September 2015 Anson, Delaware LLCs and entity classification - Practical implications for investment managers and funds Introduction In July 2015 the UK s highest authority court of appeal, the Supreme Court, released its eagerly anticipated judgment in the final stage of the Anson line of cases 1. Since the case was first heard by the First Tier Tribunal in 2010, a question mark has existed over the status of Delaware LLCs for UK tax purposes. Contrary to Anson s argument, which he eventually won, historically HM Revenue & Customs (HMRC) had maintained that LLCs were opaque for UK tax purposes and Anson represented the chance for some clarity on this and potentially entity classification more generally. Unfortunately the judgment has not provided the much hoped for clarity. Instead, it has raised various material uncertainties as to the status of Delaware LLCs, and possibly other overseas entities, for UK tax purposes. Both industry and HMRC are currently grappling with what the decision means in practice. We are aware that HMRC recognise the significance of the decision - and we expect that it will also recognise the need for certainty but a reaction that is sustainable and measured. Until a formal release from HRMC is available, which could take the form of an announced position or even a consultation or announcement on proposed legislative change, we cannot yet know what the decision in Anson fully means in practice. However steps can be taken to understand the potential impact it could have for investment managers and funds. In addition, Q3 reporting increases the need for certainty soon. Ultimately, we expect that how HMRC react is likely to be a policy decision, the key question presumably facing it now being whether to interpret the Anson decision narrowly and maintain the status quo to the extent possible, apply the decision broadly and upset the apple cart or take some middle ground approach. There have been various discussions in industry around the Anson case since its release. This article, following the background to the case set out below, focuses on the types of structures that could be affected by the decision and the practical implications the decision could have for those structures. Background It is critical to know whether an entity is opaque or transparent for tax purposes. Entity classification in broad terms whether an entity is opaque or transparent for UK tax purposes with all the resultant different tax consequences can be difficult at the best of times. This is because the test in the UK is case law based, and dependent on a range of factors such as whether those who have an interest in the entity in question are automatically entitled to the profits of the entity as they arise and whether the entity in question has legal personality, owns its assets etc (the so called Memec factors, based on the leading 1998 case on entity classification, Memec plc v Inland Revenue [1998] STC 754). These factors can be difficult to apply, particularly in relation to entities where there are no clear answers to these questions, where the answers depend on the specific constitution of the entity in question and/or a construction of local law, and/or where there are conflicting indicators of transparency and opacity. Until now, the status of a Delaware LLC for UK tax purposes has been contentious for all these reasons; HMRC have not appeared to recognise the different forms and uses of LLCs and their varying constitutions in different contexts, and indeed Anson challenged this position. Whilst HMRC publish an entity classification list in which common vehicles are listed as either opaque or transparent for UK tax purposes (with Delaware LLCs listed as opaque), HMRC s guidance 1 Anson (Appellant) v Commissioners for Her Majesty s Revenue and Customs (Respondent) [2015] UKSC 44 1
acknowledges that this is not wholly determinative since, for example, local law may have changed since the list was compiled some years ago and each entity needs to be considered on a case by case basis. For these reasons, where the position is uncertain clarification from HMRC is often sought. Certain other jurisdictions, such as the US, avoid these difficulties, for example through a check the box elective regime, where the entity in question can elect to be either opaque or transparent for local tax purposes. However, such regimes have no bearing on how HMRC view foreign entities for UK tax purposes, which is instead determined applying the various Memec factors mentioned above. Delaware LLCs are a popular vehicle for investment management, both on the manager side where investment managers are frequently structured as LLCs or have LLCs within their corporate groups, and on the Funds side, where Delaware LLCs may have been used, for example, as asset-owning or investor feeder vehicles. The decision in Anson is therefore of significant relevance to the investment management industry, as well as more generally. It is also potentially significant to management groups who have not used LLCs in their corporate or Funds structures but have used alternative non- UK vehicles, given the potential wider impact of the Anson decision on whether other non-uk entities are opaque or transparent for UK tax purposes. Coupled with some of the other changes announced in the Summer Budget, such as the reform