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Double tax treaty UK-Luxembourg
Taxes are an unavoidable part of life, but no one wants to pay more than their fair share. This is where the concept of double taxation comes into play. When income is earned across borders, such as between the UK and Luxembourg, individuals and businesses can sometimes be taxed twice on the same income, once in each country. The double tax treaty between the UK and Luxembourg is designed to prevent this.
The double tax treaty between the UK and Luxembourg has been in place since 1967, however, a new agreement was signed in June 2022, which came into effect on November 22, 2023.
Overview of the double tax treaty UK-Luxembourg
A Double Tax Treaty (DTT) is a bilateral agreement between two countries designed to prevent the same income, profits, or gains are taxed twice by both countries. This can happen when an individual or business earns income in a country different from their tax residence.
Without such a treaty, income may be taxed both in the country where it’s generated and in the country of residence, leading to double taxation. The Double Taxation Agreement between Luxembourg and the Kingdom therefore intends to avoid this situation.
Key objectives of the UK-Luxembourg double tax treaty
Avoid double taxation
The primary goal of the UK-Luxembourg Double Tax Treaty is to establish clear rules regarding where taxes should be paid, ensuring that individuals and businesses do not pay tax twice on the same income.
Define rules for specific types of income
The treaty outlines specific provisions on how different types of income—such as employment income, dividends, interest, and royalties—should be taxed, depending on whether they are earned in the UK or Luxembourg.
Promote international trade and investment
By providing clarity and preventing double taxation, the treaty encourages cross-border trade and investment between the UK and Luxembourg, fostering economic cooperation.
Prevent tax evasion
The treaty includes provisions for the exchange of information between the tax authorities of both countries. This cooperation helps combat tax evasion and ensures compliance with tax obligations.
Introduce conflict resolution mechanisms
In case of disputes regarding double taxation, the treaty provides mechanisms for resolution. Taxpayers facing issues with double taxation can approach tax authorities in both countries to resolve the situation.
Follow OECD guidelines
The UK-Luxembourg Double Tax Treaty aligns with the OECD Model Tax Convention and the Base Erosion and Profit Shifting (BEPS) framework, whose objective is to address tax avoidance and profit shifting to low-tax jurisdictions.
Taxes covered by the treaty
Another fundamental aspect of the UK-Luxembourg Double Tax Treaty is the types of taxes it covers in both jurisdictions. Let’s take a closer look at the taxes subject to this agreement:
Taxes covered in Luxembourg:
- Personal income tax: This tax applies to income earned by individuals, including salaries, professional or business income, dividends, and interest.
- Corporate income tax: This tax applies to the profits of companies and corporations that are tax residents in Luxembourg.
- Capital tax: This tax is levied on the value of the assets held by legal entities based in Luxembourg.
- Municipal taxes: Luxembourg imposes local taxes in certain cases, such as municipal business taxes, which are also covered by the treaty.
Taxes covered in the United Kingdom:
- Income tax: This tax applies to the income of individuals residing in the UK, including wages, business profits, dividends, interest, rents, and other sources of income.
- Corporation tax: This tax is levied on the profits of companies and corporations resident in the UK.
- Capital gains tax: This tax is applied to gains made from the sale of assets such as property, shares, and other investments.
Recent Changes
The Double Tax Treaty between the UK and Luxembourg has been in place since 1967, but a new agreement was signed on June 7, 2022, introducing significant updates. The new treaty came into effect for UK corporate taxes and capital gains taxes starting in April 2024, and for withholding taxes as of January 1, 2024. In Luxembourg, the treaty took effect for all taxes beginning January 1, 2024. We will go into the details of this new treaty a bit further in our article.
How does a double tax treaty work?
Double tax treaties (DTCs), such as the one between Luxembourg and the United Kingdom, mainly use two methods to avoid double taxation on income or profits an individual or entity generates in one country while residing in another.
