Contents

There’s a very cross-Atlantic feel to this month’s newsletter with an obligatory Coronavirus update for our Private Client readers.  For those interested in Corporate and International news, the focus here is on the taxation problems arising out of the Chimera that is the US Limited Liability Company.

Private Client

• COVID-19: Planning for US Citizens
• Coronavirus: Exceptional circumstances under the Statutory Residency Test
• Angel Investors: Relief on both sides of the pond

Corporate and International

• The US LLC and BEPS
• Anson Revisited
• DAC6 and LLCs
• UK Interest Restriction (in a US/UK Context)

COVID-19 – Planning for US citizens

What is the issue?

The past few weeks have seen significant turbulence in global stocks due to the economic fallout from COVID-19.

Whilst tax planning is unlikely to be high on the list of priorities for most people, US individuals are nevertheless able to take advantage of certain unique planning opportunities which result from the current depressed asset values.

Opportunity 1 – estate tax planning

Each US citizen is able to transfer $11.58m of assets out of his or her estate during lifetime and on death, without having to pay federal gift or estate taxes.

Now is, therefore, a good time to consider using this tax-free allowance in order to remove value from the US gift and estate tax net, whilst prices are low.  Note that the value of the gift for these purposes is the fair market value of the property gifted (rather than cost basis).  As an aside, it should be noted that unlike in other tax systems, for US capital gains tax purposes, the gift of an appreciated asset does not generally trigger a capital gain.  Instead the recipient of the gift simply inherits the cost basis of the donor so that any future gain on sale is taxed on the recipient.

There are lots of ways of transferring assets out of one’s estate, for example:

Outright gifts to another individual

It is generally better to make gifts of stock rather than cash whilst stock prices are low, since any subsequent appreciation in the value of the stock will be removed from the individual’s estate.

Individuals are also able to make annual tax-free gifts of up to the annual exemption of $15,000 per year without ‘eating into’ their lifetime allowance of $11.58m.  These gifts can be made to any number of individuals and, as above, can be leveraged by gifting stock, instead of cash, whilst values are low.

Gift into a trust

Alternatively, gifts may be made to a family trust.  The trust must be structured in such a way that it is outside of the individual’s estate for US purposes.

Again, whilst stock prices are low, it is generally better to fund the trust with stock, rather than cash, therefore leveraging the value of the gift.

Individuals who have used up their lifetime $11.58m allowance (or who prefer not to ‘eat into’ it) can go a step further and transfer assets into a Grantor Retained Annuity Trust, or ‘GRAT.’

A GRAT is created by transferring assets into a trust in return for the right to annuity payments from the trust for a specified number of years (usually between two and four).  The right to the annuity payments reduces the overall value of the initial gift into the trust, usually to zero so that there is no taxable gift.  The annuity is based on Internal Revenue Service (‘IRS’) interest rates.

The GRAT is usually funded with assets that have temporarily declined in value, but which are expected to recover and continue to go up in value.
The current low stock prices make GRAT planning particularly attractive at the present time.

Sale to a trust or a family member

Individuals who have used up their lifetime $11.58m gifting allowance could, instead of making gifts, sell assets to a trust or family member.

Whilst the sale proceeds would remain in the individual’s estate for US purposes, any subsequent appreciation in value would belong to the recipient trust or family member.

Opportunity 2 – capital loss harvesting

Individuals with unrealised losses in their investments might also consider selling and realising the losses on those assets, a process known as ‘loss harvesting’. Obviously, they should only do this having taken account of investment considerations.

If the individual has unrealised gains on other investments, those investments could be sold before the end of the year in order to offset the losses against the gains. Unused losses can also be carried forward indefinitely and offset against gains in future years. They cannot however be carried back to an earlier year.

Other considerations

• Individuals should seek tax advice specific to their circumstances before undertaking any planning.
• In addition to US taxes, individuals will also need to consider the tax and legal ramifications of any planning in their country of residency and domicile.  For example, individuals living in the UK may suffer detrimental UK tax charges if they gift assets to trusts.

