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2011 Spring Meeting Section of International Law, ABA

Delaware LLCs: Do They Have a Future in US Outbound Investment?

Co-Chairs Elinore J. Richardson Sonia Velasco Menal

Speakers Sam Kaywood Patrick Marley Juan Carlos Guerrero Andrea Bazzo

WASHINGTON, DC April 5, 2011

Overview

Elinore J. Richardson

Overview

 Growth of US LLCs as US outbound investment vehicles  Issues from the perspective of foreign jurisdictions  Focus of recent initiatives by foreign jurisdictions both domestically and in treaty negotiations on hybrid entities.  Should the US LLC as an outbound investment entity for use by US (or foreign) investors be categorised as an endangered species?

U.S. LLC: U.S. Overview

Sam Kaywood

DELAWARE LLCs Formation

 Simple to Form  File Certificate of Formation with Delaware Secretary of State  Contains basic information (e.g., name of entity, registered address and any other information desired)  Certificate of Formation is publicly available  No requirement to file governing documents or financial statements

DELAWARE LLCs Conversion, Transfer, etc.

 Other types of entities (including a corporation, partnership or trust) may convert into an LLC at any time  A Delaware LLC can convert to another type of entity  A Delaware LLC may transfer to or continue in a foreign jurisdiction The LLC may elect to keep its existence as an LLC in Delaware  A foreign entity may become domesticated as a Delaware LLC  All of these can be done by filing relatively simple certificates with the Delaware Secretary of State

DELAWARE LLCs Management

 An LLC can be managed by its members or by one or more managers  Voting rights of members usually covered in Operating Agreement signed by members  An LLC can be managed by traditional officers, e.g., President, Treasurer, etc., as set forth in Operating Agreement  An LLC can have a Board of Directors, again, as set forth in an Operating Agreement  Operating Agreement is not made public

Other Matters Covered in Operating Agreement

 Buy/Sell arrangements, rights of first refusal, etc.  Capital contributions and capital accounts  Distributions, allocation of income, loss, deduction, etc.  Liquidation, termination, etc.  Operating Agreements can be short and simple where there is one member, but are more elaborate where there are two or more members

US Tax Issues

 Single member LLC disregarded for US tax purposes  An LLC with two or more members is treated as a partnership for US tax purposes  Flow-through treatment: income, deductions, loss, etc., pass through to the partners  An LLC may elect to be treated as a corporation for US tax purposes Can make retroactive election for up to 75 days longer in some cases

Tax Treatment of LLCs vs. Corporations


Single Taxation Individual Members Double Taxation Individual Shareholders

LLC
 Income, loss, deductions and credits flow-through  No tax at LLC level  LLC files a Partnership Return (Form 1065)  Members increase their tax basis for their share of income and decrease for losses  Distributions are not taxable, but reduce basis

LLC Corp
 US Corp taxed at Federal rate of 35% (plus state)  Subsequent dividends also taxed currently at 15% (likely to increase)  Sale of shares taxable at capital gains rates (currently 15%)  No basis increase for income of US Corp

US

Use of LLCs for Joint Ventures

US Individual

US Corp

 US Individual Flow-through of all income, deduction, loss, etc. of foreign business Federal tax of up to 35% Flow-through of foreign tax credits No additional taxes upon distribution from LLC  US Corp Same as above except:  Shareholders of US Corp are taxed again on dividends and capital gains

US LLC

US Business

Foreign Limited Liability Companies

US Co

 Under the default rules, the foreign LLC is treated as a corporation for US tax purposes  Foreign LLC can elect to be treated as a disregarded entity (or a partnership if two or more members) for US tax purposes

Foreign LLC

LLCs With A Foreign Business

US

Foreign

 US member taxed on its share of income from foreign business  Foreign member not taxed in the US on foreign income

US LLC

No US trade or business  Distributions are tax-free to US members they have already been taxed

Foreign Business

LLCs With All Foreign Members

Foreign

Foreign

 Foreign members not taxed in the US on foreign income No US trade or business  US LLC still a US partnership and files an information return (Form 1065)  Used to avail of favorable Delaware laws, governance, etc without US tax

