Paolo Panico examines the evolution of Luxembourg's financial services offerings and how the jurisdiction has adapted to new international norms.
“Luxembourg is famous for two things: its steel industry and its rose cultivation industry”.
This quote from an Italian guidebook of the 1930s was uttered by Luxembourg’s Finance Minister Pierre Gramegna at the annual conference of the Luxembourg Directors’ Association on 17 June 2015.
The economic outlook of the tiny Grand-Duchy is quite different 80 years later. According to the latest OECD Economic Survey, 27 per cent of the value added in the Luxembourg economy is represented by the financial sector, compared to 10.5 per cent in Switzerland and 8.25 per cent in the UK. In the opinion of the OECD Secretary General Angel Gurría the Luxembourg financial sector “may have reached a size where its contribution to GDP growth might fade, and high dependence on one sector poses medium term risks”.
In fact Luxembourg, with a population of about half a million, is the largest international financial centre of the Euro zone. As of March 2015 Luxembourg ranked 17 in the Global Financial Centres Index, ahead of Frankfurt (19), Amsterdam (40) and Dublin (52). The same ranking confirmed New York and London as the first and second largest global financial centres. Zurich (6) and Geneva (13) were the only financial centres in Continental Europe with a higher ranking than Luxembourg.
Luxembourg, which is in charge of the EU presidency during the second semester of this year, is the only Eurozone country other than Germany to rely on a confirmed AAA rating by all the three major agencies (Standard & Poor’s, Moody’s, and Fitch).
Although the current outlook of the Luxembourg economy appears to be highly satisfactory its main ‘engine’, the financial sector, is indeed facing some unprecedented changes. The country’s ability to withstand the challenges of a dramatically evolving global environment will depend more than ever in the adaptability and ingenuity of its legal system. In a post-industrial, ‘knowledge economy’ consisting of high value added services, a key factor of success is a ‘legal infrastructure’ providing suitable solutions to the needs of increasingly sophisticated international investors.
A pioneering approach to collective investment funds in the 1980s laid the groundwork for the successful development of Luxembourg’s financial industry. This was further strengthened by a number of special purpose vehicles and corporate arrangements made possible under the legislation of the early years of this century (Specialised Investment Funds or SIFs; private equity and venture capital funds known under the French acronym of SICAR; tax exempt family wealth management companies or SPFs; lightly regulated securitisation vehicles).
A focussed government, quickly responsive to the professional requirements of the country’s leading industry, was able to mastermind Luxembourg’s success story for three good decades. The country’s ability to maintain its innovative records and keep up with a violently changing global environment appears to be stronger in certain areas of the financial industry than in others. This may be a consequence of the different evolutionary paths of the various branches of international finance.
Investment funds: A Consolidated Global Prominence
The investment funds sector continues to play the most important role in Luxembourg’s financial industry. Luxembourg is the second largest fund domicile after the US, with total assets under management of €3,094,987 million as of 31 December 2014. Thanks to a buoyant growth in the first months of this year, the €3,500 billion threshold was exceeded by the end of the first quarter 2015. In terms of global reach, Luxembourg is the most prominent international platform for collective investment schemes as its funds are distributed in more than 70 countries.
Luxembourg’s proactivity and innovation in relation to the fund industry was confirmed by some recent developments meant to buttress the jurisdiction’s global prominence in this field.
The Alternative Investment Fund Managers Directive (AIFMD) was implemented in Luxembourg under the Law of 12 July 2013 on alternative investment fund managers, which included some important amendments to the law and regulation of partnerships. More precisely, a new form of limited partnership, known as the ‘special limited partnership’ (société en commandite spéciale, SCSp) was introduced with a view to matching some of the features of the Anglo-American partnership.
Unlike the common limited partnership (société en commandite simple, SCS), which is a legal person under the Luxembourg Companies Law of 10 August 1915, the new form has no legal personality. As a result, a special limited partnership is not subject to the rules on consolidated accounts unless it has a regulatory status that requires it. Furthermore, limited partnerships have very limited obligations in respect of the filing of financial reports and ensure a high level of confidentiality as to the identity of their members.
