Luxembourg Signs New Double Tax Treaty With The UK - Withholding Tax

OUR INSIGHTS AT A GLANCE

On 7 June 2022, Luxembourg signed a new double tax treaty with the UK.
As expected, the main change introduced by the new double tax treaty is in relation to the taxation of Luxembourg entities with real estate investments in the UK where the impact of the new provisions should be carefully monitored.
The DTT further introduces changes regarding the rules applicable to determine the tax residence of companies in case of dual residence. The impact of this change should also be analysed in order to make sure that the current tax residence of dual resident companies for DTT purposes is not challenged in the future.
Positive changes introduced by the new double tax treaty include the granting of tax treaty benefits to Luxembourg collective investment vehicles and a full generous exemption of withholding tax on dividend distributions.
Should Luxembourg and the UK manage to finalise the ratification of the double tax treaty before year-end, the new provisions could become applicable as from 1 January 2023.

On 7 June 2022, Luxembourg and the UK signed a new double tax treaty (the “DTT”) and an additional Protocol which will replace the double tax treaty signed back in 1967 (the “old tax treaty”). The aim of the signature of this new DTT is for the UK and Luxembourg to have a tax treaty which is in line with the latest international tax standards agreed upon at OECD level over the past years. While some of these standards were already reflected in the old tax treaty through the modifications introduced recently by the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting ("Multilateral Instrument" or "MLI"), the new DTT goes a step further with some additional changes, which, for some of them, may have a significant impact on Luxembourg entities with real estate investments in the UK. We provide an overview of the most important changes to be introduced by the DTT for corporate taxpayers.

Tax residence

Luxembourg CIVs get DTT benefits

In contrast to the old tax treaty, based on Article 2 of the Protocol to the DTT, Luxembourg CIVs will be granted DTT benefits under the following conditions:

A CIV which is established and treated as a body corporate for tax purposes in Luxembourg and which receives income arising in the UK shall be treated as an individual who is a resident of Luxembourg and as the beneficial owner of the income it receives (provided that a resident of Luxembourg receiving the income in the same circumstances would have been considered as the beneficial owner thereof), but only to the extent that the beneficial interests in the CIV are owned by equivalent beneficiaries.
However, if at least 75% of the beneficial interests in the CIV are owned by equivalent beneficiaries, or if the CIV is an undertaking for collective investment in transferable securities (“UCITS”), the CIV shall be treated as a resident of Luxembourg and as the beneficial owner of all of the income it receives (provided that a resident of Luxembourg receiving the income in the same circumstances would have been considered as the beneficial owner thereof).

“Equivalent beneficiary” means a resident of Luxembourg, and a resident of any other jurisdiction with which the UK has arrangements that provide for effective and comprehensive information exchange who would, if he received the particular item of income for which benefits are being claimed under this DTT, be entitled under an income tax convention with the UK, to a rate of tax with respect to that item of income that is at least as low as the rate claimed under this DTT by the CIV with respect to that item of income.

For the purposes of this provision, CIV means: UCITS subject to Part I of the Luxembourg law of 17 December 2010; UCIs subject to Part II of the Luxembourg law of 17 December 2010; Specialised Investment Funds (“SIF”) and Reserved Alternative Investment Funds (“RAIF”) subject to the “SIF-like” tax regime, as well as any other investment fund, arrangement or entity established in Luxembourg which the competent authorities of the Contracting States agree to regard as a CIV.

The granting of DTT benefits to Luxembourg CIVs is a very positive change compared to the situation of CIVs under the old tax treaty. The fact that the “equivalent beneficiary” requirement will not apply to UCITS is also very positive as, in practice, investors in UCITS are numerous and may change daily, which makes it extremely difficult, if not impossible, in practice to track particular income streams to particular investors in order to determine whether the UCITS is held by equivalent beneficiaries. Still, for non-UCITS CIVs, so mainly for alternative investment funds, the analysis of the “equivalent beneficiary” condition will remain a challenging exercise, especially when the investor base is big, though this could be part of the various disclosures contained in the fund subscription documentation. Finally, as far as the CIV definition is concerned, the fact that RAIFs subject to the SICAR regime are not CIVs within the meaning of this provision makes sense because they are fully taxable entities under Luxembourg tax law and should, as such, already be considered as Luxembourg tax resident under Article 4 of the DTT as any other fully taxable company.

