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Anson: entity classification revisited

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8 July 2015
Card image Charles Yorke
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The Supreme Court’s judgment in Anson v HMRC has been keenly anticipated. It was never just about claiming double tax relief for investments in Delaware LLCs, but goes to the heart of entity classification. A general concern had been that the Court of Appeal's requirement for a proprietary interest in the entity's assets was too onerous for transparency.  The decision went the other way, however, and Mr Anson won. Good news for Mr Anson, but we are left with a somewhat confusing test, likely to result in the need to reconsider the classification of many non-UK entities.

Charles Yorke (Allen & Overy) reviews the Supreme Court’s decision in Anson v HMRC and its wider impact on entity classification.

The relevant facts in Anson v HMRC [2015] UKSC 44 were that Mr Anson was one of a number of members of a Delaware LLC (see figure 1 below). The LLC was transparent for US tax purposes, and Mr Anson was taxed at a rate of 45% on his share of the profits of the LLC as they arose. Mr Anson filed his UK income tax returns on the basis that the LLC was a partnership for UK tax purposes and so was taxed on a similar basis. Double tax credits were claimed and no further UK tax was thought to be due. 
 
 
HMRC, however, concluded that the LLC was opaque, and that Mr Anson was instead taxed in the UK on the distributions made to him by the LLC. It followed that no double tax credits were available, for the simple reason that the US tax was paid on one source of profits (the trade carried on by the LLC), whereas UK tax was paid on another (the distributions from the LLC). This resulted in an eye watering effective tax rate of 67% (a rate of 45% in the US, and of 40% in the UK on the residue).
 
The Court of Appeal agreed with HMRC, deciding that in order to be entitled to and therefore taxed on the profits of an entity, its members would need to have a proprietary interest in its assets. The Supreme Court disagreed. A proprietary interest in the assets held by the entity is not required. What is relevant is whether the member has an entitlement to the profits of the entity as they arise under its local law constitutive documents.
 

Relevance of the US/UK double tax treaty

This was a case about double tax relief under the 1975 US/UK treaty. The question concerned the proper interpretation of art 23(2)(a), which refers to tax on income or profits from sources within the US, and whether UK tax was computed by reference to the same income or profits.
 
A significant part of the judgment (paras 54 to 114) is devoted to considering how the treaty should be interpreted. It became clear within the first hour of the hearing that their lordships believed that the courts below had based their decisions upon an assumption that ‘the same’ meant the same for income tax purposes; rather than, for example, some economic or other substantive purpose. A comment was made that it was as if the treaty had been drafted in Lincoln’s Inn, rather than negotiated in a smoke filled room on Capitol Hill. In the end, the judgment confirms what was assumed to be the case – that this is not a broad economic test, but rather a question to be answered by reference to tax principles. Distributions are not the same profits as those earned by the LLC.
 
The remainder of the judgment then answers the question posed before the courts below. Was Mr Anson taxed in the UK on the distributions from or the profits earned by the LLC? It would be a mistake to see these early discussions about interpreting treaties as limiting the scope of the decision. The decision is about transparency for income tax purposes generally.
 

Memec

Until now, the Court of Appeal’s decision in Memec Plc v Commissioners of Inland Revenue [1998] STC 754 has been considered the leading case for determining whether or not an entity is transparent or opaque for income tax purposes. HMRC’s guidance on entity classification (starting at para INTM180000 of the International Manual) is itself based on Memec.
 
Memec was a UK company that owned a German GmbH. The case concerned dividends received by the GmbH from its wholly owned subsidiaries. Memec and the GmbH had entered into a ‘silent partnership’ which, as a matter of German law, was found to be a purely contractual arrangement between Memec and the GmbH, entitling Memec to receive an 87.4% share of the GmbH’s profits (see figure 2 above). The matter to be decided upon was whether Memec was entitled to relief for the underlying taxes paid by the GmbH’s subsidiaries as the person to whom the dividends were paid. In short, was the effect of the ‘silent partnership’ such that the dividends in fact paid to the GmbH should have been treated as paid to Memec?
 
Peter Gibson LJ gave the leading judgment, and identified the characteristics of an English and a Scottish partnership that make them transparent. He then considered whether the silent partnership had those characteristics. He gave particular weight to whether the members themselves carry on the business of the entity; and whether the members have a direct or indirect interest in the entity’s assets.
 
Here, however, the Supreme Court distinguished the issue in Memec (whether, for the purposes of the Germany/UK treaty, dividends paid to the GmbH should be treated as paid to Memec) from that in this case (whether, under UK domestic law, Mr Anson was entitled to the profits of the LLC as they arose). It therefore did not follow the same approach.
 
There is no one size fits all test for transparency. Indeed, the danger of using broad terms such as ‘transparent’ and ‘opaque’ to answer more specific questions was stressed during the hearing; such questions include ‘who is entitled to the profits?’ and ‘to whom were the dividends paid?’ Fundamentally, the test adopted in Memec was about identifying a partnership. There was no question of the GmbH itself being transparent. The question was whether the assets legally owned by the GmbH could be treated as owned by both participants in the silent partnership. It seems to me that Peter Gibson LJ was quite right to conclude that this would only be the case if the silent partnership could be treated in the same way as an English (or Scottish) partnership.
 
For identifying non-UK entities that should be treated as partnerships, Memec still has some worth.
 

