UK tax tribunal holds a Delaware LLC to be fiscally transparent

In a decision dated 22 February 2010, the United Kingdom Firsttier tribunal (the tribunal) held that a UK-resident individual who was a member of a Delaware limited liability company (LLC) was entitled to double taxation relief in the UK under the UK/US Double Taxation Convention and under certain unilateral reliefs, for US taxes paid on the profits of the LLC.

In what is certain to stimulate considerable debate — and may also have implications in other countries — the tribunal's decision is based on the conclusion that the individual LLC member was legally entitled to his share of the LLC's profits as they arose. In other words, the tribunal decided that the LLC was not just fiscally transparent for US tax purposes, but legally transparent (and for that reason fiscally transparent) with respect to its profits for UK tax purposes. However, the tribunal emphasized that this conclusion was to some extent fact specific and may not be applicable in all cases.

Nevertheless, the implications of a similar conclusion being drawn for Canadian tax purposes would be significant, both from an inbound perspective (e.g., with regard to the extension of treaty benefits) and from an outbound perspective (e.g., with regard to the treatment of Canadian members of LLCs). These matters are considered below in greater detail.


The facts

The taxpayer, Mr. Swift, was a UK-resident (non-domiciled) individual who was a member of a Delaware LLC named Sandpiper Partners LLC (SPLLC). SPLLC carried on business in the US — specifically, the management of various venture capital funds, principally through offices in Massachusetts.

Since SPLLC was fiscally transparent, being treated as a partnership, for US and Massachusetts tax purposes, Swift was subjected to those taxes directly on his share of the LLC's profits, whether or not distributed, although the profits were in fact distributed and remitted to the UK annually. For UK tax purposes, Swift also filed his return on the basis that the LLC should be treated as a partnership, and included his share of SPLLC's profit in income, and claimed foreign tax credit relief, such that there was no UK tax payable on these profits, since the rate of US taxes paid was higher. HM Revenue & Customs' (HMRC's) position was that SPLLC was a corporate entity, such that foreign tax credit relief did not apply.


The issue

The treaty issue involved the application of Article 23(2)(a) of the 1975 convention (and Article 24(4) of the 2001 convention, for the 2003-04 year of assessment), which provided as follows:

United States tax payable under the laws of the United States and in accordance with the present Convention, whether directly or by deduction, on profits or income from sources within the United States (excluding in the case of a dividend, tax payable in respect of the profits out of which the dividend is paid) shall be allowed as a credit against any United Kingdom tax computed by reference to the same profits or income by reference to which the United States tax is computed.

It was clear that Swift had profits or income from sources within the US, both from a US and a UK tax perspective, and that UK tax was computed by reference to his profits. However, what was at issue was whether or not the UK tax was computed by reference to the same profits or income as the profits on which the US tax had been computed. The issue involving the availability of unilateral relief in respect of the Massachusetts taxes was to be resolved analogously.

It was the Crown's position that the UK tax was not computed by reference to the same profits or income as those on which the US tax had been computed, but rather by reference to a separate source of income from a UK tax perspective — namely, Swift's interest as a member in SPLLC, being distinguished from the business of SPLLC as such. In contrast, it was Swift's position (among other arguments) that SPLLC was fiscally transparent from a UK tax perspective, and that he was legally entitled to his share of its profits as they arose, such that the UK tax was indeed computed by reference to the same profits or income as that on which the US tax had been computed.


The decision

As noted above, the tribunal held that SPLLC was fiscally transparent with respect to its profits for UK tax purposes. On that basis, the tribunal decided that Swift was entitled to foreign tax credit relief in respect of the US taxes paid on his share of SPLLC's profits.

In reaching this conclusion, the tribunal emphasized (at paragraph 17) that this decision was to some extent fact specific:

We start by emphasising that we are concerned with whether relief applies in relation to the profits of this particular Delaware LLC, SPLLC, which, since there is wide freedom to contract the terms of a Delaware LLC, may not be of general application.

