Luxembourg and the United Kingdom sign new double tax treaty

On 7 June 2022, Luxembourg and the United Kingdom (UK) signed a new Convention for the Elimination of Double Taxation with respect to Taxes on Income and on Capital and the Prevention of Tax Evasion and Avoidance (the Treaty), which is largely based on the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention (MTC) in its version of 2017. 

The Treaty contains the highest international tax standards on tax transparency and comprises some significant changes compared to the double tax treaty currently in force (the current treaty).

This Alert summarizes the main features of the Treaty.

Detailed discussion

Clarification that the Treaty is not intended to be used to generate double non-taxation

In line with the recommendations of the OECD in its Report on Action 6 of the Base Erosion and Profit Shifting (BEPS) Project (Preventing the Granting of Treaty Benefits in Inappropriate Circumstances), the Preamble of the Treaty provides expressly that the Treaty was concluded to eliminate double taxation 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 the Treaty for the indirect benefit of residents of third States).

Entitlement to benefits

The Treaty formally incorporates the principal purpose test as recommended by Action 6 of BEPS as one of the minimum standards to be implemented by the countries participating in the BEPS Inclusive Framework. According to this provision, a benefit under the Treaty shall not be granted in respect of any 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 new tax treaty.

Resident of a Contracting Party

Article 4 of the Treaty defines the meaning of the term “resident of a Contracting State” as a person that is liable to tax therein by reason of residence or a similar criterion. The Treaty also formally includes recognized pension funds in the definition of resident, as well as organizations that are established and operated exclusively for religious, charitable, scientific, cultural or educational purposes (or for more than one of those purposes) and that are resident of a Contracting State according to its laws, notwithstanding that all or part of their income or gains may be exempt from tax under the domestic law of that State.

In line with the OECD MTC, where a person other than an individual is resident in both states, residence for purposes of the Treaty is to be determined by mutual agreement of the competent authorities of the two states, having regard to its place of effective management, the place where it is incorporated or otherwise constituted and any other relevant factors. Under the current treaty, a person other than an individual is deemed to be a resident of the Contracting State in which its place of effective management is situated.

The Protocol to the Treaty details, without exhaustively listing them, the factors that the competent authorities should assess in this context (e.g., where the senior management of the person is carried on or the extent and nature of the economic nexus of the person to each State). The Protocol also ascertains that where a company was resident in both Luxembourg and the UK under the domestic law of those countries before the entry into force of the Treaty, and the residency of that company was determined in accordance with the provisions of the current treaty, Luxembourg and the UK will not seek to revisit that determination so long as all of the material facts remain the same. Where the material facts change after the entry into force of Treaty and the conclusion of the mutual agreement differs from the conclusion under the current treaty (or no conclusion is reached), 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).

The rules on the determination of residence of an individual that is resident in both states contained in the Treaty are identical to those in the current treaty. The Protocol also extends the benefits of the Treaty to certain Luxembourg Collective Investment Vehicles (CIVs) that are established and treated as body corporate (e.g., a Luxembourg société anonyme (SA) or société à responsabilité limitée (S. à r.l.) for tax purposes in Luxembourg. For these purposes, CIVs include:

• Undertakings for Collective Investment in Transferable Securities (UCITS) subject to Part I of the law of 17 December 2010
• Undertakings for Collective Investment subject to Part II of the law of 17 December 2010
• Specialised Investment Funds (SIF) subject to the law of 13 February 2007
• Reserved Alternative Investment Funds (RAIF) subject to the law of 23 July 2016, with the exception of RAIFs that have opted for the SICAR tax regime
• Any other investment fund, arrangement or entity established in Luxembourg which the competent authorities of the Contracting States agree to regard as a collective investment vehicle.

These CIVs will be treated as a resident individual and beneficial owner of their income (provided that a resident of Luxembourg receiving the income in the same circumstances would have been considered to be the beneficial owner thereof) for the purposes of the Treaty to the extent that the beneficial interests in the vehicle are owned by equivalent beneficiaries.

An “equivalent beneficiary” is either a resident of Luxembourg or a person resident of any other jurisdiction with which the UK has arrangements that provide for the exchange of information and that would be entitled to a tax rate at least as low as the tax rate claimed under the Treaty by the CIV.

If at least 75% of the beneficial interests in the CIV are owned by equivalent beneficiaries, or if the CIV is a UCITS within the meaning of EU Directive 2009/65,ithe CIV is treated as a resident of Luxembourg and considered as beneficial owner of all income it receives.

Permanent establishment

Article 5 of the Treaty defines the concept of permanent establishment, which purpose is to determine the right of a Contracting State to tax the profits of an enterprise of the other Contracting State. The wording of this Article largely corresponds to the wording of the OECD MTC.

Under the Treaty, a building site, a construction, installation or dredging project will constitute a permanent establishment only if it lasts more than 12 months (compared to 6 months in the current treaty).

It should be noted that the Treaty deviates from the OECD MTC with respect to dependent agents, as it does not specify that habitually playing the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise on behalf of which a person is acting may lead to the constitution of a permanent establishment. The Treaty therefore has essentially the same definition as the current treaty with respect to dependent agents.

The Treaty furthermore confirms the absence of permanent establishment where an enterprise merely carries on business in a Contracting State through a broker, general commission agent or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business.

Business profits

Article 7 of the Treaty follows the wording of the OECD MTC. It consequently includes the requirement for one Contracting State, to the extent necessary to eliminate double taxation, to make appropriate adjustments in a case where the other Contracting State has adjusted the profits that are attributable to a permanent establishment.

International shipping and air transport

In line with the OECD MTC, Article 8 of the Treaty allocates the taxation right of profits that an enterprise of a Contracting State derives from the operation of ships or aircraft in international traffic to that State. Moreover, the Treaty provides for a definition of the concept of “profits from the operation of ships or aircraft in international traffic.”

Dividends

While the current treaty provides for a maximum rate of 5% (companies) / 15% (individuals) withholding tax on dividend distributions, the Treaty provides for a withholding tax exemption, unless the dividends are paid out of income (including gains) derived directly or indirectly from immovable property by an investment vehicle which distributes most of this income annually and whose income from such immovable property is exempt from tax. In such case, a maximum withholding tax of 15% shall apply. The withholding tax exemption would however still apply if the beneficial owner of such dividends is a recognized pension fund as defined in the Treaty.

While UK law does not impose withholding tax on dividends, the Luxembourg domestic withholding tax rate amounts to 15%. It can however be reduced to nil under the domestic participation exemption, which requires, as well as conditions pertaining to the legal form of the beneficiary of the dividend and the distributing company, the holding threshold in the capital of the distributing company and the holding duration, the parent company to be fully subject to a tax corresponding to Luxembourg corporate income tax.

Interest

The rate of withholding tax on interest under the Treaty remains unchanged at 0%.

Royalties

Article 12 of the Treaty removes the 5% withholding tax on royalties that is provided by the current treaty. Under Luxembourg domestic law, no withholding tax is in principle levied on royalties. Under UK domestic law, a withholding tax rate of 20% could otherwise be applicable.

Real estate

As it is the case under the current treaty, income from immovable property, as defined in accordance with the law of the Contracting State in which the property is located and including determined items as listed in Article 6 of the Treaty, is taxable in the Contracting State of its location.

As mentioned above, the investment in real estate by an investment vehicle may also have an impact on the withholding tax to be applied on dividends paid by such vehicles (see Dividends).

The Treaty however introduces a “real estate-rich” clause according to which capital 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.

The UK tax charge on capital gains arising on the sale of UK real estate-rich vehicles applies when the vehicle derives, directly or indirectly, at least 75% of its gross value from UK property and the UK domestic threshold will need to be met before the charge applies. The change will allow the UK to tax all of any gain arising on a disposal after the treaty comes into effect, not just the proportion arising after the revised treaty has effect.

Luxembourg domestic law does not contain a specific provision with respect to the taxation of the capital gains on shares in real estate-rich companies, so the general rules apply. However, the sale of an interest in an entity that is tax transparent from a Luxembourg perspective is assimilated to the sale of the immovable property held by that entity, triggering taxation in Luxembourg unless the immovable property is located in the UK.

