ACE Magazine, October 2017

Luxembourg signs MLI: Detailed analysis of reservations and options taken

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1. Executive summary

On 7 June 2017, Luxembourg (together with 67 other jurisdictions) signed the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (the MLI). One of the main purposes of the MLI is to enable countries to meet the treaty-related minimum standards that were agreed as part of the final Base Erosion and Profit Shifting (BEPS) package, i.e., the minimum standard for the prevention of treaty abuse under Action 6 and the minimum standard for the improvement of dispute resolution under Action 14. The MLI also contains a number of alternatives or optional provisions that generally will apply only if all contracting states to a Covered Tax Agreement affirmatively choose to apply a particular alternative or option.
At the time of signature, signatories submitted a list of their tax treaties in force that they would like to designate as Covered Tax Agreements (CTAs), i.e., to be amended through the MLI. In addition, signatories submitted a preliminary list of their reservations and notifications (MLI positions) in respect of the various provisions of the MLI. The definitive MLI positions for each jurisdiction will be provided upon the deposit of its instrument of ratification, acceptance or approval of the MLI.
Luxembourg has made partial or full reservations against a number of articles of the MLI. These reservations are discussed in more detail below, together with the options chosen by Luxembourg where a provision of the MLI allowed for a choice to be made. The most important changes that will affect all of Luxembourg’s tax treaties relate to the introduction of a principal purpose test (PPT) and an amendment of the preamble that states that the relevant tax treaty is not intended to create opportunities for non-taxation or reduced taxation.
Luxembourg is one of only 25 countries that decided to apply mandatory binding arbitration.

 

2. Background

Luxembourg was one of 68 jurisdictions to sign the MLI during a signing ceremony hosted by the Organisation for Economic Co-operation and Development (OECD) in Paris on 7 June 2017. Two more jurisdictions signed the MLI shortly after and seven more jurisdictions expressed their intent to sign the MLI in the near future. The signing ceremony marks another key milestone in the BEPS project, in particular with respect to the implementation of the treaty-related BEPS minimum standards. The OECD has published on its website the list of signatories and country-specific files containing an overview of the CTAs and reservations and notifications as filed as of 11 July by those countries.
The MLI contains some minimum standard provisions for which a right to opt-out only exists to the extent the CTA already includes a similar minimum standard.

The MLI also contains a number of alternatives or optional provisions that generally will apply only if all contracting states to a Covered Tax Agreement affirmatively choose to apply a particular alternative or option. Many of these provisions are only applicable if both contracting states to a bilateral tax treaty do not make a reservation against the provision. However, for some specific articles, contracting states may choose different options resulting in an asymmetrical application of this provision. The definitive MLI positions for each jurisdiction will be provided upon the deposit of its instrument of ratification. Once a country has ratified the MLI, reservations can no longer be introduced or broadened, but reservations may be withdrawn or limited before and after ratification.

This article summarizes the positions taken by Luxembourg.

 

3. Luxembourg positions

3.1. Covered Tax Agreements (CTAs) 

Jurisdictions signing the MLI had to provide a list of tax treaties that they would like to designate as CTAs, i.e. treaties to be amended through the MLI. The list of CTAs provided by Luxembourg contains all the 80 tax treaties concluded by Luxembourg that are currently in force (and the new treaty with Senegal that has been ratified by Luxembourg). However, the extent to which these treaties will be amended as a result of the MLI depends on whether or not the other treaty partner signed the MLI as well (and what reservations and options were taken by the treaty partner). As at the date of writing, 23 of Luxembourg treaty partners have not signed the MLI, most importantly the United States. [1]

 

3.2. Reservations and options taken by Luxembourg

3.2.1. Hybrid mismatches

3.2.1.1. General

Part II of the MLI (articles 3 to 5) introduces provisions which aim to neutralize certain of the effects of hybrid mismatch arrangements based on the recommendations made in the BEPS Action 2 and 6 Final Reports released in October 2015. The provisions cover hybrid mismatches related to transparent entities, dual resident entities and elimination of double taxation. These provisions are not minimum standard provisions and therefore Contracting Jurisdictions have the right to opt to not apply these provisions to their covered tax treaties.

