As published on: mondaq.com, Thursday 3 August, 2023.
On 6 July 2023, Luxembourg and Germany signed an amending protocol ("the Protocol") to the Germany - Luxembourg double tax treaty ("DTT") signed in 2012. The Protocol introduces both amendments to the DTT and amendments to the Protocol to the DTT also signed in 2012 (the "2012 protocol") currently in force.
The Protocol mainly extends the tolerance threshold for cross-border workers from 19 to 34 days under the DTT, incorporates into the DTT the options taken by the two countries to implement the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting ("MLI"), amends the provisions applicable to treaty benefits for investment funds and adapts the current provisions of the DTT in order to take into account some recent German tax law changes (dealing with e.g. Real Estate Investment Trusts, "REITs").
We provide hereafter an overview of the changes to be introduced by the Protocol for corporate taxpayers, investment funds and cross-border workers.
New Preamble and Principal Purpose Test
In line with the latest version of the OECD Model Tax Convention and the MLI a preamble has been included in the DTT to clarify that the aim of the DTT is the elimination of double taxation with respect to taxes on income and on capital without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance (including through treaty-shopping arrangements).
In addition, the Protocol adds the principal purposes test ("PPT") into the DTT in accordance with Actions 6 and 15 of the Base Erosion and Profit Shifting ("BEPS") Action Plan. Under the PPT, a DTT benefit will be denied if it is reasonable to conclude that obtaining that tax benefit was one of the principal purposes of any arrangement or transaction (subjective test). However, DTT benefits will still be granted if it can be demonstrated that granting such benefits, in the circumstances at hand, would remain in accordance with the object and purpose of the relevant provisions of the DTT (objective test). Given the complexity in interpreting and applying this provision which will have to be read in conjunction with EU law (as defined on several occasions by the Court of Justice of the EU), it is recommended to seek advice from a tax adviser when setting up cross-border investment structures.
As far as persons covered are concerned, the Protocol adds a new provision to Article 1 of the DTT according to which tax transparent entities (partnerships) are excluded from the qualification of person for DTT purposes. Nevertheless, the DTT can be applied by either German or Luxembourg residents to income derived through a transparent entity subject to the condition that the tax transparent treatment of the partnership is also recognised by the State in which the recipient is resident. This provision is in line with the latest version of the OECD Model Tax Convention and is a mere clarification of the concept of tax transparency that is already applied in practice by both countries.
In case income derived by a resident of one of the contracting states through an entity that is located in the other contracting state is taxed in both states, because the first mentioned state considers the entity as tax transparent, while the other contracting state considers the entity as opaque (non-transparent), then the tax authorities of both states shall consult each other in the context of a mutual agreement procedure to find a suitable solution to avoid the double taxation. This is clarified by means of an amendment to the 2012 protocol.
Given that mutual agreement procedures can be very long, it is recommended to seek advice from a tax adviser to confirm whether an entity is considered as tax transparent or tax opaque in both jurisdictions in order to avoid diverging qualifications of entities which may cause double taxation.
The current DTT provides for a withholding tax ("WHT") rate of either 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% for dividends. The Protocol does not amend these WHT rates. However, in order to clarify that certain dividend distributions can only benefit from the 15% WHT rate, the Protocol amends Article 10 of the DTT and specifies that dividends paid by a German REIT-Aktiengesellschaft ("REIT-AG") or by a Luxembourg real estate company, which, from a tax point of view, essentially corresponds to a German REIT-AG, cannot benefit from the 5% WHT rate but only from the DTT rate of 15%. The same applies to dividends paid to an undertaking for collective investment ("UCI"), which can also only benefit from the 15% WHT rate.
The dividend definition is also amended to clarify that the distributions made on units issued by a UCI qualify as dividends and are therefore covered by the rules laid down in Article 10 of the DTT.
Finally, the Protocol clarifies that dividends derived by a resident of one of the contracting states through entities that are considered as tax transparent by that state should be treated for WHT purposes as if that resident had received the dividends directly. Therefore, if a Luxembourg company holds, via a foreign partnership that is considered as tax transparent by Luxembourg (e.g. a UK LP), at least 10% in the capital of a German GmbH, and receives dividends from that GmbH, it should benefit from the 5% WHT rate provided by Article 10 (2) of the DTT (subject to also successfully navigating the applicable anti-abuse and anti-treaty shopping rules pursuant to German domestic tax law and the PPT).
The existing clause in the DTT, according to which interest payments can only be taxed in the state of residence of the recipient and not in the source state, has been amended to clarify that this only applies to the extent the recipient is the beneficial owner of the interest.
As neither Luxembourg nor Germany levy WHT on interest, the application of this clause should be limited in practice.
Amendment of the provisions of the 2012 protocol dealing with treaty benefits for undertakings for collective investment (UCIs)
The 2012 protocol to the DTT already provided for rules concerning investment funds and investment companies and their entitlement to the DTT benefits arising from Articles 10 (i.e. reduced WHT on dividends received) and 11 (i.e. no taxation at source on interests received) of the DTT. This provision has been entirely redrafted and is replaced by the new Protocol, which now provides for treaty benefits for UCIs. According to the new Protocol, UCIs are considered as tax resident in the contracting state in which they are established and as the beneficial owners of the income they realise for the purpose of the DTT. However, this applies only to the extent that the UCI has not been set up as a partnership.
For the purposes of the DTT, the Protocol provides for a definition of UCIs as follows:
As mentioned above, UCIs set up in the form of a partnership are expressly carved out from the above definition. Thus, the question arises as to whether the Luxembourg common investment fund (fonds commun de placement, "FCP") will be considered as a UCI based on the new definition introduced by the Protocol. FCPs are considered as tax transparent for Luxembourg tax purposes, since the FCP is a contractual fund and has no legal form, but as tax opaque (non-transparent) from a German tax perspective. Even though FCPs are tax transparent for Luxembourg tax purposes, the FCP is not a partnership and it should therefore be covered by the new UCI definition. However, given the amendment introduced by the Protocol to Article 10 of the DTT (dividends), according to which dividends derived by a resident of one of the contracting states through entities that are considered as tax transparent by that state should be treated for WHT purposes as if that resident had received the dividends directly, a look through approach would apply in certain cases where dividends are received through FCPs, and notably where a dividend is received by a Luxembourg resident through an FCP, which invests in a German Company. In such case, Germany would need to treat that dividend as if the Luxembourg resident had received it directly and would need to apply the reduced WHT rates provided by Article 10 of the DTT accordingly (i.e. the 5% WHT rate would apply if the Luxembourg resident investor is a company which holds, through the FCP, at least 10% of the capital of the German company paying the dividends). In the absence of Luxembourg resident investors, the FCP would be considered as tax resident and beneficial owner of the dividends it receives (because it is a UCI based on the Protocol) and should therefore be able to benefit from the 15% WHT rate on dividends received as soon as the Protocol enters into force. As FCPs are tax transparent pursuant to Luxembourg tax law, a Luxembourg company distributing dividends to an FCP would always apply a look through approach. For German resident investors in the FCP, this means that the Luxembourg company would apply a 5% WHT rate if the German resident investor is a company which holds, through the FCP, at least 10% of the capital of the Luxembourg company paying the dividends and 15% WHT in all other cases.
In addition, the definition of UCIs includes all investment funds within the meaning of the RAIF law of 23 July 2016, without making any distinction between the RAIF that is subject to the same tax regime as the Specialised Investment Fund ("SIF") and the SICAR-like RAIF that is subject to Article 48 of the RAIF law of 23 July 2016. The latter, if set up in a corporate form, is a fully taxable entity and should therefore already qualify as a resident in accordance with Article 4 of the DTT. However, as all RAIFs, including those set up in a corporate form and subject to Article 48 of the RAIF law of 23 July 2016, have been included in the definition of UCI, they can only benefit from the 15% WHT rate on dividends, and not from the 5% WHT rate.
As regards the other undertakings and the condition for them to be "widely held", neither the Protocol, nor the Commentary to the OECD Model tax Convention provide for a definition of the term "widely held". The fact that the Protocol makes reference to undertakings that may be widely held suggests that there is no obligation for an undertaking to be widely held, but the mere possibility to be widely held would be sufficient for an undertaking to qualify as UCI for the purposes of the DTT, provided of course that the other conditions listed above (diversified portfolio of securities, subject to investor protection regulation) are also met and that the two contracting states agree to consider that the undertaking is to be considered as a UCI under that definition.
The Protocol amends the last paragraph of Article 13 of the DTT concerning capital gains, providing specific rules applicable to the capital gains realised upon the alienation of shares where the alienator has changed his or her tax residence prior to the sale of the shares and has been subject to exit taxation in his or her former state of residence. In such case, the state in which the alienator is resident upon the sale of the shares shall determine the taxable capital gain on the basis of the value that the first-mentioned state has used for the purposes of the exit taxation (unless this value exceeds the fair market value of the shares as of the date of the sale), and can only tax the incremental increase in value of the shares after the change of the tax residence of the alienator.
As far as employment income is concerned, the rule remains that income derived by a resident of a contracting state from employment shall be taxable only in that state, unless the employment is exercised in the other contracting state. In other words, a German tax resident employed by a Luxembourg employer is taxed in Luxembourg on his or her employment income, but only to the extent that the work is performed in Luxembourg. Here, Germany was so far entitled to tax proportionally the salary earned by a German tax resident employed by a Luxembourg employer, if the employee performed his/her work either totally or partially in Germany or in a third country on more than 19 days per year. This threshold has been increased by the new Protocol and Germany will not be able to challenge the taxation of the salary in Luxembourg as long as the number of days spent by the employee outside of Luxembourg does not exceed 34 days per year. This amendment is a welcome improvement to further adapt to a changing work environment, including the increased possibility to work remotely and aligns the rules applicable for German cross-border workers with those applicable to French and Belgian cross-border workers, to whom the 34 days threshold already applies.
Moreover, the Protocol clarifies the situation of employees working in the transportation of goods or persons, such as bus drivers, train drivers or train attendants, who cross the border several times per day and work both in Germany and in Luxembourg and even in third countries on a daily basis. Their salary will have to be split equally between all the countries which they work in (without taking into account the time effectively spent in each of the countries), and the part of the salary that is allocated to their residence state and to any third countries is taxable in their residence state, while the part of the salary allocated to the employment state is taxable in the employment state. A German resident bus driver working for a transportation company based in Luxembourg and driving on a working day through Germany, Luxembourg and France, will therefore be taxable in Germany for 2/3 of his or her salary earned for that day and in Luxembourg for 1/3 of his or her salary earned for that day.
According to the Protocol, only the days the work has effectively been carried out on need to be taken into account (meaning that holidays or days of sick leave are not taken into account) for the determination of the 34 days threshold and work is only considered as performed in a country to the extent the employee performs his or her activity for at least 30 minutes in that country.
The Protocol also slightly amends Article 17 of the DTT, which relates to pensions. Based on the DTT, pensions received by a resident of a contracting state from the other contracting state are only taxable in the first-mentioned state. However, according to the Protocol, pensions paid by Germany, and which are attributable in whole or in part to contributions which did not form part of the taxable income or were taxdeductible or tax-relieved in some other way in Germany, shall be taxable only in Germany, unless the tax relief was clawed back for any reason.
Methods to avoid double taxation
Germany generally applies the exemption method, with certain limits, to avoid double taxation. The exemption, however, does not apply in case Luxembourg applies the provisions of the DTT to exempt the income or capital from tax. In addition to the items of income which Germany already applies the credit method to as per the current DTT, Germany will also apply the credit method if Luxembourg taxes income or capital in application of the DTT but does not effectively tax such income or capital. According to the Protocol, an item of income or capital is "effectively taxed" if it is included in the taxable base based on which the tax is computed. It is however unclear whether this means that an income that is included in the taxable base but benefits from an exemption would be considered as "effectively taxed". It remains to be seen how the German tax authorities will apply this definition in practice.
