On 7th June 2022, the UK and Luxembourg signed a new double tax treaty and protocol which, once ratified and in force, will replace the existing treaty which dates back to 1967.
The key impact of the changes in the treaty for investment funds are as follows:
- The UK will have taxing rights over the sale of shares in UK property rich shares by Luxembourg resident companies
- Most dividends (except certain real estate linked dividends) will benefit from a 0% withholding tax.
- A clear definition has been provided for recognised pension funds and certain government entities. In addition, certain collective investment vehicles will be able to benefit from the treaty.
- Tax residence for non-individuals will be decided by mutual agreement of the tax authorities (and no longer by automatic change of place of effective management).
Further details of these changes and other minor changes are outlined below.
Capital Gains Tax
Under the new treaty, gains derived by a resident of a Contracting State from the disposal of shares or comparable interests, such as interests in a partnership or trust, deriving more than 50 per cent of their value directly or indirectly from immovable property, situated in the other Contracting State may be taxed in that other State.
Notwithstanding the introduction in the UK of non-resident capital gains tax in April 2019, the current UK Luxembourg treaty has continued to provide an exemption for Luxembourg entities selling shares in companies which are UK property rich (subject to certain anti-avoidance rules). Therefore the treaty change has been anticipated since these rules came into effect.
Although the treaty states a 50% threshold for the value of land being derived from property in the other state, the UK domestic law threshold is 75% which should be the effective threshold (as treaties should not create an additional tax charge above domestic law provisions).
This change, along with other recent measures, continues to bring into line the taxation of non-residents investing in UK real estate compared to investment through UK structures.
Dividend WIthholding Tax
Under the new treaty, most dividends which are beneficially owned by a resident of the other contracting state will be exempt from withholding tax. This is a welcome change to the existing treaty which only provides relief down to 5 or 15% depending on the investor. As the UK has no dividend withholding tax under domestic law (except REIT’s – see below), the impact on dividends paid from the UK will be limited.
Under Luxembourg law, dividends paid by companies which qualify for participation exemption will also be exempt, and whilst this exemption is wide ranging, since Brexit (EU recipients automatically qualify) there are instances whereby the UK parent company is either not equivalently taxed or has not met the holding criteria in order to the exemption to apply and has therefore suffered withholding tax on dividends from Luxembourg.
The only exception to the above, is for dividends paid by companies whose income is derived from immovable property, which distribute most of this income on an annual basis, and are exempt from tax on such income – such dividends may be subject to a withholding tax up to 15%. The key impact of this rule is to allow the UK to continue to collect 15% withholding tax on dividends paid by UK real estate investment trusts (REITs). The wording of this provision is not clear as to whether Luxembourg can also tax dividends paid by Luxembourg resident companies which hold UK property to a UK REIT parent company and so further clarity on this is being sought to confirm the position.
Pension Scheme, State and Collective Investment Scheme Investors
The new treaty expands the definition of ‘resident’ to include 'state and any political subdivision or local authority', as well as 'recognised pension fund' of each contracting state. The protocol to the treaty then further defines 'recognised pension fund' to provide greater certainty. The protocol also provides that a Collective Investment Vehicles (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 provision of the new DTT to such income if the beneficial interests in the CIV are owned by equivalent beneficiaries.
Equivalent beneficiaries are referring to Luxembourg residents or residents of countries having signed a convention with the UK that provides effective and comprehensive information exchange and a rate of tax with respect to the item of income at stake that is at least as low as the rate claimed under the new DTT by the CIV with respect to that item of income. Where 75% of the beneficial interests in the CIV are held by equivalent beneficiaries, or when the CIV is an undertaking for collective investment in transferable securities (UCITS) within the meaning of EU Directive 2009/65, the CIV shall be treated as a resident of Luxembourg and as the beneficial owner of all the income it receives (e.g. interest income).
These specific and extended definitions are a welcome change.
In line with the current OECD recommendations, the residence tie-breaker for persons other than individuals will be changed such that if a person is resident in both states under domestic law, then the residence shall be determined by mutual agreement between the states.
This is a change from the effective management test in the existing treaty, albeit similar criteria may be taken into account under the new rules when the mutual agreement process is undertaken. In line with existing UK policy, we do not expect HMRC to seek to change the residence determination of taxpayers who have changed tax residence prior to the treaty change, unless there has been a significant change in the facts since the original residence change occurred.
For future residence shifts, in order for certainty, tax payers may need to follow the ongoing UK consultation into corporate redomiciliation, which may permit in future periods the legal redomiciliation into (and possibly out of) the UK which would if enacted, in most situations, mean there would not be dual residence for tax purposes in the first place.
Entry into Force
Although the treaty has been signed, it still needs to be ratified by both UK and Luxembourg governments. The treaty enters into force upon the completion of the ratification process, however it takes effect from the following dates:
For corporation tax (including the taxation of capital gains for Luxembourg companies in UK property rich shares) the treaty takes effect from 1 April of the financial year following the calendar year in which the treaty enters into force. Therefore provided the ratification process is completed by 31 December 2022, the capital gains changes will take effect from 1 April 2023 (please note the reference to financial year is to the UK tax definition of a financial year which runs from 1 April to 31 March – it is not a reference to a company’s financial accounting period).
If the ratification is not completed until 2023, then the capital gains changes will take effect from 1 April 2024. Other UK changes take effect from 1 January following the entry into force for UK withholding taxes and 6 April for income and capital gains tax.
The treaty will generally take effect from 1 January following the entry into force (so for example, if the treaty is fully ratified before 31 December 2022, the new provisions on withholding tax etc, will take effect from 1 January 2023).
Whilst the changes to capital gains tax were fully expected, the other changes to the treaty are generally welcome changes for both investment in UK real estate from Luxembourg, and also for real estate structures held by the UK (including under the new QAHC regime) where the investing entity in the real estate is in Luxembourg.
If you have any queries, please contact Neil Anthony, or your usual PwC Real Estate Tax contact.