Changes to the UK/Luxembourg double tax treaty

On 19th July 2023, the Luxembourg Parliament approved the draft law endorsing the revised double tax treaty with the UK (the Treaty). Following the UK's ratification already completed in 2022, the revised tax treaty should take effect from 2024 onwards.

The Treaty contains certain significant changes, notably with respect to real estate, such that Luxembourg real estate investors holding indirect interests in UK real estate could now be subject to UK tax on capital gains, in accordance with UK domestic tax rules.

Major Changes

Capital Gains (Article 13)

In 2019 the UK Government introduced Non-Resident Capital Gains Tax (NRCGT), such that non-UK residents would be subject to tax on gains realised on the direct or indirect sale of UK real estate. 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 (a UK property rich company).

Notwithstanding the above NRCGT rule, the existing treaty allocates sole taxing rights to Luxembourg with respect to gains realised on the disposal of indirect sales of UK real estate. Accordingly, under the existing treaty a Luxembourg resident disposing of a UK property rich company would be subject to Luxembourg tax only (if applicable), and the UK NRCGT would not be applicable (subject to a UK anti-forestalling rule, which, depending on the facts, could be circumvented).

Article 13(2) of the Treaty now allocates taxing rights to the UK or, as applicable, Luxembourg, on the sale of shares (or comparable interests, such as interests in a partnership or trust) deriving more than 50% of their value directly or indirectly from real estate in the jurisdiction in which the real estate is located.

The Treaty will not supersede the UK domestic NRCGT rule (such that the 75% threshold in the definition of UK property rich, still holds true), but the new provision means that a Luxembourg resident disposing of a UK property rich company will now be subject to UK NRCGT on the gain (subject to applicable UK domestic exemptions).

For completeness, the rules are complex, but very broadly, for the NRCGT to bite, there is a minimum 25% hold requirement (a substantial indirect interest), although this minimum requirement is switched off for disposals that have an appropriate connection to a collective investment scheme as defined under the NRCGT rules.

Dividends (Article 10)

The dividend withholding tax rate under the Treaty has been reduced to 0% (down from the headline rate of 5% under the existing treaty).

Under UK domestic rules there is no withholding tax on payments of dividends, other than dividends paid from certain types of UK real estate holding entities (such as a UK REIT). Under the Treaty, to the extent that dividends are paid out of income and gains derived directly or indirectly from real estate (e.g. a UK REIT), the rate of withholding tax is 15%, unless the beneficial owner of the dividends is a “recognised pension fund”, broadly a UK pension scheme (which benefits from the 0% rate).

From a Luxembourg domestic tax perspective, post-Brexit, in order to benefit from exemption from withholding tax under Luxembourg law one would have to ascertain whether the parent company is qualifying for the domestic exemption regime by running a ‘subject-to-tax’ test (i.e. whether the parent company is subject to an income tax at a rate of at least 8.5% applied on a tax base determined by application of rules similar to those existing in Luxembourg). The Treaty is therefore welcomed in respect of dividends paid out to UK shareholders and may apply a 0% withholding tax rate even if the above ‘subject-to-tax’ test is not met (e.g., if the rate of tax is lower than 8.5%).

Interest and Royalties (Article 11 and 12)

The rate of withholding tax on royalties is reduced to 0% (reduced from 5% under the current treaty). For completeness, the rate of withholding tax on interest is unchanged at 0%.

 

Additional minor changes

Resident (Article 4)

The definition of resident under the Treaty is expanded to include recognised pension funds which are separately defined from both UK and Luxembourg domestic perspectives.

In addition, the Treaty proposes an updated version to the ‘place of effective management’ rule (the so called ‘tie-breaker’ test) in the current treaty designed to ensure that companies do not become subject to double taxation, by virtue of being dual resident. The Treaty is aligned with the OECD Model Tax Convention whereby companies that are dual resident, should instead use the mutual agreement procedure (MAP) to resolve such residency disputes.

Treaty access for CIVs (Protocol)

A Collective Investment Vehicle (CIV) established and treated as a body corporate for tax purposes in Luxembourg (including UCITs/UCIs and SIFs/RAIFs), and which receives income arising in the UK, shall be treated as a Luxembourg tax resident and beneficial owner with respect to such income arising in the UK only, for the purposes of the Treaty. This is only to the extent that the beneficial interests in the CIV are owned by equivalent beneficiaries (i.e. Luxembourg residents or residents of countries having a treaty with the UK that provide for effective and comprehensive information exchange and a rate of tax that is at least as low as the rate claimed under the Treaty).

However, if at least 75% of the beneficial interests in the CIV are owned by equivalent beneficiaries, or if the collective investment vehicle qualifies as an UCITS within the meaning of EU Directive 2009/65, the CIV will be treated as a Luxembourg tax resident and as the beneficial owner of all the income it receives (i.e. both with respect to income arising in the UK and elsewhere).

 

Entry into force

The Treaty will have effect the year following the ratification, as follows:

• UK
  
  • in relation to withholding taxes, to income derived on or after the following 1 January;
  • in relation to corporation tax, for any financial year beginning on or after the following 1 April; and
  • in relation to income and capital gains tax, for any year of assessment beginning on or after the following 6 April.
• Luxembourg
  
  • in relation to withholding taxes, to income derived on or after the following 1 January; and
  • in relation to other taxes on income and capital, to taxes chargeable for any taxable year beginning on or after the following 1 January.

As the Luxembourg Parliament recently voted the law ratifying the Treaty, it should enter into force with effect during 2024, during the dates set out above.

 

Potential impact on existing structures and restructuring options

The biggest change to the Treaty is to allocate taxing rights to the UK on the sale of a UK property rich company (i.e., deriving 75% or more of its value from UK real estate, as defined under the UK NRCGT rules). There is no grandfathering so this will apply to existing structures, i.e., to any disposal made after the entry into force, including investments where the gain has effectively accrued before that date.

HMRC had previously announced that it was in negotiations with Luxembourg to renegotiate the existing treaty, as far back as 2019, and although the changes may not therefore be surprising to many, it will have an important impact to real estate investors.

The change to the treaty will, in effect, finally level the playing field between Luxembourg on the one hand and UK (and other overseas investors) on the other. The changes to the treaty may continue the trend of ‘on-shoring’ whereby real estate investors hold investments in UK real estate through UK tax resident structures. It also demonstrates the ongoing attractiveness of other, more tax-advantaged, regimes for holding UK real estate, such as Jersey Property Unit Trusts that have made a transparency election and UK REITs.

One important win to taxpayers is that the rate of withholding taxes on royalties and dividends (other than dividends from REITs and equivalent entities) has been reduced to 0%.