Many of Luxembourg's double tax treaties indicate that the right to tax capital gains arising from a disposal of shares in a company—specifically a company that, at the time of the sale, derives over 50% of its value (directly or indirectly) from real estate—is allocated to the country in which that real estate is located (in line with Art. 13.4 of the OECD Model Tax Convention, a so-called "land-rich company" clause). This means that, in these cases, notwithstanding the existence of other value-generating assets in the sold company, the taxing right over the entire gain from these share deals would be allocated to the country where the immovable property is located (so called "situs state").
Luxembourg recently decided to not add a further layer of complexity to this land-rich company clause in its treaty network—specifically, it opted not to modify those clauses in the way suggested in the Multilateral Instrument (MLI).1 It also opted not to insert a land-rich company clause into all of its covered tax agreements.
A positive choice
This is, in our view, a good choice since the modification proposed in the MLI may have led to practical difficulties, in particular when allocating the right to tax the above-mentioned gains among different jurisdictions.
Firstly, according to the rules proposed in the MLI, the situation at the time of the sale of a real-estate-rich company would no longer be relevant to the allocation of taxing rights. If, at any time during the 12 months preceding the sale of such shares, the company being sold derived more than 50% (or another defined percentage) of its value (directly or indirectly) from immovable property, the right to tax would be allocated to the country where the underlying real estate is located. As a consequence, the evolution of the real estate value (compared to all other valuable assets) would have to be retroactively tracked, which could cause difficulties and complexity in practice. In contrast, without the application of the MLI's proposed amendment, such complexity does not exist as only the situation at the share deal date would be of relevance.
Secondly, opting for the MLI's amendment could have led to detrimental situations in which taxing rights could be allocated to various jurisdictions resulting in double taxation (provided domestic tax laws picked up the taxing rights according to the corresponding DTT).
For example, imagine that ACo1 (tax resident of State A) is the sole shareholder of the real estate company ACo2 (also tax resident in State A). ACo1 contemplates selling ACo2 on 31 December. ACo2 is the sole owner of two buildings (B1, C1) in States B and C respectively. Between 1 January and 30 June, ACo2 derived more than 50% of its value from building B1. Between 1 July and 31 December, ACo2 derived more than 50% of its value from building C1. Upon the sale of the shares on 31 December and the application of the MLI amendment, the taxation rights could be allocated to both States B and C. In these cases, where the taxing right could be allocated to two (or more) different countries, the application of the general rule of allocating the taxing right over the "entire gain" arising upon the sale of ACo2 to the situs state(s) could result in economic double taxation unless the countries in question apply for a mutual agreement. A pro-rata allocation of taxing rights between States B and C based on the values of the real estate properties could be contemplated in such scenarios. In contrast, without the application of the MLI's proposed amendment, the risk of double taxation would not occur, i.e. the taxation rights would be allocated solely to C (due to the date of sale).
Thirdly, as the situation at the time of the sale would no longer be relevant, taxing rights could theoretically be allocated to a certain country based on the above rule, even if, at the time of the share deal, the company being sold had itself already sold its real estate (asset deal), the value of which would have been taken into account for the purposes of allocating such taxing rights. As reflected in the commentary to the OECD Model Tax Convention, contracting states would have to agree on further clarifications in a treaty to avoid such inappropriate situations. In contrast—without the application of the MLI's proposed amendment—such complexity does not exist as only the situation at the share deal date would be of relevance.
The above MLI provision should become effective in coming years upon completion of the ratification process in the relevant MLI signatories. The double tax treaties signed by Luxembourg will not be affected by the MLI amendment, which, it should also be noted, is not considered to be a minimum standard for remaining BEPS-compliant. In purely practical terms, opting out of the provision means more stability and less complexity for Luxembourg's investment structures.
Footnotes
1 Luxembourg signed the MLI on 7 June 2017.
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.