Nevertheless, the implications of this decision may be broader, given the tribunal's reasoning.


The analysis

The tribunal framed the substantive issue (at paragraph 18) as a matter of determining whether or not Swift was entitled to his share of SPLLC's profits as they arose:

The Appellant was charged to tax in the US on his share of the profits of SPLLC. The issue is whether the UK tax is computed by reference to the same profits or income or whether he is taxable on the equivalent of a dividend. Asking whether SPLLC is transparent or opaque may be another way of asking the same question but we consider that it is preferable to apply the words of the Treaty. We did not find helpful Mr Ewart's approach [for the Crown] of asking what was the source of the income, to which his answer was that it was the LLC Operating Agreement rather than the business of SPLLC. For that reason we can concentrate on whether the income belongs to the Appellant as it arises, that is to say does the Appellant have a right to that income immediately as it arises?, in which case it is not relevant when it is to be paid to him.

Having so framed the issue, the tribunal's decision then followed from the earlier findings of fact with respect to the legal effect of SPLLC's governing law and operating agreement.

In this regard, the tribunal had the benefit of expert testimony on both sides of the issue, although the experts did not agree in all respects. In particular, the experts were asked to answer the questions raised in HMRC's Tax Bulletin 29 (June 1997) and 39 (February 1999), concerning the categorization of foreign entities as transparent or opaque. These questions were as follows:

1. Does the foreign entity have a legal existence separate from that of the persons who have an interest in it?

2. Does the entity issue share capital or something else which serves the same function as share capital?

3. Is the business carried on by the entity itself or jointly by the persons who have an interest in it?

4. Are the persons who have an interest in the entity entitled to share in its profits as they arise; or does the amount of profits to which they are entitled depend on a decision of the entity or its members, after the period in which the profits have arisen, to make a distribution of its profits?

5. Who is responsible for debts incurred as a result of the carrying on of the business: the entity or the persons who have an interest in it?

6. Do the assets used for carrying on the business belong beneficially to the entity or to the persons who have an interest in it?

The experts agreed on items 1, 3, 5 and 6, to the effect that SPLLC was an entity distinct from its members, and that it, and not its members, carried on its business operations, was the beneficial owner of its assets and was responsible for all its debts. These were accepted by the tribunal as findings of fact. However, there was disagreement on the remaining two questions — as to whether or not SPLLC had share capital (or something that serves the same function as share capital), and whether or not Swift had an interest in the profits of SPLLC as they arose.

With respect to the share capital‖ question, the tribunal described the task at hand as requiring a comparison of the legal characteristics of a membership interest in a Delaware LLC with those in a UK company or partnership. Beginning with a review of SPLLC's governing law, the tribunal noted that a limited liability company interest is defined as a member's share of the profits and losses of a limited liability company and a member's right to receive distributions of the limited liability company's assets (section 18-101(8) of the Delaware LLC statute (the DLLCA)).

The tribunal also noted that a limited liability company interest is personal property. A member has no interest in specific limited liability company property (section 18-701 of the DLLCA).

Moreover, the tribunal noted that, although interests in an LLC are transferable in principle, transfers may be (and in this case were) restricted by the operating agreement, and a distinction was drawn between economic interests and other membership rights such as those in relation to management — in that, for example, an assignee may benefit from economic interests but has no right to participate in the management or business except as provided in the operating agreement and on the approval of all the other members.

With respect to matters of management, the tribunal noted that members in this case had voting entitlements that were disproportionate to their ownership percentages, with the so-called managing members‖ having a majority of the votes between them. On this basis, the tribunal found (at paragraph 7(1)) that the membership interests in SPLLC were not similar to share capital but something more similar to partnership capital of an English partnership, the transfer of which requires the consent of all the partners but the economic benefits can be transferred without consent and without the transferee becoming a partner (section 31 of the Partnership Act 1890), noting that normally a share in a UK company is transferable and needs to be registered and if there are restrictions on transfer these are that the consent of the directors (not all the other shareholders) is required.

