Luxembourg ratifies amendments to UK-Luxembourg tax treaty - key considerations for investors

On 19 July 2023 Luxembourg ratified the text of the new tax treaty between the UK and Luxembourg (the Treaty). The UK ratified the Treaty last year. Changes that we addressed in our previous article will now enter into force after 1 January 2024 replacing provisions of the treaty signed in 1967.

Due to the fact that the tax year in the UK is ‘shifted’ from the calendar year, certain provisions will enter into force throughout the course of 2024. More details are set out in our previous articles but investors will have to take into consideration the following changes.

Residence test and treaty benefits

Article 4 of the Treaty updates the tax residence test for entities. In particular, it extends the tie-breaker rules by introducing additional non-exhaustive criteria that the UK and Luxembourg have to take into consideration. The UK and Luxembourg will have to bear in mind an entity’s (1) place of effective management, (2) incorporation and (3) any other relevant factors in the context of the mutual agreement procedure. It is important to note that Article 24 (Mutual agreement procedure) has effect from the date when the Treaty enters into force.

Treaty benefits are also now extended to certain collective investment schemes established and treated as bodies corporate for tax purposes in Luxembourg. This is a welcome expansion to the Treaty.

Property rich entities

The treaty introduces a concept of ‘property rich’ entities, i.e. entities that derive at least 50% of their value from immovable property (i.e., real estate) located in one of the contracting states. Under the provisions of article 13(2) of the Treaty, capital gains deriving from disposal of shares or comparable interests in a ‘property rich’ entity may be taxed in the contracting state where such property is located.

Up to this point, investors in UK  ‘property rich’ entities who hold their interest through Luxembourg had treaty protection from UK capital gains tax. However, it is important to remember that under UK legislation, the threshold for value deriving from immovable property is 75%.

This provision enters into force on 6 April 2024 (for UK capital gains tax purposes) or from 1 April 2024 (for UK corporation tax purposes) and will be applicable for gains arising in those respective periods.

Clearly, this will be a significant change for Luxembourg structures investing in UK ‘property rich’ entities. The position should remain unchanged though for investors in UK hotel businesses and other owner-occupiers where the UK property is used for the group’s own trade.  This is due to the UK rules allowing an exemption from UK gains tax where shares of a ‘UK property rich’ entity are sold, and the UK property is and has been used for a trade carried on by that entity or its group. We recommend investors in these sorts of businesses review their group structures and exit plans, to avail themselves of this UK gains tax exemption.

Withholding tax on dividends

All provisions related to taxes withheld at source will enter into force on 1 January 2024. UK investors will significantly benefit from a reduction of withholding tax, which is currently at 5% or 15% on Luxembourg dividends under the previous double tax treaty, to nil rate of withholding tax on dividends under the Treaty.

The full exemption from withholding tax for distributions will be subject to a carve out in relation to entities with income deriving from immovable property. If an entity of this type distributes most of such income annually and is exempt from tax on such income, the distributions may be subject to a withholding tax up to 15% (except where the recipient is a recognised pension fund, in which case the 0% withholding tax remains applicable).

Conclusions

The positive changes and technical novelties introduced by the Treaty should be taken into consideration when planning investment structures. These updates are especially important for UK real estate investors who want to benefit from the favourable tax treatment of their Luxembourg holding entities.

Article co-authored by Viktoriia Bilenko