US LLC

Foreign Business

Delaware LLC: U.S. Outbound Investment in Brazil

Andrea Bazzo Lauletta

INTRODUCTION
 Brazilian Scenario for Non-Resident Investments  Brazil has a specific set of rules for non-resident investments in the country in the Brazilian capital and financial markets as well as private equity and direct investments Foreign exchange mechanisms Regulatory requirements for registration of the investments Tax specific rules Tax Rules  As a rule, Brazil imposes taxes on investments made by nonresidents in respect to: (i) income assessed locally and/or paid by Brazilian source and (ii) capital gains assessed on disposal of assets located in Brazil  Beneficial tax treatment (exemptions or lower rates) may be granted in some circumstances, which does not apply to investors located in favorable tax jurisdictions (FTJ), but may apply to privileged tax regimes (PTR)

DELAWARE LLC

 Delaware LLC as Vehicle of Investment  Historically, Delaware LLC is commonly used as the vehicle for investments in Brazil, specially for investments in the Brazilian financial and capital markets (which includes transactions in stock, future and commodities exchanges, over-the-counter, investments funds, public bonds, derivatives, among others)  As a rule, Delaware LLC is well accepted and known type of vehicle

DELAWARE LLC

General Rules in Brazil for Delaware LLC  Brazil does not provide specific rules dealing with entities located abroad and their corporate status  There is no rule expressly treating differently a vehicle because of its type, corporate status or legal nature or imposing a transparent regime or a disregarded status for foreign entities

DELAWARE LLC
General Rules in Brazil for Delaware LLC  However, it is common sense and preferential to use vehicles for investments in Brazil that have legal personality and are treated as corporations/companies instead of vehicles incorporated only based on contractual arrangements. The fact that such vehicles have a transparency regime for tax purposes should not impact or change the view of having an investment made by a foreign company This approach minimizes questionings by authorities tax and regulatory potential

Delaware LLC fits this approach as it is treated in the U.S. as a separate entity with legal personality, despite of the tax regime it adopts in the U.S.

DELAWARE LLC

 Tax Rules in Brazil for Delaware LLC  Brazil has not signed a tax treaty with the U.S. As a consequence, there is no specific rule or agreement between the countries in respect to LLC  Tax authorities have not listed Delaware LLC as FTJ  Tax authorities have listed Delaware LLC as PTR Corporate entities incorporated as a State LLC held by nonresidents and not subject to federal income tax in the United States of America

DELAWARE LLC
Tax Rules in Brazil for Delaware LLC  Legal concept of FTJ: countries or dependencies which do not tax or imposes income tax at a maximum rate lower than 20% Delaware LLC is incorporated in a country highly taxed Specific tax regimes are special rules for the tax imposed in the country  Legal concept of PTR: (i) no income tax income or income tax at a maximum rate lower than 20%; (ii) tax benefits to non-resident: a) without substantial economic activity carried out locally; b) contingent upon no substantial economic activity being carried out locally; (iii) no income tax or income tax at a maximum rate lower than 20% for income assessed outside its territory; (iv) not providing access to information related to shareholding composition, ownership of goods or rights or the economic transactions carried out In fact, there might have some discussions on some characteristics of PTR in respect to Delaware LLC

DELAWARE LLC
 What Are the Problems to be PTR?  As a rule, there is no major tax impact for the most investments carried out in Brazil by a Delaware LLC  Delaware LLC as a PTR have the disadvantaged tax rules in respect to: Transfer pricing Thin capitalization Restricted rules for deduction of payments made abroad down side of certain

DELAWARE LLC
Example of Tax Benefit in Use of Delaware LLC  Exemption of income tax on capital gains on disposal of shares in the stock exchange, provided that the acquisition of the shares were made as a portfolio investment (Resolution No. 2,689) Delaware LLC FTJ Investor Dividends: no income tax Capital gain on sale on exchange: 15% Capital gain on sale as private sale or IPO: 25%

Delaware LLC

Dividends: no income tax Capital gain on sale on exchange: 0% Capital gain on sale as private sale or IPO: 15%