If you would like more information on this subject, please contact Julian Nelberg on +44 (0)7803 502 555

or Paul Lloyds on +44 (0)7518 810 993

The UK

Coronavirus: Exceptional circumstances under the Statutory Residency Test

With the COVID-19 pandemic continuing to spread across the UK and around the world, governments are imposing strict restrictions on people’s movements. For non-UK residents who manage their time in the UK, in order to avoid becoming UK resident under the Statutory Residency Test (SRT), these restrictions could create problems for their UK residency position if they are unable to leave as planned.

Are these exceptional circumstances?

Under the SRT, there is a special rule for days spent in the UK due to “exceptional circumstances”. The legislation  defines exceptional circumstances as “national or local emergencies such as war, civil unrest or natural disasters”, as well as “a sudden or life-threatening illness or injury”. Under this rule, if you are only in the UK at the end of a day as a result of exceptional circumstances outside your control, this is considered an “exceptional day” under the SRT and is not taken into account when totalling an individual’s residency days for the purposes of the SRT.

It has been unclear if an individual stuck in the UK due to COVID-19 would be able to claim exceptional circumstances. However, HMRC have already published guidance giving details on when they consider days in the UK relating to COVID-19 can be claimed as “exceptional”.

HMRC have, though, made it clear that the facts and circumstances of each individual case will need to be taken into account (so it’s not a free pass). However, under the guidance, circumstances will be considered exceptional if the individual:

• is quarantined or advised by a health professional or public health guidance to self-isolate in the UK as a result of the virus;
• is advised by official Government advice not to travel from the UK as a result of the virus;
• is unable to leave the UK as a result of the closure of international borders; or
• is asked by their employer to return to the UK temporarily as a result of the virus.

A concession, or just a clarification?

Under the SRT, a maximum of 60 days in the UK can be disregarded as exceptional circumstances. This guidance issued by HMRC has not extended this, so for the time being the conservative approach would be to assume that this 60 day limit still applies, especially as that time limit is also set out in legislation.

Exceptional circumstances also do not apply to every part of the SRT. They only apply to those rules that rely upon  calculating days spent in the UK and also concluding whether an individual meets the ‘90 day tie’ under the sufficient ties test. For example, if you are counting days of presence at your ‘home’ under the SRT, this is a separate calculation and no exception is made for days that are considered exceptional when determining UK residency days.

Also, exceptional circumstances are not taken into account when reviewing the ‘work,’ ‘family’ and ‘country’ ties for the sufficient ties test. Problems may arise,  if an individual is in the UK under exceptional circumstances (for example COVID-19 prevents them from flying home or to their place of work overseas) and they choose to work on those days. The individual could pass the threshold of the ‘work’ tie (more than 3 hours of work a day in the UK on at least 40 days in that year) and as a result, they could be considered a UK resident if this extra tie means they pass the relevant day threshold based on the number of ties they have to the UK. Although, when considering the number of days for the threshold they can take exceptional circumstances into account!

The application of exceptional circumstances under the SRT is very complex and HMRC have not changed this just by bringing COVID-19 within the scope of its definition. We still do not know how long these conditions will last, so it is likely there will be many cases where an individual’s exceptional days exceed 60 and begin to be considered days in the UK for SRT purposes. However, the SRT is an annual test and the clock begins again on 6 April, which may help some people.

HMRC have confirmed that they may update this guidance at short notice, however we do not have any indication what these updates will contain or when they will be made, so any individual who believes they may be impacted by this should start planning now, as whilst it seems HMRC have clarified their position, they most certainly have not given any concession to those affected by these limitations.

If you would like more information on this subject, please contact Andrew Parkes on +44 (0)7522 229 589 or Luke Jenkinson on +44 (0)7494 157 948.

The UK & US

Relief for Angel Investors on both sides of the pond

We wrote about the Chancellor’s decision to cut back Entrepreneurs’ Relief in our Budget Summary. Thankfully, Rishi Sunak saw sense and left Investors’ Relief alone. Interestingly, but not surprisingly, the US has its own version of IR in the form of the Qualified Small Business Stock rules. In this brief article we consider the two regimes.

UK Investors’ Relief

Investors’ Relief was introduced in the 2016 Finance Act and subjects capital gains on the sale of qualifying shares to a reduced rate of 10% as with Entrepreneurs’ Relief, up to a lifetime limit of £10 million.

