Sharing the secrets

2011 will bring with it a huge change to Luxembourg’s tradition of banking secrecy. Tom Phillips and James Swift look at what that will mean for the status of the offshore financial centre

What will the advent of 2011 bring for the world’s legal markets? In the UK, lawyers will be tackling issues such as the ongoing effects of the Legal Services Act, likely changes to libel laws and changes to conditional fee agreements (CFAs).

But for offshore financial centre ­Luxembourg it will mean a drastic change to its status, from traditions of financial ­secrecy to a guaranteed agreement to exchange information with other countries. A change as big as this requires new terminology.

“There’s a perceivable trend of ’onshorisation’,” says Chokri Bouzidi, a principal at Oostvogels Pfister Feyten. “Luxembourg will be fully an onshore jurisdiction in all respects.”

The driving force behind this reclassification is, along with death, an age-old ­certainty.

The trick of treaties

Even before the banking crash, tax was a political hot potato. After the Organisation for Economic Cooperation and Development published its white, grey and black lists in April last year, the financial centres on the grey list – which included Austria, Switzerland and Luxembourg – began ­initiating treaties with countries in order to bring themselves back into the international fold.

These treaties allow for the “exchange of information on request in all tax matters for the administration and enforcement of domestic tax law without regard to a ­domestic tax interest requirement or bank secrecy for tax purposes” as per the ­internationally agreed tax standard endorsed by G20 finance ministers at their Berlin meeting in 2004 and by the UN Committee of Experts on International Cooperation in Tax Matters in October 2008.

Luxembourg now has 50 such treaties and from 2011, it will for the first time exchange information regardless of whether it is allowed under Luxembourg law. This includes private banking investors.

“This is a major change,” says Bouzidi. “Anyone who’s invested in Luxembourg and is a tax resident in the countries with which Luxembourg has a treaty can have their Luxembourg information exchanged with the tax authorities in their home nation.”

As much as Luxembourg has fallen into line, the country has still taken a ­conservative approach to releasing details about its foreign investors.

“This is not a highway to information,” explains Bouzidi. “There’ll be no fishing expeditions. The tax authority has to give Luxembourg a minimum amount of ­information and use all the resources in its own country before the request will be ­considered. Luxembourg is ready to ­negotiate but the other country has to take all the steps it can. We open the gate but we don’t open all the windows and doors.”

This is the first time that the country has given up secrecy, under huge international pressure. There was a threat of punitively taxing US residents who have investments in grey list countries.

Invested interests

When establishing how this huge change to banking secrecy will affect law firms it is important to distinguish between two types of investor.

The first is private banking, a niche that Luxembourg shares with countries like Switzerland, where wealthy people ­consolidate their money in Luxembourg banks. The number of people investing their money in Luxembourg’s banks is likely to decrease, Bouzidi believes.

“There’ll probably be fewer investors, with some heading to other jurisdictions such as Hong Kong or Singapore,” he says.
So the private banks look set to lose out. And as for foreign direct investors who bring valuable business to the country, the ­situation is largely the same. But the new rules are also likely to mean that ­Luxembourg sees more investment, as ­corporations looking to set up shop in the country are forced to prove they have ­substantial operations on the ground or face punitive measures by their home nations for tax avoidance.

“From my daily angle as a tax lawyer, it doesn’t change much,” explains Bouzidi. “When most business investors invest in Luxembourg they already know they’ll be taxed by their own countries. If I were a corporate investor, I would not go to ­countries that don’t exchange any ­information. This could draw companies to Luxembourg.

“The only slight change is that they’ll have to have much more investment here. This is a trend that’ll largely counter-­balance the loss of investment from the banks.”

For the smaller law firms in Luxembourg that deal primarily with private clients, the move away from banking secrecy is almost certain to hurt their bottom lines, whereas for the larger firms the effects will be negligible.

But for tax lawyers as individuals, there may be an adjustment period required.

“This doesn’t fundamentally change the legal market but legal professionals will have to bring some clarity to these ­developments. There’s now an additional task to educate clients. I think the ­competition will continue to be fought, not on how tax-efficient you are or a country’s banking secrecy, but on the high quality services you offer.”

According to one lawyer at a magic circle firm, however, there is at least one type of transaction that may be affected by the new legislation.
“In a structured financing between a UK bank and a Luxembourg SPV held by a ­Luxembourg financial institution, where tax capacities are shifted between the two entities,” says the magic circle partner, “under the new exchange on information provisions in the double taxation treaty between UK and Luxembourg and subject to the conditions provided for in those ­provisions, HM Revenue & Customs [HMRC] could ask for information or ­agreements relating to the beneficial owner of the shares of the SPV.

“This could include information the ­Luxembourg tax authorities would be ­prevented [under Luxembourg banking secrecy] from obtaining from the ­Luxembourg financial institution and from exchanging with HMRC. This could have a negative impact on the treatment of the transaction in the UK, for example, by ­finding that there was no real transfer of risks to the SPV or that the SPV is not ­beneficially owned by the Luxembourg financial institution.”

The implications of openness

Of course, this is just one kind of ­transaction. But while the impact of the changes to banking secrecy in Luxembourg looks like it will be a soft blow, there is ­legislation on the horizon that could have much wider-reaching implications.

“There’s a new savings directive draft on the table of the EU Council that could have an even bigger effect on the banking sector than the changes in the tax treaties for enabling the exchange of information despite the Luxembourg banking secrecy,” says the magic circle partner.

“In the directive as it currently stands, there’s a series of income which does not fall under the scope of the directive. Because of this, the impact of the initial directive was quite limited, but the scope of the new ­savings directive draft might be extended in the future to cover certain derivative ­products and unit-linked insurance ­products, and to cover not only UCITs but also non-UCITs funds.”

The EU Savings Directive is aimed at ­savings income in the form of interest ­payments made in one member state to a beneficial owner who is an individual ­resident in another EU member state.

Austria and Luxembourg are authorised to opt for withholding taxes on the savings income, instead of exchanging information (if the beneficial owner of the income does not opt for the exchange of information method). From 1 July 2011 the withholding tax rate under the directive will go up (from 20 per cent) to 35 per cent, and if the ­Savings Directive draft is adopted, it will cover more incomes on which withholding tax can be charged.