The taxpayer, a UK resident and ordinarily resident but non-domiciled individual, was a member of a Delaware LLC (HarbourVest). HarbourVest operated under an LLC Operating Agreement. This set out, among other things, the process for determining the distribution of profits. Under the LLC Operating Agreement, HarbourVest's profits were distributed to its participants. Profit allocations were credited to the members' capital accounts and distributions were charged against these. Therefore, the taxpayer was entitled to (and was paid) sums that (as a matter of calculation, at least) amounted to a share of the profits of HarbourVest. However, the LLC Operating Agreement provided for HarbourVest to withhold amounts that would otherwise be distributable to its members to meet liabilities (including future or contingent liabilities).

As HarbourVest had not elected to be treated as a corporation for US tax purposes, each member (rather than HarbourVest itself) was subject to US federal and state tax on their distributive share of HarbourVest's profits (whether this share was actually distributed or retained by HarbourVest).

The taxpayer remitted his gross profit share from the LLC to the UK. The appellant claimed foreign tax credit relief for his income from HarbourVest. HMRC denied that such relief was available on the basis that HarbourVest was an opaque entity for UK tax purposes, which had paid the equivalent of a dividend. Accordingly, as the taxpayer had not been taxed in the UK on the same income as that on which HarbourVest had been taxed in the US, it issued discovery assessments against the appellant, who appealed to the First-tier Tribunal.

The First-tier Tribunal found in favour of the taxpayer, holding that he was entitled to relief under the US/UK double tax treaty. Applying Memec (see Background), the First-tier Tribunal held that the nature of HarbourVest was somewhere between a Scottish partnership and a company, falling nearer the former. In the context of the US/UK double tax treaty, the main question was whether the members of HarbourVest were entitled to its profits as they arose. The First-tier Tribunal considered the test in the treaty (whether the taxpayer was subject to tax "computed by reference to the same profits or income" as that on which HarbourVest was taxed) rather than the question of whether HarbourVest was transparent or opaque for tax purposes. Having determined that the members of the LLC were entitled to its profits as they arose, the First-tier Tribunal held that the taxpayer was entitled to relief under the treaty. For further details, see Legal update, Double tax relief for share of profits from Delaware LLC.

The Upper Tribunal reversed the decision of the First-tier Tribunal. The Upper Tribunal, like the First-tier Tribunal before it, considered that the key question was whether the taxpayer was entitled to share in HarbourVest's profits as they arose. However, also applying Memec, the Upper Tribunal stated that the question was one of transparency. It seemed clear to the Upper Tribunal that the taxpayer was not taxed on the same profits that were taxed in the US, which was the test to be met for treaty relief to apply. Whether the taxpayer had a proprietary right in the underlying assets of HarbourVest was a crucial factor in the view of the Upper Tribunal, which held that the taxpayer had no such right. HarbourVest’s profits belonged to it and the mere contractual obligation to credit and distribute (and the corresponding contractual right held by the taxpayer and other members of HarbourVest) did not make those profits the members' (at least, for UK tax purposes). For further details, see Legal update, No treaty relief for Delaware LLC profit share.

The taxpayer appealed to the Court of Appeal.

(Note: The Upper Tribunal also found in favour of HMRC in relation to another issue in this case, concerning the application of the "transfer of assets" rules in what was section 739 of the Income and Corporation Taxes Act 1988, which was not subject to this appeal: see Legal update, Transactions involving Delaware LLC had no tax avoidance purpose (Upper Tribunal).)

It was common ground that, to be entitled to treaty relief, the taxpayer had to establish that his share of HarbourVest's profits were the same as the profits by reference to which he was taxed in the US. The Court of Appeal held that, following Memec (see Background), the relevant test was whether the source of the profits was the same in each case. The question was whether the source of the taxpayer's income was the profits of HarbourVest (the source of which was HarbourVest's own trading) or merely a distribution out of its profits.