These methods are the exemption method and the tax credit method, which may sometimes be used in combination. In addition, the treaty incorporates BEPS (Base Erosion and Profit Shifting) mechanisms and the Principal Purpose Test (PPT) to prevent aggressive tax planning strategies that could inappropriately reduce or eliminate tax liabilities. Let’s take a closer look at these mechanisms:
Exemptions
Under this method, the country of residence exempts the income already taxed in the country where it was generated. In other words, the resident country waives its right to tax certain foreign income. There are two variations of this method: full exemption and exemption with progression. In the first case, foreign income is entirely exempt from tax in the country of residence. For progressive method, the foreign income is not taxed directly, but it is considered when calculating the tax rate applied to other taxable income. While the exempt income is not taxed, it may affect the tax rate applied to the remaining income.
Tax credits
In this approach, the country of residence does not exempt foreign income but allows the taxpayer to deduct the taxes already paid abroad from the total taxes owed in their home country. This ensures that while all income is taxed, the country of residence recognizes taxes already paid abroad, thereby avoiding double taxation.
Combined methods
In some cases, double tax treaties, including the one between Luxembourg and the UK, apply a combination of both methods, depending on the specific type of income or benefits involved. For example, certain types of income, such as dividends or interest, may be subject to tax credits, while other types of income may qualify for exemptions. This approach offers flexibility to accommodate the specific nature of the income and the tax policies of both countries.
Base Erosion and Profit Shifting (BEPS)
BEPS refers to tax planning strategies used by multinational companies to shift profits to low or no-tax jurisdictions, thereby eroding the tax base of the countries where they operate. This often leads to an unfair reduction in tax revenues and creates an uneven playing field for businesses.
In 2013, the OECD and the G20 started the BEPS Project to tackle these issues. The goal is to reform international tax rules to stop companies shifting profits to lower-tax regions. The BEPS Project outlines 15 actions to help countries fight tax avoidance. The UK-Luxembourg Double Tax Treaty incorporates these principles, ensuring that multinational enterprises cannot unduly reduce their tax burden by shifting profits.
The PPT is an anti-abuse rule included in many international tax treaties, including the UK-Luxembourg Double Tax Treaty. As part of the OECD BEPS Action 6, the PPT aims to prevent treaty abuse, specifically when transactions or structures are designed solely or mainly to benefit from the tax advantages offered by the treaty.
Consider a multinational company based in the UK that sets up a subsidiary in Luxembourg, whose sole purpose is to receive dividends from other companies in the group located in various countries.
The primary reason for establishing this subsidiary is to benefit from the reduced withholding tax rates on dividends provided by the Double Tax Treaty between the UK and Luxembourg.
If the tax authorities in the UK or Luxembourg determine that this structure was created mainly to take advantage of the treaty’s provisions, they can apply the PPT to deny the treaty benefits.
Key provision of the new treaty
The updated Double Tax Treaty between Luxembourg and the UK introduces several significant changes that modernize the tax relationship between the two countries.
Clause on property-rich companies
The new treaty allows for taxation of gains arising from the sale of shares in a "property-rich" company (a company where more than 50% of its value comes from real estate) in the country where the property is located.
Withholding on royalties
Withholding tax on royalty payments has been reduced to 0%, down from the previous 5%. This change aligns with Luxembourg’s internal laws, where there is no withholding tax on royalties, making cross-border payments more tax-efficient.
Withholding on dividends
Most dividends will now be subject to a 0% withholding tax, compared to the previous 15%. However, dividends from Real Estate Investment Trusts (REITs) may still be subject to a withholding tax of up to 15%, unless the beneficiary is a pension fund, in which case the withholding remains at 0%.
Corporate residence tiebreaker
To resolve cases where companies have dual tax residency, the new treaty moves away from using the "place of effective management" as the sole criterion. Instead, it relies on mutual agreement between the tax authorities of both countries, considering various factors to determine corporate residence more accurately.
Treatment of collective investment vehicles
Luxembourg’s collective investment vehicles, such as UCITS, SIFs, and RAIFs, may now be treated as residents for treaty purposes and thus eligible for its benefits, provided they meet certain ownership and beneficiary requirements. However, this provision does not apply to UK collective vehicles.