New tie-breaker rule for dual resident companies

So far, almost all Luxembourg tax treaties include a tie-breaker rule according to which a company is deemed to be resident in the Contracting State in which its place of effective management is situated. This is also the case of the old tax treaty with the UK.

Article 4 Paragraph 3 of the new DTT incorporates the provisions of the 2017 OECD Model tax Convention according to which, in the case of a company with a dual residence, the competent authorities of both Contracting States shall endeavour to determine, by mutual agreement, the state of residence of the company having regard to the place of effective management, the place where it is incorporated or otherwise constituted and any other relevant factors. In the absence of such agreement, the Company shall not be entitled to any relief or exemption from tax under the DTT.

Unfortunately, since any matters requiring mutual agreement by competent authorities tend to be lengthy, this change will bring a lot of tax uncertainty to corporate taxpayers which rely on DTT benefits and have their place of incorporation in one of the Contracting States and their place of effective management in the other Contracting State. For these corporate taxpayers, the place of effective management criterion will no longer prevail automatically when determining the tax residence. Instead, the competent authorities of Luxembourg and the UK will first have to agree on a case-by-case basis on where the Company should be considered as a tax resident for DTT purposes.

The Protocol to the DTT provides a non-exhaustive list of factors which will be considered when the authorities of the 2 countries will perform their case-by-case analysis:

place where the senior management of the company is carried on;
place where the meetings of the board of directors or equivalent body are held;
place where the headquarters are located;
the extent and nature of the economic nexus of the Company to each State; and
whether determining that the Company is a resident of one of the Contracting States but not of the other State for the purposes of the DTT would carry the risk of an improper use of the DTT or inappropriate application of the domestic law of either State.

Finally, the Protocol to the DTT provides that the competent authorities of Luxembourg and the UK will not seek to revisit the tax residence status determined under the old tax treaty rules (i.e. based on the place of effective management criterion), but only as long as all the material facts remain the same. In case these material facts change after the entry into force of the DTT and the competent authorities determine that the company should be regarded as a resident of the other State (or the competent authorities do not reach a mutual agreement), that new determination (or the loss of treaty benefits pursuant to the absence of a mutual agreement) will apply only to income or gains arising after the new determination (or notice to the taxpayer of the absence of an agreement).

Dividends

While the old tax treaty only reduced the withholding tax on dividends up to 5% under certain conditions, Article 10, Paragraph 1, of the DTT introduces a full exemption from dividend withholding tax (“WHT”), provided that the recipient of the dividend is the beneficial owner of the income.

However, according to Article 10 Paragraph 2 of the DTT, except in the case where the beneficial owner of the dividend is a recognised pension fund¹ established in the other Contracting State, this exemption will not apply if the dividend is paid out of income (including gains) derived directly or indirectly from immovable property by an investment vehicle which distributes most of this income annually (that would be the case of a REIT) and whose income from such immovable property is exempted from tax. In such case, the DTT provides a maximum withholding tax of 15%. The UK does not levy WHT on dividends, other than for certain distributions from UK REITs, which are subject to 20% UK WHT. Based on the new DTT, the WHT applicable on these distributions will be reduced to 15%.

Interest

As in the old tax treaty, Article 11 of the DTT provides that interest arising in a Contracting State and beneficially owned by a resident of the other Contracting State shall be taxable only in the State of residence of the beneficiary. Therefore, in such case, interest will be exempt from withholding in the source country under the DTT. While Luxembourg tax law does not provide any withholding tax on interest, the UK does at 20%.

Royalties

While the old tax treaty only grants a withholding tax reduction of 5% where the recipient is the beneficial owner of the royalties, Article 12, Paragraph 1 of the new DTT fully exempts from WHT royalties arising in a Contracting State and beneficially owned by a resident of the other Contracting State. While Luxembourg tax law does not provide any WHT on royalties, the UK does at 20%. The DTT exemption of WHT on royalties will be of primary benefit to Luxembourg taxpayers holding IP investments in the UK who could no longer rely on the exemption provided by the EU Interest and Royalty Directive due to Brexit but will now be able to benefit from the WHT exemption provided by the new DTT.

Capital gains & real estate rich companies

The old tax treaty currently prevents the UK from taxing gains realised by Luxembourg investors on the sale of shares or other interest in real estate rich companies holding real estate assets in the UK. Under the old tax treaty, such gains are only taxable in the country of the seller (i.e. Luxembourg) who can benefit from a full exemption under the Luxembourg internal participation exemption regime if the relevant conditions are met.

