UK Government launches consultation on solving the LLC double taxation problem

The UK Government has published a consultation on a legislative solution to deal with double tax issues which can arise where UK resident individuals hold interests in US limited liability companies (LLCs). In short, the proposal would be to treat LLCs which are transparent for US tax purposes (and potentially other entities with similar characteristics) as transparent for UK tax purposes as well, to the extent LLC interests are held by individuals. 

This is a significant and welcome step towards resolving a problem that has caused genuine difficulties for affected taxpayers and has been damaging to the UK's attractiveness as a place to live and do business. 

The consultation has been anticipated since April, when suggestions emerged that the Chancellor of the Exchequer, Rachel Reeves, was going to announce a review of the UK tax treatment of US LLCs during the IMF Spring Meetings in Washington DC. This was to be part of a wider message, pitching the UK as “open for business”, with a particular focus on attracting US citizens to live and invest in the UK.

This note sets out the background, explains the proposals in the consultation, and highlights areas that will need to be addressed as the legislation takes shape. The consultation closes on 31 July.

What’s the issue?

LLCs are a common investment and business ownership vehicle in the US. For US tax purposes, the default position is that an LLC is “transparent” - that is, an LLC's profits are taxed in the hands of its members as the profits arise, irrespective of whether those profits have been distributed.

It is possible for an election to be made to treat an LLC instead as “opaque” for US tax purposes (meaning that members are only taxed in the US when profits are distributed), but this is less common in practice.

The UK double tax issue stems from the question of whether a US LLC should be treated as transparent or opaque for UK tax purposes.

If LLCs are transparent for UK purposes, matching the usual US treatment, then a UK resident member of an LLC should in principle be entitled to credit any US tax paid on their LLC profit share against their UK tax liability on the same profit (whether in the form of income or capital gains).

If, however, LLCs are treated as opaque for UK purposes, then the UK tax system would regard LLC distributions essentially as dividends rather than a direct share of the LLC’s underlying profit. In that situation, the US and the UK would be taxing different amounts - the underlying items of LLC profit in the US, and the dividend in the UK. This mismatch creates the potential for double tax, as neither the US/UK Double Tax Treaty nor UK domestic law offer a clear route to a credit as between the US and UK tax that has been suffered. 

Background

Historically, there has been some uncertainty around how LLCs should be categorised for UK tax purposes. In 2015, the UK Supreme Court concluded in Anson v HMRC [2015] UKSC 44 that, under the terms of the relevant LLC operating agreement and Delaware law, the profits of a Delaware LLC arose directly to the members at the point the profits were credited to their capital accounts within the LLC, rather than upon the subsequent distribution of those profits. It followed that the UK and the US were taxing the same amounts, double tax relief should be available, and double taxation was prevented as a result.

Following the Supreme Court’s decision, HMRC issued guidance stating that Anson was limited to its specific facts. However, this was regarded by some as an attempt to be helpful, by allowing corporate groups scope to preserve group reliefs in situations where it made sense to treat LLCs as opaque. HMRC also accepted in a number of cases that the Anson decision should be applied more broadly, and many taxpayers filed their UK tax returns on the basis of the Supreme Court’s conclusions.

However, on 12 December 2023 (some eight years later), HMRC issued updated guidance which represented a considerable hardening of its position. In essence, the December 2023 guidance contended that the profits of an LLC will generally belong to the LLC in the first instance and that members should not be treated as receiving or being entitled to those profits as they arise. The guidance went so far as to suggest that HMRC would investigate taxpayers who take a contrary position - notwithstanding the existence of a Supreme Court decision supporting the taxpayers’ stance. In HMRC's revised view, the taxable event for UK purposes is the distribution from the LLC, which is then characterised as a dividend, rather than the underlying allocation of profits within the LLC.

Consequences of HMRC’s position

The consequences of HMRC's approach are significant. As noted above, because the US taxes LLC profits as they arise, whereas HMRC would tax only on distribution (treating the LLC as opaque), there is a fundamental mismatch in both the timing and the characterisation of the amounts. This mismatch undermines the operation of the UK/US Double Tax Treaty and can prevent credits from being available in either jurisdiction. The result, in many cases, is genuine and significant double taxation. On worked examples, effective tax rates under HMRC's approach have been shown to exceed 70%. The Government’s consultation paper refers to rates as high as 75%.

The issue affects a wide category of individuals, including UK resident US citizens participating in trading businesses. It has deterred internationally mobile individuals from coming to the UK and, in some cases, driven existing UK residents away. The uncertainty created by the revised guidance has also placed taxpayers in an impossible position: they must choose between filing in accordance with what most practitioners consider to be the correct legal position (following the Supreme Court's decision in Anson) - but at the risk of HMRC challenge - or filing in accordance with HMRC's guidance and potentially paying double tax. 