The new regime for special limited partnerships and the corresponding make-over of the existing common limited partnership regime place a great emphasis on contractual freedom. Both entities may be created by virtue of a private agreement and not necessarily in the form of a notarial deed. The allocation of benefits according to the terms of the partnership agreement need not follow the members’ contributions. Under the new regime it is possible to reimburse an outgoing member, which was previously barred under Luxembourg law.
In spite of its lack of legal personality, the new SCSp benefits from a robust ring-fencing regime where the assets held in its name are not available to the personal creditors of the partners and its registered office is deemed to be its place of administration, thus subjecting it to Luxembourg law even in the event that all its partners are foreign entities or individuals.
The new Luxembourg limited partnership, both in the amended version of its original model (SCS) and in the newly introduced form (SCSp), is therefore a vehicle of choice for private equity or venture capital investments, either as a simple unregulated entity or in accordance with the regulatory requirements for SIFs or SICARs.
Both forms of Luxembourg limited partnerships (SCS and SCSp) are transparent for tax purposes and therefore exempt from corporate income tax. A Circular Letter by the Luxembourg tax administration of 9 January 2015 has further clarified that a limited partnership is exempt from municipal business tax to the extent that it does not carry on a commercial activity and its general partner holds less than a five per cent interest. A number of activities qualifying as “private wealth management” are expressly mentioned in the Circular Letter as falling outside the definition of commercial activity. This clarification is welcome because the common practice of using a Luxembourg limited company as general partner might trigger some tax consequences in the form of the municipal business tax at a rate set by the relevant municipality (6.75 per cent in Luxembourg city).
In another Circular Letter of 12 February 2015 the Luxembourg revenue authorities provided some clarifications and guidance as to the issue of certificates of residence for investment funds (UCIs) with a view to facilitating the application of double tax treaty benefits. To this effect, the amendments to the double tax treaty between Luxembourg and Germany, which came into force in 2013, reduced the scope for cross-border tax planning arrangements but introduced more favourable conditions in relation to investment funds.
As regards EU passport investment funds complying with the UCITS Directives, it is worth noting that the Luxembourg financial regulator (Commission de Surveillance du Secteur Financier, CSSF) issued a Circular Letter 14/587 a few days before the UCITS V Directive was adopted at the EU legislative level. A UCITS V compliant regulatory framework is thus already available for Luxembourg fund managers even ahead of the implementation of the Directive, which is due in all EU member states by 18 March 2016.
Private Banking in an ‘Age of Transparency’
The fund industry is perhaps the least affected by the global, and particularly European, ‘crusade’ towards a new ‘age of transparency’. Private banking and corporate services are struggling with a swiftly changing global framework that may have a significant bearing on the profitability, if not on the very existence, of some branches of the financial industry.
Some of the recent developments in the relevant legislation bear witness to Luxembourg’s willingness to adapt to the new emerging global standards.
In 2015 Luxembourg abandoned the anonymous withholding tax regime and moved to the automatic exchange of information in relation to interest income of individuals under the EU Savings Directive. This is limited information exchange is going to be replaced by a much wider paradigm as early as next year following Luxembourg’s decision to be an ‘early adopter’ of the Common Reporting Standard (CRS) promoted by the OECD. As a result, Luxembourg’s financial institution will take part in the process leading to the automatic exchange of tax information in 2017 with respect to the financial situation of the year 2016. The same result is being achieved at the EU level under the amendments to the Administrative Cooperation Directive and the simultaneous repeal of the Savings Directive.
The severe limitation of banking secrecy as a result of these developments has had an inevitable impact on the private banking industry. The aggregate data as of 31 December 2014 exhibit a clear trend. Luxembourg private banking is specialising in ultra HNWIs from a more diversified regional provenance. More precisely, the accounts of €20 million or more represented 51 per cent of the total assets of Luxembourg private banks in 2014 compared to 41 per cent in 2011 while the account balances of less than one million euro fell from 24 per cent in 2011 to 15 per cent in 2014. At the same time the percentage of clients from the neighbouring European countries (Belgium, France, Germany) represented 18 per cent in 2014, compared to 25 per cent in 2011 while the share of clients from the “rest of the world” increased to 29 per cent from 18 per cent in 2011.
