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 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 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.