BEPS - When are Luxembourg's tax treaties going to change?

One of the main outcomes of the OECD/G20 Base Erosion and Profit Shifting (BEPS) Project, agreed three years ago, was that the global network of tax treaties needed revamping. The aim was that tax treaties, while continuing to encourage economic development by preventing double taxation, should cease to be tools that were handy for aggressive tax planning, and instead act clearly to prevent such activity.

The BEPS Project came up with all the revised recommended tax-treaty wording to ensure that this objective would be fulfilled – it now forms part of the latest edition of the OECD's Model Tax Convention on Income and on Capital, published in December 2017. This OECD Model Convention has been the "cut-and-paste" template for the majority of bilateral double tax treaties negotiated or renegotiated since the 1960s. Since it also contains a very detailed and helpful commentary on the updated model, which incorporates the BEPS Project’s recommendations, it should be on the bookshelf of everyone dealing with issues related to international tax.

However, the question remained: how were these recommendations going to be implemented? The OECD saw that if countries were simply left to renegotiate bilaterally the approximately 3,500 double tax treaties forming the global network, this was not going to take years, but decades. The solution that the BEPS Project came up with was the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (the "MLI"). The concept was that every country that had committed to the BEPS Project - now over 120 - would sign the MLI, thus agreeing that their tax treaties with all other signatory countries would then operate as having been modified by the clauses set out in the MLI.

In practice, things are not quite so simple - every country has the right to opt out of many of the clauses or, in other areas, choose one of several ways for a specific clause to work. Several clauses - including the most important ones targeting the abuse of treaties - do not provide opt-outs. Even so, countries can make certain choices, as long as they achieve the overall aims of the BEPS Project. The MLI is thus a complex, 48-page agreement - longer than most of the tax treaties it modifies!

A key indication of the amount of political will in many countries to tackle tax avoidance has been the enthusiasm shown for signing the MLI. The OECD organised a mass signing ceremony in Paris in June 2017. 68 countries signed the MLI and submitted papers detailing their opt-outs and choices. There are currently 84 signatory countries, and another 6 countries have declared that they are going to sign. All 28 EU countries (including Luxembourg, one of the original Paris signatories) have now signed. However, a notable absence from the list is the USA.

So, does this mean that Luxembourg’s tax treaties now apply all the anti-BEPS measures set out in the MLI? Well, Rome wasn’t built in a day, and changes to tax treaties cannot happen overnight. The road to having all the changes actually in effect is a long and winding one.

Luxembourg has begun to make its way down this road. Since tax treaties are part of tax law, they need to be ratified. In Luxembourg, this requires Parliament to vote, in the same way as for any other change to the law. The draft legislation needed to ratify the MLI - Bill No. 7333 - was published on 3 July 2018. This Bill, which contains two articles and is only half a page long, approves the MLI based on Luxembourg’s choices and opt-outs as filed with the OECD upon signature. However, at the time of writing, this is as far as things have progressed and, following the election on 14 October 2018, the vote on this Bill cannot occur until Luxembourg's new government is in place. Nevertheless, it should be noted that Luxembourg is not really lagging behind in this respect - the latest OECD report shows that only 15 countries (including Austria, France, Japan, Poland, Sweden and the UK) have so far told the OECD that they have ratified the MLI.

So, what happens after ratification? At this point, the MLI sets out its own timetable. Let us assume that the new Luxembourg government votes to approve Bill No. 7333 in December 2018, and notifies the OECD before 31 December that this has been done. The next step is for the MLI to enter into force, which will happen on a country-by-country basis. In cases where Luxembourg has a tax treaty with a country that has already ratified the MLI (and notified the OECD of this) before Luxembourg, the MLI will enter into force at the beginning of the fourth month after Luxembourg notifies the OECD of its ratification. So, in our example, this would mean that entry into force, although only between these “early ratifier” countries (e.g. the UK, as stated above) and Luxembourg, would be on 1 April 2019.

For Luxembourg's tax-treaty partner countries that ratify after Luxembourg, the date on which the partner country notifies the OECD that it has ratified the MLI is the decisive one. As an example, let us assume that, as well as Luxembourg ratifying in December 2018, China notifies the OECD in mid-March 2019 that it has ratified the MLI. The MLI then enters into force between Luxembourg and China on 1 July 2019, i.e. the beginning of the fourth month after China, being the later of the two countries involved, has notified the OECD.

Even so, there is another delay before the MLI measures enter into effect. It is here that the complex choices offered by the MLI could make a big difference in the timing. However, the general rule is as follows.

If MLI provisions affect a flow (e.g. of dividends or interest, etc.) which involves withholding taxes, then the MLI is effective for any event that causes a withholding tax obligation to arise (often, a payment of the flow) taking place on or after 1 January of the year following the date of entry into force. So, for example, one effect of the MLI could be to cause some interest payments from both the UK and China to Luxembourg to be no longer eligible for tax treaty benefits (i.e. a low, or nil rate of withholding tax). For flows to both countries, based on the timing assumptions noted above, any higher non-treaty rates of withholding tax would, in each case, apply from 1 January 2020. This is because the MLI entered into force between Luxembourg and both the UK and China over the course of 2019.

For any other taxes affected by the MLI measures, the general rule is that the MLI is effective for taxable periods beginning six months or more after entry into force. As a result, for the China example noted above, entry into force on 1 July 2019 would mean that the MLI measures affecting taxes other than withholding taxes would apply to a taxpayer's taxable periods beginning on or after 1 January 2020.

In conclusion, it currently looks as if the MLI will not really begin to affect how Luxembourg's tax-treaty network operates until 1 January 2020. However, assuming (as is reasonable) that, by 30 June 2019, many more countries will have worked through the legislative process of ratification, 1 January 2020 could well see a sizeable proportion of Luxembourg's tax-treaty network becoming subject to the new post-BEPS MLI regime and provisions.

Chief among these provisions is the new tax treaty article regarding "entitlement to benefits". For Luxembourg’s tax treaties, this will introduce the Principal Purposes Test (PPT), denying treaty benefits where obtaining a treaty benefit was one of the principal purposes of any arrangement resulting in that benefit. In other words, “if you did this to try to get treaty benefits, then you don’t get treaty benefits”.

For the Luxembourg private equity sector, this new PPT is of enormous importance. Any structure that cannot demonstrate that it exists for mainly commercial reasons is at risk of suffering withholding tax leakages at non-treaty rates (often above 20%) on interest or dividends flowing to Luxembourg, or of seeing countries where investments are made claiming the right to tax exit gains accruing to Luxembourg shareholders. By 1 January 2020, the era of "super-substance" will have truly begun.

Contact us

Vincent Lebrun

Private Equity Leader, PwC Luxembourg

Tel: +352 49 48 48 3193

David Roach

Director, PwC Luxembourg

Tel: +352 49 48 48 3057

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