For an individual to claim for Investors’ Relief, the following conditions must be met:

• throughout the entire shareholding period the company must have been trading or have been the holding company of a trading group;
• the shares must not have been listed on a recognised stock exchange at the date of issue; and
• the shares must be ordinary, subscribed for and fully paid in cash, and held for at least three years.

Investors’ Relief can be very appealing for business angels looking to invest in the UK. There are limited exemptions allowing directors and employees to benefit from the relief.  Specialist advice, as usual, is required.

Qualified Small Business Stock (QSBS).

An individual who owns QSBS can be exempt from taxation gains on the sale up to $10mn, or 10 times the adjusted basis (in this case the amount of cash plus the fair market value of any property contributed to the corporation in exchange for the stock) of the QSBS disposed – whichever is greater. The gain in excess of this amount is then taxed in the US at 28%.

What qualifies as QSBS?

For stock to qualify as QSBS, it must meet the following conditions:

• the company must be a US entity that is taxed separately from its owners (e.g. C Corporation);
• the stock must be acquired directly by the taxpayer from the company in exchange for money or property (not shares);
• the stock must be issued after August 10 1993; and
• the Fair Market Value (FMV) of the corporation’s total assets must, at all times, have been less than $50mn, until immediately after the individual’s stock has been issued (i.e. the size of the company at the time shares are issued cannot exceed $50mn).

QSBS may be very appealing to UK resident US citizens claiming the remittance basis of taxation. Despite being taxed in the US on their worldwide income and gains, any gain realised will be exempt from US taxation (up to the thresholds) as well as being exempt from UK tax, provided the proceeds are not remitted to the UK.

How can we help?

Investors may not be aware of the tax relief opportunities available to them when making an investment, or in some cases even after they have disposed of their interest. At this point the sun may have set on the window of opportunity to make a claim for relief. We can advise on what reliefs may be available to you both before you make your investment and after.

If you would like more information on this subject, or US tax matters in general, please contact Julian Nelberg on +44 (0)7803 502 555 or Luke Jenkinson on +44 (0)7494 157 948.

The US

Limited Liability Companies (LLCs) and Base Erosion and Profit Sharing(BEPS)

The OECD’s project to counteract BEPS has altered the tax landscape considerably. However, because the US has either opted out of (or is not fully implementing) a number of the BEPS’ actions (such as Action 2 re Hybrids and Action 15 re the Multilateral Instrument), many US multinationals are having to review their overseas structures to ensure they are compliant with the changes that have been introduced everywhere else. A major issue is how US LLCs fail to be treated now that the BEPS dust is finally beginning to settle.

The Chimera

The LLC is perhaps the most widely used business entity in the US One of the reasons for this is that taxpayers can elect how it is treated for US tax purposes: either as a partnership (i.e. transparent) or as company (opaque).

The classification of an LLC can be changed by “checking the box” on IRS Form 8832. Checked open means the LLC is transparent and taxed as a partnership (or simply disregarded if there is only one owner), whilst checked closed means the LLC is opaque and taxed as a corporation.

The ability to check entities is not just limited to US entities, as many (but not all) non-US entities can be checked too. For example, a UK limited company can be checked by its US parent so that it disappears for US tax purposes, becoming like an LLC – either a partnership or a branch depending on the number of members. The same trick can’t be done with a UK PLC though, as that is a “per se” entity for US purposes, whose classification cannot be changed.

Where a UK entity is “checked open”, its third party income and expenses effectively become the income and expenses of the next US taxable entity in the ownership chain which is not checked open. The reason we say third party is that if the UK receives income from, or pays expenses to, the US taxable entity, then that income and those expenses disappear for US tax purposes, often leaving a tax deductible expense in the UK, with no taxable pick-up in the US.

For many private equity owned groups, where all the US entities were transparent LLCs or LLPs, there were no taxable entities in the US and the first one that could be seen by the IRS would be the fund in the Caribbean. This meant that there would be no taxable entity and possibly no taxable presence at all in the US.  From a US point of view, any payments from the UK company, or its customers, would flow straight to the non-taxable fund entity in the Caribbean.

The Dilemma

The UK has of course signed up to BEPS and implemented Action 2 relating to hybrids which affects the treatment of both US LLCs and UK companies that have been “checked” for US tax purposes. In many cases the UK rules will now either disallow deductions in the UK company, or even import income to offset the non-taxation in the US.  This can lead to a higher effective rate of tax for the group. The impact of these provisions, coupled with the UK’s corporate interest restrictions rules, is highlighted by Warren Howells below.

