As recently announced, the French and Luxembourg governments are finalising a new double tax treaty between the two countries (the «DTT»).
We outline below the key revisions and their potential impact.
1. Withholding tax on dividends
> A significant increase of the withholding tax rate for distributions made by a French OPCI to a Luxembourg holding company
Under the current DTT, subject to certain conditions, dividend distributions made by an OPCI to a Luxembourg company holding a participation of at least 25% are subject to French withholding tax at a reduced rate of 5%.
Once the new DTT will have come into force, such distributions will be subject to the domestic rate, currently 30%, except for distributions to Luxembourg shareholders holding less than 10% in the OPCI and to Luxembourg investments funds which can be considered as similar to certain French investment funds, who will benefit, under certain conditions, from a reduced rate of 15%.
This regime is in line with the provisions of some of the latest DTT concluded by France, such as the UK-France and Germany-France DTT.
> A wider scope of application of the withholding tax on dividends
The current version of the DTT provides for a narrow definition of dividends. As a result, distributions which do not qualify as a dividend from a legal standpoint (e.g. deemed distributions arising from a mismanagement act, liquidation bonuses, etc.) are exempt from dividend withholding tax.
The definition of dividends under the new DTT (article 10) will include any distribution which is treated as dividend for tax purposes by the source country, as this is the case in most DTT concluded by France. Deemed dividends will therefore fall within the scope of the withholding tax.
2. Scope of application of the DTT - Definition of resident
The current DTT provides that the residency of a person (other than a natural person) is located where this person has its effective place of management (centre effectif de direction). This provision allows persons (such as certain investment funds) which are not subject to tax to benefit from the DTT. Under the new DTT, a resident is defined (as per OECD standards) as a person who is subject to tax in a jurisdiction by reason of having its domicile, residency, place of management, (…), in such jurisdiction. This new definition will have the effect of excluding from DTT benefits entities which are not subject to tax. There is however a provision in the Protocol (in its paragraph 2) which provides that collective investment scheme established in a jurisdiction (and which are assimilated in the other jurisdiction to local collective investment scheme) benefit from the DTT provisions as regards dividends and interest in proportion to their shareholders or unitholders which are residents of France, Luxembourg or any State having entered into a treaty containing an administrative assistance provision with the jurisdiction where the dividend/interest arises.
3. Anti-abuse - Principal purpose test
The exact wording of the principal purpose test provision developed by the OECD (as part of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting, signed on 7 June 2017 (the «MLI»)) has been inserted into the new DTT.
The principal purpose test, which is an anti-abuse rule, provides that a treaty benefit shall not be granted to a taxpayer if it is reasonable to conclude that obtaining that benefit was one of the principal purposes of any arrangement or transaction (subjective test), unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the new DTT (objective test).
At this stage, the way such rule would be applied by the French tax authorities to deny treaty benefits is uncertain. It is therefore impossible to assess accurately the actual impact it could have, although one may notice that the first subjective test of the anti-abuse rule may be interpreted very broadly by the French tax authorities to deny a treaty benefit.
4. Elimination of double taxation - Taxation in Luxembourg participation of dividends received from French tax exempt funds
Article 22 of the DTT addresses elimination of double taxation. France relies on the credit method to eliminate double taxation.
Luxembourg typically exempts income which is taxable in France, except where this income is covered by the dividend, royalty or artists and sportsmen articles. In that case, double taxation is eliminated in Luxembourg by the credit method.
Compared to the current DTT, Luxembourg does no longer exempt dividends received from a French vehicle in case a substantial participation is held. Accordingly, in the future, the domestic participation exemption will be applicable, which requires that the French distributing subsidiary either falls within the scope of the parent-subsidiary directive or is considered a fully taxable company, by comparison to Luxembourg income tax criteria. It is no longer possible to rely on the participation exemption, as previously embodied in the DTT, in case the distributing vehicle is a resident of France under the double tax treaty, regardless its tax status. Dividends from an OPCI will therefore no longer qualify for a participation exemption based on the DTT.
5. Permanent establishment - Commissionaire arrangements and similar strategies
The permanent establishment definition has been widened in the new DTT and is now in line with the BEPS wording.
Under the new definition, in circumstance where contracts are substantially negotiated in France by a dependent agent and are merely authorised in Luxembourg, a Luxembourg entity should now be considered to have a permanent establishment in France, unless the agent is performing its activity in the course of an independent business (other than for group clients).
These amendments may in particular catch arrangements where a Luxembourg fund or other investment vehicle benefits from the services of an investment advisor exercising in France.
6. Employment income
A provision of the new DTT which will have significant impact in practice is the new rule on the taxation of employment income. In line with the OECD model convention, employment income received by a resident of one contracting State is taxable in the residence country of the beneficiary, unless he or she performs his or her salaried activity in the other country. In line with Luxembourg habitual treaty policy, there is no provision on frontier workers.
Item 3 of the protocol provides that if a resident of one contracting State, exercising his or her salaried profession in the other State, but is present in the first State or in third countries for his/her employment for periods not exceeding 29 days, will be considered as performing this professional activity in the country of activity during the entire fiscal period. In practice, this means that a French resident, who is employed by a Luxembourg employer and who mainly works in Luxembourg, should not exercise his/her professional activity in France or in a third country for periods exceeding 29 days per tax year, as otherwise French income taxation would apply on the employment income. Similar provisions have been introduced recently in the double tax treaties Luxembourg has signed with Germany and with Belgium.
7. Entry into force
In a nutshell, the new DTT will come into force as from the 1st of January of the year following the ratification of the treaty by the parliaments of both countries. This could possibly take place as soon as 1 January 2019.
The new DTT will in particular have a significant impact on the real estate investment structures.