Article 13, Paragraph 2 of the new DTT introduces a real estate rich company clause according to which gains derived by a resident of a Contracting State from the alienation of shares or comparable interests, such as interests in a partnership or trust, deriving more than 50% of their value directly or indirectly from immovable property, situated in the other Contracting State may be taxed in that other State.

Based on this new provision, the UK will now be able to tax gains realised by Luxembourg investors on shares or comparable interests in another company (no matter the country in which that company is a tax resident), which derives more than 50% of its value directly or indirectly from UK immovable property.

This change was anticipated as the UK changed its domestic law in April 2019 to tax non-UK resident owners of commercial property (both direct and indirect). So far, the UK was not able to tax Luxembourg investors on such gains since the old tax treaty granted an exclusive taxing right to Luxembourg. Based on this new provision, the UK will now be able to tax gains realised by Luxembourg investors on shares or comparable interests in companies considered to be “property-rich” from a UK tax perspective.

Methods to eliminate double taxation

Luxembourg will generally apply the exemption method to eliminate double taxation.

However, the credit method will apply in certain situations, including when tax is levied in the UK in accordance with Article 10 (dividend WHT) or Article 13, Paragraph 2 (capital gain taxation). In such case, the deduction shall not exceed that part of the tax, as computed before the deduction is given, which is attributable to such items of income derived from the UK.

Prevention of DTT abuse

The so-called “principal purpose test” already included in the old tax treaty since the entry into force of the MLI is also included in the new DTT. Accordingly, a DTT benefit shall not be granted in respect of an item of income or capital, or a capital gain, if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the DTT.

In addition, the preamble to the DTT, which was also included in the old tax treaty since the entry into force of the MLI, is included in the DTT and provides that the UK and Luxembourg intend to conclude a DTT without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance (including through treaty-shopping arrangements aimed at obtaining reliefs provided in this DTT for the indirect benefit of residents of third States).

Entry into force

The new DTT will enter into force as soon as it has been ratified by both Luxembourg and the UK.

In Luxembourg, it will apply:

in respect of taxes withheld at source, to income derived on or after 1 January of the calendar year next following the year in which the DTT enters into force - that would be 1 January 2023 at the earliest; and
in respect of other taxes on income, and taxes on capital, to taxes chargeable for any taxable year beginning on or after 1 January of the calendar year next following the year in which the DTT enters into force - that would also be as from tax years beginning on or after 1 January 2023 at the earliest.

In the UK, the DTT will apply

in respect of taxes withheld at source, to income derived from 1 January of the calendar year following the DTT coming into force – the earliest would therefore also be 1 January 2023;
in respect of income and capital gains tax, to any year of assessment from 6 April following of the calendar year after – the earliest would therefore be 6 April 2023; and
for corporation tax (including corporation tax on capital gains), for any financial year beginning on or after 1 April of the calendar year after the DTT coming into force – here, that would be 1 April 2023 at the earliest but most probably rather 1 January 2024 at the earliest given that most companies have financial years starting on 1 January.

Implications

The new DTT brings, above all, potential negative tax implications for Luxembourg taxpayers investing in real estate in the UK which should carefully review their existing investment structure in order to assess the potential impact of the DTT and analyse whether any action needs to be taken. The impact of the new DTT should also be carefully analysed by dual resident companies in order to make sure that their current tax residence for DTT purposes is not impacted. Finally, the DTT will be positive for Luxembourg CIVs investing in the UK as they will now be able, under certain conditions, to benefit from an exemption of UK withholding tax on interest and they already benefit from the dividend WHT exemption under the UK internal rules.

Whether the changes to be introduced by the new DTT will apply as soon as 2023 will depend on how quickly Luxembourg and the UK launch their internal ratification procedure. We will keep you updated on any development as they occur.

Footnote

1. Luxembourg recognised pension funds includes pension-savings companies with variable capital (sociétés d'épargne-pension à capital variable, “SEPCAV), Pension-savings associations (associations d'épargne-pension: “ASSEP”), Pension funds subject to supervision and regulation by the Insurance Commissioner (Commissariat aux assurances) and the Social Security Compensation Fund (Fonds de Compensation de la Sécurité Sociale: “SICAV-FIS”).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

Luxembourg: Luxembourg Signs New Double Tax Treaty With The UK