to the dividend rules, the potential impact is even greater. Some specific examples of who may be affected by the Anson decision are considered below. What was Anson about? George Anson, a UK resident non domiciled principal of HarbourVest Partners LLC, a US investment manager, was subject to US tax and UK tax on his income distributions from the LLC that he remitted to the UK, resulting in an effective tax rate for him of 67%. The specific finding of the Supreme Court was that the US tax and UK tax was computed by reference to the same profits or income for treaty relief purposes, which was a requirement for Anson to be entitled under the US-UK double tax treaty to credit against his UK tax liability for the US tax paid, resulting in no UK tax in practice. The Supreme Court rejected HMRC s argument that the LLC was transparent for US purposes but opaque for UK tax purposes and that Anson s US tax was therefore paid on one source of income (his share of the profits of the LLC s trade) but that his UK tax was paid on a separate source of income (his distributions from the LLC) which would have precluded treaty relief. The finding was the result of Delaware law and the LLC s specific constitution, the combined effect of which was that George Anson and the other members of the LLC were automatically entitled to the profits of the LLC as they arose, which was held to be the crucial determining factor in reaching the same income conclusion. The decision implies that the LLC was transparent, at least for UK income tax purposes. However, the Supreme Court judgment seems to have deliberately avoided questions of transparency and opacity, found a way of distinguishing the case on its facts to avoid applying the usual Memec test, and in general has left various questions unanswered. The common sense interpretation is that the LLC in Anson was transparent for UK tax purposes. However, the Supreme Court stopped short of acknowledging this. Other questions the decision raises are: was the LLC in question transparent for capital gains purposes? Are the members of the LLC treated for UK tax purposes as carrying on the underlying trade, as in the case of a partnership? Are the UK resident members of an LLC subject to UK tax on an arising basis, even if there are no distributions? What weighting was given to the Delaware law and what weighting was given to the LLC agreement in question in other words does one have the ability to establish either a tax transparent or opaque LLC? What is the status of the Memec test (Memec was a Court of Appeal decision, and hence lower authority than Anson) now? Does the decision affect the position of other entities, for example Scottish limited partnerships, and where does Anson leave entity classification more generally? 2
Who could be affected? LLCs used in investment management groups Investment managers with LLCs in their corporate group will need to assess the potential implications of the decision. A finding that an LLC is in fact transparent for UK tax purposes, where previously, in line with HMRC s position, it was treated as opaque, is likely to have significant implications. There may be UK resident taxpayers in a similar position to George Anson who are entitled to tax refunds depending on the circumstances. By way of contrast, an adverse consequence may be that UK resident taxpayers are taxed on an arising basis. The correct tax treatment of historic profits may also need to be examined. Any restructuring of the corporate group involving an LLC that has been undertaken would also need to be re-examined, since the tax consequences may be significantly different to those that were understood to apply at the time, although this, and the other possible effects, raise interesting questions of legitimate expectations. Private equity houses who have paid carried interest through an LLC are also likely to be affected. Where that LLC has been treated as transparent, albeit that these types of LLC may be in the minority, any finding following Anson that the LLC, whilst transparent for UK income tax purposes is opaque for UK capital gains tax purposes, similar to a Baker trust, will change the tax treatment of the carry. The notional tax credit that usually attaches to dividend distributions should mean in such a case that the tax differential is reduced but one would need to be comfortable that the credit was in fact available. In addition, the dividend rules reform announced in the Summer Budget will increase this differential significantly. Many of the UK grouping and other rules operate in a way that may have meant that investment managers or advisers have relied on LLCs in their structure being opaque for UK tax purposes. If the position is not as expected, then these transactions, and the ability to rely on the grouping rules going forward, will need to be re-examined. LLCs used in Fund structures LLCs used as asset-owning vehicles, for example in private equity, hedge, infrastructure or real estate funds, will need to be re-examined. Typically, these have been used in such contexts as opaque corporate blockers. Any impact following a change in the entity classification of an LLC will depend in part on the wider fund structure but in principle a flow through to UK investors or executives of the manager/adviser will result in a different tax treatment