Dual tax residence: when the tie does not break
This article was originally published in Agefi Luxembourg, May 2021 and is reproduced with permission from the publisher.
During the year 2020, 156 requests for initiating a Mutual Agreement Procedure (MAP) under the double tax treaties concluded by Luxembourg were filed with the Luxembourg tax authorities (LTA) by taxpayers. This procedure, enabled by Article 25 of the OECD Model Tax Convention (or similar tax convention provisions), is a tool, independent of domestic legal remedies, allowing taxpayers to seek resolution of a double taxation situation by the competent tax authorities. Indeed, although double tax treaties by their very nature attempt to address such issues, an individual may be required by personal circumstances to file a MAP in order, inter alia, to resolve a dual tax residence situation.
The matter of tax residence is a key issue in most of the world's tax jurisdictions, as it typically implies, for the State where the tax residence is established, the right to levy taxes on private income, as well as on employment income when the occupation is performed in the same country. It sets out the scope of the taxpayer's tax liability towards the competent jurisdiction. In Luxembourg, for instance, a tax resident individual is subject to an unlimited tax liability on his/her worldwide income, whereas a non-resident will see his/her tax liability limited to his/her income from Luxembourg sources. The question of tax residence is therefore decisive and directly impacts the taxpayer involved.
How is tax residence determined?
Tax residence is first determined on the basis of the domestic law of the jurisdictions involved. In a very straightforward situation, where the individual at hand lives and operates in the same jurisdiction, the residence criteria set out in the domestic tax laws will often be met and such individual will be deemed resident in that State. However, where foreign or cross-border elements are at play, multiple jurisdictions may play the tax residence game and consider whether, from their domestic perspective, the individual will be treated as a tax resident.
Obviously, the question would be meaningless if all the States concerned had strictly the same internal criteria for determining residence and if the criteria of each country excluded any risk of conflict with those of another, but this is typically not the case. In Luxembourg, an individual taxpayer qualifies as a Luxembourg resident when his/her tax domicile or usual abode is located in Luxembourg (alternative criteria). The tax domicile is generally acknowledged as the permanent place of residence of the taxpayer actually using it with an intention to maintain it, whereas the usual abode criterion is fulfilled for a person continually present in Luxembourg for six months (which period can overlap two calendar years). In the Netherlands, for example, tax residence is established by determining the center of vital interests of the individual, based on all the facts and circumstances of the case.
How could an individual end up being simultaneously tax resident in different countries?
The difference between the criteria of several jurisdictions, combined with a personal situation that is often very complex and scattered internationally, can thus lead to various countries considering simultaneously the same individual to be a tax resident on the basis of their domestic law. On this basis, the taxpayer will be subject to tax obligations in each relevant State, resulting in a situation of juridical double taxation (i.e. an overlapping of personal taxes on the same individual). So who is right, who is wrong? Well, each jurisdiction has the right to strictly apply its domestic law and to fully exercise its tax sovereignty over its entire tax territory; no higher authority can restrict the taxing power of States.
This is where tax treaties for the avoidance of double taxation come into play. When a tax residency conflict arises, it is first necessary to check whether the jurisdictions involved have concluded a treaty and, if so, to apply it in order to resolve the double taxation issue. Article 4 of the OECD Model Tax Convention (the model used as a basis for most of the double taxation treaties), deals with residence conflicts through successive and alternative criteria (the so-called “tie-breaker rules”) which allocate residence of the “dual resident” to one of the States, so that this person is treated as a resident solely of that State for the purposes of the treaty.
Based on Article 4, an individual is deemed to be a resident only of the State in which (i) he/she has a permanent home available to him/her or, if he/she has a permanent home available to him/her in both States, he/she will be deemed to be a resident only of the State with which his/her personal and economic relations are closer (the “center of vital interests”), (ii) in the absence of a permanent home, the State in which he/she has an habitual abode, (iii) if he/she has an habitual abode in both States or in neither of them, he/she will be deemed to be a resident only of the State of which he/she is a national, (iv) if he/she is a national of both States or of neither of them, the question must be settled by mutual agreement between the relevant States.
Although the tie-breaker rules make it possible to settle a substantial number of dual tax residence situations, some personal situations remain unresolved by these criteria, which are subject to interpretation.
What would a double tax residence situation mean in practice?
Let's take the example of a Danish national with a husband who is a Dutch resident and national, with whom she has two children, both Danish and Netherlands citizens. The family lives in a house in the Netherlands, which they own. The Danish individual used to work and live partly during the year in Denmark. She is now working on a fulltime basis during the week in Luxembourg under a permanent employment contract, and she has bought an apartment to stay during the week and some weekends during the year depending on her workload. Based on the facts and circumstances, we assume that she is treated as a tax resident of the Netherlands.
