US LLCs are one of the most common structures that Americans (and non-Americans) use for trading.

LLC treatment In the U.S.

In the U.S., LLCs can choose their tax treatment. They can choose to treated as pass-through entities (in the event that they have a single owner), a partnership, an S-Corporation or a C-Corporation.

This note refers to LLCs that elected to be treated as partnerships.

Under U.S. law, such entities are transparent and are not subject to tax in the corporate level. Instead, their income is allocated to their members who are taxed as individuals. The taxation follows the source of the income, so income from services provided, for example, is normally subject to self-employment tax.

It is important to note, however, that whilst the tax treatment in the US is similar to that of partnerships in the UK, the two entities (US LLC and UK partnership) are not identical. A US LLC is a company for purposes other than tax and has unique features that do not exist in a UK partnership.

U.S. LLC Treatment in the UK – the Anson case

Like many other countries, the UK does not automatically accept the classification of the U.S. Prior to 2015, the UK tax authorities (HRMC) have always classified U.S. LLCs as opaque entities, akin to UK Limited Companies.

In most cases, such classification allowed HMRC to charge more tax and to reject requests to apply credit for tax paid in the U.S. The argument used by HMRC was that self-employment tax paid in the U.S. is not the same as tax on profit distribution being demanded in the UK, allowing for an effective double taxation despite the tax treaty trying to prevent such double taxation.

This is the matter that led Mr. Anson to argue his case and appeal all the way to the supreme court.

Anson v HMRC [2015] UKSC 44

The facts of the Anson case were that Anson, a UK resident, was a member of a Delaware LLC. He argued that profits from the LLC should be treated as his own income, not as income of a separate entity, so he could claim foreign tax credit relief in the UK for the US tax paid.

HMRC argued the LLC was opaque (akin to a company), so there was double taxation. HRMC’s argument was that the US applied tax at the LLC level and the UK at the individual level.

The Supreme Court accepted Anson’s argument, and held that in that specific Delaware LLC, members had a proprietary right to the profits as they arose, meaning the profits “belonged” to them, not to the entity. Therefore, Mr. Anson could claim foreign tax credit relief.

Following the case, HMRC published a clarification that the findings are limited to the fact of the case, and HMRC will assess LLCs on a case-by-case basis, looking into whether there is a proprietary right to the profits as they arise and examining the operating agreement and state law in this regard.

A tax planning opportunity under the FIG rules

Under the Foreign Income and Gain (FIG) regime that replaced the non-dom regime, new residents in the UK that meet certain criteria (essentially have not been residents in the UK for 10 years prior to becoming residents) are able to exempt certain foreign-sourced income from tax in the UK, even if the income is brought into the UK.

This includes profits from trade carried on wholly outside the UK  as well as dividends from non-UK resident companies and other types of income such as interest and royalties.

This opens up an exciting tax planning opportunity. HRMC’s stance that LLCs are opaque could now work against it and lead to income from US LLCs being classified as foreign-sourced and thus not subject to tax in the UK.

Risks of using an LLC and arguing that the profits are foreign sourced

It is important to be careful. LLCs can be used as a vehicle but there are associated risks that should be taken into account and HRMC can try and tax such income despite the FIG regime.

Risk 1 – “trade carried out wholly outside the UK”

One path to taxation would be arguing that trade is indeed carried out by the member in the UK and that the “trade” clause applies and not the “dividend” clause.

Risk 2 – the entity will be seen as tax resident in the UK

Under the treaty, an entity that is managed from the UK could be seen as a UK tax resident even if it is incorporated in the US. HMRC could argue that managing the entity from the UK could lead to such classification.

There is no single definition of the "place of effective management" but some guidance is offered in paragraph 24 in the Commentary on Article 4 which was included in the 2000 Update to the OECD Model:

“24. …The place of effective management is the place where key management and commercial decisions that are necessary for the conduct of the enterprise’s business are in substance made. The place of effective management will ordinarily be where the most senior person or group of persons (for example a board of directors) makes its decisions, the place where the actions to be taken by the enterprise as a whole are determined; however, no definitive rule can be given and all relevant facts and circumstances must be examined to determine the place of effective management. An enterprise may have more than one place of management, but it can have only one place of effective management at any one time.” 

Different factors that have been taken by courts over the world have been: 

− Place of incorporation.
− Place of residence of shareholders and directors.
− Where the business operations take place.
− Where financial dealings of the company occurred; and
− Where the seal and minute books of the company were kept.

Risk 3 - permanent establishment

Even if effective management of the company is not the UK, the income associated with a permanent establishment could be taxed in the UK. Permanent establishment is often created when there is a permanent physical office in the UK (an office will typically be seen as permanent if it exists for more than 6 months) or where a director with the ability to bind the company in contracts resides in UK territory.

Risk 4 – general anti avoidance provisions

As with all tax matters, tax authorities now-a-days have extensive powers to look through any arrangements made purely for the purpose of avoiding tax. Such an argument, however, is hard to prove when LLCs existed and traded prior to the move to the UK.

Defending LLCs from UK taxation

Despite the risks, there are relevant mitigation strategies and we believe that LLCs could be effectively shielded from taxation in the UK with proper planning.

This is particularly important to Americans who are subjected to extensive reporting requirements and additional bureaucracy if they form non-US companies.

As can be seen above, there are multiple ways for tax authorities to try and tax income. In practice, authorities would rarely carry out an FBI-style enquiry and would normally focus on relatively "low hanging fruit". 

For our clients who are considering LLC structures, we often offer the following advice:

- Partnerships are more defensible than single-person-disregarded entities.

- An overseas management reduces the risk dramatically. Management should be documented properly.

- An office in the UK or a manager in the UK with the right to bind the company in contracts increases the chances of a permanent establishment.

 - Loans and intellectual property can be utilised as part of effective tax planning.

Many people trade from LLCs and are oblivious to the risks and to the ways to mitigate them.

It is important to remember that when a structure is created purely for tax optimisation, it often looks just like what it is, whilst genuine partnerships between people in different countries are much easier to defend. We therefore always advise on trying to work with real relationships.