Taxes are an unavoidable part of life, but no one wants to pay more than their fair share. This is where the concept of double taxation comes into play. When income is earned across borders, such as between the UK and Luxembourg, individuals and businesses can sometimes be taxed twice on the same income, once in each country. The double tax treaty between the UK and Luxembourg is designed to prevent this.
The double tax treaty between the UK and Luxembourg has been in place since 1967, however, a new agreement was signed in June 2022, which came into effect on November 22, 2023.
A Double Tax Treaty (DTT) is a bilateral agreement between two countries designed to prevent the same income, profits, or gains are taxed twice by both countries. This can happen when an individual or business earns income in a country different from their tax residence.
Without such a treaty, income may be taxed both in the country where it’s generated and in the country of residence, leading to double taxation. The Double Taxation Agreement between Luxembourg and the Kingdom therefore intends to avoid this situation.
Another fundamental aspect of the UK-Luxembourg Double Tax Treaty is the types of taxes it covers in both jurisdictions. Let’s take a closer look at the taxes subject to this agreement:
The Double Tax Treaty between the UK and Luxembourg has been in place since 1967, but a new agreement was signed on June 7, 2022, introducing significant updates. The new treaty came into effect for UK corporate taxes and capital gains taxes starting in April 2024, and for withholding taxes as of January 1, 2024. In Luxembourg, the treaty took effect for all taxes beginning January 1, 2024. We will go into the details of this new treaty a bit further in our article.
Double tax treaties (DTCs), such as the one between Luxembourg and the United Kingdom, mainly use two methods to avoid double taxation on income or profits an individual or entity generates in one country while residing in another.
These methods are the exemption method and the tax credit method, which may sometimes be used in combination. In addition, the treaty incorporates BEPS (Base Erosion and Profit Shifting) mechanisms and the Principal Purpose Test (PPT) to prevent aggressive tax planning strategies that could inappropriately reduce or eliminate tax liabilities. Let’s take a closer look at these mechanisms:
Under this method, the country of residence exempts the income already taxed in the country where it was generated. In other words, the resident country waives its right to tax certain foreign income. There are two variations of this method: full exemption and exemption with progression. In the first case, foreign income is entirely exempt from tax in the country of residence. For progressive method, the foreign income is not taxed directly, but it is considered when calculating the tax rate applied to other taxable income. While the exempt income is not taxed, it may affect the tax rate applied to the remaining income.
In this approach, the country of residence does not exempt foreign income but allows the taxpayer to deduct the taxes already paid abroad from the total taxes owed in their home country. This ensures that while all income is taxed, the country of residence recognizes taxes already paid abroad, thereby avoiding double taxation.
In some cases, double tax treaties, including the one between Luxembourg and the UK, apply a combination of both methods, depending on the specific type of income or benefits involved. For example, certain types of income, such as dividends or interest, may be subject to tax credits, while other types of income may qualify for exemptions. This approach offers flexibility to accommodate the specific nature of the income and the tax policies of both countries.
BEPS refers to tax planning strategies used by multinational companies to shift profits to low or no-tax jurisdictions, thereby eroding the tax base of the countries where they operate. This often leads to an unfair reduction in tax revenues and creates an uneven playing field for businesses.
In 2013, the OECD and the G20 started the BEPS Project to tackle these issues. The goal is to reform international tax rules to stop companies shifting profits to lower-tax regions. The BEPS Project outlines 15 actions to help countries fight tax avoidance. The UK-Luxembourg Double Tax Treaty incorporates these principles, ensuring that multinational enterprises cannot unduly reduce their tax burden by shifting profits.
The PPT is an anti-abuse rule included in many international tax treaties, including the UK-Luxembourg Double Tax Treaty. As part of the OECD BEPS Action 6, the PPT aims to prevent treaty abuse, specifically when transactions or structures are designed solely or mainly to benefit from the tax advantages offered by the treaty.
Consider a multinational company based in the UK that sets up a subsidiary in Luxembourg, whose sole purpose is to receive dividends from other companies in the group located in various countries.
The primary reason for establishing this subsidiary is to benefit from the reduced withholding tax rates on dividends provided by the Double Tax Treaty between the UK and Luxembourg.
If the tax authorities in the UK or Luxembourg determine that this structure was created mainly to take advantage of the treaty’s provisions, they can apply the PPT to deny the treaty benefits.
The updated Double Tax Treaty between Luxembourg and the UK introduces several significant changes that modernize the tax relationship between the two countries.
The previous treaty between Luxembourg and the UK had been in force for many years and needed an update to align it with modern tax practices and OECD principles. The new treaty introduces numerous benefits, including reduced withholding taxes, clearer rules on taxation for property-rich companies and enhanced dispute resolution mechanisms.
Provision | Old treaty (1967) | New treaty (2023) |
Property-rich clause | Did not include this clause. | Taxation of the sale of shares in companies deriving more than 50% of their value from immovable property in the country where the property is located. |
Withholding tax on royalties | 5% withholding tax. | Reduced to 0% withholding tax. |
Withholding tax on dividends | General rate of 15%, reduced to 5% if the recipient held at least 25% of the voting power. | 0% rate in most cases, except dividends from REITs (up to 15%). |
Tie-breaker for company residence | Based on "place of effective management." | Now resolved by mutual agreement between the tax authorities of both countries. |
Treatment of collective investment vehicles | No specific mention of collective investment vehicles. | Includes specific rules for UCITS, SIFs, and RAIFs. |
Permanent establishment (PE) definition | The threshold for construction projects was 6 months. | Threshold for construction projects extended to 12 months, with BEPS rules added to prevent abuse. |
Business profits | More prescriptive and detailed rules. | Aligned with OECD principles, with less prescriptive rules. |
Arbitration procedures | Arbitration involved a detailed 7-page process. | Simplified rules with a single paragraph, leaving details to the tax authorities. |
Cross-border tax collection | No provision for assistance in tax collection. | Introduces a new provision for assistance in the collection of taxes. |
Access to treaty benefits (PPT) | Already included under the MLI (Multilateral Instrument). | The PPT is now formally incorporated into the treaty. |
The new Double Tax Treaty introduces several significant changes that bring important benefits for businesses and investors, simplifying cross-border operations and enhancing tax certainty.
While we have provided a general overview of the key changes and their implications in straightforward language, for those seeking a deeper and more detailed understanding, we recommend consulting the full text of the treaty and seeking advice from a tax professional.
Source: impotsdirects.public.lu, impotsdirects.public.lu, taxscape.deloitte.com, gov.uk, harneys.com, oecd-ilibrary.org, pure.eur.nl
We took photos from these sources: Artur Tumasjan on Unsplash