than expected. The Anson decision may also have significant implications for various investor groups. UK pension funds, which are, broadly speaking, exempt from UK tax on their investment income but taxable on trading income, may find that they have taxable trading income if invested in a transparent LLC rather than exempt investment income via what they had thought was an opaque LLC. UK charities are similarly sensitive to trading income. In addition, whether an underlying investment vehicle is opaque or transparent is important for UK charity investors in considering, for example, whether they could have an exposure to taxable section 13 attributed (as opposed to actual) gains or offshore income gains given HMRC s position that attributed gains and offshore income gains fall outside the charities exemption, although the Anson decision may not materially affect existing structures in this respect due to wider structural features where UK charities are concerned. Finally, the position of taxpayers subject to UK corporation tax that are invested through an LLC may need to be re-examined in the event that the LLC can no longer be treated as opaque, since such a change may call into question whether distributions from the LLC are, and have been, exempt under the UK dividend exemption rules. 3
Other non-uk entities The Anson decision also raises questions as to the correct entity classification of other entities, beyond Delaware. If, for example, either Anson represents a revision of the usual Memec test (albeit unlikely) or results in a legislative test, then the position of other non-uk entities in investment manager and fund groups may need to be considered. Whilst the Supreme Court appeared to take care in not calling into question the continuing validity of the Memec test, by finding that its application was not appropriate in the specific circumstances of the Anson case, albeit that the basis for this distinction is not clear, it is understood that HMRC are not giving entity classification rulings for the time being, while the position is considered. On balance, the Anson decision is likely to, at best, reinforce the position for certain entities historically accepted as transparent such as Scottish and Guernsey/Jersey limited partnerships or, at worst, leave them unaffected. But there may be cases at the margin that are less clear cut. Could Anson affect taxpayers, other investors or fund managers in other jurisdictions? Whilst the Supreme Court s decision in Anson, and HMRC s reaction to it, once known, is not binding outside the UK, in practice certain other jurisdictions base their tax rules on UK developments. For example, the Irish tax authorities have, consistent with HMRC s historic position, treated Delaware LLCs as opaque for Irish tax purposes. Moreover, Ireland has been following the progress of the Anson line of cases and it is highly likely that HMRC s treatment of Delaware LLCs following the decision will influence how they are treated for Irish tax purposes. The implications of the decision may, therefore, affect investors and others beyond these shores. Conclusion There will not be certainty until it is known what position HMRC will take following the Anson decision. We expect that this position is likely to be based on policy grounds. However, at this stage some action could be taken to increase the likelihood of obtaining certainty as to the expected treatment involving Delaware LLCs, albeit that where a tax transparent LLC is required the uncertainty is greater until HMRC s formal position is known. As far as Delaware LLCs are concerned, the most sensible approach, and the expectation, is that the an LLC will either be transparent or opaque for UK tax purposes depending on the terms of its LLC agreement, which will need to be reviewed on a case by case basis. If this is the outcome, then given that the LLC agreement of the HarbourVest Partners LLC in Anson is fairly representative of LLC agreements in general, numerous LLCs may be affected. As far as other entities are concerned, it remains to be seen whether the approach to entity classification, based on the Memec test, will continue or whether HMRC consider that a different approach is necessary. One can see the attraction in HMRC seeking to construe the Anson decision as narrowly as possible to seek to maintain the status quo. This would involve taking the position that the finding in Anson is relevant only for the purposes of a claim for tax credit relief under the US-UK treaty in the specific circumstance of the case. Such a position may, however, be difficult to justify. Regardless of the detail of the position ultimately taken, it is highly likely that investment managers, among others, will need to consider the possible impact for them and their investors. A version of this article first appeared in International Tax Review. Reproduced with permission. 4
For more information contact Dan Roman Partner, KPMG LLP (UK) T: +44 (0)20 7694 5726 E: dan.roman@kpmg.co.uk Aron Joy Senior Manager, KPMG LLP (UK) T: +44 (0)20 7694 8957 E: aron.joy@kpmg.co.uk www.kpmg.co.uk The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. 2015 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. The KPMG name, logo and "cutting through complexity" are registered trademarks or trademarks of KPMG International. 5