Moreover, the already existing exemption of dividend income derived by a German resident company from a Luxembourg resident company in which the German company directly holds at least 10% of the share capital continues to apply. However, the Protocol clarifies that this exemption does not apply to dividends distributed by a tax-exempt entity, nor to dividends that have been tax deductible in Luxembourg at the level of the distributing company. This latter limitation should however already apply based on domestic law since 2016, as it has already been introduced by the Council Directive 2014/86/EU, which amended the EU Parent-Subsidiary Directive accordingly and had to be transposed by all Member States into domestic law by 31 December 2015.
Luxembourg generally applies the exemption method. However, the credit method applies to dividends, royalties and income of artists and sportsmen. Luxembourg also applies the credit method to income from employment, where Germany has the right to tax such income (i.e. in case of cross-border workers working more than 34 days from Germany or abroad) but does not effectively tax such income.
Mutual agreement procedure and arbitration
The Protocol abolishes the last paragraph of Article 24 of the DTT, which provides for an arbitration procedure, in case both contracting states were unable to reach an agreement to resolve a case that has been submitted to the mutual agreement procedure ("MAP") within two years from the presentation of the case. The MAP remains however applicable and can be used in case a taxpayer has suffered double taxation that is not in accordance with the provisions of the DTT.
However, if the competent authorities of both states do not find an agreement after two years, it is no longer possible to submit the case to the arbitration procedure, meaning that the MAP may last for more than two years and the case may eventually remain unresolved, as the contracting states are not obliged to find an agreement under the MAP, but shall merely endeavour to resolve by mutual agreement any difficulties or doubts arising as to the interpretation or application of the DTT.
The abolishment of the arbitration procedure is surprising considering that Germany, when ratifying the MLI, had reserved the right not to apply the arbitration procedure included in the MLI to all of its double tax treaties that already provide for mandatory binding arbitration of unresolved issues arising from a MAP case, including the DTT with Luxembourg. Now that the paragraph of Article 24, which provides for the arbitration procedure, is abolished, the question arises as to how this impacts the reservation made upon ratification of the MLI. It remains to be seen if clarifications regarding the reason for the abolishment of the arbitration procedure will be provided in the commentaries to the law once the draft law ratifying the Protocol is issued.
In practice, both Luxembourg and Germany have also implemented the Council Directive (EU) 2017/1852 of 10 October 2017 on tax dispute resolution mechanisms in the European Union, which provides for a MAP amongst Member States in case of double taxation disputes arising from the interpretation and application of agreements and conventions that provide for the elimination of double taxation of income and, where applicable, capital. This Directive also provides for an arbitration procedure (in the form of an Advisory Commission) that can be launched by the taxpayer in case the competent authorities of the Member States cannot find an agreement under the MAP. Therefore, even though the arbitration procedure as per the DTT has been abolished, it will still be applicable in case a MAP is launched in accordance with the aforementioned Directive. However, if a taxpayer has submitted a request for a MAP in application of Article 24 of the DTT, which is not resolved by the contracting states, it cannot directly request the set-up of an Advisory Commission, but it will first have to launch another MAP under the domestic law implementing the Directive. Given that a MAP can only be requested within three years from the receipt of the first notification of the action resulting in taxation not in accordance with the provisions of the DTT, it may in practice be preferable to directly submit a request for a MAP in application of the Directive rather than in application of Article 24 of the DTT.
Entry into force
The new Protocol will enter into force as soon as it has been ratified by both Luxembourg and Germany. For that purpose, on 28 July 2023, the Luxembourg government launched the ratification process by approving a draft law in order to ratify the new Protocol.
It will apply: