HMRC reverse hybrid consultation: The impact on fund structures and investor groups

HMRC has published a consultation on the UK tax treatment of UK-resident individuals who are members of “reverse hybrid” entities, including US limited liability companies (LLCs). The consultation, which runs until 31 July 2026, recognises that the current UK approach can result in high effective tax rates for UK-resident individuals, driven by differences in how the UK and US classify LLCs. HMRC is seeking views on potential legislative changes to address this outcome.

Broadly, HMRC is considering whether the UK tax treatment for individuals should align more closely with the treatment in the overseas jurisdiction, so that income derived through LLCs would be taxed on a transparent basis in the UK rather than on distribution. While the focus is on individuals, the proposals have implications for a range of fund structures and investor groups.

Under existing rules, US LLCs are generally treated as transparent for US tax purposes, but as opaque entities in the UK. For UK-resident individuals, that mismatch can result in taxation on underlying profits in the US and then again on distributions in the UK. As those charges arise on different bases, double tax relief is not usually available. This can result in very high effective rates of tax.

The consultation also sits against the background of Anson v HMRC. In this case the Supreme Court held that, on the particular facts of a Delaware LLC used in a fund management context, the UK taxpayer was taxable on the same underlying profits as those taxed in the US. He was therefore entitled to double tax relief.

HMRC has not treated Anson as establishing a general rule for US LLCs, however, and the consultation reflects a desire to replace that fact-specific uncertainty with a clearer legislative regime for eligible UK-resident individuals.

The consultation notes that a possible approach would be for eligible UK-resident individuals to be taxed on their share of underlying profits, income and gains on a transparent basis for UK purposes, with UK tax computed under domestic rules.

The consultation suggests this treatment could apply automatically rather than by election and would be limited to individuals, with corporates remaining outside scope. The consultation also indicates that any new regime would apply only to defined categories of reverse hybrid entity: broadly those treated as transparent in their home jurisdiction but opaque in the UK, rather than to all overseas entities or all LLCs. Finally, the consultation seeks views on alternative options.

The proposed changes are particularly relevant for US citizens who are resident in the UK, as well as UK individuals with business interests, investments or carried interest linked to the US.

Under the current position, the mismatch in entity classification can result in taxation on different bases in the UK and US, with limited ability to obtain effective double tax relief. A move to transparent treatment in the UK would align the UK tax position more closely with the US treatment of LLCs. In many cases, this should improve the prospect of effective double tax relief and reduce the risk of double taxation arising from differences in classification.

If implemented, the changes could make the UK a more workable jurisdiction for US founders and other UK-resident individuals with interests in US managers or investment structures.

One immediate question is whether the long-standing use of blocker entities remains the right answer for UK individual investors.

Historically, blockers have been a practical way to avoid direct US trading income – effectively connected income (ECI) – exposure and the associated compliance obligations. If UK taxation shifts to a transparent basis with credit for US tax, the case for their use may no longer be obvious. For some investors, particularly in private equity strategies where ECI is expected, direct exposure through an LLC may provide a lower effective tax rate in some circumstances.

However, blockers are unlikely to completely fall out of use. The need to accommodate different investor types, varying appetite for US tax filings and the difficulty of revisiting established structures mean they remain part of the toolkit. For UK individuals, however, they may become an option rather than the default, and this will likely be considered carefully in the context of house co-investment structures

A move to transparency shifts the focus from legal classification to data and reporting. UK-resident individuals would need sufficient information to compute taxable income on a UK basis and identify amounts eligible for foreign tax credit.

In practice, this means relying heavily on US tax reporting, particularly Schedule K 1s, and adapting that information for UK purposes. The underlying information is useful, but not aligned, and there are likely to be timing and other differences between the US and UK positions.

Managers may need to provide additional investor reporting. This potentially has cost and operational implications that are not directly addressed in the consultation. 

These practical aspects are likely to be an important part of the consultation process.

If UK tax is computed using UK rules while US tax follows US principles, there are likely to be differences around depreciation, loss utilisation and the recognition of income. Those differences may not prevent relief being claimed, but they are likely to affect when relief is available and the extent to which it can be used in a particular period.  

For certain strategies, particularly where US tax attributes are significant, this is likely to require modelling – for example, in the case of capital-intensive projects with significant tax depreciation.

The possible interaction with the carried interest regime is not addressed directly in the consultation. That is perhaps unsurprising, as the consultation is not aimed solely at asset managers, notwithstanding HMRC’s use of a debt fund in one of its examples.

With any reform, careful analysis of taxing rights, character, timing and the availability of double tax relief will be required.

The consultation covers a number of technical design points, including:

• Whether the regime should apply automatically or by election
• How relevant entities are defined
• How partnership-style tax principles would be applied in practice
• How transitions from opaque to transparent treatment are managed

Outside these technical aspects, it will also be important to consider how the proposals interact with specific fund strategies. This includes the tax outcomes for private equity strategies with ECI exposure, real estate strategies where Foreign Investment in Real Property Tax Act (FIRPTA) considerations arise, and the continued role of blockers in credit fund structures.

Although the consultation is focused on UK-resident individuals, there may still be indirect implications for wider fund structuring, including arrangements in which LLCs are used as blockers for particular investor categories such as pension investors.

We will be considering the potential impacts of the proposals in more detail as the consultation progresses. The consultation will run for seven weeks from 10 June to 31 July 2026, with the government promising a response in due course.