Changes to UK/Luxembourg Double Taxation Treaty and arbitration procedures

Give and take: key changes to UK / Luxembourg tax affairs

The UK and Luxembourg have agreed a number of changes in the past few months that will impact taxpayers that operate in both jurisdictions.

Hot on the heels of agreeing a revised double tax treaty, the jurisdictions have also announced an agreement in respect of the procedures to arbitrate disputes on double tax treaty points.  We highlight the key points below.

Arbitration of disputes

The Memorandum of Understanding provides a mechanism for issues under the UK/Luxembourg double tax treaty to be resolved by a panel of independent arbitrators.

The decisions will be binding but would not (in most cases) create a precedent. This procedure applies from 5 August 2022 to the double tax treaty that is currently in force, and will also apply to the revised treaty that is not yet in force.

The UK / Luxembourg Double Tax Treaty

The revised UK/Luxembourg Double Tax Treaty (the “revised DTT”) was signed on 7 June 2022. When the new treaty comes into force (after being ratified) it will bring changes for lots of taxpayers and especially Luxembourg entities investing in UK property.  The earliest dates on which the new rules will come into force are 1 January 2023 in Luxembourg and 1 April 2023 in the UK.

Withholding tax on dividends

The definition of dividends has been tailored, to be aligned with the domestic law of both jurisdictions.  

It now refers to “income from shares, or other rights, not being debt-claims, participating in profits, as well as any other item which is treated as income from shares by the taxation laws of the State of which the company making the distribution is a resident”.

The revised DTT now provides for a withholding tax exemption on dividends paid by a company resident in one Contracting State to a company resident in the other Contracting State, provided the receiving company is the beneficial owner of the dividend payment.

However if the dividends are paid out of income derived directly or indirectly from immovable property by an investment vehicle which distributes most of its income annually and benefits from an exemption from tax on such income (e.g. a REIT in the UK), withholding tax of up to15% can apply.

From a Luxembourg standpoint, the withholding tax can be reduced based on the application of the Luxembourg participation exemption regime.  In the UK, withholding tax is generally not charged on dividend payments (though it would on dividend payments by a REIT, for example).

Withholding tax on royalties    

The current double tax treaty allows for withholding tax to be charged on royalties, though it provides for a maximum rate of 5% withholding tax on royalty payments where the recipient is the beneficial owner.

Under the revised treaty, no withholding tax now applies on royalty payments.

From a Luxembourg standpoint, no withholding tax should arise on royalty payments, so that the update should not have much of an effect in Luxembourg.

UK tax on chargeable gains and new rules for property rich entities

The UK introduced tax on chargeable gains (both capital gains tax and corporation tax, referred to collectively as CGT in this article) made by non-UK investors in property rich vehicles in 2019. 

Luxembourg investors are currently protected from the CGT charge by treaty relief where a disposal is made of a property rich vehicle (subject to applicable anti-avoidance in the UK rules). Once the new treaty comes into force, this protection will no longer apply. Luxembourg investors selling interests in entities in respect of which 75% of their value is derived directly or indirectly from UK land will be liable to UK CGT.

This change is not unexpected: it was announced by the UK government in 2018 and came into force some time ago in respect of structures that were established with a tax motivation – see our article here.

Structures established since 2019 are therefore likely to have taken this cost into account. Given the increase in tax costs going forward for Luxembourg investors, other structures may seek to dispose of investments before the new treaty comes into force. The earliest the new rules could apply to Luxembourg investors is 1 April 2023.

For further details of the impact of CGT for Luxembourg and other non-resident corporates and funds please click here.

Luxembourg Collective Investment Vehicles (CIV) gaining treaty protection

At present, a Luxembourg CIV cannot benefit from treaty protection in respect of income arising in the UK. Under the new treaty’s protocol, a Luxembourg CIV receiving income arising in the UK may be treated as being resident in Luxembourg and beneficially entitled to some or all of that UK income. Once the new treaty comes into force, a Luxembourg CIV would benefit from the protections of the treaty afforded to Luxembourg entities.

Entities that will benefit include UCITS, UCIs part II, SIFs and some RAIFs where these are treated as bodies corporate under Luxembourg law.

The CIV will be treated as the beneficial owner of all the income if 75% or more of the interests in the CIV are held by “equivalent beneficiaries” or a UCITS. If this 75% test is not met, the CIV is treated as the beneficial owner to the extent that the CIV is held by “equivalent beneficiaries”.

“Equivalent beneficiaries” means:

• residents of Luxembourg; and
• residents of other jurisdictions where the UK has arrangements for exchange of information who would be taxed at the same, or a lower, rate as the CIV.

For more information, please contact Helen Coward in London or Yacine Diallo in Luxembourg.