Tax reclaim opportunity for US tax suffered on sale of an interest in a US LLC

Mon 25 Sep 2017

A recent US Tax Court decision has overturned the IRS’s view of the disposal tax treatment of the owner of an interest in a US Limited Liability Company (LLC) otherwise taxed as a partnership for US tax purposes. The Court ruled the disposal was of an interest in an entity, rather than a disposal of a share in the LLC’s underlying assets.

As a result there may be potential for non-US persons that have sold interests in such US LLC’s and paid US tax on the basis of a share in the LLC’s underlying assets (other than real estate), to claim a refund of the US tax paid. Conversely those non-US persons who have realised US losses on such disposals may not be able to treat such losses as US tax losses.

Background

The US Tax Court considered a case where a Greek mining company owned an interest in a Delaware LLC treated as a partnership which undertook mining operations in the US from a Pennsylvania headquarter.  The Greek company originally purchased a 15% share for $1.8m in 2001, but this was reduced to 12.6% on the later introduction of another ‘partner’.  The company’s capital interest in the partnership varied over time, but was approximately $4.4m at the time of redemption in 2008.  The LLC’s redeemed the Greek company’s 12.6% share for $10.6m.  It was agreed that $2.2m of the $6.2m gain was attributable to US real estate, and accepted that this element was liable to US tax, so the dispute concerned the remaining $4m gain.

The previously published IRS ruling (91-32) outlined that the disposal of an interest in a partnership with a US trade or business should be considered ‘effectively connected income’ and therefore subject to US tax on the basis of the seller’s share of the partnership’s underlying assets.  The US Court considered that US capital gains tax was only due on capital that could be regarded as ‘effectively connected income’ where that gain has a US source.

In the case of personal property, the default US rule is that the sale of such an asset by a US resident has a US source, but a sale by a non-US resident does not. The IRS argued the Greek company was nevertheless liable under the ‘office rule’ exception to the default rule and that the gain was attributable to the ‘partnership’s’ US office and assets.  The Court considered that the office itself did not influence the transaction by which the Greek Company realised its gain (the sale of its partnership interest), but rather was an on-going asset of the partnership business.

The US tax Court also considered the exception to the default rule depended on whether the principles of the US tax code, relating to whether a US office or fixed place of business was material to the realisation of the gain, could be applied to the US LLC’s fixed place of business. It held they could not.  In order to apply the exception to the default rule, the sale would had to have been made in the ordinary course of the US LLC’s business.  The occasion of redemption arose from the LLC’s agreement to purchase an interest arising from an offer by a member to sell their interest, triggering a requirement under the LLC’s constitution to offer to purchase any other member’s interest on the same terms.  The Greek company ‘partner’ was the only one to accept, and the US Tax Court held this was not a transaction in the ordinary course of the LLC’s business (the LLC’s business being in mining and not in the sale of partnership interests).

As a result the US Court held that the redemption of the Greek Company’s interest in the LLC was not taxable in the US. It is not yet known whether the IRS will appeal the decision or whether the decision will stand.

Implications for former UK owners of an interest in a US LLC treated as a partnership

Individual UK taxpayers with an interest in a US LLC may have suffered US tax on the basis of the previous IRS ruling on the basis that the transaction should be taxed as a disposal of a share in US assets. They may then have been subject to UK CGT, with a credit for any US tax paid.  Where the conditions for entrepreneurs’ relief are met, the overall amount of tax suffered may have been lower if no US tax had been paid.  With the US tax rate on capital gains generally being in the region of 15% to 20%, UK individual taxpayers will need to consider the merits of submitting a claim for repayment of US tax already paid (with the consequent reduction in tax credit for UK tax purposes) on their overall tax position.

Corporate UK taxpayers with an interest in a US LLC may have already been treated for UK tax purposes as the owner of an interest in an opaque entity under the interpretation outlined in HMRC’s manuals at DT19853A.  In the context of the disposal of an interest in a US LLC this interpretation does not seem to be immediately in contravention with the decision in the Supreme Court in the case of Anson (that decision could have implications for the tax treatment of income or revenue transactions, but here we are concerned with capital transactions).  Where the substantial shareholdings exemption applies, there would be no UK corporation tax on the disposal.  Consequently the potential recovery of any US tax paid and not previously recovered could be worth exploring.

For a further discussion of the tax implications of this case please get in touch with the Mazars international tax or corporate tax team.