The UK and Luxembourg signed a new double tax treaty on 7 June 2022, which will eventually replace the existing treaty between the countries. The new treaty has significant implications for UK real estate investors with Luxembourg holding structures, as it will allow UK taxation on certain indirect disposals of UK land. Other (more positive) changes may impact certain fund structures and potentially improve the ability of fund investors to obtain treaty protection.
We have summarised some of the key points below. Readers can access the text of the treaty via this link.
Why have the countries negotiated a new treaty?
The current tax treaty in place between the UK and Luxembourg was signed in 1967. Tax treaty practice has changed significantly since then and several features of the current treaty now appear outdated.
Notably, the treaty is one of the few UK treaties without a securitised land provision that allocates the taxing right to gains from disposing of property-rich companies. This omission became important in 2019 when the UK extended its capital gains tax rules to tax non-resident investors on gains from direct and indirect disposals of UK real estate.
For example, if the Fund depicted below wanted to sell the underlying real estate, a direct disposal would be unattractive as PropCo Limited would be subject to UK tax on any gain. It would be more efficient for LuxCo Sàrl to sell its shares in PropCo Limited as the current treaty would prevent the UK from taxing any gain.
The UK government is understandably concerned to prevent this avoidance and opened negotiations with Luxembourg on a new tax treaty in 2018.
Indirect disposals of real estate under the new treaty
This treatment will change under the new treaty. The new gains article allows a jurisdiction to tax gains from disposals of shares and similar interests that derive more than 50% of their value (directly or indirectly) from land situated in that jurisdiction.
Hence, in our earlier example, the new treaty would not protect LuxCo Sàrl from a UK tax charge, assuming the shares in PropCo Limited derive more than 50% of their value from UK real estate. Interposing an additional company between LuxCo Sàrl and PropCo Limited (as shown below) would not change the position as the new treaty allocates taxing rights to the UK where shares derive more than 50% of their value "indirectly" from UK real estate.
While the new treaty expands the UK's taxing rights considerably, it is worth noting that there continue to be some differences between the scope of the UK's domestic charging provisions and the allocation of taxing rights under the treaty. For example, the domestic provisions also catch disposals of certain debt instruments, such as profit participating loans and similar debts with quasi-equity features. It is unclear whether these instruments are sufficiently similar to shares for the UK to have taxing rights under the new treaty.
Special rules for certain funds
A more positive aspect of the new treaty is that it includes a number of specific provisions for certain investment funds. To summarise some of the key changes:
- Fund investors that can benefit from the treaty in their own right will no longer need to file individual claims for relief from withholding tax on interest and dividends, and such claims can be made by an authorised representative of the fund directly. However, the UK and Luxembourg tax authorities still need to finalise details of these arrangements and the devil could well be in the detail.
- Treaty benefits will be extended to certain Luxembourg fund vehicles that have a corporate form, such as a SICAV (société d'investissement à capital variable), SIF (special investment fund) or corporate RAIF (reserved alternative investment funds). This treatment will apply where the fund is a UCITS (undertaking for collective investment in transferable securities), or on a pro rata basis to the extent that fund investors are themselves able to benefit from one of the UK's other comprehensive tax treaties.