New Luxembourg-UK Double Tax Treaty Will Introduce Key Changes Including Access to Treaty Benefits for CIVs / Investment Funds | Dechert LLP

Following the Luxembourg parliament’s ratification of the new Luxembourg-UK double tax treaty (“DTT”) on 19 July 2023, the new DTT should take effect in 2024. The UK ratified the new DTT on 7 June 2022.

In summary, key changes from the new DTT include:

• Widening the scope of access to treaty benefits for Luxembourg corporate collective investment vehicles provided that, where not a UCITS, a beneficial ownership test is met (75 percent or more of the beneficial interests in the investment fund are held by “equivalent beneficiaries”).
• A reallocation of taxing rights in respect of property-related capital gains, enabling the state in which real estate is located to tax capital gains on the disposal of shares or comparable interests deriving more than 50 percent of their value directly or indirectly from real estate in that country. As a consequence, Luxembourg investors disposing of interests in UK property rich companies (either directly or indirectly via certain fund structures) are more likely to fall within the UK non-resident capital gains tax regime.
• Dividend withholding tax is mostly reduced to 0 percent (instead of 5 percent for companies or 15 percent for individuals under the current DTT), with an exception for certain dividends paid out of income deriving from real estate (such as from a UK REIT). This is a welcome change for UK shareholders receiving dividends from Luxembourg companies. Withholding tax on royalties has also been reduced to 0 percent.
• Alignments to the OECD model treaty, including the residence tiebreaker (i.e., mutual agreement, rather than the previous effective management test) and principal purpose test for access to treaty benefits

Treaty Benefit Scope Expansion

The Protocol to the new DTT extends treaty benefits to certain collective investment vehicles (“CIVs“). This includes the following Luxembourg corporate forms of CIV: société anonyme (“SA“), société à responsabilité limitée (“Sà r.l.”) or société en commandite par actions (“SCA“) including those regulated as UCITS, so called Part II Funds, SIFs, RAIFs, ASSEP, SEPCAV and pension funds subject to the supervision of the commissariat aux assurances. In summary, CIVs established as body corporates in Luxembourg (and certain pension funds) and receiving income arising in the UK will be treated as residents of Luxembourg for the purposes of the DTT and the beneficial owner of their income, provided that at least 75 percent of the beneficial interests in the CIV are owned by “equivalent beneficiaries.”

Equivalent beneficiaries are Luxembourg residents and residents of other jurisdictions with which the UK has a treaty providing for effective and comprehensive information exchange and a rate of tax at least as low as the rate claimed under the new DTT. UCITS are treated as Luxembourg resident and the beneficial owner of all income received, regardless of ownership by “equivalent beneficiaries.”

Amongst other things, this change could enable certain Luxembourg credit funds to avoid UK withholding tax on interest payments from UK borrowers for the first time without the need for listed notes or other downstream entities subject to their specific investor mix from 1 January 2024.

Real Estate Taxing Rights

Under the current DTT, a Luxembourg resident disposing of shares (or comparable interests) in a UK property-rich entity is only subject to Luxembourg tax. This overrides the UK’s non-resident capital gains tax (“NRCGT”) rules that, broadly, charge non-residents to tax on gains realised on a direct or indirect sale of UK land.

The new DTT allocates taxing rights to the state in which the land is located, where the shares or other interests derive 50 percent or more their value, directly or indirectly, from land. However, the NRCGT rules only apply to an indirect disposal where the relevant interest derives 75 percent or more of its gross value from UK real estate (i.e., the vehicle is UK property rich), which means that a charge will only arise if this higher threshold is met and the transaction otherwise falls within the scope of the rules.

No grandfathering provisions apply, and affected persons/structures should consider the impacts before the rules come into effect in April 2024, including on gains accrued but not realized prior to the new DTT’s entry into force.

Dividend Withholding

Withholding on dividends has generally been reduced to 0 percent, in a welcome reduction from the current treaty that imposes withholding at 5 percent for companies or 15 percent for individuals. The UK does not generally impose withholding tax on dividends, but this change will impact dividends paid from out of Luxembourg to UK shareholders from 1 January 2024.

The exemption from withholding does not apply to dividends paid out of income/gains derived directly or indirectly from immovable property by an investment vehicle distributing most of this income annually and whose income from immovable property is exempted from tax. This notably includes UK REITs, and withholding tax of up to 15 percent will apply, except where the beneficial owner of the dividends is a recognized pension fund (in which case the 0 percent rate applies).