New UK/Luxembourg double tax treaty agreed

The new double tax treaty agreed between the UK and Luxembourg was ratified by Luxembourg on 19 July 2023. The new treaty was signed on 7 June 2022 and ratified by the UK in October 2022 and contains some significant changes compared with the existing treaty. In particular, changes to the provisions dealing with capital gains will mean that, once the treaty is in force, Luxembourg resident investors in UK real estate held indirectly will be subject to UK tax on any gains arising on indirect disposals of that real estate (eg through a share sale) in many cases.

The new treaty is expected to enter into force for UK corporation tax/capital gains tax purposes from April 2024 and for withholding taxes from 1 January 2024. It is expected to enter into force for Luxembourg tax purposes with effect from 1 January 2024. As a result, investors in UK real estate held through Luxembourg structures should take this opportunity to review those structures and take action where necessary.

The new UK/Luxembourg treaty

The new treaty contains a substantial number of changes to the existing treaty, some potentially beneficial to taxpayers compared to the current treaty, others adverse. Two in particular may be especially significant with regard to cross-border investment structures.

Firstly, the new treaty will introduce a change to the capital gains article (Article 13) of particular significance to investors in UK real estate held in companies or other UK opaque tax structures (such as JPUTs which have not made a so-called "transparency election") which are owned via companies or other persons which are resident in Luxembourg. Once the new treaty comes into force, Article 13(2) will provide that gains derived by a Luxembourg resident entity from the disposal of shares or comparable interests, such as partnership interests or trust interests, deriving more than 50% of their value directly or indirectly from immovable property situated in the UK, may be taxed in the UK.

Since April 2019, gains arising on many indirect disposals of UK real estate via disposals of shares or other interests in companies and other UK tax opaque entities were brought into the charge to UK corporation tax/capital gains tax.  Broadly that UK charge is relevant where the entity derives, directly or indirectly, at least 75% of its gross value from UK real estate rather than the lower 50% threshold in the new capital gains article, so the change will only in practice impact those structures for which the 75% threshold is met.

The existing UK/Luxembourg treaty gives sole taxing rights over the disposal of such indirect interests to Luxembourg, although this is subject to the application of a domestic anti-avoidance rule combating "treaty shopping" arrangements implemented after 22 November 2017.

The new treaty does not grandfather any existing structures and so the entry into force of the new treaty will, essentially, give rise to a cliff edge. It will bring into the charge to UK tax all affected gains realised on indirect disposals made after the new treaty enters into force, including the element of any gain that effectively accrued prior to the entry into force of the new treaty.

Secondly, Article 10 of the new treaty will generally introduce a 0% withholding tax for dividends paid from Luxembourg to a UK shareholder who is the beneficial owner of those dividends (the UK does not generally impose withholding tax on dividends). This is welcome as the current treaty only reduces withholding taxes to 5% and, since the UK left the EU, UK shareholders may, in some cases, no longer be able to rely on the Parent/Subsidiary Directive.

However, the exemption from withholding taxes will not apply to dividends which are paid out of income or 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", such as a UK REIT, other than where dividends are beneficially owned by a recognised pension fund. Where such dividends are paid to another person, the withholding tax applied to dividends shall not exceed 15%.

The new treaty contains a number of other changes, including the following:

• Article 4 (Resident) has been amended to include recognised pension schemes and, in addition, the tie-breaker provision has been aligned with the OECD model convention providing for a mutual agreement procedure (rather than by reference only to the place of effective management). However, the Protocol sets out that, where the status of a company was determined under the existing treaty, neither the UK nor Luxembourg will seek to revisit that determination so long as all the material facts remain the same.
• Article 11 (Interest and Royalties) now provides for 0% withholding tax on payments of royalties (compared to the existing 5% provision)
• Article 28 (Entitlement to Benefits) has been formally updated to incorporate the principal purpose test which is read into the current treaty by virtue of the Multilateral Instrument (MLI). As is already the case by virtue of the MLI, treaty benefits will 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 treaty.
• Paragraph 2 of the Protocol to the treaty provides that a Collective Investment Vehicle (CIV) established and treated as a body corporate for tax purposes in Luxembourg and which receives income arising in the UK shall be treated as resident of Luxembourg and beneficial owner of such income for purposes of applying the provisions of the new treaty to the extent that the beneficial interests in the CIV are owned by Luxembourg residents or residents of countries which have a treaty with the UK that provides effective and comprehensive information exchange and a rate of tax that is at least as low as the rate claimed under the new DTT. However, where 75% of the beneficial interests in the CIV are held by such persons (or the CIV is a UCITS) then the CIV will be treated as a Luxembourg resident in respect of all the income it receives.

Comment

The new treaty is something of a mixed bag for taxpayers. On the whole, the changes, especially to the withholding tax provisions, will be welcome following the UK's exit from the EU. However, the changes to the capital gains article, whilst not unexpected given the UK's focus on taxing income and gains from UK real estate, may have a significant impact on existing investment structures for UK real estate.

The fact that the new treaty will not enter into force until April 2024 (for corporation tax/capital gains tax purposes) provides a window of opportunity for taxpayers potentially affected by these changes to review their structures and take the opportunity to implement any appropriate steps to mitigate the impact of these changes. Careful consideration will be necessary, particularly in relation to any existing structures involving UK real estate and, accordingly, early consideration is recommended.