On June 7, 2022, Luxembourg and the UK signed a long-awaited new double tax treaty for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and on capital (the new DTT), and an additional protocol which will replace the double tax treaty signed back on May 24, 1967. The redesign of the DTT is to reflect the latest Organisation for Economic Co-operation and Development standards, some of which have already been reflected through the introduction of the multilateral convention to prevent base erosion and profit shifting on June 7, 2017 (the MLI).
The new DTT includes several changes and introduces an exemption from withholding tax on dividend payments, as well as the so-called “real estate rich” company clause, however with certain particularities, as detailed below.
Capital Gains (Article 13)—Introduction of a Land-Rich Clause
While the DTT gave the taxing rights on capital gains upon disposal of shares to the seller’s jurisdiction, the new DTT now provides that this rule would no longer be absolute. Indeed, taxing rights on capital gains arising from the sale of shares, which wealth predominantly derives from the holding of real estate properties situated in a given country, will also be allocated to that country. The gain arising from the disposal in a Luxembourg company or UK company having as its sole asset a property in the UK will also be taxable in the UK by virtue of the treaty.
Along with the alignment with OECD standards, this shift also has its source in the change in UK domestic law in April 2019, implementing a tax for nonresidents realizing capital gains on the direct and indirect sale of UK real estate (the UK NRCGT). The indirect sale of UK real estate could apply to the sale of a company which derives 75% or more of its gross value, directly or indirectly, from UK real estate.
To determine if a company is land-rich for the purposes of the treaty, Article 13(2) of the new DTT sets the threshold at 50%, meaning that an entity deriving more than 50% of its value or worth directly or indirectly from immovable property located in either of the signing countries will be caught by the rules of the new DTT.
Such threshold should be assessed at the time of the relevant transactions or operations and does not include a retrospective 365-day testing period.
For the sake of completeness, these relevant transactions and operations could be a transfer of shares pursuant to a share purchase agreement or even a liquidation, hive up, merger, or demerger of the land-rich company. Indeed, any operation whereby latent capital gains are revealed from a tax perspective could also raise UK tax as per Article 13(2) of the new DTT.
The new DTT, by virtue of the principle of subsidiarity of international treaties, will now support the new UK NRCGT rule and allow the UK to tax nonresidents on the disposals of shares of land-rich companies in a Luxembourg/UK context, provided that such gain covered by the new DTT is indeed taxable in the UK according to domestic rules.
As there is no grandfathering of this change, the entire gain from the disposal of an interest in a UK land-rich company by a Luxembourg resident would then be subject to UK tax as soon as this amendment enters into force, including any part that has accrued before the changes to the treaty came into effect.
Dividends (Article 10)
While the DTT provided for a 15% or 5% withholding tax (WHT) on dividends (depending on the participation rate in the paying company), the new DTT introduces a full WHT exemption on dividends, irrespective of holding period, size of participation, or “subject-to-tax” requirements at the level of the payee. This will be especially relevant for Luxembourg-source dividends as the UK does not provide for WHT on dividends. These conditions are more favorable than the domestic Luxembourg rules.
The new DTT in its Article 10(2)(b) also enshrines a special rule for dividends deriving from real estate income and paid by real estate investment holding entities that distribute most of their income annually and whose income from such immovable property is exempted from tax, such as real estate investment trusts or similar entities: Dividends they paid will be subject to a maximum WHT rate of 15%, which can be reduced to 0% where the beneficial owner of the dividends is a recognized pension fund.
Interest and Royalties (Articles 11 and 12)
While the DTT provided for a rate of 5%, the new DTT reduces the rate to 0%. The rate of withholding tax on interest is unchanged and remains at 0%. This provision would not actually be relevant for Luxembourg-source income but rather for interest/royalty paid by a UK-based payer or having its source in the UK.
Elimination of Double Taxation (Article 22)
While the DTT stated the exemption method (with progression) is the main method to eliminate double taxation in both Luxembourg and the UK, the new DTT foresees that the credit method will apply in some circumstances.
The credit method will notably apply when tax is levied in the UK pursuant to Articles 13 (capital gains tax) and 10 (dividend WHT). The credit method would allow, where applicable, a deduction from the payee’s Luxembourg corporate income tax of an amount equal to the relevant UK tax paid, which shall not exceed that part of the tax, as computed before the deduction is given, which is attributable to such items of income or gains which may be taxed in the UK.