Pensions

Unlike the OECD MTC, the Treaty does not provide for the allocation of taxation rights of pensions and other similar remuneration to the State of residence only, but rather provides for an allocation of taxation rights to the source country. With respect to pensions and other similar remuneration (including lump-sum payments) arising in Luxembourg and paid to a resident of the UK, the exclusive taxation rights are allocated to Luxembourg insofar as such payments derive from contributions paid to or from provisions made under a complementary pension scheme by the recipient or on his behalf and to the extent that these contributions, provisions, or the pensions or other similar remuneration have been subjected to tax in Luxembourg under the ordinary rules of its tax laws.

Income received by trustees

Article 20 of the Treaty includes a specific provision with respect to an amount of income paid out of income received by trustees and personal representatives administering the estate of deceased persons, according to which such amount shall be treated as arising from the same sources, and in the same proportions, as the income received by the trustees or personal representatives out of which that amount is paid. Any tax paid by the trustees or personal representatives in respect of the income paid to the beneficiary shall be treated as if it had been paid by the beneficiary.

Elimination of double taxation

In line with Luxembourg practice, Luxembourg generally applies the exemption method to avoid double taxation. Consequently, where a Luxembourg resident derives income or owns capital that may be taxed in the UK, Luxembourg will exempt such income or capital, but will, in order to calculate the amount of tax on the remaining income or capital, apply the same rates of tax as if the income or capital had not been exempted (exemption with progression).

As regards specifically dividends, capital gains derived from the alienation of shares in a real estate-rich company, income from employment as a member of the regular complement of a ship or aircraft, as well as income of entertainers and sportspersons and other income that may be subject to tax in the UK, Luxembourg grants a tax credit of an amount equal to the tax paid in the UK. The tax credit may not exceed that part of the tax, as computed before the credit is given, which is attributable to such items of income derived from the UK.

In line with the OECD MTC, the exemption shall however not apply to income derived or capital owned by a resident of Luxembourg where the UK applies the provisions of the Treaty to exempt such income or capital from tax or applies a withholding tax in the case of dividends. The aim of this provision is to avoid double non-taxation resulting from disagreements between the two Contracting States on the facts and circumstances of a specific case or on the interpretation of the Treaty provisions.

The UK , as a general rule, applies the tax credit method to eliminate double taxation. Tax exemption is granted for dividends paid by a Luxembourg company to a UK company when the conditions for the exemption under UK law are met. An exemption can also apply by election to profits of a permanent establishment in Luxembourg of a UK company. Where the conditions to benefit from a dividend exemption under UK law are not met, the Luxembourg tax payable by the distributing company on the profits in respect of which such dividend is paid may be credited against UK tax under the general credit method, provided that the UK recipient of the dividend is a company which is resident of the UK and which controls directly or indirectly at least 10% of the voting power in the company paying the dividend.

These provisions shall however not apply where the Luxembourg tax payable is in accordance with the provisions of the Treaty solely because the income, profits or chargeable gains referred to in these provisions is also income derived by a resident of Luxembourg.

Mutual agreement procedure

Article 24 of the Treaty provides for a mutual agreement procedure in line with the OECD MTC.

Exchange of information

Article 25 of the Treaty contains an exchange of information provision in line with the OECD MTC.

Entry into force

The Treaty will enter into force once ratification instruments are exchanged, and its provisions will apply:

• In Luxembourg from 1 January of the year following entry into force
• In the UK:

o   For withholding tax from 1 January of the year following entry into force

o   For income and capital gains taxes from 6 April of the year following entry into force

o   For corporation tax from 1 April of the year following entry into force

The provisions of Article 24 (Mutual agreement procedure) and Article 25 (Exchange of information) shall have effect from the date of entry into force of the Treaty without regard to the taxable period to which the matter relates. However, in the case of Article 25, this is subject to the condition that the information could have been supplied under the provisions of the prior Treaty.

Application of Controlled Foreign Company (CFC) rules

The Protocol confirms that the provisions of the Treaty do not prevent Luxembourg from applying its CFC provisions or any other similar provision that would amend or replace the CFC provisions.

iDirective 2009/65/EC of the European Parliament and of the Council of 13 July 22009 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS)