U.S.-Luxembourg Tax Treaty: Key Provisions and Tax Implications

The tax treaty between the United States and Luxembourg is designed to prevent double taxation and reduce tax evasion for individuals and businesses operating in both countries. It establishes rules on how different types of income are taxed, determines which country has taxing rights, and sets limits on withholding taxes. This agreement helps facilitate cross-border trade and investment by providing greater tax certainty.

Covered Income Categories

The U.S.-Luxembourg tax treaty defines how different types of income are taxed when earned across both countries. Business profits are generally taxable only in the country where the company is based unless it has a taxable presence, or permanent establishment (PE), in the other country.

Employment income is taxed where the work is performed, with exceptions for short-term assignments. If an employee spends less than 183 days in a 12-month period in the other country and their salary is paid by an employer outside that country, the income remains taxable only in the home country.

Capital gains taxation depends on the asset sold. Gains from real estate are taxed in the country where the property is located. Gains from selling shares are generally taxed in the seller’s country of residence unless the shares derive most of their value from real estate.

Pension income and social security benefits are treated differently. Pensions are usually taxed in the recipient’s country of residence, while social security payments are taxed only in the country making the payment.

Tax Residency Criteria

Determining tax residency under the treaty dictates which country has the primary right to tax an individual or entity. Residency is based on factors such as domicile, physical presence, and the location of an entity’s management. Luxembourg considers a person a tax resident if they have their primary home in the country or spend more than six months there in a calendar year. The U.S. applies the substantial presence test, which calculates residency based on the number of days spent in the country over a three-year period. U.S. citizens and green card holders are always considered tax residents.

When an individual qualifies as a tax resident in both countries, tie-breaker rules determine which country has primary taxing rights. These rules evaluate factors such as permanent home location, center of vital interests, habitual abode, and nationality. If these criteria do not resolve the issue, tax authorities consult to reach an agreement.

For legal entities, residency is typically determined by the place of incorporation or the location of effective management. Luxembourg considers a company a resident if it has its central administration or registered office in the country. The U.S. treats corporations as residents if they are incorporated under U.S. law. The treaty provides guidance for resolving residency conflicts by considering where key management decisions are made and where primary business activities occur.

Permanent Establishment

A business operating across borders must understand when its activities in another country create a permanent establishment (PE), as this determines tax liabilities under the treaty. A PE is a fixed place of business through which an enterprise conducts operations, such as an office, branch, factory, or workshop. If a company has a PE in Luxembourg or the U.S., the profits attributable to that establishment are taxable in the host country.

A PE can also be created through dependent agents. If a person or entity habitually exercises authority to conclude contracts on behalf of a foreign enterprise, that business may be considered to have a taxable presence. Independent agents, such as brokers or commission-based intermediaries, do not trigger a PE as long as they act in the ordinary course of their business.

Certain activities do not create a PE under the treaty. These include facilities used solely for storage, display, or delivery of goods, as well as preparatory or auxiliary activities like market research or advertising. However, if multiple exempt activities are combined in a way that forms a cohesive business operation, tax authorities may argue that a PE exists.

Withholding Taxes on Dividends, Interest, and Royalties

Cross-border payments between the U.S. and Luxembourg often trigger withholding tax obligations, which the treaty regulates by capping tax rates on dividends, interest, and royalties. Without treaty protections, these payments could be subject to high domestic withholding rates—30% in the U.S. under Internal Revenue Code 1441 and varying rates in Luxembourg. The treaty reduces these rates to encourage investment and prevent excessive tax burdens on passive income.

Dividend withholding tax rates depend on the shareholder’s ownership percentage. A 5% rate applies when a company owns at least 10% of the voting stock in the paying corporation, while a 15% rate applies in all other cases. Certain tax-exempt pension funds and government entities may qualify for a full exemption.

Interest payments benefit from a 0% withholding tax, eliminating barriers for cross-border lending. This provision benefits Luxembourg-based financial institutions providing loans to U.S. borrowers and U.S. companies issuing bonds purchased by Luxembourg investors.

Royalty payments for intellectual property, including patents, trademarks, and copyrights, are also exempt from withholding tax. This fosters technology transfers and licensing agreements by ensuring that Luxembourg companies licensing software or trademarks to U.S. businesses receive full payments without tax leakage.

Limitation on Benefits Clause

To prevent treaty abuse, the U.S.-Luxembourg tax treaty includes a Limitation on Benefits (LOB) clause, which restricts treaty benefits to entities with legitimate economic ties to either country. This prevents third-country residents from using Luxembourg as a conduit to access reduced tax rates on U.S.-sourced income.

Eligibility for treaty benefits depends on specific criteria. Publicly traded companies qualify if their principal class of shares is regularly traded on a recognized stock exchange in either country. Subsidiaries of such companies also qualify if at least 50% of their shares are owned by a publicly traded parent. Private companies must meet ownership and base erosion tests, ensuring that a majority of their owners are residents of either the U.S. or Luxembourg and that they do not distribute most of their income to non-qualifying entities. Financial institutions, pension funds, and charitable organizations may also qualify under specific provisions.

For entities that do not meet these automatic tests, the treaty allows for discretionary relief. Tax authorities in the U.S. or Luxembourg can grant treaty benefits if the entity demonstrates that its establishment and operations serve a legitimate business purpose beyond tax avoidance.

Elimination of Double Taxation

The treaty provides mechanisms to ensure that income is not taxed twice. Each country applies different methods to relieve double taxation, aligning with their domestic tax systems.

The U.S. primarily uses the foreign tax credit method, allowing taxpayers to offset U.S. taxes with taxes paid to Luxembourg. If a U.S. citizen earns income in Luxembourg and pays Luxembourgish tax, they can claim a credit against their U.S. tax liability. This credit is subject to limitations under Internal Revenue Code 904, which restricts the amount to the lesser of the foreign tax paid or the U.S. tax due on the same income.

Luxembourg generally applies the exemption method for certain types of income, meaning Luxembourg residents are not taxed on U.S.-sourced income if it is taxable in the U.S. For income not covered by the exemption method, Luxembourg allows a foreign tax credit similar to the U.S. system.

Exchange of Information

To combat tax evasion and ensure compliance, the treaty includes provisions for the exchange of tax-related information between the U.S. and Luxembourg. This cooperation allows tax authorities to share relevant financial data, ensuring that taxpayers cannot hide income or assets in either jurisdiction.

The treaty follows the OECD standard for information exchange, meaning Luxembourg must provide information upon request, even if the data is not needed for domestic tax purposes. This includes bank records, ownership details of companies and trusts, and other financial documents. The U.S. can request information to verify tax filings, investigate potential fraud, or enforce tax laws. Luxembourg’s participation in the Foreign Account Tax Compliance Act (FATCA) further strengthens transparency by requiring financial institutions to report U.S. account holders.