 

3.2.1.2. Transparent entities (article 3 MLI)

Article 3 addresses the situation of hybrid mismatches as a result of entities that one or both Contracting Jurisdictions treat as wholly or partly transparent for tax purposes. The provision will apply in all cases in which all the parties to a CTA agree on its application.
Luxembourg decided to apply paragraph 1 of article 3, which clarifies that income derived by or through an entity or arrangement that one of the contracting states considers as wholly or partly fiscally transparent will be treated as income of a resident of a contracting state, to the extent it is treated as income of a resident of that contracting state for taxation purposes in that contracting state. Luxembourg-source dividends, for example, that are derived by a foreign partnership would be able to benefit from the withholding tax reduction under a tax treaty provided the partners of the partnership are subject to tax on the Luxembourg-source dividend in the other contracting state.
The inclusion of this paragraph in Luxembourg treaties may be welcomed as it clarifies that look-through treatment may also be applied for tax treaty purposes. Its application to a specific CTA will require the other contracting party to have made the same choice.
Luxembourg reserved its right not to apply paragraph 2 of article 3. That provision would result in CTAs not providing relief for double taxation where the other State’s tax is levied solely on the basis of residence (of the partners). There may be situations where this results in unrelieved double taxation which may explain Luxembourg’s reservation.
Luxembourg is among the majority of jurisdictions that have made a full or partial reservation to article 3. While it is only one of four countries that reserved their right not to apply article 3 (2), another 43 countries opted out of article 3 in its entirety.

 

3.2.1.3. Dual resident entities (article 4)

This provision would replace the current tie-breaker rules applicable to dual-resident companies (which typically consider the country where the place of effective management is situated as the residence country) by a mutual agreement process. Luxembourg is one of 40 countries that have made a full reservation against this article, which means that existing tie-breakers would continue to apply. Typically this would mean that the state where the place of effective management is situated will continue to be considered as the residence state.

 

3.2.1.4. Methods for Elimination of Double Taxation (article 5)

Article 5 allows signatories to choose between applying one of three different options, but also allows them to choose to apply none of the options. Where contracting states to a CTA choose different options, the option chosen by a contracting state would apply to its own residents only.
While 30 jurisdictions chose to make a complete reservation to this article, Luxembourg (together with four other jurisdictions) has chosen option A. Under that option, Luxembourg would not grant an exemption otherwise foreseen in the CTA where the other contracting state applies the provisions of the CTA to exempt such income or capital from tax or to limit the rate at which such income or capital may be taxed. Instead, Luxembourg would grant a tax credit for the foreign tax on the income or capital (within the ordinary limits that apply to tax credits in Luxembourg). This amendment would apply to all the 80 agreements that are currently in force.
By choosing this option Luxembourg appears to address situations where income is subject to double non-taxation, such as income attributable to a “hybrid” permanent establishment (PE), i.e., an arrangement treated as giving rise to a PE in one country but not in the other (source) country, that is not subject to tax in the source country but derives interest income from the source country.
At first blush, one may get the impression that the chosen option may also result in the dividend exemption under Luxembourg tax treaties being denied. A number of tax treaties concluded by Luxembourg specifically provide that dividends are exempt from Luxembourg tax provided certain minimum holding requirements are met. Where the other contracting state applies the tax treaty to reduce withholding taxes on the dividend payment, one may think that this exemption would no longer apply as a result of option A. However, according to the explanatory statement to the MLI [2]  the denial of the exemption is “based on Article 23A(4) of the OECD Model Tax Convention, as described in paragraph 444 (pages 146-147) and Note 1 (page 149) of the Action 2 Report [3]”.  According to the Commentaries to the OECD Model Tax Convention, the purpose of para. 4 of Article 23A is to “avoid double non-taxation resulting from disagreements between the Contracting States on the facts of the case or on the interpretation of the provisions of the Convention. In particular, article 23A(4) provides that in  such a situation the residence state is not bound to exempt the income as provided under article 23A(1) [4].”  Where the payment is considered a dividend by both contracting states, there would not be a disagreement as to the facts of the case or the interpretation of the provisions of the Convention. As a result, art. 23A (4) of the OECD Model Tax Convention would not be applicable to such situations. As a result, in the authors’ view dividend exemptions under tax treaties would not be affected by option A (provided the source country also considers the payment to be a dividend). 

Luxembourg has also chosen to reserve the right not to permit certain identified contracting states to apply option C to treaties with Luxembourg. Option C provides in relation to income or capital that may be taxed in a contracting state that the other contracting state applies the credit method to avoid double taxation, rather than the exemption method. The list of contracting states that Luxembourg chose not to allow to apply option C in its treaties with Luxembourg consists of CTAs with 20 countries, including Belgium, France, Germany, the Netherlands and Switzerland.  [5]

3.2.2. Treaty abuse


3.2.2.1. General

Part III of the MLI (articles 6 to 13) contains six provisions related to the prevention of treaty abuse, which correspond to changes proposed in the Report on Action 6 (Preventing the Granting of Treaty Benefits in Inappropriate Circumstances). In particular, the Report contains provisions relating to the so-called “minimum standard” aimed at ensuring a minimum level of protection against treaty shopping (article 6 and article 7 of the MLI).

3.2.2.2. Purpose of a CTA (article 6)


All treaties concluded by Luxembourg (with the exception of the treaty with Senegal, which already has an equivalent provision) will be amended to include the following preamble text:
“Intending to eliminate double taxation with respect to the taxes covered by this agreement without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance (including through treaty-shopping arrangements aimed at obtaining reliefs provided in this agreement for the indirect benefit of residents of third jurisdictions),”.
This provision is a minimum standard and no reservations could be made against it. It is a significant change compared to current tax treaties, which apply (in the absence of specific exclusions) also to situations where a double taxation is merely possible, without the need for there to be actual double taxation. At the same time, to what extent this amendment will result in an actual change in a specific situation will have to be analyzed on a case-by-case basis.
In addition to the above change, Luxembourg also opted to include in all of its agreements specific language referring to a desire to develop an economic relationship or to enhance cooperation in tax matters.

3.2.2.3. Prevention of treaty abuse (article 7)
 

All treaties concluded by Luxembourg (with the exception of the treaty with Senegal, which already has an equivalent provision) will be amended to include a “principal purpose test” (PPT). It is not possible to make a complete reservation against this provision and countries could only choose between (i) the PPT, (ii) a detailed limitation on benefits (LOB) provision modeled on the one contained in the US Model Tax Treaty supplemented by specific rules targeting conduit financing arrangements (which are not provided for in the MLI), or (iii) or a combination of PPT and a simplified LOB provision. Where the other contracting state has not opted for the PPT, but for a detailed LOB provision, the MLI would not result in a direct change of the relevant tax treaty and the two states “shall endeavor to reach a mutually satisfactory solution” that meets the BEPS minimum standard. If the other contracting state has opted for a simplified LOB provision, but Luxembourg does not affirmatively agree to the simplified LOB application by the other contracting state, only the PPT can be applied.
The PPT is worded as follows:
“Notwithstanding any provisions of a CTA, a benefit under the CTA shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that 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 Covered Tax Agreement.”
Luxembourg is one of 26 jurisdictions that opted to include a competent authority relief provision, under which a person that is denied the benefits of a CTA may still be granted the benefits of the CTA as a result of a decision by the competent authority, “if such competent authority […] determines that such benefits would have been granted to that person in the absence of the transaction or arrangement.” Granting treaty access in these circumstances requires consultation with the competent authority of the other contracting state.
A PPT analysis will be very case-specific. It is not a substance-test, but refers to the purpose of an arrangement or transaction. Where treaty access is relevant, it will therefore be important to document the purpose and intention of a transaction.
The Action 6 report contains a number of examples that are intended to explain what arrangements or transactions would be considered as having tax as one of their principal purposes. However, in a number of cases these examples cover rather obvious situations, while other cases are not addressed. As a result, there is a certain degree of uncertainty as to what would be considered to have tax as one of the principal purposes. Moreover, there will not be a uniform interpretation of the PPT. For countries that have already applied a PPT-like domestic abuse provision to treaty situations before the MLI the PPT will not result in a significant change. Other countries may have been less focused on anti-abuse or may have considered that anti-abuse provisions cannot be applied in a treaty context and for these countries the inclusion of the PPT in their CTAs will now potentially lead to a change in treaty practice. This would seem to include Luxembourg, which has made a general reservation to the application of anti-abuse provisions in its tax treaties. [6]  Whether there will be a difference in the Luxembourg application of PPT compared to the application of the domestic anti-abuse provision of art. 6 StAnpG will have to be seen, particularly as PPT would only require tax to be “one of the principal purposes” while art. 6 StAnpG would seem to be applicable only where tax is the main driver.

3.2.2.4. Dividend transfer transactions (article 8)


This provision is intended to deal with abuse in relation to dividend withholding tax exemptions or reductions by among other things introducing a minimum holding period. Luxembourg has made a full reservation against this article, as have 43 other jurisdictions. No explanation is given, but possibly it was felt that the amendment to the preamble  [7] together with existing safeguards were sufficient to deal with such transactions. The article requires approval by both contracting states, which means that no change to the dividend withholding tax provisions of Luxembourg tax treaties is expected as a result of the MLI.

3.2.2.5. Capital gains from alienation of shares in “real estate-rich companies” (article 9)


Luxembourg has made a reservation against the amendment of existing provisions of CTAs that allocate the right to tax capital gains from shares in “real estate-rich companies” to the country where the real estate is situated. Article 9 would allocate the right to tax such gains if a relevant value threshold is met at any time during the 365 days preceding the sale, and would require that the rule is expanded to apply to shares or comparable interests such as interests in a partnership or trust. Luxembourg is one of 36 countries that have made a full reservation to this article.
As a result of the Luxembourg reservation, the existing provisions will remain in place and will not be amended to include reference to partnership interests or trusts. Luxembourg has also not opted to include a specific rule for real estate-rich companies in those CTAs that currently do not contain such clause. Under this rule, capital gains realized on shares in entities deriving their value principally from immovable property is taxable in the state where the immovable property is situated (and not in the seller’s state of residence). This would have been an “opt-in” provision, which Luxembourg decided not to pursue. The reason for this may be that the relevant existing tax treaties have already been amended or are in process of being amended to address land-rich companies.

3.2.2.6. Third-country PEs (article 10)


This provision deals with situations where an enterprise of one contracting state has a PE in a third country to which income from the other contracting state is allocated and exempt from tax in the first-mentioned state (triangulation situations). If the income is taxed at a low rate (less than 60% of the tax that would be imposed in the jurisdiction of the head office), the benefits of the treaty will not apply. Instead, the income remains fully taxable according to the domestic law of the other contracting state. The provision is modeled on the “triangulation clause” found in US treaties.
Luxembourg reserved its right not to apply this provision, as did 45 other jurisdictions. Only 19 states did not make any reservations with respect to this article.

3.2.2.7. Restrictions to taxing own residents (article 11)


Luxembourg (and 45 other countries) reserved its right not to apply a provision according to which a tax treaty would not restrict the rights of Luxembourg to tax its own residents, with certain exceptions.

3.2.3. Recognition of a PE (articles 12-14)


Part IV of the MLI (articles 12 to 15) describes the mechanism by which the PE definition in existing tax treaties may be amended pursuant to the BEPS Action 7 Final Report to prevent the artificial avoidance of PE status through: (i) commissionaire arrangements and similar strategies (article 12); (ii) the specific activity exemptions (article 13); and (iii) the splitting-up of contracts (article 14). Article 15 of the MLI provides the definition of the term “closely related to an enterprise,” which is used in articles 12 through 14 (which aim at expanding the PE definition by, inter alia, also considering activities of closely related enterprises).
Luxembourg made reservations on most of the changes dealt with in part IV (together with 38 or 44 other countries that made full reservations on article 12 or 14, respectively). Without these reservations, the threshold for the recognition of a PE would have been significantly lowered. As regards the provision dealing with specific activity exemptions (article 13), Luxembourg chose option B (as did six other countries). In essence, option B provides that a specific list of activities that was deemed not to constitute a PE in the CTA (prior to the MLI) will also not create a PE as a result of the MLI. This is irrespective of whether that activity is of a preparatory or auxiliary character (unless explicitly provided to the contrary in the relevant CTA). For any other activities carried out through a fixed place of business, it does become important, under option B, whether the activity is preparatory or auxiliary in nature. Of those other activities, only those that are preparatory or auxiliary in character are deemed not to constitute a PE.

3.2.4. Mandatory binding arbitration


As part of the options contained in the MLI, jurisdictions can opt into mandatory binding arbitration, an element of BEPS Action 14 on dispute resolution. Of the currently 70 jurisdictions that signed the MLI, 25 opted in for mandatory binding arbitration. Luxembourg is among these 25.  If the other contracting state also opted for mandatory arbitration, the Luxembourg tax treaty with that state would be amended to include mandatory arbitration, which would allow a person to request that a case on which the competent authorities are unable to find a mutual agreement under the mutual agreement procedure be submitted to arbitration. However, Luxembourg chose to not extend this possibility to those cases where a decision on the issue in question has been rendered by a court or tribunal of either contracting state before the arbitration decision. Luxembourg also chose to apply a provision that would allow the competent authorities to reach a different decision than the arbitration decision if such provision is reached within three months of the delivery of the arbitration decision.
The mandatory arbitration provisions of the MLI would not apply to those treaties that already contain an equivalent provision. In that case the existing arbitration provisions would continue to apply. 

4. Timing


The MLI will enter into force after five jurisdictions have deposited their instrument of ratification, acceptance or approval of the MLI. During the ratification process the choices made by jurisdictions may still change. With respect to a specific bilateral tax treaty, the measures will only enter into effect after both parties to the treaty have deposited its instrument of ratification, acceptance or approval of the MLI and a specified time has passed. The specified time differs for different provisions. For example, for provisions relating to withholding taxes, the entry into force date is the 1 January of the following year after the last party has notified its ratification. It is possible that the changes made as a result of being a party to the MLI would be effective in 2019, though it is theoretically possible that some tax treaties may be affected as early as sometime in 2018.

5. Implications

The expectation that 1,100 tax treaties would be modified as a result of currently 70 jurisdictions signing the MLI constitutes an unprecedented moment in international taxation. It is also a key milestone in the implementation of the treaty-based BEPS recommendations. Even though Luxembourg has made a number of reservations, the introduction of a PPT and a number of other changes will still result in an unprecedented wave of amendments to Luxembourg tax treaties.

 


 

[1] The treaty partners that have not signed the MLI are: Azerbaijan, Bahrain, Barbados, Brazil, Estonia,   Kazakhstan,, Macedonia, Malaysia, , Moldova, Morocco, Panama, Qatar, Saudi Arabia, Sri Lanka, Taiwan, Tajikistan, Thailand, Trinidad & Tobago, Tunisia, United Arab Emirates, United States of America, Uzbekistan and Vietnam. Three of these countries expressed their intent to sign the MLI in the near future, viz. Estonia, Panama and Tunisia.

[2] Explanatory Statement to the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS, para 61.

[3] Article 23A (4) of the OECD Model Tax Convention reads as follows: “The provisions of paragraph 1 [i.e. the exemption] shall not apply to income derived or capital owned by a resident of a Contracting State where the other Contracting State applies the provisions of this Convention to exempt such income or capital from tax or applies the provisions of paragraph 2 of Article 10 or 11 to such income.”

[4] Commentaries to Article 23 of the OECD Model Tax Convention, para 56.2

[5] The other states being Austria, Bulgaria, Estonia, Hungary, Iceland, Liechtenstein, Monaco, Morocco, Panama, Poland, Romania, San Marino, Saudi Arabia, the Seychelles, and Slovakia.

[6] “Luxembourg does not share the interpretation in paragraphs 9.2, 22.1 and 23 which provide that there is generally no conflict between anti-abuse provisions of the domestic law of a Contracting State and the provisions of its tax conventions. Absent an express provision in the Convention, Luxembourg therefore believes that a State can only apply its domestic anti-abuse provisions in specific cases after recourse to the mutual agreement procedure.” Para 27.6 Commentaries to article 1 OECD Model Tax Convention

[7] See 3.2.2.2. above