The UK and Luxembourg have signed a long-awaited re-negotiated tax treaty which will come into force in 2023 if approved by both countries by the end of 2022.
The new treaty differs from the current version in a number of respects. The most significant change for real estate investors is the introduction of a rule which allows the UK to tax Luxembourg residents on gains arising on indirect disposals of UK real estate (and vice versa for indirect disposals by UK residents of Luxembourg real estate). Until now, the absence of this rule had made Luxembourg a popular choice for holding structures to invest into UK land.
The other (non-real estate) headline is that the withholding tax rates for dividends and royalties have been reduced to 0%. This is welcome, but the reduction does not apply to property income distributions paid by a REIT (or similar vehicle), in which case a 15% rate generally applies.
Some more detail
Under the terms of the current treaty, the UK has no taxing rights over gains from the sale of indirect investments in UK real estate. This means that Luxembourg tax resident investors do not have to pay UK tax on the sale of an investment which derives the majority of its value from UK land and which would, but for the treaty, be taxable under the UK's non-resident CGT rules.
Unsurprisingly, the UK has been pushing for a change to this element of the treaty since the introduction of the current non-resident CGT rules in 2019. Under the new treaty, the UK will now be able to tax Luxembourg residents on the sale of shares or comparable interests (such as interests in a partnership or trust), if those shares or interests derive over 50% of their value, directly or indirectly, from UK land (and vice versa).
However, this change does not mean that sales by Luxembourg residents of all shares (or comparable interests) that derive over 50% of their value from UK land will, in fact, be taxed in the UK. This is because, broadly, disposals of interests in tax opaque property owning entities are currently only within the scope of the UK's domestic non-resident CGT rules where the relevant interest derives over 75% of its value from UK land.
As this aspect of the treaty could come into force as soon as next April, real estate investors should (if they have not already done so) start considering its impact on their current and future structures. In doing so, such investors should have regard to the fact that there is no grandfathering of this change, meaning that the entire gain from the disposal of an interest in a UK property-rich vehicle by a Luxembourg resident would be subject to UK tax, including any part that has accrued before the changes to the treaty came into effect.
The availability of full relief from withholding tax on dividends and royalties (in addition to interest which already benefits) is welcome news. Full relief will not be available to dividends paid out of tax exempt income and gains derived (directly or indirectly) from real estate by investment vehicles which annually distribute most of those amounts. Instead, for such dividends, the treaty allows withholding tax at rates of up to 15% (unless the dividend is paid to a recognised pension fund established in the other jurisdiction, in which case full relief will apply). The effect of the treaty is therefore that dividends paid between Luxembourg and the UK should be free of withholding tax other than most property income distributions (PIDs) paid by REITs (and equivalent distributions by similar vehicles). The exclusion for REITs (and equivalent vehicles) is unsurprising, as a full exemption from withholding tax on PIDs would allow non-resident investors to avoid domestic tax on domestic property business profits by investing via such entities.
The availability under the treaty of full relief from withholding tax for interest, royalties and (most) dividends will put UK residents in a similar position in relation to Luxembourg withholding tax as they would have been in had they still had access to the EU's Interest and Royalties and Parent-Subsidiary directives.
When do these changes come into effect?
If the UK and Luxembourg governments each notify the other that they have ratified the treaty by the end of 2022:
- the changes to withholding tax will come into force from 1 January 2023; and
- the changes to the UK of taxation of indirect disposals will come into force (i) from 6 April 2023 (for capital gains tax payers) or (ii) for financial years beginning on or after 1 April 2023 (for corporation tax payers).
The new treaty can be found here.