Key changes to the Luxembourg-UK double tax treaty – the beginning of a new era

The new treaty is likely to significantly impact tax structuring with the UK (especially in relation to real estate investments) as some of the new treaty provisions are materially different from the double tax treaty currently in force, which dates back to 1967. The new treaty widens the definition of resident and is more beneficial for Luxembourg outbound dividend payments.

In a nutshell, the key changes are:

• Full withholding tax exemption on most Luxembourg dividend distributions
• Extension of the treaty benefits to certain collective investment vehicles/investment funds
• Reallocation of taxing rights in relation to real-estate rich companies to the country where the real-estate is located

Dividend

Under the new treaty, dividends would benefit from a full exemption if distributed to a recipient who is the beneficial owner of the payment and resident in the UK . This should be seen as a major step as the old treaty, which followed the OECD model tax convention, provided for a reduced withholding tax rate of only 5 per cent on dividend distribution in certain conditions. This new provision would not affect outbound dividends distributed from the UK, as the UK has no withholding tax on dividend distribution. Still, it is important for outbound dividends distributed from Luxembourg as the Luxembourg domestic tax on outbound dividends is 15 per cent.

Even if a full exemption is also available under Luxembourg domestic law in applying the Luxembourg participation exemption regime, since the UK has left the European Union, it was more difficult in practice to rely on the domestic provision to benefit from the full exemption. Indeed, one of the conditions to benefit from the Luxembourg participation exemption for companies non-resident in the EU is to be subject to a tax comparable to Luxembourg corporate income tax (at least 8.5 per cent) and assessed on a tax base similar to the Luxembourg tax base (the so-called comparable income tax test).

However, the withholding tax exemption on outbound dividends would not be available for dividends paid out by investment vehicles deriving income and gains (directly or indirectly) from immovable property and who distribute most of its income annually and whose income is exempted from tax. This new provision is in line with UK domestic law, which applies a withholding tax on dividends distributed by certain types of UK real estate holding companies (eg UK real estate investment trust – REIT). In such case, however, the withholding tax is limited to 15 per cent.

Interest and royalties

Even if, from a Luxembourg perspective, interest and royalty payments are, in principle, not subject to withholding tax, the new treaty confirms this and reduces the rates to zero per cent for royalty payments by four stating that such payments should only be subject to tax in the contracting state where the beneficial owner is resident.

The definition of resident is extended to include “recognised” pension funds and collective investment vehicles.

The Protocol describes in further detail what constitutes a recognised pension fund. For Luxembourg, it notably includes pension-savings companies with variable capital (SEPCAV), pension-savings association (ASSEP), pension funds subject to the supervision and regulation of the Insurance Commissioner, and social security compensation funds.

Collective investment vehicles (CIVs) will qualify as residents under the treaty if they are incorporated as a corporate body for Luxembourg tax purposes (private limited liability company (Sàrl), public limited liability company (SA), and partnership limited by shares (SCA).

The CIVs should either be:

• An undertaking for collective investment in transferable securities (UCITS) subject to Part I of the law of 17 December 2010
• An undertaking for collective investment subject to Part II of the law of 17 December 2010
• A special investment fund (SIF) subject to the law of 13 February 2007
• A reserved alternative investment fund (RAIF) subject to the law of 23 July 2016 (with the exception of RAIF subject to article 48 (this is the risk capital, SICAR like RAIFs)
• Any other Luxembourg investment fund, arrangement, or entity established in Luxembourg that the competent authorities of each contracting State agree to treat as a collective investment vehicle

In such case, these entities receiving income from the UK would be treated as individuals and be considered beneficial owners provided that equivalent beneficiaries own at least 75 per cent of the interest in the CIV or if the CIV is a UCITS within the meaning of EU Directive 2009/65. The Protocol defines the notion of equivalent beneficiary as a resident of Luxembourg or any other jurisdiction with which the UK has signed an exchange of information agreement and who would be entitled to at least as low as the rate claimed under the Luxembourg – UK double tax treaty.

The new treaty redefines the taxing rights between contracting states and aligns the capital gains provision with the OECD model tax convention.

Under the current double tax treaty, capital gains realised on the sale of shares by a Luxembourg parent in a UK subsidiary should only be taxable in Luxembourg, irrespective of the type of assets held by this subsidiary. On that basis, these gains could be taxable in Luxembourg in the hands of the Luxembourg parent but similarly could benefit from an exemption if the conditions of the Luxembourg participation exemption are met.

Under the new treaty, if a Luxembourg parent sale its shares in a UK subsidiary which derives more than 50 per cent if its value directly or indirectly from immovable property the taxing right will be allocated to the UK. Luxembourg would lose its right to tax such capital gain but also the possibility to exempt it.

The treaty has been ratified in the UK and Luxembourg; on that basis, it should enter into force in Luxembourg as of 1 January 2024.

For the UK, the entry into force will be as follows:

• 1 January 2024 for withholding tax
• 1 April 2024 for income tax and capital gains tax
• 1 April 2024 for corporation tax

To conclude, the new treaty between Luxembourg and the UK aligns with the OECD model tax convention and redefines the taxing rights between the two countries. Additionally, the particularity of Luxembourg and the importance of the investment fund sector is recognised by granting treaty benefits to Luxembourg funds under certain circumstances. The new treaty should therefore open the door to new opportunities for investors.

This article was originally published in AGEFI in October 2023.