Public traded corporation

DELAWARE LLC
Example of Tax Benefit in Use of Delaware LLC  Exemption of income tax for investments in private equity funds (FIP), provided that the investor does not hold more that 40% of the FIP or receives more than 40% of the income from the FIP Delaware LLC (<40%)
Delaware Delaware Delaware LLC 1 LLC 2 LLC 3

FTJ Investor Distribution form the FIP: 15% Capital gain on sale of FIP on exchange: 15% Capital gain on sale of FIP on private sale or liquidation: 15%

Distribution form the FIP: 0% Capital gain on sale of FIP on exchange: 0%

FIP

Target Brazilian Company

Capital gain on sale of FIP on private sale or liquidation: 0%

DELAWARE LLC
Conclusions  Currently, Delaware LLC is still an attractive tax alternative vehicle for investments in the Brazilian capital and financial markets as well as private equity and direct investments The main current tax benefits applicable to investments held in Brazil are still valid for an investor through Delaware LLC Although listed as PTR, the use of Delaware LLC for investment purposes does not generate major tax disadvantages  Legislation may change to limit the application of certain beneficial tax rules  Brazil and U.S. Tax Treaty under discussion may have specific considerations for LLC  Potential future discussions on substance over form on use of LLC  Some investors are considering the use or using other jurisdictions as alternatives: Luxembourg, Netherlands, UK

US LLCs: Canadas Perspective

Patrick Marley

US LLCs: Canadas Perspective

Treatment of LLCs in Canada Common Uses for LLCs in Canada Access to tax treaties Comparisons to other entities

US LLCs: Canadas Perspective

Canada Revenue Agency generally treats US LLCs as corporations for Canadian tax purposes. Limited case law Legal test is to characterize LLC based on a preponderance of its characteristics is it more like a Canadian corporation or partnership?  See UK Swift case

US LLCs: Canadas Perspective

Common Uses for LLCs in Canada


 Hybrid entity (treated as corporation in Canada, disregarded or partnership in US) Foreign tax credit planning for Canadian investments Loans to US corporations (led to IRC 894(c)) More flexible rules for distributions (such as return of capital v. dividend) for US inbound investment

US LLCs: Canadas Perspective


Availability of tax treaty benefits
  CRAs historic position was no treaty benefits for LLCs, regardless of whether income of LLC was taxed in the US. Contrary to CRAs position on partnerships (generally look through to members to determine treaty benefits) or Scorporations (generally eligible for treaty benefits)

US LLCs: Canadas Perspective


Availability of tax treaty benefits
 Article IV(6) of Canada-US Treaty Intended to reverse prior CRA position, look-through LLC to determine whether member eligible for tax treaty benefits. CRAs historic position successfully challenged in TD Securities LLC treated as US resident, eligible itself for tax treaty benefits.

TD Securities (USA)
Branch Profits Tax Rate 5% or 25%

TD Bank Canadian Treaty Resident

Canada

TD USA U.S. Treaty Resident

United States

Holding s II U.S. Treaty Resident

Consolidated Group For U.S. Federal Income Tax Purposes

Securities LLC U.S. Treaty Resident?

US LLCs: Canadas Perspective

TD Securities
  Interpreted Canada-US treaty (prior to Article IV(6)) Held liable to tax based in part on OECD Commentary, 1999 OECD Partnership Report, having regard to text, context and purpose of treaty provisions. Court sought consistency with treatment of other entities (such as partnerships, S-corps)

US LLCs: Canadas Perspective

Interaction of TD Securities and Article IV(6)


  CRA did not appeal TD Securities, but disagrees with the result. CRA considers LLCs to not be resident for tax treaty purposes (Article IV(6) looks through LLC to determine whether member gets benefits). Continued inconsistent treatment between LLCs, partnerships and S-corps.

US LLCs: Canadas Perspective

Article IV(7) of Canada-US Treaty


  Denies treaty benefits to certain hybrid entities Canadian ULCs and most US LLCs are treated as corporations in Canada eligible for check the box in the US. Most payments by hybrid Canadian ULC to US are denied treaty benefits.

