The Amended Luxembourg PE Definition: Is There Really Something New?

OUR INSIGHTS AT A GLANCE 

• The PE concept is relevant for both Luxembourg residents and non-residents. Where Luxembourg non-residents have a PE situated in Luxembourg, the profits attributable to this PE are subject to income tax (individuals) or corporate income tax (companies) and municipal business tax. Moreover, non-resident companies are subject to Luxembourg net wealth tax levied on the unitary value of their Luxembourg PE.
• As part of the 2019 tax reform, the PE definition has been extended to deal with foreign PEs of Luxembourg taxpayers. According to the new provision, the only criteria to be considered in order to assess whether a Luxembourg taxpayer has a PE in a country with which Luxembourg has concluded a tax treaty are the criteria defined in the applicable tax treaty. Accordingly, the PE definition included in the tax treaty will be relevant for the analysis as to whether a Luxembourg taxpayer has a foreign PE.
• On 22 February 2019, the Luxembourg tax authorities released a circular that provides further guidance concerning the interpretation of the permanent establishment (“PE”) concept in cases where Luxembourg taxpayers have a PE in a treaty country.
• The extended definition as it appears in the new paragraph 5 of Section 16 of the Fiscal Adaptation Law seems to merely confirm the requirements that already existed before the amendment of the Luxembourg PE definition. It may, however, be expected that the Luxembourg tax authorities will verify even more carefully than before whether the criteria of the PE definition in an applicable tax treaties are satisfied.

The 2019 tax reform implements the EU Anti-Tax Avoidance Directive (“ATAD”) and other Base Erosion and Profit Shifting (“BEPS”) related measures into Luxembourg tax law, including an amendment of the permanent establishment (“PE”) definition. The new provision concerns the interpretation of the PE concept in cases where Luxembourg taxpayers have a PE in a treaty country. On 22 February 2019, the Luxembourg tax authorities released a circular (the “Circular”) that provides further guidance in this respect. In this article, we analyse the content of the Circular and consider the practical implications of the amended PE definition.

Introduction

The concept of PE plays a prominent role in the tax treatment of cross-border business activities and is relevant for the application of both domestic tax law and tax treaties. However, the purpose of the PE concept is not the same for these respective areas of law.

Under Luxembourg tax law, the PE definition is mainly used to determine if a non-resident enterprise is subject to (corporate) income tax and municipal business tax on its profits realised through a Luxembourg PE. In contrast, the main purpose of the PE concept under tax treaties is to determine the right of a Contracting State to tax the profits of an enterprise which is resident in the other Contracting State. This is because according to Article 7 of the OECD Model Tax Convention on Income and on Capital (“OECD Model”), a Contracting State cannot tax business profits of enterprises resident in the other Contracting State unless it carries out its business through a PE located therein.

When an enterprise operates through a PE in the other Contracting State, Article 7 of the OECD Model allocates an unlimited primary taxing right to the host state of the PE. In this regard, the residence state of the enterprise has to adopt a method for the elimination of double taxation. With regard to Luxembourg taxpayers who have a PE in another Contracting State, Luxembourg frequently adopts the exemption method. Thus, Luxembourg is required to exempt profits that are attributable to a foreign PE.

Definition of PEs under Luxembourg tax law

Opening comments

The PE concept in Luxembourg tax law is defined in Section 16 of the Fiscal Adaptation Law that provides for a general PE definition (paragraph 1) and a non-exhaustive list of examples (paragraph 2) which are deemed to constitute a PE for Luxembourg tax purposes.

The PE concept is relevant for both Luxembourg residents and non- residents. Where Luxembourg non-residents have a PE situated in Luxembourg, the profits attributable to this PE are subject to income tax (individuals) or corporate income tax (companies) and municipal business tax. Moreover, non-resident companies are subject to Luxembourg net wealth tax levied on the unitary value of their Luxembourg PE.

Only very little Luxembourg case law regarding the interpretation of the PE definition exists under Luxembourg tax law. It is, however, widely accepted in Luxembourg literature that German case law is a useful source of interpretation given the German origin of the Fiscal Adaptation Law.

The general PE definition

According to the general PE definition provided in Section 16 (1) of the Fiscal Adaptation Law “a permanent establishment in the sense of tax law is every fixed place of equipment or business facility which serves for the operation of an established business”. Thus, the definition of PEs under Luxembourg tax law contains the following conditions:

• ƒ  the existence of a “place of equipment or business facility”, i.e. a facility such as premises or, in certain instances, machinery or equipment;
• ƒ  this place of equipment or business facility must be “fixed”, i.e. it must be established at a distinct place with a certain degree of permanence;
• ƒ  the carrying out of the business of the enterprise through this fixed place of equipment or business facility.

“A fixed place of equipment or business facility” may be any premises, facilities or installations serving the business activities of a non-resident enterprise irrespective of whether such facilities are suitable for the presence of people or not. Even simple storage areas, a pipeline or an internet server may constitute a PE for Luxembourg tax purposes. Hence, whether or not certain premises, facilities or installations are a place of equipment or business facility within the meaning of this provision depends on the specific activities carried out by the enterprise.

In order to qualify as a PE, the fixed place of equipment or business facility must be maintained by the taxpayer for more than a temporary period. This requires the taxpayer to have a legal right to the property which cannot be revoked or changed without the consent of the taxpayer. This does not, however, require ownership of the property. Instead, renting, sub-letting, leasehold and even gratuitous cession of the property may be sufficient to the extent it suffices for the purposes of the business activities. The control requirement will not be met if the activities are carried out in the premises of a business partner.

The equipment or business facility must further be “fixed” in terms of geographical location. Permanent business facilities or equipment include, without doubt, buildings, office premises and other facilities permanently attached to the ground. It should be noted that facilities do not need to be permanently attached to the ground. Transportable facilities such as mobile newspaper stands, maintenance vehicles, camping trailers or tents may be fixed within the meaning of this provision insofar as they are located permanently or frequently (over a longer period of time) at a specific location.

The decisive period for the “permanency test” cannot generally be stated. As a practical guideline, a period of six months may be considered in analogy to the time threshold set out in relation to building and construction sites; this is, however, not a binding rule. Where activities are of a unique or short-term nature, a fixed place of equipment or business facility should generally not constitute a PE.

The fixed place of equipment or business facility must further “serve for the operation of an established business”. The term “established business” clarifies that the PE concept is only relevant for commercial activities. In the absence of a commercial business, investments in real estate, the renting of tangible assets or licensing intangible assets do not constitute a PE.

Whether or not “a fixed place of equipment or business facility” serves the main purpose of the business or is ancillary thereto is irrelevant for the existence of a PE as long as it serves the business of the non-resident enterprise. Furthermore, the commercial activity does not necessarily have to be carried out by employees of the non-resident enterprise. Instead, it may be possible to subcontract the activities to independent subcontractors. In specific cases, a fixed place of equipment or business facility that is fully automated or mechanical without requiring the frequent presence of staff may constitute a PE. Facilities which only indirectly serve the business of a non-resident enterprise should, however, not constitute a PE.

Overall, the threshold that must be met for a PE to be constituted in accordance with the PE definition provided in Section 16 (1) of the Fiscal Adaptation Law is rather low.

PE examples listed in Section 16 (2) of the Fiscal Adaptation Law

Section 16 (2) of the Fiscal Adaptation Law provides a non- exhaustive list of examples which are deemed to constitute a PE. The most relevant examples are:
ƒ

• The place of corporate management;
• Branch offices;
• Factories;
• Warehouses;
• Places of purchase and sale; ƒ
• Permanent agents;
• Building and construction sites or installation projects.

While most of these examples fall within the definition of Section 16 (1) of the Fiscal Adaptation Law, some examples do extend the scope of the PE definition.

The new provision relating to foreign PEs

As part of the 2019 tax reform, the PE Definition has been extended by a 5th paragraph dealing with foreign PEs of Luxembourg taxpayers. According to the new provision, the only criteria to be considered in order to assess whether a Luxembourg taxpayer has a PE in a country with which Luxembourg has concluded a tax treaty are the criteria defined in the applicable tax treaty. Accordingly, the PE definition included in the tax treaty will be relevant for the analysis as to whether a Luxembourg taxpayer has a foreign PE.

According to Section 16 (5) of the Fiscal Adaptation Law, a taxpayer will only be considered to carry out all or part of its business through a PE situated in the other Contracting State to the extent that the activity performed, when viewed in isolation, constitutes a separate activity and represents a participation in the general economic life of the other Contracting State, unless a specific provision in the applicable tax treaty provides otherwise.

In order to be able to verify the existence of a PE, the Luxembourg tax authorities may request Luxembourg taxpayers to provide confirmation that the other Contracting State considers a PE to exist (for example, a certificate of registration). It is further stated that such confirmation has to be provided when the applicable tax treaty does not provide for a provision that would allow Luxembourg, as residence state of the enterprise, to decline the tax exemption of the income or capital and the other Contracting State interprets the provisions of the tax treaty in a way that excludes or limits its own taxing right.

This provision resembles Article 23A (4) of the OECD Model which allows the residence state of a taxpayer to deny the application of the exemption method in case the other Contracting State interprets the tax treaty in a way that would restrict or exclude its taxing rights. This provision aims at avoiding double non-taxation in case of conflicts of interpretation by the two Contracting States.

Analysis of the new provision and the related Circular

Opening comments

The new provision regarding foreign PEs and the related Circular seem to change the interpretation of the PE concept in outbound cases through the adding of additional requirements. The purpose of this new provision is to avoid conflicts of interpretations deriving from the interaction between domestic tax law and the provisions of a tax treaty.

However, the question arises whether the amended PE definition leads to any requirements that did not exist before. Moreover, it has to be analysed whether Luxembourg would be able to unilaterally eliminate its obligation to exempt profits attributable to a PE located in a tax treaty jurisdiction through a change of domestic tax law.

Considerations regarding Art. 23A (4) of the OECD Model

The new paragraph 5 of Section 16 of the Tax Adaption Law refers to situations where the other Contracting State interprets the provisions of the tax treaty in such a way that would exclude or limit its taxing right. This language is inspired by Art. 23A (4) of the OECD Model that is also referred to in the Circular.

Art. 23A (4) of the OECD Model was included in the 2000 Revision of the OECD Model. The purpose of Article 23A (4) of the OECD Model is to avoid double non-taxation resulting from disagreements between the Contracting States on the facts of a case or on the interpretation of the distributive rules.

Article 23A (4) of the OECD Model applies in the following circumstances:

(i) the source state interprets the facts of a case or the provisions of the Convention in such a way that an item of income or capital falls under a provision of the Convention that eliminates its right to tax that item or limits the tax that it can levy;

(ii) the residence state adopts a different interpretation of the facts or of the provisions of the Convention in that it considers that the item may, in accordance with the Convention, be taxed in the other Contracting State. If paragraph 4 of Article 23 A of the OECD Model did not exist, the residence state would be obliged to exempt that item of income or capital.

Accordingly, the income and capital would either not be taxed at all or, in case of dividends and interest, taxed at a limited rate in the source state. In these circumstances, Article 23A (4) of the OECD Model confirms the taxing right of the residence state and double taxation is avoided via application of the credit method.

The Circular states that a provision drafted along the lines of Article 23A (4) of the OECD Model has been included in around 40 tax treaties concluded by Luxembourg. Nevertheless, this provision may only apply if the host state of the PE considers that its taxing right is restricted by the tax treaty. Whether or not the host state effectively taxes the profits attributable to the PE is wholly irrelevant for the purposes of Article 23A (4) of the OECD Model. This has been acknowledged in the Circular. Thus, when the host state of the PE simply does not exercise its taxing right provided under the tax treaty, the application of the credit method cannot be based on this provision.

The relation between tax treaties and domestic tax law

Domestic tax law and tax treaty law constitute two independent and functionally distinct legal spheres. Whilst domestic law determines the objects and scope of domestic tax liabilities, tax treaty law only determines which of the two Contracting States are entitled to actually exercise the taxing rights under its domestic tax law. Tax treaties may never generate taxing rights under domestic tax law. Rather, as lex specialis vis-à-vis the domestic tax provisions, tax treaties only restrict the taxing rights as provided under domestic tax law. Domestic tax law remains, however, unaffected as long as those rights have not been limited by the treaty.

Not only do tax treaties not dictate that allocated taxing rights must be exercised by a country, they also do not dictate how they are to be exercised (except in certain respects in order to ensure effectiveness). Whether and how those rights are exercised is usually left to the respective ordinary domestic laws. It is therefore possible and common to have a situation where there is a right under a treaty to impose a form of taxation but where the legislature has not decided to impose (or has actively decided not to impose) such a tax liability under domestic law.

Applied to PEs, this means that a Contracting State may not make use of its taxing right provided in accordance with Article 5 and 7 (2) of the OECD Model because of a more restrictive concept of trade or business under domestic tax law. Here, Luxembourg as residence state of the enterprise may, in the absence of specific anti-abuse provisions, not deny the application of the exemption method even if the result is double non- taxation.

A future legislature may pass legislation exercising the taxing right and this would be consistent with the treaty. When new legislation is proposed, the consistency of such legislation with a State’s treaty obligations will sometimes be an issue. Importantly, additional taxing rights may only be exercised to the extent they are not restricted under a tax treaty. Nevertheless, the scope of taxing rights under a State’s various tax treaties is not identical; while some tax treaties may restrict certain taxing rights under domestic tax law, others may not.

From the point of view of the taxpayer, where one Contracting State does not currently take up its full taxing rights under a treaty, the tax treaty at least serves as a guarantee to the taxpayer that future taxation cannot go beyond the level fixed by the treaty (unless the tax treaty is first abrogated or amended).

Domestic interpretation of the term “business”

The Circular states that Luxembourg may refer to domestic tax law when interpreting terms that are not defined in a tax treaty. This is consistent with Article 3 (2) of the OECD Model which provides that any undefined term in the tax treaty will have the same meaning it has under the law of the Contracting State applying the tax treaty, unless the context requires otherwise.

As regards the interpretation of the term “business”, the new Luxembourg PE definition provides that a Luxembourg taxpayer would only be considered to have a PE in the other Contracting State if the activity on its own is an independent activity which represents a participation in the general economic life of the other State. This suggests that to meet the definition, the PE should perform an activity that comes within the scope of a commercial activity within the meaning of Luxembourg tax law.

According to Luxembourg tax law, any activity performed by a Luxembourg company is deemed to be a commercial activity. Thus, one may take the view that any activity performed by a Luxembourg company via a fixed place of business in the other Contracting State should be considered as part of the business of the Luxembourg company which constitutes a PE within the meaning of the tax treaty.

However, according to paragraph 5 of Section 16 of the Tax Adaptation Law, a foreign PE of a Luxembourg company has to, on its own, perform a commercial activity. According to Article 14 (1) of the LITL, the carrying out of a commercial activity requires cumulatively (i) an independent activity (ii) of permanent character, (iii) that is carried out with the intent to realise profits and (iv) participation in the general economic life.

(i) Independent activity

The criterion “independent activity” assumes an activity that is carried out by the taxpayer in its own name and on its own behalf. The taxpayer further needs to be able to exercise business initiative and bear the risk of the activity which includes that the profits or losses deriving from the activity are directly allocated to the taxpayer.

(ii) Permanent character

The notion of “permanence” is meant to distinguish commercial activity from one-time transactions and wealth management. An activity frequently has a permanent character if, from the beginning, there has been an intention to carry out a lasting activity expected to result in a source of income. Permanence does not, however, require a minimum period or an activity that is performed without interruptions; a temporary or recurring activity may suffice. Given that a PE is only constituted when a fixed place of business has a certain degree of permanency, this criterion should often be met.

(iii) Carried out with the intent to realise profits

The activity must be undertaken with the intent to realise profits. Whether or not losses are realised in the start-up phase or during certain periods is irrelevant. Instead, the decisive factor is whether the taxpayer intends to realise an overall profit during the period when the activity occurs. As companies are deemed to have a profit motive, this criterion should frequently be met.

(iv) Participation in the general economic life

This criterion partly overlaps with the criteria of permanence and the intent to realise profits and is meant to distinguish commercial activities from wealth management. The commercial activity must be part of the general economic life, or in other words, the enterprise must take part in the provision of goods or services to the market and its activity must be visible to the general public.

In this regard, the existence of a certain organisation, physical substance and publicity may be indications. Whether or not the activity is restricted to a limited circle of customers is irrelevant. In the extreme, it may suffice to have only one customer. In a company group context, a permanent establishment only doing business with affiliates may suffice.

When a Luxembourg company operates part of its commercial activities via a fixed place of business in the other Contracting State, all the conditions of commercial activity as defined in Article 14 (1) of the LITL should generally be met. In any case, the concept of commercial activity as well as the interpretation rule provided under Article 3 (2) of the OECD Model are nothing new and should have already been applied by the Luxembourg tax authorities before the 2019 tax reform.

Illegitimate tax treaty override

An issue that is closely linked with the interpretation and application of tax treaties is the issue of treaty override. The term “treaty override” refers to the enactment of subsequent domestic legislation which conflicts with obligations undertaken by a prior and binding tax treaty. Conflicting domestic legislation may, for example, take the form of a provision stating that treaty provisions are to be disregarded in certain circumstances.

Two situations need to be distinguished:

(i) “Intentional treaty override”: where one state knowingly and intentionally enacts legislation conflicting with a treaty obligation;

(ii) “unintentional treaty override”: where there is no such intention.

In case of unintentional treaty override, it may be possible to reconcile the tax treaty and the domestic law. In contrast, where intentional treaty override occurs, conflict is manifest and the issue comes down to whether the changes in domestic law prevail.

Importantly, a tax treaty is an international treaty that is binding on the Contracting States. Consequently, the subsequent enactment of domestic legislation which is intended to override a treaty constitutes a breach of international law and a state’s international obligations. In this regard, Articles 26 and 27 of the Vienna Convention provide clear rules on the performance of treaties. According to Article 26 of the Vienna Convention, every treaty in force is binding upon the parties to it and must be performed by them in good faith. Furthermore, Article 27 of the Vienna Convention explicitly states that a party to a treaty may not invoke the provisions of its internal law as justification for its failure to perform a treaty.

The overriding of a treaty provision by domestic law may lead to a complaint under the mutual agreement procedure of the treaty, to a referral to an international arbitral body or to the termination of the treaty by the other party.

With regard to profits attributable to a PE located in a Contracting State, Luxembourg frequently adopts the exemption method for the elimination of double taxation. The application of the exemption method is generally not conditional to an effective taxation in the other Contracting State. Thus, Luxembourg is required to exempt such income unless the tax treaty provides for a specific clause that would allow Luxembourg to deny the exemption in the absence of effective taxation in the host state of the PE (i.e. a subject-to- tax or a switch-over clause that provides for the application of the credit method). Otherwise, denying the application of the exemption method when a Luxembourg company has a PE in a Contracting State within the meaning of the applicable tax treaty would represent an illegitimate tax treaty override.

Confirmations to be produced by taxpayers

The Circular further determines how taxpayers have to evidence the existence of a foreign PE. According to the Circular, the tax authorities may always request confirmation that the host state of the PE recognises the PE. This might, for example, be a registration of the PE in the other Contracting State. This is consistent with the taxpayers’ cooperation duties; taxpayers have, upon request, to provide evidence that the statements made in the tax returns are correct. The relevant documents should be annexed to the corporate tax returns.

When an applicable tax treaty does not allow Luxembourg to deny the application of the exemption method or the other Contracting State interprets the provisions of the tax treaty in a way that its taxing right is limited or excluded, the taxpayer has to produce confirmation of the existence of the PE in the other Contracting State.

Where a taxpayer fails to produce such evidence, the Luxembourg tax authorities will consider that the Luxembourg taxpayer has no PE in the other Contracting State.

As regards the type of information to be provided, the Circular states that taxpayers have to produce a document that proves that the competent authorities of the other Contracting State consider a PE to exist. This might be a tax assessment or a certificate in which the competent authorities of the other Contracting State confirm the existence of the PE.

According to the Circular, it would not suffice to produce a certificate confirming the existence of a commercial activity in the territory of the other Contracting State if that activity does not constitute a PE. However, if the other Contracting State does not make use of its taxing right provided under the tax treaty, Luxembourg cannot unilaterally decide to refuse the application of the exemption method unless the applicable tax treaty provides for a specific anti- abuse provision.

Considerations regarding the amended PE definition

The question arises as to whether the amended PE definition introduces new requirements with regard to foreign PEs of Luxembourg taxpayers or if the new provision is merely a clarification and formalisation of the requirements that already existed.

According to the amended PE definition, the only criteria to be considered when analysing whether a Luxembourg taxpayer has a PE in a treaty jurisdiction are the criteria determined in the PE definition of the applicable tax treaty. This is consistent with the general principle that in a tax treaty context a PE is only constituted (and the host state has only an unlimited primary taxing right over business profits of a non-resident enterprise) to the extent a non- resident enterprise has a PE in accordance with the applicable tax treaty.

As regards the interpretation of the term “business” under Luxembourg tax law and the interpretation rule provided in Article 3 (2) of the OECD Model, the amended PE definition should be considered as a mere clarification. The concept of commercial activity has not changed and was considered in accordance with Article 3 (2) of the OECD Model before the amendment of the domestic PE definition.

Moreover, Article 23A (4) of the OECD Model cannot be used to eliminate double non-taxation where both Contracting States consider that the profits attributable to the PE “may be taxed” by the host state of the PE regardless of whether the latter exercises its taxing right.

Likewise, the Luxembourg tax authorities retain the right to request evidence and documentation from Luxembourg taxpayers that prove the existence of a PE in a treaty jurisdiction; this is part of the taxpayers’ cooperation duty.

In light of the above, the new paragraph 5 of Section 16 of the Fiscal Adaptation Law seems to merely confirm the requirements that already existed before the amendment of the Luxembourg PE definition. It may, however, be expected that the Luxembourg tax authorities will verify even more carefully than before whether the criteria of the PE definition in applicable tax treaties are satisfied.

Conclusion

The new provision included in the domestic PE definition concerns situations in which Luxembourg taxpayers have a PE in a country with which Luxembourg has concluded a tax treaty. The basic idea behind this amendment is the elimination of conflicts of interpretation resulting from the interaction between the domestic PE concept and the PE definition included in tax treaties.

According to the amended PE definition, the only criteria to be considered when assessing whether a Luxembourg taxpayer has a PE in a tax treaty country are the criteria defined in the applicable tax treaty. Moreover, a Luxembourg taxpayer should only be considered to carry out business in the other Contracting State if the activity on its own constitutes an independent activity that represents a participation in the general economic life of that other state.

However, these requirements already existed despite not having been formalised in the PE definition. In the McDonald’s State Aid decision, the EU Commission confirmed that Luxembourg correctly applied its domestic tax law and the tax treaty concluded with the US. Ultimately, double non-taxation as it occurred in the case of McDonald’s may only be resolved through the amendment of the applicable tax treaty and the inclusion of specific anti-abuse rules such as a subject-to-tax or a switch-over clause which result in the application of the credit method when profits are not taxed in the host state of the PE.