This Focusing on Funds update looks at a specific hot tax topic affecting how and where funds are structured. In addition to the increased general focus on domiciliation policies, fund managers and investors need to think twice if they are investing in French real estate through Luxembourg holding vehicles.

New double tax treaty

France and Luxembourg have signed a new double tax treaty which is likely to come into force in early 2019 and affect investment in French real estate. It includes several changes to implement the OECD Multilateral Instrument, part of the international BEPS project. Significant changes include:

  • an anti-treaty shopping provision;
  • tougher permanent establishment rules;
  • higher withholding taxes; and
  • extended rules to tax Luxembourg companies holding French real estate. 

Background

Many funds and asset holding structures are influenced by tax considerations. Jurisdictions such as Luxembourg, which combine advantageous holding company regimes with a wide network of double tax treaties, are widely used. Their treaties allow income and gains to be repatriated from other countries with minimal withholding taxes and their domestic tax laws result in little tax cost in the holding vehicle.

What is BEPS (Base Erosion and Profit Shifting) about?

BEPS is a G20 initiative designed to protect the tax bases of developed economies and prevent the shifting of taxable profits to tax havens and other low tax jurisdictions.

All participating states have agreed to introduce some form of anti-abuse clause in their treaties. BEPS includes a Multilateral Instrument (“MLI”). It is designed to modify the tax treaties of participating states, generally where they opt for the same provisions, to implement key BEPS actions without the need to amend all their individual bilateral treaties.

Treaty abuse (treaty shopping)

One of the key concerns of the BEPS project was to prevent the setting up of entities with no real substance in a particular jurisdiction merely to access its tax treaties.

The France and Luxembourg double tax treaty introduces an anti-treaty shopping provision dis-applying treaty benefits if itis reasonable to conclude that obtaining treaty protection was one of the principal purposes of a transaction or arrangement.

Fund managers should be alert to this risk where their funds are heavily reliant on treaty relief. A Luxembourg holding company will therefore need to show it had substance in Luxembourg and had been set up there for commercial reasons rather than solely or mainly to secure benefits of the France/Luxembourg treaty.

Permanent establishment

Most double tax treaties provide that a commercial enterprise of one state will only be taxed in the other state if it is carrying on business there through a permanent establishment such as a branch or dependent agent.

Many have successfully avoided creating a permanent establishment in a particular country by ensuring that their representatives there did not have the authority to enter into contracts; representatives could negotiate terms but had to refer customers to the company’s overseas headquarters for formal conclusion of contracts. The MLI contains optional provisions which treat such arrangements as giving rise to a permanent establishment.

Under the new double tax treaty it will be more difficult for Luxembourg enterprises with agents in France to avoid creating a permanent establishment (a taxable presence) in France; if an agent habitually negotiates contracts in France which are routinely concluded without material modification in Luxembourg, the Luxembourg company is now likely to have a permanent establishment in France.

Withholding taxes

Dividends paid by real estate investment companies such as French OPCIs will be subject to higher withholding taxes.

Currently withholding tax is only 5% if the shareholder holds 25% or more of the OPCI, but this will increase to 15% if the shareholder holds less than 10% and to 30% if it holds 10% or more, unless the shareholder is a Luxembourg vehicle equivalent to a French fund (i.e. regulated at fund level), for example a Luxembourg SIF, in which case the rate is 15%.

Luxembourg companies holding French real estate

The rule which permits France to tax Luxembourg residents’ gains on the sale of shares (where the value of the shares is derived as to more than 50% from land in France) is now stated to apply where the 50% threshold has been exceeded at any time during the 365 days preceding the disposal, so cannot be circumvented by disposing of the property in the months before the share sale.