On 14 February 2019, the Luxembourg Chamber of Deputies voted to approve the OECD sponsored Multilateral Convention to Implement the Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (commonly referred to as the "Multilateral Instrument" or "MLI").
The MLI is an innovative, new multilateral approach to curb tax treaty abuse as part of the OECD's Base Erosion and Profit Shifting ("BEPS") initiative to close certain inconsistencies in bilateral tax treaties that gave rise to perceived tax treaty abuses.
The MLI will impact the use of tax treaties in international tax planning with a "principal purpose test" that may deny tax treaty benefits, such as reduced or eliminated withholding taxes, if there is not a sufficient business purpose (non-tax reason) or economic substance in the tax treaty jurisdiction.
The MLI is anticipated to enter into force in Luxembourg in autumn 2019 and would impact on withholding tax benefits as of January 2020.
In 2017, Luxembourg was one of the 68 original jurisdictions to sign the MLI, which is designed to allow each of the signatory countries to modify their existing network of bilateral tax treaties by signing one multilateral instrument, thus avoiding the cumbersome approach of each country having to renegotiate each of its bilateral tax treaties one at a time. Currently, there are 87 jurisdictions which have signed up to participate in the MLI.
Each signatory jurisdiction can choose to have all or some of its bilateral tax treaties apply to the MLI as a "Covered Tax Agreement" and Luxembourg has opted to have each of its 83 bilateral tax treaties as Covered Tax Agreements. However, for the MLI to apply the other bilateral tax treaty partner must also agree. The USA, for example, has now opted out of the MLI even though it signed the MLI originally.
The MLI will not replace the existing bilateral tax treaties but will nevertheless modify the content of such treaties as Covered Tax Agreements if both signatory jurisdictions to the bilateral tax treaty have also signed and ratified the MLI and opted specifically to apply the treaty to the MLI.
The MLI contains mandatory "minimum standard" provisions, which the signatory jurisdictions can only opt-out of if a similar minimum standard already exists in their domestic laws. The MLI also contains a number of alternatives that will only apply if both contracting states to a Covered Tax Agreement choose to apply the same options pursuant to the MLI.
The Principal Purpose Test
The most notable provision in the MLI's "minimum standard" is the Principal Purpose Test ("PTT") which denies treaty benefits (such as a reduced or zero rate of withholding tax on dividends, interest or royalties) if "...it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining such benefit was one of the principal purposes of the transaction."1The overwhelming majority of all MLI signatory jurisdictions including Luxembourg have opted for the application of the PPT for most of the Covered Tax Agreements.
The PPT is primarily targeted at shutting down so-called "treaty shopping", i.e. the use of holding companies and other structures in certain tax treaty jurisdictions mainly for obtaining tax treaty benefits, but without sufficient (non-tax) business reasons or economic substance.
The PPT has raised alarm bells among the international tax practitioner community in light of its somewhat subjective language, where if "one of the principal purposes" is to obtain treaty benefits, the PPT could be triggered and thus be used to deny the tax payer of any treaty benefits it would otherwise be entitled to under the relevant treaty. However, the OECD itself has provided examples where the PPT test may be satisfied based on valid and non-tax related business reasons provided that sufficient economic substance is in place. Whether the PPT is satisfied should be analysed on a case-by-case basis and is primarily facts driven.
Other significant changes to Luxembourg's tax treaty network in light of the MLI
The MLI's preamble text expands the purpose of bilateral tax treaties to include a new multilateral approach to not only prevent the risk of double taxation, but also to avoid creating opportunities for double non-taxation or tax evasion.
Under the MLI, the methods for the elimination of double taxation should also undergo changes. Notably, Luxembourg opted for the MLI to modify Covered Tax Agreements to avoid double non-taxation. Any exemptions foreseen by a Covered Tax Agreement should not be granted where both Luxembourg and the other contracting state exempts or limits the tax on the same income or capital and thus inadvertently causes a double exemption to arise (i.e. the treaty actually causes items of income to be taxed nowhere). For example, some of Luxembourg's bilateral tax treaties can inadvertently result in situations where a branch in a treaty partner country is not subject to tax in either treaty partner country, thus resulting in double tax exemptions on the profits of the branch. The MLI foresees that at least one of the parties to the bilateral tax treaty now has taxation rights. The MLI further provides for the availability of foreign tax credits in such situations to mitigate any double taxation risk that might arise from the reformed application of the tax treaty under the MLI.
Luxembourg opted to implement an MLI provision with the purpose of clarifying transparent entity treatment by providing a "look through" rule for transparent entities (e.g. partnerships). This allows for the ability to disregard the entity and look through to the ultimate beneficial owners who may then benefit from applicable tax treaty benefits such as reduced withholding taxes. Conversely, Luxembourg opted-out of the MLI's new tie breaker rules on dual-resident companies, thus the old tie breaker rules for dual-resident companies under Luxembourg's bilateral tax treaty will continue to apply.
Luxembourg also opted in to the MLI's mandatory binding arbitration arrangements in the event where the two treaty partners' competent authorities cannot reach an agreement to resolve conflicts of taxation arising under the applicable bilateral tax treaty using the mutual agreement procedure contained in the relevant treaty.
The MLI further provides for an updated recognition of a permanent establishment, which lowers the threshold of what constitutes a permanent establishment. However, Luxembourg opted-out of most of these provisions in order to maintain the pre-MLI (higher) threshold for creating a permanent establishment. Luxembourg did however opt in to "Option B" under the permanent establishment provisions. Option B provides a list of activities that will not constitute a permanent establishment irrespective of whether they are preparatory or auxiliary in nature.
What is the impact of the MLI on Luxembourg's existing tax treaty network?
The application of the MLI should be analysed on a case-by-case basis when applying its impact on any of Luxembourg's bilateral tax treaties. While 87 jurisdictions have signed the MLI, each jurisdiction has taken its own tailor-made approach to selecting which provisions of the MLI will apply and which articles in each of its bilateral tax treaties will be included in the MLI as "Covered Tax Agreements". In light of the complexity of keeping track of the thousands of "Covered Tax Agreements" in the MLI, the OECD has set up an online database called the "MLI Matching Database (beta)" for each "Covered Tax Agreement" and in order to summarise which provisions of the MLI actually apply (if any) to any particular bilateral tax treaty.
When is the MLI expected to enter into force?
The application of the MLI is dependent on each of the 87 signatory jurisdictions to both ratify the MLI and also deposit the ratification proof with the OECD. Each of the signatory jurisdictions are proceeding at differing paces and it is estimated that it will take several months (and in some cases years) for all of the signatory jurisdictions to go through the ratification and deposit process.
Any provision of the MLI impacting withholding taxes, such as the PPT denying reduced withholding taxes under a particular treaty, will not take effect until 1 January of the year following the ratification and deposit process. For Luxembourg and most MLI signatory jurisdictions this should be 1 January 2020.
As of 25 February 2019, only 21 of the total 87 signatory treaty jurisdictions had both ratified and deposited their MLI approvals with the OECD. Austria was the first country to achieve this on 22 September 2017. While many other jurisdictions such as France, Japan and the UK have all deposited with the OECD, others like Canada, Germany and several other EU Member States have not yet completed the deposit process. Luxembourg is expected to deposit its ratification documentation with the OECD by the end of February.
1 OECD/G20 BEPS Project, Preventing the Granting of Treaty Benefits in Inappropriate Circumstances – Action 6: Final Report.