18 October 2004
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When, in response to the question “Where do you live?”, one replies “Luxembourg”, often the second question is: “Now, where’s Luxembourg exactly?” Once the second question is answered (a tiny landlocked country situated between Germany, France and Belgium) and one adds in some interesting facts (Luxembourg has the highest income per capita in the world and is home to one of the largest concentrations of banks and investment funds in Europe), your interrogator is surprised that a country slightly smaller than Rhode Island has achieved this.
Luxembourg’s success can be linked partly to its membership of the EU, but there are other factors that have ensured the growth of its financial sector. The status of Luxembourg as one of Europe’s leading jurisdictions in the domiciliation and administration of investment funds can be traced to the adoption of the European Undertakings for Collective Investment in Transferable Securities (UCITS) Directive in 1988. The directive (as transposed into Luxembourg law) requires that the central administration be performed where the fund is incorporated. This has resulted in the development of deep competencies in the entire central fund administration process in Luxembourg.
Over time the perception has developed that Luxembourg is the ‘UCITS centre’, whereas Dublin is the ‘hedge fund centre’. This analysis is not truly justified, as Luxembourg law does provide for the establishment and administration of alternative investment funds. For example, it has been possible since 1991 for single–manager hedge funds investing mainly in derivatives to exist. Dublin’s reputation as a hedge fund centre developed largely from the possibility for offshore funds to list on the Irish Stock Exchange (ISE).
In theory, offshore funds can be listed on the Luxembourg Stock Exchange (LuxSE), but in practice it has been difficult. Recently, the LuxSE’s rules have been modified to permit foreign funds listing in the hope of establishing Luxembourg as a jurisdiction for the administration and distribution of offshore funds, particularly hedge funds. The main change is that offshore funds, incorporated for example in the British Virgin Islands or the Isle of Man, can be listed on the LuxSE even though their shares are not restricted to sophisticated investors investing a minimum $100,000 (£559,000), which remains an ISE requirement.
In a further effort to grow and diversify its fund industry, Luxembourg recently introduced a flexible and tax-efficient vehicle for ‘qualified’ private equity and venture capital investors, called the Société d’lnvestissement en Capital à Risque (Sicar). Furthermore, Sicars are regulated by the Commission de Surveillance du Secteur Financier (CSSF) and can be listed on the LuxSE.
Securitisation, which involves pooling assets and transferring them to a special purpose vehicle (SPV), which in turn issues securities to the market, is the subject of another recent Luxembourg law. Although securitisation has existed for some time in other jurisdictions, the Luxembourg alternative broadly provides a flexible legal framework for the structuring of the securitisation deals without limiting the types of assets to be securitised, while also providing tax neutrality and a high level of investor protection.
The existence of banking secrecy in Luxembourg has contributed to the establishment of approximately 170 different banks and credit institutions in Luxembourg. However, in recent years the words ‘banking secrecy’, like the word ‘offshore’, have become somewhat stigmatised. The purpose of banking secrecy is to protect information concerning professionals of the financial sector and their respective clients from access by third parties, whether private or official. In this sense it is similar to the professional secrecy of doctors and lawyers, being no more than the protection of the private sphere of the citizen. Luxembourg banking secrecy is lifted when there is sufficient evidence to indicate that the funds are derived from a range of criminal activities (such as terrorism). The existence of banking secrecy does give Luxembourg an edge over its competitors, but in reality the reason behind Luxembourg’s success as a financial centre can be attributed to its ability to implement and benefit from European legislation quickly and efficiently.
Luxembourg, like many other EU countries, is keen to protect its financial sector from EU directives that may have a negative effect. This is demonstrated by the Luxembourg government’s attitude to the implementation of the EU Savings Tax Directive, which will go ahead only if the directive is implemented simultaneously in all relevant jurisdictions. Recently, the EU has opted to delay the implementation of the Savings Tax Directive by six months to 1 July 2005. This has been agreed to give certain non-EU countries more time to implement the necessary ‘equivalent measures’.
Luxembourg offers a favourable corporate tax system. There are two parallel tax regimes in the country: the first is the ‘holding company regime’ and the second ‘the participation exemption regime’ (Soparfi).
Holding companies are tax-exempt, save for tax on capital at formation and subsequent capital increases plus an annual subscription tax. In exchange, holding companies may not conduct any form of active business such as, for example, the exploitation of copyright, and they are normally excluded from double tax treaties.
Under certain circumstances, a Luxembourg holding company is ideal for receiving income from domestic and foreign investments. But the holding company regime is under threat of abolition. Should it be abolished, all existing holding companies would be grandfathered for a significant period, which will be specified in the legislation.
Soparfis are fully taxable companies benefiting from the participation exemption regime. The participation exemption from tax extends to dividend income from qualifying participations and capital gains on the disposal of qualifying participations. The qualification requirements are slightly different for each of these two exemptions, but they relate essentially to certain minimum percentage holdings and minimum holding periods in taxable companies. Soparfis generally benefit from the provisions of double tax treaties, and distributions of dividends to a resident of a treaty country are typically at reduced rates of withholding tax, instead of the basic rate of 20 per cent.
Luxembourg has a relatively low effective corporate tax rate of 30.38 per cent. Since VAT has been introduced within the EU, Luxembourg has applied one of the lowest VAT rates with a standard rate of 15 per cent. A further tax that may be relevant in deciding whether to incorporate a Soparfi is net wealth tax, which is 0.5 per cent annually on the total net assets of a company. The participation exemption from tax extends to net wealth tax, where the assets qualify under the participation exemption requirements.
Generally, there is no withholding tax on interest payments made by a Luxembourg company. This does not mean that a company can be heavily leveraged with interest-bearing loans from its parent, as the Luxembourg tax authorities have adopted a rule in relation to the levels of gearing which a Luxembourg company should be allowed to support. The present understanding of this policy is that the interest bearing debt should not exceed six times the paid-up capital of the company.
The Commission de Surveillance du Secteur Financier (CSSF) is the authority for the prudential supervision and regulation of Luxembourg’s financial sector. The CSSF also heads the Comité Pour le Développement de la Place Financière (Codeplafi). This is an organisation composed of top-level officials and experts from the financial sector and which acts as a strategic think-tank for the development and expansion of the financial sector.
As an FATF member, Luxembourg is particularly alert to money laundering and the prevention of terrorist financing. It has a regulatory framework that meets both European and international requirements.
The willingness of the government to cultivate an environment favourable to the development of the financial sector should continue to fuel Luxembourg’s growth and development as a major financial centre.
Vanessa Molloy is associate adviser for Maitland, the European affiliate of South African law firm Webber Wentzel Bowens