If you would like more information on this subject, or BEPS generally, please contact Miles Dean on +44 (0)7785 770 431

or Andrew Parkes on +44 (0)7522 229 589.

The US/UK

Anson Revisited

Opaque or Transparent, that is the question! Why do we care? It might seem far fetched to think that the terms ‘opaque’ and ‘transparent’ have such a meaning in the world of taxation. However, their definitions are of utmost importance for UK tax resident individuals who are members of a US LLC and the terms should be interpreted with caution.

An LLC set up under US law (in particular Delaware) is an attractive entity because it is seen as ‘transparent’ (flow-through) for US tax purposes. This means that any profits generated by the LLC are not recognised by the company, but are instead taxed as income on the LLC members – this is similar to a partnership structure in the UK.

In the absence of a sophisticated ‘check the box’ regime, the UK solely relies on case law and guidance from HMRC to determine the characteristics of certain foreign entities. HMRC’s International Manual sets out a list of foreign entities that are classified as ‘opaque’ and ‘transparent’, as well as summarising the factors or hallmarks that an entity must possess in order to fall into each category (e.g. the issuing of ordinary share capital usually means that an entity is considered as a company and is therefore is opaque). The rules are certainly not as clear cut as the US and rely heavily on interpretation.

The problem

With differing rules, it is not surprising that there is room for confusion between the UK and US tax treatment of US LLCs.

Although an LLC is considered transparent under Federal law, HMRC’s guidance indicates that a US LLC is considered as an opaque entity in the UK, treated as a company and therefore the individual is taxed on the distributions from the LLC as they are received.

The first problem here is that there can be a timing issue between the taxing events: a US LLC might produce annual income that is taxable on it’s members on a yearly basis, but it might only distribute the profits of the LLC once every 5 years. This means that there would be a US taxing event every year, but a UK taxing event only every 5 years. This clearly causes a mis-match in timing for claiming foreign tax credits and although some solutions have been thought of to try and rectify the issue, these have recently come under scrutiny from HMRC.

Regardless of whether the LLC distributes every year, there is a second issue. HMRC can consider the receipt of a ‘distribution’ and a ‘share of profit’ as two different types of income and a foreign tax credit can only be claimed against income of the same type. Hence, the possibility of being exposed to double taxation in both the UK and the US.

Anson v HMRC [2015] UKSC 44

Mr Anson was a UK resident non-UK domiciled individual. He was also a member of a Delaware LLC, thus presenting a rather unfortunate set of facts.

He paid Federal tax on his member’s share of the profits of the LLC in accordance with US Federal law, and remitted some of the profits he received to the UK (the remittance being subject to UK income tax), while claiming double taxation relief for the US tax. However, HMRC denied the claim for relief and made amendments to Mr Anson’s tax returns and raised discovery assessments. The First Tier Tribunal (FTT) allowed Mr Anson’s claim for tax relief for the US tax paid on the LLC profits against the UK tax due upon the remittances. This was on the basis that, as a member of the LLC, which did not have anything equivalent to share capital, Mr Anson was entitled to the profits of the LLC as they arose and accordingly was taxed upon the same income in both the UK and the US. He was, therefore, entitled to double taxation relief under the UK/US double taxation agreement.

This decision was overturned by the Upper Tier, denying Mr Anson his relief, and the Upper Tier’s decision was upheld by the Court of Appeal in a unanimous decision.

Surprisingly, the Supreme Court went on to overturn the decision of the UTT and Court of Appeal. The Court confirmed that the FTT had found, as a fact, that Mr Anson had received the same income as the LLC and as they had no reason to find against that finding relief should be allowed. The court held that the income was personally received by Mr Anson from both a UK and US perspective, and allowed a credit for foreign taxes paid.

Although Mr Anson ended up with a positive result, this is not set in stone. To summarise HMRC’s announcement in Brief 15 (2015), ‘individuals that are claiming double tax relief and relying on the Anson vs HMRC decision will be considered on a case by case basis‘.  Andrew Parkes, who was part of the HMRC team on this case (and who never tires of telling people that HMRC won his point), confirms that during the hearing itself the Supreme Court commented that it was open to a different First Tier Tribunal, when faced with the same facts, to find that the income was not the same. Whether HMRC decide to test this is a different question.

