January 17, 2012
U.K. Ruling Poses Potential Problem for U.K. Investors in U.S. LLCs
Recently, an upper UK court reversed a lower court decision and has held that a Delaware limited liability company ("LLC") should not be characterized as a partnership or transparent entity for U.K. income tax purposes. The case, entitled The Commissioners for Her Majesty's Revenue and Customs and George Anson, concluded that an LLC is not transparent for U.K. tax purposes and therefore a U.K. individual investor in the LLC is not eligible to claim a credit in the UK for taxes he paid in the U.S. on the LLC's profits. The court's decision puts U.K. individual investors who invest through U.S. LLC’s at risk of double taxation.
The case at hand involves a nonresident individual (investor) from the U.K. who invested in a Delaware. LLC. The LLC was treated for U.S. tax purposes as a partnership. The investor paid U.S. income tax on his share of the LLC's profits. When the LLC made a non-taxable distribution to the investor, the investor claimed a credit in the U.K. for taxes that he paid in the U.S. The investor was relying on the income tax treaty between the U.S. and the U.K. ("Treaty") that provides a credit to U.K. taxpayers for taxes paid to the United States to the extent the U.K. tax is computed by reference "to the same profits, income or chargeable gains by reference to which the United States tax is computed."
The U.K. tax authority (HM Revenue and Customs ("HMRC")) sought to tax the distribution from the LLC as the equivalent to a dividend from a U.S. corporation and thus asserted that no U.K. tax credit could be obtained for the U.S. tax paid by the investor on the LLC's profits. Based on HMRC's position, the investor would suffer a combined U.S. and U.K. tax rate of more than 67%.
Initially, the lower court concluded that the LLC should be viewed as more similar to a partnership than a corporation. Thus, under the lower court's analysis, the investor would have been entitled to a U.K. tax credit for his proportional share of U.S. tax paid by the LLC. HMRC appealed that decision based on the premise that a tax credit should not be allowed to the U.K. investor because the tax payable in the U.K. was not referenced to the same income that was taxed in the U.S.
The upper court focused its analysis on the fact that the members of the LLC are not considered to own the property held by the LLC. As a result, the court concluded that under Delaware law a member of an LLC has no proprietary interest in the profits of the LLC, and therefore the LLC should not be viewed as transparent for U.K. tax purposes. Instead, the court found that the investor merely had a "contractual entitlement" to receive amounts credited to his capital account as determined under the LLC operating agreement. Based on this analysis, the upper court held that the income being taxed in the U.S. (i.e., the profits of the LLC) was not the same income that was taxed in the U.K,(i.e., the distributions from the LLC.) Accordingly, the court agreed with HMRC and denied the investor’s claim for double tax relief under the Treaty.