On 7 June 2022, the United-Kingdom (UK) and Luxembourg signed the text of the new double tax treaty.
The date on which the treaty will enter into force will depend on the ratification processes in the UK and in Luxembourg. Therefore, investors in UK real estate have the opportunity to consider the impact of the new provisions, which we set out below.
New taxing rights for gains on disposals of entities deriving value from “immovable property”
The 2019 introduction of the UK’s non-residents capital gains (“NRCGT”) charge to disposals of: (i) all UK real estate and (ii) disposals of UK “property rich” entities (broadly being entities deriving at least 75% of their value from UK real estate) will be well known to overseas investors in UK real estate. The previous treaty did not contain such a concept in relation to “property rich” entities, such that, on a taxpayer’s successful application of the treaty, gains arising to a Luxembourg resident from the disposal of a UK real estate holding company would not be subject to tax in the UK (and would typically be exempt in Luxembourg under the Luxembourg participation exemption regime).
The new treaty now contains a similar “property rich” concept. Under Article 13(2) of such treaty, gains derived by a resident of Luxembourg from the disposal of shares (as well as interests in transparent entities such as partnership, or trust interests) will be taxable in the UK should the shares (or other interests) derive directly or indirectly more than 50% of their value from UK real estate. Note that, for investors in UK real estate, the “key figure” in terms of value derived from UK real estate will remain at 75%, as the UK will not seek to tax the gain until it is within charge under domestic legislation. Therefore, in practice, this new treaty provision will only affect structures for which the 75% threshold is met.
Other considerations for investors
One benefit of this addition is that Luxembourg investors will no longer cause collective investment schemes seeking to make an exemption election under the NRCGT regime to fail the “UK tax condition”. Broadly, this condition requires that no more than 25% of the total value returned to investors be exempt from tax in the UK because of the allocation of taxing rights under a relevant double tax treaty with the UK.
It should also be noted that unfortunately the new treaty does not include the fairly common carve-out for the disposal of listed shares deriving their value from UK real estate, which can be of benefit to investors in REITs and other listed vehicles.
It is not yet clear whether the drafting in Article 10(2)(b) (which refers to “an investment vehicle which distributes most of this income annually and whose income from such immovable property is exempted from tax”) will capture only those entities which are statutorily obliged to distribute their income annually – or whether it will be deemed sufficient for the vehicle to, in practice, distribute their income annually. The latter would have consequences for many more entities than may be apparent.
In conjunction with the increase in UK corporation tax to 25% on 1 April 2023, this new taxing right is likely to make UK real estate investors re-consider the most efficient structures for their UK real estate holdings, where the shares or interests are held by Luxembourg holding structures. This addition to the treaty has been widely expected since the UK introduced NRCGT in 2019, and therefore many investors may already have begun reconsidering the structure of their investments.
Residence & the extension of treaty benefits to Luxembourg CIVs
Via paragraph 2 to the Protocol to the new treaty, treaty benefits are extended to CIVs receiving income arising in the UK, which are established and treated as body corporates for tax purposes in Luxembourg. Such CIVs will be treated as resident of Luxembourg and as beneficial owner of the income they receive to the extent they:
are owned by “equivalent beneficiaries”; or
where at least 75% of their interests are held by “equivalent beneficiaries”.
Additionally, if the CIV is an undertaking for collective investment in transferable securities (UCITS), it will be treated as a (tax) resident in Luxembourg and considered the beneficial owner of all the income it receives.
Broadly, an “equivalent beneficiary” is a resident of Luxembourg, or a resident:
of a jurisdiction with which the UK has arrangements for effective and comprehensive exchange of information; and
who would be entitled under a double tax treaty to a rate of tax as beneficial as the one claimed under this Luxembourg-UK treaty in respect of the income received by the CIV.
The Protocol sets out that (i) UCITS subject to Part I of the law of 17 December 2010, (ii) Specialized Investment Funds subject to the law of 13 February 2007 (SIF), and (iii) Reserve Alternative Investment Funds subject to the law of 23 July 2016, with the exception of reserved alternative investment funds which choose to subject themselves to the regime of Article 48 of the said law, (RAIF) (which are SIF like) will all be considered to be “CIVs” – as well as any other investment funds, arrangements or entities established in Luxembourg which the competent authorities of the UK and Luxembourg agree to regard as a CIV.
Withholding tax on dividends
A key difference between the taxing systems of the UK and Luxembourg is that, generally, the UK does not levy withholding tax on dividends (whereas Luxembourg does (at a 15% rate). The previous treaty provided for a reduced dividend withholding tax rate of 5%, meaning that UK resident recipients of dividends arising in Luxembourg would be subject to 5% withholding tax in Luxembourg. While, in many cases, the Parent-Subsidiary Directive would previously have ensured a nil rate of withholding, this was no longer effective once the UK exited the European Union To continue being considered as a qualifying shareholder and benefit from the domestic exemption, the UK parent company has to pass the “subject to tax” test based on Luxembourg domestic law. Principally, this means that the UK parent must be subject in the UK to an income tax of at least 8.5% calculated on a tax base similar to the one of a Luxembourg company. The new treaty now provides (Article 10(2)) for a 0% rate of withholding in most cases, where the beneficial owner of the dividends is resident in the UK.
In terms of UK real estate investment considerations, the 0% rate of withholding will not apply where the dividend is paid by “an investment vehicle which distributes most of this income annually and whose income from such immovable property is exempted from tax”; instead, the treaty reduces the withholding tax rate on such dividends to 15% - except where the beneficial owner of the dividend is a pension fund, in which case the rate is reduced to nil.
It is understood that a UK REIT will be treated as such an investment vehicle. As such, the UK’s 20% withholding tax rates for REIT property income distributions (PIDs) will be reduced to 15% where the beneficial owner is resident in Luxembourg.
Removal of the tax residence tie breaker rule
In line with the OECD Model Convention 2017, the new treaty provides for the residence tie-breaker rule to be in the form of a mutual agreement procedure, rather than the traditional “place of effective management” rule.
While the move towards the “mutual agreement procedure” in favour of the “place of effective management” test generally creates uncertainty for taxpayers, the Protocol to the new treaty provides a list of factors to which the competent authorities of each state should have regard. These include factors which will previously have been relevant in determining the place of effective management, including the location of senior management, where board meetings are held, and where the HQ is located.
However, the Protocol also specifies that where the tax resident status of a company was determined in accordance with the provisions of the previous double tax treaty (i.e., the one currently in force), the competent authorities of the UK and Luxembourg will not seek to revisit that determination provided all the material facts remain unchanged.
In conclusion, the new treaty is clearly aligned with the trend towards in-country taxing rights in relation to real estate. While there are positive changes for some taxpayers (Luxembourg resident CIVs in particular), and the absence of the benefit of the Parent-Subsidiary Directive will no longer be felt as keenly, UK real estate investors holding their investments through Luxembourg structures should closely consider the appropriate structures for holding real estate in the UK.
At the same time, taxpayers should also consider new investment opportunities considering the new favourable dividend withholding exemption clause and the possibility for Luxembourg CIVs to be entitled to treaty benefits under certain conditions (i.e. the UK withholding tax exemption on interest).