US LLCs: Canadas Perspective


Article IV(7) Work Around for ULC Dividends
    Step 1 ULC increases its capital causing deemed dividend in Canada. Step 2 ULC makes a distribution as a return of the capital increased in Step 1. Article IV(7) not applicable since Step 1 ignored in US. CRAs view is that this solution does not apply where ULC held by US LLC.

US LLCs: Canadas Perspective

CRAs current approach to Article IV(6) and LLCs likely to be litigated.


  Does not take into account context and purpose of treaty provisions. Could lead to anomalous results: 5% withholding on ULC distribution to S-corp. 15% withholding on ULC distribution to partnership held by US individuals. 25% withholding on ULC distribution to LLC held by US individuals.

Disregarded payment to LLC: CRA View #2009-0345351C6


US Resident
CRA: better view is that Art. IV(6)(a) is not satisfied (payment by ULC is disregarded in US, so not derived by US resident through LLC for US tax purposes)

LLC
Distributi on

100 %

US Canada

ULC

US LLCs: Canadas Perspective


Branch Profits Issue US LLC wanting to commence business in Canada.
   CRAs view is that 25% withholding tax on branch profits if LLC held by US individuals. Contrast to 5% withholding on branch profits of US S-corp. May not be suitable alternative (potential issues with LLC forming a US corporation or Canadian corporation, likely not practical to reorganize LLC into a partnership).

US LLCs: Canadas Perspective

LLCs investing in Canada:


   Should get treaty benefits if all members of LLC are US treaty residents. Treaty benefits denied under Article IV(6) to the extent members of LLC are resident in other countries. May be preference to use partnership or S-Corp for Canadian investments to avoid anomalous CRA positions.

U.S. LLC: Outbound Investment in Mexico

Juan Carlos Guerrero

US LLCs: Mexicos Perspective


Vehicles created abroad are afforded different tax regimes based on their legal nature:
 Foreign Entities are defined as corporations and other vehicles that have separate legal personality from its shareholders or members. Foreign Legal Figures are defined as partnerships, trusts, investment funds and any other similar figures that lack legal personality.

US LLCs: Mexicos Perspective


Mexican Income Tax Law does not grant a disregarded status to any type of corporations (domestic or foreign) This is true even in the case of CFC rules applicable to Mexican residents
Net profit must be determined based on tax regime applicable to Mexican corporations Resulting net income taxed in the hands of the shareholders.

US LLCs: Mexicos Perspective


US LLCs were difficult to decipher because they have separate legal personality, but their income is commonly taxed in the US in the hands of its members It was not clear under the USMexico Treaty whether or not treaty benefits are applicable to US LLCs.  Protocol 2(b) addressed the case of US Partnerships, Trusts and Estates, but does not specifically address LLCs.  US Partnerships, Estates and Trusts are considered US residents for Treaty purposes to the extent that income is subject to tax in the US as income of a US resident person, either in the hands of the vehicle or in the hands of its members.

US LLCs: Mexicos Perspective


Mexico and US signed a Mutual Agreement on August 2005. The conclusions were not clear, so it was replaced by a new MA signed on December 2005.

US LLCs: Mexicos Perspective


Second MA makes it clear that:
Mexico will consider a US LLC as a US tax resident for Treaty purposes in proportion to the amount of its income that is taxed in the US as income of a US resident. Same regime applicable to non-US LLCs that have US resident members, provided that such jurisdiction has a TIEA with Mexico. However, Mexico will continue to regard the LLC as a separate legal person (e.g: capital gains exemption on interest < 25% determined at LLC level).

US LLCs: Mexicos Perspective


This means that any income obtained by a US LLC that is not taxed in the US as income of a resident will never have access to treaty benefits, even if members are resident of a treaty jurisdiction. Even worse, income of a US LLC that is allocated to nonUS members could be subject to a punitive 40% withholding tax rate if the Mexican payor is a related party of the US LLC.

US LLCs: Mexicos Perspective


Conclusions:  US LLC is a good option to invest in Mexico if members are US residents.  Not a good idea when members include non-US residents that could otherwise have access to treaty benefits.  Terrible idea when the members include Mexican resident individuals (may lead to double taxation on dividends).  Terrible idea when members include non-US residents and the LLC is a related party to Mexican payor (40% withholding tax may apply).

