On 6 April 2020, the Luxembourg law ratifying the amendment, signed on 10 October 2019 (the "Amendment"), to the new double tax treaty between France and Luxembourg and its protocol (respectively the "New Tax Treaty" and the "Protocol"), both signed on 20 March 2018 (the "Law"), has been published in the Luxembourg Official Journal. In essence, the Amendment aims at softening, as regards employment income received by French cross-border workers, the tax-credit method chosen by France to eliminate double taxation in relation to such income, in order to produce the same effects as the more usual tax-exemption method with progression.
Although the New Tax Treaty and its Protocol were signed by the Luxembourg and the French Governments more than two years ago, they have entered into force on 19 August 2019 and are applicable since the 1st January of this year only. The Amendment is also applicable with retroactive effect as from that date.
This blog aims to deal with the key provisions of the New Tax Treaty, the Protocol and the Amendment.
A New Tax Treaty For New Standards
The double tax treaty initially concluded between France and Luxembourg in 1958 (the "1958 Tax Treaty") was a forerunner at the time of its conclusion in 1958 (as the first model tax convention of the OECD appeared in 1963). Even though the 1958 Tax Treaty has undergone over time a substantial overhaul, the recent profound changes in the international tax landscape and especially the release of the Base Erosion and Profit Shifting ("BEPS") reports in 2013, had made its renegotiation inevitable.
Instead of adding an umpteenth modification to the 1958 Tax Treaty, Luxembourg and France finally decided to start their negotiations from the most recent standards provided by the OECD, i.e. the 2017 Model Tax Convention and the Multilateral Instrument ("MLI"). In addition, the desire to eliminate double taxation without allowing double non-taxation of income is spread unequivocally in the preamble and certain provisions of the New Tax Treaty as well as in the Protocol.
Finally, the New Tax Treaty includes a principal purpose test, according to which its benefits will not be granted if it is reasonable to conclude that obtaining these benefits was one of the principal purposes of any arrangement or transaction.
What Are The Main Changes?
1. Reshaping of the concept of residence
The New Tax Treaty defines a tax resident as a person who, on the basis of the law of a Contracting State, is liable to tax in that State by reason of his/her domicile, residence, place of management or place of exploitation or any other criterion of a similar nature.
The inclusion of a "liable-to-tax" test within the definition of a tax resident for the purposes of the New Tax Treaty, which is in the line with the latest OECD Model Tax Convention, represents a major difference with the 1958 Tax Treaty, although the latter contained a liable-to-tax provision for certain types of income such as dividends, interest payments and royalties. As a consequence, there shall be no doubt that tax exempt vehicles such as French real estate investment vehicles ("REIV") or Luxembourg specialized investment funds should not qualify for the benefits of the New Tax Treaty. This is in line with the position recently adopted by French jurisdictions which refused the application of the double tax treaty concluded between France and Spain to entities benefiting from a general exemption (e.g. undertakings for collective investments ("UCI"))*.
In addition, the New Tax Treaty specifies that French partnerships or similar entities are considered as tax residents for the purposes of the New Tax Treaty as long as they have their place of effective management in France, are subject to tax in France and all of their members are personally liable to tax in France in respect of their share of profits of that partnerships or entities (i.e. French translucent entities).
Further, new tie-breaker rules have been adopted in cases of dual residency. Indeed, whilst the permanent home remains the first tie-breaker regarding the residence of natural persons resident in the two Contracting States, the alternative criteria of the 2017 Model Convention have been added.
Finally, the criterion of "effective place of management" of the 2014 OECD Model convention has also been adopted as the tie-breaker rule for the residence of legal persons.
2. Updating of the permanent establishment and depend agent concepts
Firstly, the New Tax Treaty extends the concept of dependent agent in a Contracting State, which is constitutive of permanent establishment ("PE"). According to the 1958 Tax Treaty, it was notably applicable to a representative or an employee having general authority to negotiate and conclude contracts in the name of the enterprise, unless his/her activities were limited to the purchase of material and merchandise. The New Tax Treaty now also includes cases where that person is merely key in leading to the conclusion of such contracts, independently of the existence of formal bargaining or signing power as required under the 1958 Tax Treaty.
Secondly, the New Tax Treaty provides that commissionaires acting exclusively or almost exclusively on behalf of one or more enterprises to which they are closely related shall also be regarded as constituting a PE. The provision is written in such a way that mere arrangements do, however, not entail a requalification into a PE.
Thirdly, the New Tax Treaty prevents the formal fragmentation of one activity performed abroad into several preparatory or auxiliary activities for the sole purpose of avoiding the recognition of a PE.
Finally, the time required for a construction site to be considered as a PE was increased from 6 to 12 months.
3. Maximum withholding tax rates on dividend and interest payments
Based on the 1958 Tax Treaty, the State of residence of the paying company could levy a maximum 15% withholding tax ("WHT") in case of dividend distributions. A reduced WHT rate of 5% was nonetheless granted to companies directly holding 25% in the distributing company.
The New Tax Treaty provides for a full WHT exemption where the beneficial owners are companies which directly hold at least 5% of the capital of the distributing company for a period of 365 days preceding the distribution. This WHT exemption is more favorable than the former one as the shareholding threshold requirement is only 5% and will allow Luxembourg companies to distribute, in some circumstances, dividends without any WHT to French companies benefitting from the New Tax Treaty not all the conditions of the Luxembourg participation exemption regime on WHT are fulfilled.