With respect to the question of whether or not the members of SPLLC had an interest in its profits as they arose, the discussion (at paragraph 7(2)) seemed to turn on the proper interpretation to be given to the provisions of the DLLCA and of the operating agreement, in the face of the diametrically opposed positions of the parties. That is, it was Swift's position in this regard that he was legally entitled to his share of SPLLC's profits as they arose on the basis that the distribution of the profits credited to a member's capital accounts was mandatory (though subject to the availability of cash and to certain other restrictions in the operating agreement). In contrast, it was the Crown's position that Swift was not legally entitled to his share of SPLLC's profits as they arose on the basis that distributions of profit were at the discretion of the managing members.

In resolving the matter, the tribunal again turned first to the provisions of the DLLCA, noting that the definition of ―limited liability company interest‖ implies that the members have a share in the profits of an LLC, given the reference to ―a member's share of the profits and losses of a limited liability company and a member's right to receive distributions of the limited liability company's assets.‖ [emphasis added]

The tribunal then distinguished a member's interest in the profits as they arise from a member's right to receive distributions:

The fact that the right to receive distributions is dealt with separately from the allocation of the profit suggests that the second part [of the definition] is dealing with what in a partnership situation is called drawings (in addition to distributions on a winding-up).

Moreover, the tribunal observed 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. (section 18-503 of the DLLCA) Thus, although the existence of a default rule under DLLCA was also acknowledged, the tribunal found that a member's right to receive distributions depends solely on the LLC agreement, to which the focus then turned.

In this regard, the tribunal found (at paragraphs 8(4) to (6)) that SPLLC's operating agreement provided, among other things, that capital accounts would be maintained for each member and would be adjusted at least annually, with credits and debits determined based on a complicated allocation and sharing formula that took many factors into consideration, including different sharing ratios for different aspects of SPLLC's operations, but essentially that the whole of the book profit for the year was allocated to the members' capital accounts.

The tribunal then considered (at paragraph 8(7)) the question of whether or not the fact that the book profit had to be allocated (and could be reallocated) at least as often as annually‖ might indicate that the profits must belong to the LLC until the allocation is carried out, concluding that this language gave rise to no such inference, in that it was consistent with the view that allocations were mandatory (though could be done more frequently than annually). It was also found (at paragraph 8(11)) that members could withdraw at any time, and would be entitled to allocations to the time of their withdrawal.

The tribunal then turned (at paragraph 8(8)) to section 5.1 of the operating agreement, which provided for distributions. The relevant language of this provision stated that to the extent cash is available, distributions of all [net income allocated to capital accounts] with respect to any calendar year will be made by the Company at such time within seventy-five (75) days following the end of such calendar year and in such amounts as the Managing Members may determine in their sole discretion. Such distributions had to be made in accordance with a complicated ordering formula that applied as a function of members' capital accounts, and the possibility of interim distributions was also contemplated.

Moreover, it was provided that distributable amounts could be withheld by SPLLC in a variety of circumstances, including to deal with contingent liabilities, to set off claims against members and to comply with any withholding tax requirements. Despite some uncertainty and disagreement among the experts, the tribunal concluded (at paragraph 11) that distributions were indeed mandatory — although they could be sprinkled at the discretion of the managing members within the first 75 days after the year.

Interestingly, however, the tribunal's decision was not premised on the finding that distributions were mandatory. Rather, the decision appears to be predicated on the tribunal's interpretation (at paragraph 10) of the provisions of SPLLC's governing law that relate to allocations of profit and loss — and the finding that these allocations are mandatory:

We regard it as important that limited liability company interest‖ is defined to include a member's share of the profits and losses of a limited liability company… (s 18-101(8) of the Act), and 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 (s 18-503 of the Act) with a default rule if the LLC agreement does not so provide. 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 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 true, as Mr Talley said, that the assets representing those profits do belong to the LLC until the distribution is actually made but we do not consider that this means that the profits do not belong to the members; presumably the same is true for a Scots partnership. Conceptually, profits and assets are different, as is demonstrated by the reference to both in the definition of limited liability company interest(see paragraph 7(1)(a) above). There is a corresponding liability to the members evidenced by the allocation to their capital accounts rather than a balance of undistributed profits (even though that is what the audited accounts say, but they cannot override the terms of the LLC Operating Agreement in view of s 18-503 of the Act, which does not contemplate that profits can belong to the LLC as they must always be allocated to the members, and in any case they are consolidated accounts). Accordingly, our finding of fact in the light of the terms of the LLC Operating Agreement and the views of the experts is that the members of SPLLC have an interest in the profits of SPLLC as they arise.

The implications of this finding of fact were then analyzed by the tribunal (at paragraph 20) in accordance with the principles confirmed by the UK Court of Appeal in Memec v IRC [1998] STC 754:

Although we have said that we prefer to concentrate on the words of the Treaty rather than ask whether SPLLC [is] transparent or opaque, we shall apply the Memec approach to it. We have considered above the characteristics of SPLLC in accordance with Delaware law and concluded that it (and not the members) carries on its business as principal; it (and not the members) is liable for its debts and obligations; and it (and not the members) owns the business; and it does not have anything equivalent to share capital. However, the members are entitled to the profits as they arose. We can compare it with an English or Scottish partnership and a UK company. There is a spectrum running from

(1) the English partnership: not a legal person, with the partners owning the assets jointly and incurring the liabilities, carrying on the business, and being entitled to the profits; through

(2) the Scots partnership: legal person (in consequence of an agreement) owning the assets and incurring the liabilities with a secondary liability on the partners, with the partners nevertheless carrying on the business (since that is the definition of partnership) and being entitled to the profits; to

(3) the UK company: legal person (in consequence of registration) owning the assets and incurring the liabilities with no liability on the members (or a liability only on winding-up for an unlimited company) and carrying on its business with the members holding shares and being entitled to profits only after either payment by the directors or recommendation by the directors and a resolution to declare dividends by the members. (Mr Peacock pointed out that the articles of a UK company could provide for automatic dividends: see Bond v Barrow Haematite Steel Co [1902] 1 Ch 353, Re Accrington Corporation Steam Tramways Co [1909] 2 Ch 40, although it seems that in neither of these cases the articles did so.)

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.

On this basis, Swift was entitled to UK foreign tax credits in respect of US taxes paid by him on his share of SPLLC's income, since the UK tax was computed by reference to ―the same profits or income‖ as that on which the US tax had been computed.


Other observations

We have three additional observations. First, it is interesting to note the tribunal's observations (at paragraph 7) with regard to Delaware partnerships:

Mr Abrams made some comparisons between the member's interest in an LLC and a Delaware corporation and a Delaware partnership (which is a legal person), particularly a limited partnership. We did not find this useful as the task for us will be to compare the membership interest in a Delaware LLC with a UK company or partnership, and particularly Delaware partnerships are not the same as partnerships in England (although general partnerships seem to be more similar to Scots partnerships). What was helpful was their description of the nature of the membership interest in a Delaware LLC….

Although the treatment of Delaware partnerships did not arise directly, these comments suggest that the tribunal would have viewed them as partnerships for UK tax purposes.

Second, the tribunal did not in any way rely on the Organisation for Economic Cooperation and Development's (OECD's) commentary to the OECD Model Double Taxation Convention on Income and on Capital, which now incorporates many of the interpretive suggestions first outlined in the OECD's 1999 report, The Application of the OECD Model Tax Convention to Partnerships. Indeed, this commentary is not even referred to in Swift.

Third, caution is in order in considering the scope of the Swift decision. The tribunal did not conclude that SPLLC should be characterized as transparent for every aspect of UK taxation; rather, its decision was restricted to how its profits should be treated in respect of its members. It is, for example, conceivable that the tribunal might have considered SPLLC to be opaque (i.e., as a body corporate) for other aspects of UK tax law.