Don’t panic – we’re here to help

The classification of foreign entities in the UK and the US is a complex matter and an understanding of the statutory and treaty provisions is often required to determine the type of entity in question.  We are often asked to assist clients faced with unusual circumstances involving companies, hybrid entities, trusts and foundations. So, if you live in the UK and are a member of a US LLC and think you might be affected by these rules, please get in touch with our team who can help.

If you would like more information on this subject, or BEPS generally, contact Holly Fletcher on +44 (0)7835 413 123 or Andrew Parkes on +44 (0)7522 229 589.

DAC6

Reporting of transactions with US LLCs

Background

DAC6 is the short name for EU Council Directive 2018/822/EU of 25 May 2018 that sets out circumstances in which EU intermediaries or a relevant taxpayer must report cross-border tax arrangements (i.e. transactions between parties not in the same jurisdiction). The purpose of which is to provide tax authorities with an “early warning mechanism” on new risks of tax avoidance and, therefore, enable them to carry out tax audits more effectively.

Hallmark C

Not all cross-border arrangements are reportable. Only those that fall within one of five Hallmarks (A-E) must be reported. This article considers only Hallmark C.

Hallmark C applies to deductible cross-border payments between two or more associated enterprises and a report is due where one of four conditions are met in relation to a cross-border payment. Here we are concerned only with condition 1 and in the context of deductible payments from an EU/EEA entity to a US LLC.

Hallmark C, condition 1, requires a report where “the recipient is not resident for tax purposes in any jurisdiction”.

We have debated how to apply this residence requirement in the context of LLCs. A US LLC’s default classification is a disregarded entity where it has one member or a partnership where it has more than one member (i.e. effectively transparent for tax purposes). From a UK perspective (and most other EU/EEA member states) it is a corporate (i.e. opaque for tax purposes). Consequently, the prudent approach would be to conclude that neither the UK or the US claim residence over an LLC and, therefore, it is not resident in any tax jurisdiction. This being the case, all deductible payments made by a UK company to a US LLC would require a report (and in principle the same applies to payments made by any EU/EEA company to a US LLC).

An alternative approach would be to consider that the LLC is transparent in the jurisdiction in which it is established (the US). This being the case, the recipient for the purposes of assessing the residence requirement is the member(s) in the LLC. If some or all of the members of the LLC were resident in a jurisdiction that (i) did not impose Corporation Tax (CT), (ii) imposed CT at a rate of zero or less than 1%, (iii) exempted the payment from tax or (iv) subjected it to a preferential rate of tax, a report would still be due.

However, Hallmark C(1) is subject to a “main benefit test”. This means that, if it can be demonstrated the main reason or one of the main reasons for the inclusion of the US LLC and its members’ was not to secure a tax advantage, then no report would be due. This may be useful where a minority of the members is resident in a jurisdiction that does not impose CT etc. However, for more complex structures, for example the fund and private equity industry (which frequently involve multiple layers of partnerships), this may be very difficult to demonstrate.

Reporting

DAC6 is effective for all cross-border tax arrangements where the first step was made on or after 25 June 2018. The first report for transactions between this date and 30 June 2020 will be within 30 days (i.e. by 31 August 2020). Thereafter, in respect of Hallmark C, the report must be made within the 30 days of (i) the earlier of the day it is ready for implementation and (ii) the day the first step in implementation is made. The first exchange of information is due on 31 October 2020.

The information to be reported is extensive (it is listed in the Directive) including identification of all EU taxpayers (including taxpayers in another member state that may be indirectly affected by the transactions), associated persons and intermediaries involved, details of the applicable Hallmark, a summary of the arrangement and business activities, details of the relevant local law, and the value of the transaction(s). Where the intermediary is based in the US, the reporting obligation will fall onto the EU based taxpayer; care will be needed in respect of terms of restriction in intermediaries engagement letters on the provision of information to third parties. Furthermore, it is reasonable to expect that all taxpayers and intermediaries will want to input in and review the submission.

If you would like more information on this subject, please contact Zoe Wyatt on +44 (0)7909 786 144.