US LLCs: Mexicos Perspective


Conclusions:
 When pass-through status/treaty benefits desired for all participants, a legal figure should be used instead.  Administrative rule grants automatic pass-through status to legal figures established in TIEA jurisdictions.  Also, legal figures established in non-TIEA jurisdictions can obtain pass through status by applying for a private ruling.

US LLCs: Mexicos Perspective


Conclusions:
 US LLCs are still attractive for some Mexican residents doing business in the US.  Not attractive for wealth planning structures Complexity of reporting requirements (FBARs) Exposure to US Estate Tax

US LLC: Spanish perspective and other UE countries

Sonia Velasco

Characterization of U.S. LLCs by Spain Competent Authority Mutual Agreement - SpainU.S. Treaty
The Competent Authority Mutual Agreement entered into force January 1st, 1998 but signed in 2006 Clarifies treatment of LLCs, S corps, and other entities, organized within or without the US, treated as partnerships or disregarded entities for U.S. tax purposes Income will be treated as derived by a resident of the US to the extent that income received by the LLC or other entity is subject to U.S. tax as the income of a U.S. resident

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Characterization of U.S. LLCs by Spain - Domestic Characterization


Inconsistent opinion of the Spanish tax authorities Entities incorporated abroad the legal nature of which is identical or analogous to a Spanish transparent entity will be treated as look-through entities Ruling V0997-05 (June 2, 2009) does not analyze the legal/tax nature of the LLC but qualifies it as a transparent entity Ruling V2097-09 (September 21, 2009) treats the LLC as not tax transparent US LP is clearly fiscally transparent (need to analyze the tax residency of partners)

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Characterization of U.S. LLCs by Germany - Article 1(7) GermanyU.S. Treaty


An item of income, profit or gain derived by or through a person that is fiscally transparent under the laws of either Contracting State, will be considered to be derived by a resident of a State to the extent that the item is treated for the purposes of the taxation laws of that State as the income, profit or gain of a resident

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Characterization of U.S. LLCs by Germany Federal Finance Ministry Circular Issued March 19, 2004
Affirmed by German Supreme Tax Court, decision dated August 20, 2008 docket # I R 34/08) Criteria that qualify an LLC as a corporation
        Centralised management (as opposed to management and representation by partners) Limitation of liability Transfer of LLC interest without consent requirements Profit distribution requires a resolution before owners have a claim Contribution of capital required Unlimited lifetime of the company (irrespective of whether a partner dies/retires) Profit distribution is proportional to the nominal share capital Registration of LLC as a formal requirement for formation

There is no beat all criterion (all facts and circumstances have to be considered) An LLC is deemed to be a corporation if a majority of the first five criteria are met
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Use of an Intermediary Jurisdiction between the US LLC and the Jurisdiction of Investment- Equity
Foreign investor
DIVIDEND

US investor

DELAWARE LLC
DIVIDEND

LUX LLC
DIVIDEND

SPAIN

BRAZIL

CANADA

MEXICO
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Use of an Intermediary Jurisdiction between the US LLC and the Jurisdiction of Investment- Debt Financing
LOAN

US CO.

US LLC
LOAN

FOREIGN ENTITY

LOAN

FOREIGN OP CO

Foreign entity could be a corporation or a pass through. 57

Thank You!
Elinore J. Richardson Sonia Velasco Menal Juan Carlos Guerrero Patrick Marley Andrea Bazzo Toronto, Ontario, Canada +1 416 859 8631 erichardson@int-tax.org Cuatrecasas, Goncalves Pereira Spain +34 93 2905590 sonia.velasco@cuatrecasas.com Chavez, Ruiz, Zamarripa Mexico +1 212. 223. 4434 juancg@chevez.com Osler Canada +1 416.862.6580 pmarley@osler.com Mattos Filho Veiga Filho Marrey Jr. e Quiroga Advogados Brazil +55 (11) 3147 7600 / 7799 abazzo@mattosfilho.com.br Alston & Bird LLP US +1 404 881 7000 skaywood@alston.com

Sam Kaywood

#4299075.v5

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