Permanent Establishment (PE) definition
New rules restrict activities that can be considered exempt from being classified as a permanent establishment. Additionally, the minimum duration for construction projects to be deemed a permanent establishment increases from 6 to 12 months.
Business profits
The new treaty adopts a more OECD-aligned approach to profit allocation, particularly in relation to permanent establishments, using transfer pricing principles. This simplifies the rules and eliminates some previous complexities in determining business profits.
Arbitration procedures
Arbitration rules have been streamlined, now consisting of a single paragraph requiring tax authorities to agree on how arbitration will be applied. This is a more flexible and simplified procedure compared to the more detailed provisions in the previous treaty.
Cross-border tax collection
A new provision allows tax authorities in both countries to collaborate on cross-border tax collection. However, a country can refuse to assist if it deems the other country’s tax claim inconsistent with generally accepted tax principles.
Access to treaty benefits, Principal Purpose Test (PPT)
The treaty formally incorporates the Principal Purpose Test (PPT), preventing taxpayers from accessing treaty benefits if the main purpose of the transaction is to gain a tax advantage. While already present under the Multilateral Instrument (MLI), the PPT is now directly embedded in the treaty.
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The previous treaty between Luxembourg and the UK had been in force for many years and needed an update to align it with modern tax practices and OECD principles. The new treaty introduces numerous benefits, including reduced withholding taxes, clearer rules on taxation for property-rich companies and enhanced dispute resolution mechanisms.
What has changed in the new double tax treaty UK + Luxembourg 2023?
| Provision | Old treaty (1967) | New treaty (2023) |
| Property-rich clause | Did not include this clause. | Taxation of the sale of shares in companies deriving more than 50% of their value from immovable property in the country where the property is located. |
| Withholding tax on royalties | 5% withholding tax. | Reduced to 0% withholding tax. |
| Withholding tax on dividends | General rate of 15%, reduced to 5% if the recipient held at least 25% of the voting power. | 0% rate in most cases, except dividends from REITs (up to 15%). |
| Tie-breaker for company residence | Based on "place of effective management." | Now resolved by mutual agreement between the tax authorities of both countries. |
| Treatment of collective investment vehicles | No specific mention of collective investment vehicles. | Includes specific rules for UCITS, SIFs, and RAIFs. |
| Permanent establishment (PE) definition | The threshold for construction projects was 6 months. | Threshold for construction projects extended to 12 months, with BEPS rules added to prevent abuse. |
| Business profits | More prescriptive and detailed rules. | Aligned with OECD principles, with less prescriptive rules. |
| Arbitration procedures | Arbitration involved a detailed 7-page process. | Simplified rules with a single paragraph, leaving details to the tax authorities. |
| Cross-border tax collection | No provision for assistance in tax collection. | Introduces a new provision for assistance in the collection of taxes. |
| Access to treaty benefits (PPT) | Already included under the MLI (Multilateral Instrument). | The PPT is now formally incorporated into the treaty. |
Benefits and implications of the treaty between UK and Luxembourg
The new Double Tax Treaty introduces several significant changes that bring important benefits for businesses and investors, simplifying cross-border operations and enhancing tax certainty.
Elimination of withholding tax on royalties (0% WHT)
One of the most notable benefits is the removal of the 5% withholding tax on royalties. Companies and individuals receiving royalties will no longer face this tax burden, which makes it easier for businesses to make royalty payments between the two countries. This change is particularly advantageous for industries reliant on intellectual property, such as tech and pharmaceutical companies, fostering smoother cross-border transactions.
Significant reduction in withholding tax on dividends
The new treaty establishes a 0% withholding tax on most dividends, a significant improvement over the previous 15% rate. This gives an incentive for investors dealing in stocks and funds across Luxembourg and the UK.