From a Luxembourg perspective, an individual is treated as a resident for Luxembourg income tax purposes if his/her domicile or principal place of abode is in Luxembourg, the usual abode being defined as the place where the individual stays for a certain period of time (as opposed to a short-term stay; the law however does not provide for a minimum period of time). The Danish individual will thus also be treated as a resident of Luxembourg by the Luxembourg tax authorities.
It is therefore appropriate to use the tie-breaker rules under Article 4 of the treaty between the Netherlands and Luxembourg to solve this double tax residence issue. The first criterion (permanent home) is ineffective since we can easily consider that she has a permanent home available in both countries. Also, it would be tricky to determine to which country the “center of vital interests” should be allocated, as the economic relations are closer to the place of work whereas the personal relations tend to be rather in the country where the family is located. In this regard, the OECD Commentary on the Model Tax Convention indicates that family and social relationships, occupations, political, cultural or other activities should be taken into account. However, the circumstances must be examined as a whole, but considerations based on the personal actions of the individual must also be given special attention. For example, if our Danish individual had always lived in the Netherlands before moving to work in Luxembourg, this could demonstrate that she maintained the center of her vital interests in the Netherlands. The next criterion of the tie-breaker rule is the usual abode, which does not give any indication on the period to be taken into account to determine whether an individual has an habitual abode in one or both States. Frequency, duration and regularity of the stays will be taken into account, but here again our example is not solved through those criteria, as the individual at hand resides on average 4 nights and 5 days a week in one country, to return for weekends and vacations in the other. Finally, the last criterion, nationality, does not help either since the individual has neither Dutch nor Luxembourgish nationality. The result of the ineffectiveness of the tie-breaker rules is that the situation of double residence will persist, allowing each State (here the Netherlands and Luxembourg) to tax the individual on her worldwide income, resulting in a situation of double taxation. In such a case, the last resort for the taxpayer is the MAP.
How could a MAP be the solution?
Although the MAP may seem at first glance unreachable for a natural person in matters of private taxation, the request is open to any taxpayer to the extent certain conditions are fulfilled, and remains free of charge in Luxembourg.
Luxembourg has an extensive tax treaty network with more than 80 treaties which all contain a provision relating to MAP and generally follow Article 25 of the OECD Model Tax Convention. The MAP allows a taxpayer who considers that the actions of one or both States result or will result for him/her in a taxation not in accordance with an applicable double tax treaty (such as a dual tax residence situation), to present his/her case to the competent authority of the State of which he/she is a resident. The competent authority will then, if the objection appears to be justified, attempt to resolve the case by mutual agreement with the other State’s competent authority. Both States may consult together for that purpose.
In Luxembourg, the procedure was covered by Circular L.G. - Conv. D.I. n° 60 of 28 August 2017, repealed and replaced by recent Circular L.G. - Conv. D.I. n° 60 of 11 March 2021 (the Circular) in which the tax authorities clarified how taxpayers can make a MAP initiation request, what steps are involved, and what are the associated costs. The opening of the mutual agreement procedure is notably subject to the prior existence of a measure that may lead either to immediate taxation or to future taxation, sufficiently specific in its principle (e.g. disclosure of the taxpayer and tax concerned, years in question, the reasons for the taxation) to enable the competent authorities to assess the risk of taxation which is allegedly not in accordance with the treaty.
For a Luxembourg MAP request, the contested measure should notably include the notification of a tax assessment or notice in accordance with Luxembourg Income Tax Law, or the audit of a taxpayer where it is likely that the audit will result in a taxation not in accordance with the treaty. Thus, in a case of dual tax residence, the procedure can generally be triggered in Luxembourg only when tax assessments are issued as well as probably in the other involved State, i.e. it is not possible to apply for a MAP in anticipation of a potential tax residence conflict.
The Circular specifies that the taxpayer must submit his/her request within three years from the first notification of the measure which results or will result in a taxation not in accordance with the treaty. After an internal phase of study of the file and possible exchange of information with the other competent authority, the Luxembourg authority can settle the file unilaterally (e.g. in considering that the tax residence is not established in Luxembourg). If this is not the case, the Luxembourg authority must send a statement to the competent authority of the other State. This communication must respond to the arguments put forward by the taxpayer and set out the grounds and reasons for the position adopted by Luxembourg. Although the authorities are not bound by an obligation of result, they must endeavor to find a satisfactory solution.
Thus, individuals whose personal living or working situation has an international element have every interest in ensuring that there is no risk of double tax residence. If, in such a case, the applicable treaty (if any) is unable to resolve the conflict, a mutual agreement procedure should be initiated with the competent authorities to avoid double taxation.
