Luxembourg: New income tax treaty with UK is signed

A new Luxembourg-UK income tax treaty was signed on 7 June 2022. The new treaty will replace the currently applicable income tax treaty and will enter into force once both countries have ratified the text and exchanged the ratification instruments.  

The main new provisions of the new treaty are summarized below.

The new treaty defines the term “resident of a Contracting State” as any person who, under the laws of that state, is liable to tax therein by reason of its domicile, residence, place of management, place of incorporation, place of registered office or any other criterion of a similar nature. The current treaty does not refer to the place of incorporation or registered office. In addition, recognized pension funds are now explicitly considered to be tax residents for the purpose of the new treaty.

Luxembourg collective investment vehicles (CIVs), such as Luxembourg UCITS, UCIs part II, SIFs and RAIFs, are considered to be Luxembourg residents if: (1) they are treated as body corporates for Luxembourg tax purposes, and (2) to the extent they are held by so-called “equivalent beneficiaries.” However, if the CIV is a UCITS, or its unitholders are composed of at least 75% of “equivalent beneficiaries,” the CIV is considered as a de facto resident of Luxembourg and the beneficial owner of the income it receives.

A person is considered to be an “equivalent beneficiary” if it is (1) a resident of Luxembourg, or (2) a resident of any other jurisdiction with which the UK has arrangements that provide for the exchange of information and who would be entitled under an income tax treaty with the UK to a tax rate at least as low as the rate claimed under the new treaty by the CIV, when receiving the particular item of income for which the new treaty benefits can be claimed.

Where a person (other than an individual) is considered to be a resident of both the UK and Luxembourg based on the provisions of the new treaty, the place of effective management is no longer considered to be the definitive tie-breaker rule. Instead, the new treaty provides that the competent tax authorities shall determine by mutual agreement where this person is considered to be a tax resident, having considering its place of effective management, the place where it is incorporated or constituted and any other relevant factors. In case no agreement is reached, the person should not be entitled to the benefit of the new treaty, except if provided otherwise by the competent tax authorities.

Taxpayers benefiting from the tie-breaker rule under the current treaty will not be affected by the mutual agreement procedure prescribed by the new treaty, provided that the material facts remain unchanged. 

Where the competent tax authorities of a contracting state apply an additional tax surcharge to a transaction between associated enterprises which they deem to not be in accordance with the arm’s length principle, the other contracting state should make a corresponding adjustment. The competent tax authorities may consult each other if needed.

The new treaty provides that dividend distributions from a company resident in one contracting state, to a beneficial owner resident in the other contracting state shall not be subject to withholding tax in the source state. The current treaty provides for a 5% withholding tax at source subject to specific conditions.

The withholding tax exemption under the new treaty does not apply when 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 exempted from tax. In such a case, the dividends would be subject to a 15% withholding tax.

However, the withholding tax exemption can be relied on when the investment vehicle distributes the dividend to a recognized pension fund and the fund is considered to be the beneficial owner.

Under the new treaty, the state of residence of the beneficial owner has the exclusive right to tax royalty payments. The current treaty permits the source state to levy a 5% withholding tax on royalty payments. 

The new treaty introduces a land-rich clause, pursuant to which 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, may be taxed in the state where the immovable property is located.

The principal purpose test provided by the Multilateral Instrument (MLI) has been formally incorporated in the text of the new treaty (among other changes made by the MLI to the current treaty). As a result of which, a benefit under the new treaty would be denied 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 treaty.

The new treaty will not prevent Luxembourg from applying controlled foreign corporation (CFC) rules under article 164ter of Luxembourg income tax law. 

Once the new treaty enters into force, its provisions will become applicable as follows, depending on the contracting state and type of tax concerned:

In the United Kingdom:

• In respect of withholding tax, to income derived on or after 1 January of the calendar year next following the year in which the new treaty enters into force
• In respect of income tax and capital gains tax, for any year of assessment beginning on or after 6 April of the calendar year next following the year in which the new treaty enters into force
• In respect of corporation tax, for any financial year beginning on or after 1 April of the calendar year next following the year in which the new treaty enters into force

In Luxembourg:

• In respect of withholding tax, to income derived on or after 1 January of the calendar year next following the year in which the new treaty enters into force
• In respect of other taxes on income, and taxes on capital, to taxes chargeable for any taxable year beginning on or after 1 January of the calendar year next following the year in which the new treaty enters into force

The provisions on mutual agreement procedures and exchange of information will be applicable from the date the new treaty enters into force, regardless of the tax period to which the matter relates.

Read a June 2022 report prepared by the KPMG member firm in Luxembourg