The UK

Interest Restrictions

We were recently engaged by one of our clients to undertake tax due diligence on a UK trading group. The UK Group was private equity backed by one of the large US funds.
The US fund acquired the UK Group for approximately £80m in 2015 and a typical US private equity structure was put in place, consisting of a four-tier Jersey structure (TopCo, DebtCo1, DebtCo2 and BidCo). The Fund structure consisted of two Cayman Partnerships. Very little capital was invested by the fund in the UK Group and acquisition debt of £80m consisting of unsecured 12% payment in kind (PIK) loan notes was lent by the fund to DebtCo1. There was an immaterial amount of management debt but no third-party debt from a financial institution.

For US tax purposes the two Cayman partnerships were treated as partnerships, Topco was treated as a partnership and DebtCo1 was treated as a disregarded entity.
The UK Group was minded to be compliant and in 2015 commissioned a thin capitalisation report. The report determined that 60% of the acquisition debt should be treated as allowable. The UK Group did not enter into an Advance Thin Capitalisation Agreement with HMRC, so it self-assessed its interest deductibility on the loan notes in its tax returns. HM Revenue and Customs (HMRC) have not raised any enquiries in this regard.

In January 2017, the UK introduced its anti-hybrid legislation. As the fund had filed elections treating TopCo as a partnership and DebtCo1 as a disregarded entity, the new anti-hybrid legislation was in point. Again, the UK Group was minded to be compliant and engaged a third-party tax adviser to determine whether there would be an interest disallowance under the anti-hybrid rules.

In order to evaluate whether such a disallowance will occur it is necessary to understand the tax profile of the investors in the fund. The US fund was helpful and provided the UK Group an exhaustive list of investors (not by name but jurisdiction and tax status).
As expected, the fund consisted of US taxable, non-US taxable, US exempt and non-US exempt investors. There were also a number of investors whose tax status was unknown, such as funds of funds.

The report stated the loan notes were vanilla in nature, so the hybrid instrument rules were not in point. Neither were the hybrid payee rules as the investors treated the Cayman partnerships as partnerships. However, the hybrid payer rules did apply as DebtCo1 had been checked open as a disregarded entity for US tax purposes, while in the UK it is treated as a company.

Ultimately, the anti-hybrid report determined that 30% of the fund were US investors, 6% of the fund was unknown and 64% of the fund were non-US investors (taxable and exempt).  On this basis there was a 36% interest disallowance under anti-hybrid rules.
In April 2017 the UK introduced the Corporate Interest Restriction (CIR) rules. The basic rule is that deductions for interest above the de-minimis amount of £2mn will be restricted to the extent that it exceeds 30% of the UK Group’s EBITDA (fixed ratio) as calculated for UK tax purposes. If the worldwide group has a level of interest expense on external debt which exceeds 30% of the group’s EBITDA, this threshold may be raised to that level by making a group ratio election.

Unfortunately, the group ratio election carves out related party debt and as there is no third-party debt in the structure, the corporate interest restriction disallowed interest above 30% of the UK tax EBITDA ratio.

HMRC have also stated that the transfer pricing and anti-hybrid calculations should take place before the corporate interest restriction.

Considering all provisions above let’s look at the impact on the 2018 tax computation.

• Interest accrual c.£12m. UK EBITDA was £12m.
• Interest disallowable under the transfer pricing rules was £4.8m.
• Interest disallowable under the anti-hybrid rules £4.3m
• Interest disallowable under the corporate interest restriction was £8.4m.

The UK Group claimed interest deductions of £3.6m and disallowed interest of £8.4m in its tax computation.

The allowable interest was paid by the UK Group within 12 months of the year end in order not to fall foul of the late payment rules.

Note that, in December 2019 HMRC changed their view in respect of the interaction between anti-hybrid legislation and transfer pricing. HMRC’s view now is that you calculate either the transfer pricing disallowance and then you apply the hybrid disallowance (or vice-versa). This could create further disallowable interest in the 2019 tax computation.

It is clear that for US private equity backed groups with significant shareholder debt, the interest deductibility in their UK portfolio companies may be severely hindered by the extent of the UK’s anti-avoidance rules.

If you are concerned about the application of the above rules to your facts and circumstances, please contact Kevin Hindley +44 (0)7939 468 157

or Warren Howells +44 (0)7939 468 157.