Luxembourg Tax Alert 2024-04

On 6 July 2023 Luxembourg and Germany signed an amending Protocol (hereafter ‘the Amending Protocol) to the Germany-Luxembourg tax treaty (hereafter ‘the DTT’), which has been recently commented by a circular issued by the Luxembourg tax authorities¹ (hereafter ‘the Circular’). 

The Amending Protocol incorporates certain provisions implementing the BEPS Multilateral Instrument (hereafter ‘the MLI’) and modifies several significant provisions affecting employees, employers, corporate taxpayers and investment funds. 

The key changes are the following:

• Extension of the tolerance threshold for cross-border workers to 34 days; 

• Introduction of a new ‘effectively taxed’ clause (hereafter ‘the Clause’) to avoid double non-taxation;

• Amendment of the provisions related to treaty benefits granted to investment funds; 

• Revision of the provisions on exit tax in the case of a change of tax residence; and

• Insertion of the anti-abuse provision of the MLI (preamble and principal purpose test).  

Given that these provisions already apply since 1 January 2024, we generally recommend that a careful impact assessment of current situations or structures is performed.

Whilst the following tax alert is focusing on corporate taxpayers and investment funds, please refer to our separate tax alert for an overview of the impacts for individuals and cross-border workers.

The Amending Protocol did not change the withholding tax (hereafter “WHT”) rates, and as such article 10 of the DTT still provides the following WHT relief on dividend income: WHT can be reduced to 5%, if the beneficial owner is a company which directly holds at least 10% of the capital of the company paying the dividends, or 15%, in all other cases.

However, it is now specified that dividends paid by a German real estate investment trust company (REIT-AG) or by a Luxembourg real estate company which essentially corresponds to a German REIT-AG for tax purposes, and dividends paid to an undertaking for collective investment (hereafter ‘UCI’) can only benefit from the 15% WHT (and not the reduced 5% rate). 

The Protocol also provides that the definition of dividend income includes distributions arising from UCI meaning these specific distributions will now be covered by article 10 of the amended DTT.

A key consideration from the Amending Protocol is that the following UCI (to the extent they are not setup as partnerships) may now have access to treaty benefits (notably for dividends and also interest):  (1) an investment fund within the meaning of either the UCI law, the SIF law or the RAIF law (operating either under the SIF or the SICAR regime) for Luxembourg; (2)  an investment fund within the meaning of the Investment Tax Act ("Investmentsteuergesetz") for Germany; and (3) certain other Luxembourg or German investment funds agreed by the competent authorities of the Contracting States to the extent they meet specific criteria². 

Finally, the amended DTT now also provides for a look-through approach:

• When the dividend income is derived by an entity considered as transparent by one Contracting State and is attributable for tax purposes to a person resident in the same Contracting State, such a person is then considered to derive the dividend income directly for the purpose of the amended article 10. 

• As a result, when a contractual fund such as a Luxembourg FCP receives a German source dividend and is held by residents of Luxembourg, the latter should be entitled to treaty benefits as the direct recipients of the German source dividend. In practice, it may force Germany to consider a Luxembourg FCP as tax transparent in the situation above described even though Germany treats it as opaque based on its domestic law.

• However, if the German source dividend is distributed to a Luxembourg FCP held by non-Luxembourg resident investors and (necessarily) qualifying as a UCI, such Luxembourg FCP would itself directly be considered as having access to the reduced WHT rate of 15% under article 10 of the amended DTT as a resident. 

Article 6 of the Amending Protocol provides a new paragraph replacing paragraph 6 of Article 13 of the DTT. This provision covers the disposal of shares by a person (an individual or company) resident in one Contracting State but previously resident in the other State. 

If the other State has taxed the latent capital gains on the shares upon exit, the new State of tax residence would then have to compute the taxable gain on the basis of the value used upon exit in the other State, provided that such a basis does not exceed the fair market value. In other words, the new State of tax residence would only tax a potential incremental gain.

Germany was already applying the credit method to specific types of income (e.g. capital gains on the shares of land-rich companies) based on the previous DTT. The Amending Protocol now provides that Germany also applies the credit method to items of income or elements of capital whose taxation right is allocated to Luxembourg under the DTT, but which are not effectively taxed in Luxembourg.

Whilst such a clause was inserted in several double tax treaties concluded by Germany, the interpretation of this concept of “effectively taxed” may in practice trigger extensive discussions.

You would find some clarifications in the Amending Protocol³ as well as useful examples on employment income in the Mutual Agreement⁴ and in the Circular. However, it remains relatively unclear to which extent an income (other than the specific income always subject to the credit method) whose taxation right is attributable to Luxembourg based on the DTT, but which is in practice tax exempt based on Luxembourg domestic law (for example, under the participation exemption regime), would be considered as “effectively taxed”.

We recommend monitoring this topic going forward.

In practice, we expect potential areas of risks in situations where an income is subject to the credit method in Germany but it is also not exempt under German domestic law.

The Preamble has been amended in accordance with the MLI and now provides that the DTT intends to eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance (including through treaty-shopping arrangements). 

Article 12 of the Amending Protocol has incorporated the PPT as provided by the MLI into Article 27 of the DTT. As a result, a benefit under the DTT should be denied if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining the benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, 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 DTT.