Interestingly, Article 5 of the Protocol specifies that the new DTT does not prejudice the application of Luxembourg “controlled foreign corporation” rules (Article 164 ter of the Luxembourg income tax law), which allows the taxation in Luxembourg of undistributed income and gains realized by nonresident subsidiaries or foreign permanent establishments under certain conditions.
Benefits of the Provisions of the New DTT to Investment Funds
While the DTT did not foresee this option, the new DTT extends the benefits of its provisions to Luxembourg collective investment vehicles (CIVs) having the legal form of body corporate (i.e., not partnership) according to Article 2 of the Protocol of the new DTT. The term CIV covers the following investment vehicles:
- Undertakings for collective investment in transferable securities (UCITS) subject to Part I of the law of Dec. 17, 2010;
- Undertakings for collective investment subject to Part II of the law of Dec. 17, 2010;
- Specialized investment funds subject to the law of Feb. 13, 2007; and
- Reserved alternative investment funds (RAIF) subject to the law of July 23, 2016, with the exception of RAIF which choose to subject themselves to the regime of Article 48 of the law (so-called RAIF-SICAR).
Additionally included is any other investment fund, arrangement, or entity established in Luxembourg which the competent authorities of the contracting states agree to be regarded as a CIV.
However, to avoid the improper use of the CIV by third-country investors who would not have enjoyed the treaty benefits had they invested directly in the CIV, the new DTT provides for anti-treaty shopping rules.
Therefore, with respect to these investors, the notion of equivalent beneficiaries has been introduced in the new DTT. An “equivalent beneficiary” refers to (i) either a resident of Luxembourg, or (ii) a resident of any other jurisdiction with which the UK has agreed for comprehensive exchange of information and who is entitled under an income tax convention with the UK to a rate of tax with respect to a relevant item of income that is at least as low as the rate claimed under the new DTT by the CIV with respect to that item of income.
In this respect, the CIV receiving income arising in the UK will be able to claim treaty benefits for such income but only to the extent that the beneficial interests in the CIV are owned by “equivalent beneficiaries.” In other words, treaty benefits for that income will be available pro rata to the proportion of interest held by equivalent beneficiaries in the CIV. This limitation of benefits will not be applicable if at least 75% of the beneficial interest in the CIV is owned by equivalent beneficiaries, or if the CIV is a UCITS.
Resident (Article 4)
While the DTT did not provide for such a broad scope, the new DTT extends the notion of “resident” to include recognized pension funds, which has its own meaning depending on the jurisdiction.
Recognized pension funds are defined in the Protocol. In Luxembourg, this includes (i) pension-savings companies with variable capital (SEPCAV), (ii) pension-savings associations (ASSEP), (iii) pension funds subject to supervision and regulation by the Insurance Commissioner, and (iv) the Social Security Compensation Fund (SICAV-FIS).
While the DTT includes a tie-breaker rule according to which a company is deemed to be resident in a contracting state in which its place of effective management is situated, the new DTT includes, pursuant to Article 4(4) and in line with the MLI and OECD standards, a competent authority/mutual agreement dual-residency tiebreaker.
Article 3 of the Protocol to the new DTT sets out additional factors for the competent authorities to have regard to:
- Location of senior management of the company;
- Location of director and board meetings (or equivalent);
- Location of the headquarters;
- Extent and nature of the economic nexus of the company in Luxembourg and the UK; and
- Whether determining that the company is a resident of one contracting state but not of the other for the purposes of the new DTT would carry the risk of an improper use of the new DTT or inappropriate application of the domestic law of the UK or Luxembourg.
The entry into force is subject to completion of the ratification processes in both countries, and is not expected before Jan. 1, 2023. More specifically, the new DTT will be applicable:
- In Luxembourg as from Jan. 1 of the year following ratification; and
- In the UK as from Jan. 1 of the year following ratification with respect to withholding taxes, April 6 of the year following ratification for income and capital gain taxes, April 1 of the year following ratification with respect to corporation tax.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
William Jean-Baptiste is a partner and Arthur Mendegris is an associate with Ogier Luxembourg.