On June 22, 2016, the United States and the Grand Duchy of Luxembourg announced that, as a part of ongoing negotiations, they have agreed to a specific change to the existing US-Luxembourg tax treaty (Announcement). This change would modify the existing so-called triangular provision to be consistent with the provision in the 2016 US Model Treaty. Accordingly, treaty benefits generally would be denied when a resident of one state earns income from the other state through a permanent establishment (PE) situated outside of the state of residence, and the resident is subject to a significantly lower tax rate on income attributable to the PE. In connection with the negotiation of amendments to the tax treaty, the Announcement indicates that the Grand Duchy of Luxembourg introduced a bill to its Parliament on the new triangular provision. It is expected that, if the US-Luxembourg tax treaty is amended by a protocol containing the new triangular provision, and if the protocol so provides, upon entry into force of such protocol, the new triangular provision would have effect for amounts paid or credited on or after the third day following publication in the Official Gazette in Luxembourg indicating that the bill has become law in Luxembourg.Importantly, the Announcement also acknowledges on-going negotiations are considering the amendment of a number of other provisions in the tax treaty.

Detailed discussion

The United States and the Grand Duchy of Luxembourg are currently negotiating a protocol to amend several provisions in the US-Luxembourg tax treaty (the Treaty), which entered into force on December 20, 2000. As part of those negotiations, the governments have agreed to modify the Treaty to eliminate double taxation without allowing for non-taxation or reduced taxation through tax evasion or avoidance.

According to the Announcement, the US Treasury Department and the Luxembourg Ministry of Fiscal Affairs became aware of cases in which US-source income is paid to Luxembourg residents, which is attributable to a US PE under Luxembourg tax law. At the same time, the income is treated as exempt from tax in the United States. As a result, the US-source income may be exempt from tax in Luxembourg and the United States.

Both countries agree that US taxing rights should not be reduced in these circumstances. Thus, as part of the negotiations to modify the existing Treaty to resolve this issue, the Grand Duchy of Luxembourg introduced Bill Number 7006 (Bill) to its Parliament. Specifically, the Bill provides, in part, that if the Treaty is amended by a protocol containing the provision below, and if the protocol so provides, upon entry into force of that protocol, the following provision would have effect for amounts paid or credited on or after the third day following publication of this law in the Official Gazette in Luxembourg:

"Where an enterprise of a Contracting State derives income from the other Contracting State, and the first-mentioned Contracting State treats that income as profits attributable to a permanent establishment situated outside of that Contracting State, the benefits of this Convention shall not apply to that income if:

a) the income that is treated as profits attributable to the permanent establishment is subject to a combined aggregate effective rate of tax in the first-mentioned Contracting State and the state in which the permanent establishment is situated that is less than the lesser of (i) 15% or (ii) 60% of the general statutory rate of company tax applicable in the first-mentioned Contracting State; or

b) the permanent establishment is situated in a third state that does not have a comprehensive convention for the avoidance of double taxation in force with the Contracting State from which the benefits of this Convention are being claimed, unless the first-mentioned Contracting State includes the income treated as profits attributable to the permanent establishment in its tax base.

However, if a resident of a Contracting State is denied the benefits of this Convention pursuant to this paragraph, the competent authority of the other Contracting State may, nevertheless, grant the benefits of this Convention with respect to a specific item of income if such competent authority determines that such grant of benefits is justified in light of the reasons such resident did not satisfy the requirements of this paragraph (such as the existence of losses). The competent authority of the Contracting State to which a request has been made shall consult with the competent authority of the other Contracting State before either granting or denying the request made under this paragraph by a resident of that other Contracting State."

This new provision is consistent with the triangular provision contained in Article 1(8) of 2016 US Model Treaty released in February 2016 (see Tax Alert 2016-386).

Implications

In general in the US, treaties and protocols amending existing treaties enter into force when the agreements have gone through the advice and consent procedures of the United States Senate and the President signs the instruments of ratification. The Announcement by the US and Luxembourg that the new triangular provision would have retroactive effect is unusual but not without precedent. In 2000, the US and Canada announced changes relating to the residence status of corporations that were effective as of the date of the announcement, notwithstanding that those changes where part of a protocol that entered into force several years after the date of the announcement.

Although it is not entirely clear, the Luxembourg Parliament may well vote on the Bill before it is set to adjourn for summer on July 18, 2016. Publication of the law in the Official Gazette in Luxembourg could take place as early as the last week of June 2016. Thus, the new triangular provision would have effect based on the date that the law is published in the Official Gazette, rather than the date that the protocol enters into force. The application of this new provision does depend, however, on its inclusion in the protocol and the protocol entering into force. Assuming that this is the case, the triangular provision would have retroactive effect based on the date that the law is published in the Gazette (for amounts paid or credited on or after the third day following publication) notwithstanding that the protocol might enter into force possibly several years from now.

The triangular provision is consistent with the 2016 Model Treaty, which introduced several new provisions and made changes to tighten many of the preexisting rules. Given that the governments are negotiating a protocol to amend a number of other provisions in the Treaty, at this stage it is unclear what other changes would be made, and whether they would be also be consistent with the 2016 Model Treaty. It will be important to continue to monitor these developments.

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