Income tax transparency

A mere seven paragraphs of the judgment out of 120 answer the decisive question of how, for domestic UK income tax purposes, one should decide whether a member of a non-UK entity is subject to income tax on the profits of that entity as they arise, or on distributions made out of those profits. This depends upon the legal regime governing the respective rights of the entity and its members in relation to the profit. Whether or not an entity’s constitutive documents entitle its members to its profits as they arise is solely a question of local non-tax law. The FTT held that there had been such an entitlement as a matter of Delaware law; and the Supreme Court concluded that there was no basis for overturning that finding of fact.
 
The finding (at para 10 of the anonymised FTT decision in Swift v HMRC [2010] SFTD 533) was that the members’ entitlement to profits arose from the Delaware LLC Act and from the LLC agreement. The Delaware LLC Act provides that the interest of a member of an LLC includes his or her share of the profits and losses of the LLC; and those profits and losses are allocated in accordance with the LLC agreement. One must then turn to article IV of the LLC agreement, which provided for allocation to the members’ capital accounts periodically and at least annually. The FTT concluded that this was sufficient for an immediate entitlement.
 
There were two subsidiary findings of fact which will be important in applying this test to other LLCs and non-UK entities. The periodic, rather than immediate, allocation did not defer the entitlement (presumably because the drawing up of capital accounts is merely an exercise in bookkeeping but did not affect entitlement to the profits). Furthermore, the timing of distributions of cash and whether cash distributions were discretionary or mandatory were not considered relevant. 
 
Mr Anson’s entitlement derived from the combination of the Delaware LLC Act and the LLC agreement. These were not mere contractual arrangements entered into by the LLC, pursuant to which it agreed to transfer its profits to its members (which would have been rather like the silent partnership in Memec); rather, they were its constitutive documents. It seems clear that the fact that the entitlement arose from the LLC’s constitutive documents was important.
 

The practical implications of this decision

The most immediate implications of this decision are for UK investors in Delaware LLCs. It is not clear whether this decision was based on the particular profit allocation provisions for this LLC, or the part of the Delaware LLC Act that provides that a member’s interest includes an entitlement to profits. This will be crucial in determining how many LLCs the decision affects. For some, like Mr Anson, a tax repayment will be due. For a few, extra tax may be payable, although I suspect only during that short period of 50% tax rates, when US credits would not have exceeded the UK tax.
 
There are, of course, implications for entity classification more generally. The biggest cause for concern is that HMRC’s classification of specific types of entities as transparent or opaque at para INTM180030 of the International Manual is now suspect. In the absence of new guidance, tax advisors will need to apply this new test on a case by case basis to whichever type of entity is in point, and by reference to its constitutive documents and the company law which governs it. We know that this is not an economic or commercial test, and that the right to receive cash distributions is (largely) irrelevant. Local company law advice will be essential.
 
However, I suspect it will often be difficult to obtain a clear answer to the question: ‘Are members entitled to the entity’s profits?’ While it is easy to understand (and explain) the concept of a ‘legal entitlement’ and the concept of ‘profit’, the concept of a legal entitlement to profit is slippery in the extreme. Intuitively, it seems that a member can either have a present right in the actual assets held by the entity, or a right to receive a distribution from the entity in the future. Neither of these is what this test is getting at though. I suspect it is a concept which can only be understood within the framework of company law, and has little if any relevance outside of that framework.
 
The type of English law entitlement that seems to me to be broadly similar is that which a shareholder in an English company limited by shares has in the share capital of the company. Under English law (see Bradbury v English Sewing Cotton Company [1923] AC 744), a shareholder has an entitlement to the share capital of the company, but not in retained profit until a dividend is declared. This concept of entitlement to share capital has little relevance outside of company law, and yet it is a reality under company law. Perhaps the approach to the Anson test will simply be to ask whether there is a similar rule of local company law that extends to retained profit.
 
It may well often be the case that the question cannot be answered because local company law only contemplates the ownership of assets, and says nothing about profit except in the context of distributions. This would not be surprising, given that it seems to be purely a matter of jurisprudence with no practical implications. It would make sense if the default position were, in the case of entities with separate legal personality and full legal and beneficial ownership of assets, to assume that the members are not entitled to the profits of the entity. The test would at least then be workable: transparency if there is a clear legal right to retained profits; and opacity if the local law provides to the contrary or does not say anything about entitlement to profits except in the context of distributions.
 

What now?

This decision raises many questions. Taxpayers need predictability, otherwise inevitably there will be fiscal disincentives for outbound investment. Let’s hope that HMRC, the tax profession and business can work together to find a practical solution – and swiftly.
 
Some of my own thoughts are below.
  • This LLC was not particularly complicated. However, complex ‘special allocations’ are not uncommon for LLCs. How will our tax code cope with these? Will HMRC respect an allocation of losses in income form and gains in capital form? 
  • Profit cannot be owned – it is an accounting concept – and therefore entitlement cannot mean a proprietary interest. Other types of income (or at least the right to receive other types of income) can be owned. Could this mean that other types of income require a proprietary interest and so fall outside the scope of this judgment?
  • What if the LLC had been in receipt of UK source income? Would both the LLC and its members have been subject to income tax? This is probably not dissimilar to an interest-in-possession Baker trust, in relation to which either the trustee or the beneficiary can be charged to income tax.
  • Does this judgment apply to corporation tax? I cannot see why not. If so, what if the LLC had been UK resident? Would it have been subject to corporation tax in its own name?
  • Was the LLC found to be a partnership? I doubt it – there are many other factors relevant in identifying a partnership. A transparent body corporate or company has therefore become a reality; something that our tax code does not contemplate.
  • Is the decision relevant to capital gains tax or grouping tests? Again, I doubt it – I suspect beneficial ownership of assets is still determinative there.
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