Canadian implications

Canadian tax law and practice reflect a relatively generally accepted approach to the characterization of foreign associations, including US LLCs. In that regard, it is generally accepted that US LLCs should be treated as corporations, that their membership interests should be treated as ―shares,‖ and that their profit distributions should be treated as dividends. It is also generally accepted that the profits of an LLC do not belong to, and are not directly earned by, or directly taxable in the hands of, their members, on the basis that these profits belong only to the LLC. This view has been consistently expressed by the Canada Revenue Agency (CRA) in numerous technical interpretations over the years, involving a number of different US states, and many variations in the terms of the governing operating agreements.

In the inbound context, this approach has led the CRA to deny treaty benefits to payments made to LLCs, based on the CRA's view that the LLC is the relevant taxpayer from a Canadian perspective, because of the CRA's view that the LLC is the legal owner of the relevant income, but is not entitled to treaty benefits if it is fiscally transparent under the laws of the relevant foreign jurisdiction. This view, in turn, has led to the introduction of paragraphs 6 and 7 of Article IV of the Canada-US Income Tax Convention, which are designed to regulate the availability of treaty benefits in the context of amounts derived through or from certain fiscally transparent entities. If the reasoning in Swift is applicable from a Canadian perspective, this would mark a significant departure from current practice, with implications for the period before these specific treaty provisions took effect, and also for situations that may fall outside the technical scope of these provisions, such as the availability of treaty benefits to deemed dividends, as well as other items derived by LLCs.

In the outbound context, with respect to the availability of Canadian foreign tax credit and similar relief in respect of US taxes paid by a Canadian-resident individual member of an LLC that is fiscally transparent for US tax purposes (i.e., facts analogous to those in Swift), the CRA currently accepts the position that such taxes may give rise to certain limited credits and deductions under subsections 20(11) and (12) and section 126, on the basis that such taxes are paid in respect of the taxpayer's membership interest in the LLC.

Moreover, the CRA currently accepts the view that US taxes paid by a foreign affiliate in respect of the foreign accrual property income (FAPI) of another foreign affiliate that is a fiscally transparent LLC can be regarded as deductible foreign accrual taxes‖ if the FAPI is distributed by the LLC. If the reasoning in Swift were applicable from a Canadian perspective, this would seem to mean that such taxes should instead be considered to have been paid in respect of the member's share of the LLC's income, with quite uncertain Canadian tax implications.

In addition, and perhaps more important, there are many outbound financing structures that would produce materially different Canadian tax consequences if the reasoning in Swift were applicable from a Canadian perspective. For example, in the well-known tower financing structure, the shares of an LLC are usually held by a Canadian unlimited liability company in turn held under a partnership with Canadian members, and the LLC earns interest income. That income would be taxable in Canada if it were considered to belong to or to have been derived directly by the LLC's members.

Despite these relatively generally accepted practices, there is understandably at least one dispute before the Tax Court of Canada involving the availability of treaty benefits for the Canadian-source income of a fiscally transparent LLC. One such case is TD Securities (USA) LLC v the Queen (2008-2314(IT)G), which has been heard, so the judgment should be forthcoming. However, the taxpayer's primary position in that case is that the LLC should be regarded as a resident of the US for treaty purposes, and therefore is entitled to treaty benefits in its own right. Alternatively, the taxpayer's position also appears to be that the LLC should be entitled to treaty benefits in respect of its income because that income is considered to be derived by its members (and is taxable in their hands) for US tax purposes. While the decision in Swift would not have any bearing on the taxpayer's primary position, and is not quite the same as the taxpayer's alternative position, it would seem to support the conclusion asserted by the taxpayer.

In light of the Swift decision, it will be advisable to review current LLC operating agreements and related arrangements — including structural arrangements — to minimize the risk that their provisions may be interpreted or may apply in a manner that produces undesirable consequences, and to maximize potential opportunities.

TAX NEWS - march 2010

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