The consultation proposals

The consultation is a welcome step forward, both in terms of recognising the issue and the hardship it is causing for taxpayers, and in putting forward a suggested solution.

The Government’s proposal is that legislation would be introduced which deems US LLCs to be transparent for UK purposes automatically if they meet certain criteria. Broadly, the criteria are that (1) the LLC is taxed on a transparent basis in the US; and (2) the LLC is neither itself a UK tax resident entity, nor is it trading in the UK through a UK base (known as a permanent establishment). The proposed automatic transparency rule would only apply to individuals. Corporate members of US LLCs would not be subject to the same treatment.

This is framed in terms of minimising disruption to corporate groups, where group tax reliefs are often an important consideration. As such, the focus on an automatic deeming rule rather than an election appears to be intended as a helpful measure, charting a course that caters for the needs of both individuals and corporates. In responding to the consultation, it will be important to consider any situations where the status quo is preferred and whether an ability to elect is something the Government would be open to.

Although the focus of the consultation is on US LLCs, the consultation indicates that this legislative solution would also be open to other types of non-UK entity which have the same mismatch problem. There is no indication yet as to which types of non-UK entity might fall within the scope of this, but further details are likely to emerge as the consultation progresses.

Importantly, and helpfully, the consultation proposes that the automatic transparency rule would operate by deeming individual members of LLCs which carry on a trade or business to be partners in a partnership for UK tax purposes. The effect would be to bring those members within the normal income tax and capital gains tax rules for partnerships. In the case of LLCs with a single member, the member would be treated as a sole trader (for a trading LLC) or holding assets on their own account (for investment LLCs). This opens up access to certain allowances and reliefs. The details will need to be worked through as the proposals develop, including for example how the deeming of individual LLC members as partners in a partnership will interact with the UK’s Salaried Member Rules (which can recharacterise certain LLP income as employment income subject to PAYE and National Insurance contributions). However, in principle this is a welcome development.

Open points

Although there are a number of positives to take from the consultation, a few important points remain open.

Only prospective application?

The first is that the consultation does not contain any suggestion as to how the Government proposes to deal with the past. It describes transparent treatment as something that would apply “prospectively”, but does not offer any indication as to how prior tax years should be addressed (other than a reference to transitional considerations, discussed further below).

This is a key point for taxpayers. As noted above, many will have filed their UK tax returns on the basis of the Anson decision, and others will have adopted the competing approach set out in HMRC’s existing guidance and are now facing the question of whether the consultation proposals, in effect, put Anson on a legislative footing, meaning that the past may need to be revisited. In some instances, HMRC have opened enquiries into taxpayers who have relied upon Anson. The consultation offers no solution as to how these uncertainties (and other points flowing from them) should be addressed.

We expect this to be a key focus of the responses to the consultation, and in our view is of central importance if the Government wishes the legislative solution to be effective in restoring confidence and encouraging US citizens to live and do business in the UK. Dealing with the past is, inevitably, less straightforward than the future, but it will be an important topic – particularly for taxpayers with active HMRC enquiries. It remains to be seen whether HMRC will adopt a pragmatic approach or whether affected taxpayers will be left in an uncertain position pending resolution of individual cases.

Transitional rules

The second open point is what sort of transitional rules might be introduced to cover situations where an LLC moves from opaque to transparent treatment (as a result of the proposed deeming rule) or vice versa.

For example, from a practical perspective, clarity will be needed as to the treatment of unrealised gains accrued during the “opaque period” (in situations where taxpayers have so far adopted the approach in HMRC’s existing guidance), the base cost of assets for CGT purposes going forward, and the treatment of profits allocated, but not yet distributed to members, before the transition date.

The consultation does not propose solutions on these points, but asks for input from stakeholders. We intend to make representations in our consultation response.

What does this mean in practice?

The Government’s commitment to resolving the LLC issue is to be welcomed. It has caused real difficulty for affected taxpayers, and the uncertainty created by HMRC’s current position has undermined the UK’s reputation as a stable and predictable tax environment. 

At this stage, it is clear that there are a number of important points that will need to be addressed as the proposals develop. However, a carefully considered and properly designed legislative solution has the potential to resolve the problem definitively for the future.

We look forward to engaging with HM Treasury and HMRC through the consultation process and will provide further commentary as the position becomes clearer.

If you would like to discuss this issue and the potential impact of these developments, please get in touch with your usual Macfarlanes contact.