The New Tax Treaty however introduces a specific regime applicable to dividends distributed by REIV, such as French SIIC (société d'investissement immobilier côtée)or SPPICAV(société à préponderance immobilière à capital variable). Such dividends will be subject to 15% WHT when its beneficial owner holds, directly or indirectly, a stake of less than 10% in the capital of the REIV, and 30% if such condition is not met.
An exception has nonetheless been made regarding dividend distributions by REIV to certain UCI. Indeed, a UCI which is established in a Contracting State and which is assimilated to the UCI of the other Contracting State according to its own law, benefits from the advantages of the New Tax Treaty for the fraction of dividend income corresponding to the rights held by residents in one of the Contracting States or in any other State with which the Contracting State from which dividends originate has concluded an administrative assistance agreement with a view to combating tax evasion and avoidance. The portion of dividend distributed by a REIV to a domestic-like UCI which correspond to the rights held by residents in one of the Contracting States or in any other State with which the Contracting State from which dividends originate has concluded an administrative assistance agreement with a view to combating tax evasion and avoidance should be subject to a WHT of 15% notwithstanding the holding percentage of the UCI in the REIV.
b. Interests and royalties
With the exception of interests not respecting the arm's length principle and consequently treated as dividends, the State of the source will not be able to levy a WHT on interest income whereas the 1958 Tax Treaty allowed a WHT 10%. These new provisions reflect the current domestic legislation of Luxembourg and France where there is, in principle, no withholding tax on interest payments.
The specific advantage highlighted in the previous section regarding dividend distributions by REIV to certain UCI is also applicable as regards interest payments by REIV to such UCI.
The State of source of royalties is entitled to levy a WHT of 5% maximum while no WHT was allowed in such a case in the frame of the 1958 Tax Treaty.
4. Taxation of capital gains
As a general rule, capital gains are exclusively taxable in the Contracting State of which the alienator is a resident.
However, capital gains derived by a resident of Luxembourg on the sale of shares in a real estate rich company shall continue to be taxable in the State where the immovable property is situated. The New Tax Treaty, however, introduces an additional criterion regarding the period during which shares in the real estate rich company are held. Indeed, the shares will be considered as shares of a real estate rich company for the purposes of the New Tax Treaty to the extent that at any time during the 365 days preceding the alienation, the shares derived more than 50% of their value directly or indirectly from immovable property.
This system seems particularly severe, in that it allows France to impose gains on the sale of shares of a company that do no longer substantially derive its value from real estate at the time of the transfer. Structures with entities being no longer real estate rich companies or being not mostly real estate companies need to be carefully monitored, to assure to comply with, respectively to not exceed - even punctually - the ratio of 50% of real estate during, the 365 days preceding alienation.
Finally, the New Tax Treaty provides specific provisions in relation to capital gains realized by individuals on significant participations. According to these new provisions, gains derived by an individual who is a resident of a Contracting State from the alienation of shares forming part of a substantial participation in the capital of a company which is a resident of the other Contracting State may be taxed in that other State. A substantial participation is deemed to exist when the alienator, alone or together with related persons, holds directly or indirectly shares or other rights the total of which gives right to 25% or more of the profits of the company. However, this specific provision only applies to a resident of a Contracting State who has been a resident of the other Contracting State at any time during the five years preceding the alienation of shares from such significant participations.
5. Taxation of cross-border workers
The Protocol provides specific provisions for cross-border workers of a Contracting State who usually exercise their activity in the other Contracting State but partly also from their State of residence or a third State. Without these specific provisions, such workers should, in principle, be taxable in their State of residence or potentially in the third State for the period where they physically performed their working activity from such countries. To avoid the administrative burden resulting from this situation, the Protocol provides that periods not exceeding in total 29 days in the State of residence or the third State will be considered to be actually exercised in the State of usual activity.
Due to the geographic position of Luxembourg, similar measures have already been taken with Germany and Belgium.
In addition, due to the Codiv-19 pandemic, French and Luxembourg authorities agreed that, as of 14 March 2020, the time during which a cross-border worker would have to stay at home due to the lockdown would not be taken into account for the computation of the 29 days until further notice.
6. Method of elimination of double taxation
France and Luxembourg have each opted for a different method to eliminate double taxation. France adopted the tax credit method for all types of income (subject to certain adjustments resulting from the Amendment for employment income) whereas Luxembourg continues to use a combination of the exemption method for certain types of income (e.g. employment income, immovable property, capital gains) and the tax credit method for other types of income.
However, France has softened under the Amendment the application of the tax credit method for employment income. While the tax credit granted by France on Luxembourg-sourced income cannot in principle exceed the amount of the French tax corresponding to such income, the tax credit for employment income will be equal to the amount of the French tax corresponding to such income provided that they are effectively subject/liable to tax in Luxembourg. Such approach should, in most cases, produce in fact the same effects as the exemption with progression method.
In addition, Luxembourg did (unfortunately) not maintain, in the New Tax Treaty, the participation exemption provisions included in the 1958 Tax Treaty according to which dividend income received by Luxembourg companies limited by shareholding more than 25% in the capital of a French company limited by share were exempt.
* Case n°371132, 9 November 2015, French Council of State (§8)