The Court of Appeal stated that if a taxpayer becomes entitled to the profits of an entity because of some contractual arrangement to which he is a party, he must show that the contract is actually the source of the profit rather than a mechanism to secure a right to a profit derived from another source. This will, in general, mean that he has to show a proprietary right to the profits. Again deriving the relevant principles from Memec, the Court of Appeal commented that it was not enough for the taxpayer to show a contractual right to receive a profit: the profit must always have belonged to him. If a profit is earned by an entity and the source of the profit for a taxpayer as a member of that entity is a contract between the members, in the view of the Court of Appeal, the source of his income must (usually) be different to that of the entity itself. The existence of a contract, generally, suggests that there is a disposition of a right to the profits from one person to another. That result may, however, be avoided if the member has a proprietary right to the profits as they arise.

Expanding on this test, the Court of Appeal stated that, for the source of the taxpayer's income to be the same as the source of the entity's profits, the taxpayer must have a right to (part of) the profits as they are created or accrue. In determining this, consideration should be given to factors such as those set out in paragraphs INTM180000 onwards of HMRC's International Manual (see Background). In the view of the Court of Appeal, provisions in the agreement between the members that make it possible to assign an interest may also throw light on whether the profits are those of the members.

The member's interest may amount to a share of the profits from the moment they arise, or it may simply be a right to receive a share of the profits. However, as profits do not arise until accounts are made up for a period and there are, generally, no particular assets of an entity can be said to represent an entity's profit, a member seeking to show that he is entitled to profits from the moment that they arise will have to show that he has an interest in the entity's assets to the value of the profit. This must be a proprietary interest. The Court of Appeal agreed with HMRC that it would be difficult or unusual for an entity with a separate legal personality to be tax transparent for English law purposes (such that the entity's profits belong to another person or other persons). However, this would not be impossible, examples being a Scottish partnership and a company acting as agent.

Therefore, the Court of Appeal agreed with the Upper Tribunal's substantive decision on the test to apply.

The Court of Appeal was invited to consider whether the Upper Tribunal was permitted, as a matter of jurisdiction, to overturn the decision of the First-tier Tribunal on this issue. The appellant argued that the question of entitlement to profits was a matter of Delaware law and, therefore, a matter of fact from a UK law perspective. The Court of Appeal disagreed, holding that the features of the taxpayer's interest in HarbourVest were to be established by reference to Delaware law but that English law was then to be applied to those features.

The Court of Appeal held that the Upper Tribunal was right to conclude on the facts that the profits of HarbourVest did not belong to its members. The members' right to have profits allocated to their capital accounts represented a transfer of an entitlement to the profits, and the profits as they arose belonged to HarbourVest. HarbourVest was a separate legal entity and there was nothing to suggest that it did not have an unqualified ownership of (or that its members had an interest in) its assets. The Court of Appeal noted, in particular, the ability of HarbourVest to deduct amounts from the distributions that it made to its members (see Dispute) and stated that the First-tier Tribunal had been wrong to see this as inconsequential in determining whether HarbourVest's members were entitled to its profits from when they arose: the amounts to which HarbourVest's members were entitled was only a residual amount after deductions. While allocation of amounts payable by HarbourVest to its members was automatic, this merely reflected an agreement by the members to impose in advance certain limits on what was, in reality, a distribution by HarbourVest to its members out of its profits. (The Court of Appeal noted that such automatic allocation and distribution was not unknown under the articles of association of UK companies.)

The appellant sought to raise a new argument based on the exchange of notes between the UK and the US at the time of entering into the 2001 UK/US double tax treaty. The appellant sought permission to appeal on the basis that this exchange of notes made it unnecessary to show that tax was paid on the same profits to benefit from treaty relief. However, as there was some room for dispute as to the effect of the exchange of notes and the appellant had only raised this issue after the Upper Tribunal had given its decision, the Court of Appeal refused permission to appeal on this point.