Property-rich companies clause
The new treaty introduces a clause allowing taxation of gains from the sale of shares in companies whose value is derived more than 50% from real estate. The tax is imposed in the country where the property is located. This offers clearer rules on the taxation of real estate investments, reducing the risk of tax avoidance and ensuring that gains from real estate transactions are taxed fairly.
Special treatment for Luxembourg collective investment vehicles
Luxembourg collective investment vehicles (UCITS, SIFs, and RAIFs) are now explicitly recognized in the treaty and can access treaty benefits as Luxembourg residents. This clarity provides greater security for investors and strengthens Luxembourg’s position as a global financial hub for investment funds.
Resolution of dual corporate residence disputes
The new approach for resolving dual-residence disputes between tax authorities gives multinational companies greater certainty. Instead of relying on the "place of effective management," the treaty now requires mutual agreement between the UK and Luxembourg authorities. This reduces the likelihood of tax conflicts and clarifies the tax residency status for companies operating in both countries.
Clearer definition of Permanent Establishment (PE)
The new rules provide more transparency regarding what constitutes a permanent establishment (PE). This prevents businesses from using artificial structures to avoid establishing a PE in the other country, which would subject them to local taxation. The clearer definition enhances tax transparency and minimizes uncertainty about when a company is liable for taxes in a given jurisdiction.
Simplified rules for business profits
The treaty aligns more closely with OECD principles on transfer pricing, simplifying the allocation of profits to permanent establishments. This adjustment reduces administrative burdens on businesses and makes it easier for multinational companies to comply with tax regulations.
More efficient arbitration mechanisms
The simplified arbitration rules make resolving international tax disputes quicker and more efficient. With a more streamlined process, multinational businesses can resolve conflicts with tax authorities faster, reducing the risk of prolonged disputes and potential double taxation.
Collaboration on cross-border tax collection
A new provision in the treaty allows tax authorities from both countries to collaborate on collecting unpaid taxes. This cooperation enhances tax administration efficiency and strengthens the fight against tax evasion. However, one country can refuse assistance if it believes the other country’s tax claims are inconsistent with accepted tax principles.
Formalization of the Principal Purpose Test (PPT)
The formal inclusion of the Principal Purpose Test (PPT) strengthens the ability of both countries to prevent tax abuse. The PPT ensures that transactions between Luxembourg and the UK have a genuine economic purpose, beyond merely exploiting the tax benefits of the treaty. This reinforces fairness in taxation and helps prevent inappropriate tax avoidance schemes.
While we have provided a general overview of the key changes and their implications in straightforward language, for those seeking a deeper and more detailed understanding, we recommend consulting the full text of the treaty and seeking advice from a tax professional.
Frequently Asked Questions (FAQ)
What is the purpose of the Double Tax Treaty between the UK and Luxembourg?
The purpose of the Double Tax Treaty between the UK and Luxembourg is to prevent individuals and businesses from being taxed twice on the same income in both countries. It establishes clear rules on how income, profits, and gains are taxed, ensuring that cross-border transactions and investments are not subject to excessive tax burdens. The treaty also aims to promote international trade and investment by providing tax certainty and avoiding potential disputes.
What is the Principal Purpose Test (PPT) and how does it impact businesses?
The Principal Purpose Test (PPT) is an anti-abuse provision included in the treaty to prevent taxpayers from using the treaty’s benefits solely for tax avoidance purposes. It ensures that transactions have a genuine economic purpose and are not structured purely to gain favorable tax treatment.
What are the main methods used to avoid double taxation under the treaty?
The main methods used to avoid double taxation under the treaty are the exemption method and the tax credit method. These methods either exempt foreign income from taxation in the resident country or provide tax credits for taxes already paid abroad.
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Source: impotsdirects.public.lu, impotsdirects.public.lu, taxscape.deloitte.com, www.gov.uk, www.harneys.com, www.yoursadvisory.com, www.oecd-ilibrary.org, pure.eur.nl
We took photos from these sources: Artur Tumasjan on Unsplash
Authors: Luz
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