The Luxembourg Ministry of Finance introduced recently the draft law 7006 (the "Draft Law") aiming at preventing, potentially retroactively, certain tax planning practices used by companies established in Luxembourg that receive income from United States sources. These planning opportunities result from a different interpretation of the permanent establishment concept by Luxembourg and the United States tax authorities.
Why has the draft law been introduced?
The Draft Law has been submitted in the context of the current negotiations of the double tax treaty between the United States and Luxembourg signed on April 3, 1996, and entered into force on December 20, 2000 (the "Convention"). The United States and Luxembourg are indeed currently negotiating a protocol to amend a number of provisions of the Convention. As part of the negotiation, the negotiators have agreed to a specific change to the Convention that is considered vital to carry out the object and purpose of the Convention, which was and still is the elimination of double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or aggressive tax avoidance. Indeed, the Treasury Department and the Luxembourg Ministry of Fiscal Affairs have realized that based on the current interpretation of the Convention, U.S. source income paid to Luxembourg residents is exempt from tax in Luxembourg as, for purposes of Luxembourg tax law, Luxembourg treats this income as attributable to a permanent establishment in the United States, while at the same time the United States does not tax such income. As a consequence, such U.S. source income may be exempt from tax in both Luxembourg and the United States. In these specific cases, it has been agreed that US taxing rights should not be reduced by means of the Convention and that the latter should thus be amended accordingly.
It is interesting to note that this situation of double non-taxation has also led recently the European Commission to open a formal investigation into Luxembourg's tax treatment of McDonald's based on a potential breach of EU State aid rules. In its decision released on 6 June 2016, the Commission explains its intention to assess whether Luxembourg tax authorities selectively derogated from the provisions of their national tax law and the Convention, respectively deviated from standard administrative practices, and thereby gave McDonald's an advantage not available to other companies in a comparable factual and legal situation.
What does the Draft Law entail?
The Draft Law aims in summary to authorize the United States as source country to deny the application of advantageous withholding tax rates under the Convention to income that under Luxembourg domestic law is treated as income attributable to a permanent establishment of another state and thus not taxable in accordance with its local tax provisions.
The Draft Law provides the following provision, which is also in line with the triangular provision contained in Article 1(8) of 2016 US Model Treaty released in February 2016:
Where an enterprise of a Contracting State derives income from the other Contracting State, and the first-mentioned Contracting State treats that income as profits attributable to a permanent establishment situated outside of that Contracting State, the benefits of this Convention shall not apply to that income if:
The income that is treated as profits attributable to the permanent establishment is subject to a combined aggregate effective rate of tax in the first-mentioned Contracting State and the state in which the permanent establishment is situated that is less than the lesser of (i) 15 percent or (ii) 60 percent of the general statutory rate of company tax applicable in the first-mentioned Contracting State; or
The permanent establishment is situated in a third state that does not have a comprehensive convention for the avoidance of double taxation in force with the Contracting State from which the benefits of this Convention are being claimed, unless the first-mentioned Contracting State includes the income treated as profits attributable to the permanent establishment in its tax base.
However, if a resident of a Contracting State is denied the benefits of this Convention pursuant to this paragraph, the competent authority of the other Contracting State may, nevertheless, grant the benefits of this Convention with respect to a specific item of income if such competent authority determines that such grant of benefits is justified in light of the reasons such resident did not satisfy the requirements of this paragraph (such as the existence of losses). The competent authority of the Contracting State to which a request has been made shall consult with the competent authority of the other Contracting State before either granting or denying the request made under this paragraph by a resident of that other Contracting State.
What are the next steps?
The Draft Law will have no immediate effects as it will have to undergo the Luxembourg legislative process. In this context, the implementation in domestic law of a protocol that is still under negotiation between Luxembourg and the United States could raise questions, notably from the Council of State (Conseil d'Etat).
Even if the Draft Law would be adopted, problems may occur in the future as regards to the adopted law and its validity if another wording would in the end be retained in the final protocol amending the Convention. Indeed, the Draft Law specifies that the above mentioned provision will be applicable only if a protocol amending the Convention enters into force and contains such provision.
Once a protocol amending the Convention enters into force and contains such triangular provision, the new provision will have effect for amounts paid or credited on or after the third day following the publication of the adopted Draft Law in the Luxembourg Official Journal, provided that the provision of the final protocol dealing with its entry into force will include the same retroactive effect stipulation.
In view of this potential retroactive effect, and also considering that a number of other provisions of the Convention may possibly be amended in the context of the negotiations between the United States and Luxembourg, the developments regarding the changes to the Convention will have to be monitored closely.
What is our conclusion?
The Draft Law is in line with the general tendency nowadays to tackle tax evasion and tax-avoidance through unsound aggressive tax planning as contemplated by the OECD BEPS Action Plan and the proposed anti-tax avoidance EU directive aiming at implementing certain measures provided in the BEPS Action Plan.
It will take quite some time before the entry into force of the new protocol amending the Convention and thus for the Draft Law to become, if at all, effective, as treaty revision is a quite long and complicated process. For instance the ratification process of the protocol to the Convention signed on 20 May 2009 is still ongoing, whilst in February 2016, the competent Senate Committee urged the full US Senate to advice on and consent to ratification of such protocol.
However, considering the wish of the United States and the Grand Duchy of Luxembourg to apply the new protocol amending the Convention not once it has gone through typical advice and consent procedures with a due subsequent ratification process but retroactively, which is rather unusual but not without precedent, one may welcome the approach of the Ministry of Finance as it informs taxpayers now about a future change that will be applied, if adopted, probably retroactively.