Luxembourg and the United Kingdom signed a new tax treaty in June 2022 which revises the terms under which both contracting states may exercise their taxing rights. The new treaty differs from its predecessor, which has been in place since 1968, in that it expands its scope of application to Luxembourg collective investment vehicles, it provides for a full exemption from withholding taxes levied on certain dividend payments and, most notably perhaps, it introduces a ‘real-estate-rich’ entity provision. Moreover, the new treaty implements the minimum standards under the OECD multilateral instrument and, as a result, tax authorities can deny access to the tax treaty if one of the principal purposes of the action undertaken by the taxpayer was to obtain a tax benefit.
The treaty and its impact on real estate structures in a nutshell
Luxembourg tax exempt corporate real estate funds can obtain treaty benefits
The protocol to the new treaty provides that a Luxembourg collective investment vehicle (CIV) taking a tax opaque legal form eg, a Luxembourg société anonyme (SA), société à responsabilité limitée (SARL), or société en commandite par actions (SCA) shall be entitled to treaty benefits, subject to passing a beneficial ownership test. CIVs typically include undertakings for collective investments (UCIs), specialised investment funds (SIFs) and reserved alternative investment funds (RAIFs). This is a clear improvement compared to the previous treaty, as it clarifies that investment funds can have tax treaty access despite being exempt from income taxation in Luxembourg. Attaining resident and beneficial owner status is contingent on the requirement that 75% or more of the CIV is owned by equivalent beneficiaries, ie, such persons who would be entitled to a tax rate at least as beneficial as the rate applicable under this treaty. It is additionally extended to any undertakings for collective investments in transferable securities (ie UCITS), without the need for the 75% test to be met. This is a welcome clarification especially for the Luxembourg real estate fund sector, which will going forward be able to rely on the clear wording of the treaty to benefit from eg, an exemption from UK source taxation on interest payments. As treaty benefits are subject to the investors in the CIV being equivalent beneficiaries, a regular monitoring of the CIV’s investor base, be it during the onboarding phase or in secondaries transactions, is required.
Post-Brexit withholding tax exemption on dividend payments reinstated
Where it can be evidenced that the recipient is the beneficial owner of a dividend payment, the new treaty bars source states from taxing such payments made to entities in the resident state. Profits from investments into Luxembourg real estate may as a result be distributed free of Luxembourg withholding tax to UK investors, without such investor being required to demonstrate that it is subject to a tax that can be considered comparable to the Luxembourg corporate income tax, a condition that would have needed to be met without this provision of the new treaty. The exemption is expected to contribute to making investments by UK investors into Luxembourg more attractive, especially after the loss of such investors of the benefits of EU directives after Brexit.
The exemption does, however, not extend to investment vehicles that annually distribute most of their income and whose income or gains deriving from real estate are exempt from tax. In such an event, the source state may levy up to 15% withholding tax on such payments. Such income may, however, not be subject to withholding tax where the recipient is a recognised pension fund. In the absence of a Luxembourg real estate investment trust (REIT) regime, this paragraph mainly ensures that investors into UK REITs pay a minimum amount of tax of 15% on their UK real estate investments.
Extended source country capital gains taxing rights
The new provision on capital gains differs from the previous tax treaty which protected Luxembourg resident investors against UK capital gains tax on UK real estate investments held through Luxembourg property companies. It was introduced into the treaty in order to effectively allow the UK to levy non-resident capital gains taxation on the alienation of shares in ‘real-estate-rich’ entities. This UK non-resident capital gains tax applies to the direct disposal of UK property and on the alienation of shares in entities deriving at least 75% of their value from UK real estate.
Under the new treaty, tax may be levied by the source state on gains realised from the alienation of shares or comparable interests deriving more than 50% of their value directly or indirectly from immovable property situated in the source state. It appears that the 50% threshold is assessed at the time of alienation of the shares and the realisation of the gain. As Luxembourg does not tax capital gains derived on ‘real-estate-rich’ share deals under its domestic law, the extension of the source country taxing rights is expected to have an impact mainly on UK inbound real estate investments. This is likely to affect how UK inbound real estate investments will be structured going forward. As the treaty currently only targets alienations of shares in a ‘real-estate-rich’ entity, it remains unclear whether the UK would also consider share buy-backs or liquidations as an event that may trigger the ‘real-estate-rich’ entity clause.
When will these changes enter into effect ?
In Luxembourg, the new treaty should become effective as of 1 January of the year following ratification from both states for all types of taxes.
In the UK, it should become effective as of 1 April of the year following ratification for UK corporation tax, and 6 April of that year for the purposes of UK income tax and capital gains tax. As far as UK withholding tax is concerned, the new treaty should become effective as of 1 January of the year following ratification from both states.
The UK has signed and ratified the new treaty and its accompanying protocol already in October 2022. Luxembourg, however, has not yet ratified the treaty and its protocol. Whilst there was a lot of uncertainty at the end of last year whether Luxembourg would still ratify the new text in 2022, it is now expected that it will do so in 2023, which would mean that the new treaty would take effect as from 1 January 2024.
This affords affected structures some time to adjust and reorient themselves, especially in light of the extended source state capital gains taxing rights.