tax to a corporate taxpayer, not to an individual. However, in other cases or under other treaties, the conditions for underlying tax relief may appear to be fulfilled. However, this is typically limited to underlying tax paid by a company. An earlier case 9 illustrates that an entity that fails to meet the conditions for transparency will not necessarily be treated as a company for these purposes. The distinction between a partnership and a company is not always the same as the distinction between a transparent and an opaque entity. A similar issue needs to be considered by corporation taxpayers in determining whether the UK s distribution exemption 10 will apply to distributions received from a non-uk entity that is treated as opaque. If a taxpayer is considering taking an uncertain position on an entity being treated as transparent, that taxpayer should consider carefully whether an adverse finding could have an unexpected downside. For UK-resident individuals, the availability of a credit under the Treaty means that in most circumstances they are likely to prefer transparent entities. However, there are a number of other factors to consider if a choice of entity is available. If an entity is transparent for income purposes, it is also likely to be transparent for the purposes of UK tax on capital gains on the basis that it is a partnership within section 9 10 Memec plc v IRC [1998] STC 754 Part 9A of the Corporation Tax Act 2009 ( CTA ) -6-

7 59 Taxation of Chargeable Gains Act This means that a member will be treated as disposing of his fractional share of any capital asset disposed of by the entity (a credit for any US tax should be available). The amount and timing of the income inclusion will also be different if an entity is transparent. This will be particularly significant if the entity (e.g., a LLC) rolls up its income rather than distributing it. The rules are similar for UK corporation taxpayers but they are likely to have a different perspective particularly as, following recent changes, distributions from opaque vehicles will be tax-exempt in most cases and so they are less likely to be concerned about the availability of credit under a double taxation agreement. They will also want to have regard to the tax grouping issues mentioned above. WIDER IMPLICATIONS While this note has concentrated on LLCs, the same principles are applicable to other non-uk entities. Other entities which give rise to particular uncertainty include Dutch CVs, LLCs established under the laws of other US states and German silent partnerships. However, regard should also be had to entity classification principles in cases where it might be thought that the treatment is well established, particularly if any unusual provisions are included in the documents governing the relevant entity. It is not automatically the case that a non-uk entity described as a partnership will be treated as a partnership for UK tax purposes. There are detailed provisions dealing with the treatment of fiscally transparent entities in the Treaty and in other more recent UK double tax agreements 12. Hence, entity classification issues are to some extent reduced in the UK/US context. However, tax authorities have traditionally had some trouble with the treatment of such entities, particularly under double tax agreements where the jurisdictions in question treat an entity differently for tax purposes 13. The UK now has legislation overriding attempts by UK residents to exploit some of the UK s older treaties so that fiscal transparency leads to income being taxable in neither jurisdiction. Such legislation was recently enhanced with retrospective effect 14. On the other hand, it is not necessarily the case that the UK tax rules will be effective to prevent economic double taxation where such hybrid treatment arises. Despite the Tribunal s decision, the overall result remains highly unsatisfactory. Not only is the law and HMRC guidance unclear but there is also a lack of guiding principle as to when entities should be treated as transparent for UK tax purposes and what this means. As the Swift case shows, key classification Although there are now situations where partnership-type arrangements for collective investment are required by statute to be treated as opaque for the purposes of UK tax on capital gains. See for example the 2008 agreement with France See the Report of the OECD Committee on Fiscal Affairs on the Application of the OECD Model Tax Convention to Partnerships, 1999 Section 58 of the Finance Act 2008, the retrospective nature of which was recently upheld in R (ex parte Huitson) v HMRC [2010] EWHC 97-7-

8 questions can turn on very fine distinctions based on detailed examination of non-uk law and the constitutional documents of non-uk entities. It was the cost, complexity and uncertainty of such an approach which led the US to adopt the check-the-box rules in Unfortunately, the UK still seems a long way from adopting an equally practical solution. * * * Copyright Sullivan & Cromwell LLP

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