This trend may take a toll on the profitability of Luxembourg private banks as the resulting model relying on fewer larger clients may put additional pressure on the margins of banking services. More generally the private wealth system’s ability to attract HNWIs from various regions of the world is dependent on the flexibility and ingenuity of the arrangements made possible by the Luxembourg legal system. The Law of 21 December 2012, which introduced a regulatory regime for Family Offices was an early move in this direction and it is gradually attracting these professionals to Luxembourg. On the other hand, a bill meant to introduce private foundations under similar lines to those of Liechtenstein as well as Dutch foundation - so to speak a continental ‘response’ to the common law trust - has been lagging behind for more than two years and it is eagerly awaited by many branches of the financial industry.
Corporate Tax Planning in Anticipation of BEPS
The deadline of 18 February 2015 brought about a limitation to the use of bearer shares for Luxembourg companies. The Law of 28 July 2014 concerning the compulsory deposit and immobilisation of shares and units in bearer form provided that all bearer shares should be entrusted with an appointed custodian (a regulated financial intermediary or a member of the legal professions) or registered in the name of the relevant shareholders within such date. Failure to comply with these new provisions would imply the suspension of the voting rights on the relevant shares. Any remaining bearer shares other than those deposited with an eligible custodian would be cancelled on 18 February 2016. Nonetheless, it should be noted that no limitations are imposed on nominee shareholding and that the Luxembourg Trade and Companies Register does not publish the identity of the shareholders of a company incorporated in the form of an SA (société anonyme). Of course, these provisions will be modified in 2017 when the Fourth EU Anti Money Laundering Directive will come into force and all EU member states will have to maintain public registers of the beneficial owners of their companies.
In another attempt to enhanced transparency in corporate tax matters, the Luxembourg government introduced a new statutory framework for tax rulings. The relevant measures were enacted under the Law of 19 December 2014 (the Budget Law 2015) in the context of the first part of a far reaching ‘package for the future’ (Zukunftpak), which is intended to bring about a major overhaul of Luxembourg’s tax system.
Although the actual timing appears to be related to the international press furore of November 2014 as a result of the abusive publication of hundreds of tax rulings legitimately issued by the Luxembourg tax administration (‘LuxLeaks’), the relevant bill had been introduced on 15 October 2014. Tax rulings, which were previously granted in the absence of a statutory framework on the grounds of good faith and legitimate trust (“bonne foi et confiance légitime”), are forthwith going to be based on the new §29a of the General Tax Law (Abgabenordnung), a statute dating back to the 1930s and laying down the basic principles of the Luxembourg system of direct taxation. The new statutory framework relies on a Tax Ruling Commission (Commission des Décisions Anticipées) as well as the publication of all the rulings issued during the financial year, on an anonymous basis, in the revenue authority’s annual report.
The same Budget Law 2015 introduced some provisions in relation to transfer pricing. More precisely, the new Art 56 of the Income Tax Law of 4 December 1967 follows closely the formulation of Art 9 of the OECD Model Convention and provides for upward or downward adjustments when two related enterprises enter into financial transactions on terms that differ from those which would apply between independent enterprises.
This arm’s length principle applies to both cross-border and domestic transactions between corporate entities but not between a company and the individuals who hold its shares. Furthermore, a new paragraph 171(3) was introduced into the same Income Tax Law to the effect that taxpayers must produce adequate documentation on any transactions with related parties. This provision is an element of the general duty of taxpayers to fully cooperate with the tax authorities, which is complemented by the tax authorities’ duty to consider all the relevant facts and circumstances of a case under §204(1) of the Abgabenordnung.
To the extent that the new statutory provisions do not specify the nature and scope of the required transfer pricing documentation, guidance should be found in the OECD Transfer Pricing Guidelines. Some changes can be expected in this area as a result of Action 13 of the BEPS project, which in its current formulation is likely to impose a material increase in compliance costs on international business.
In the same spirit of adopting a ‘BEPS compliant’ approach to corporate tax planning, the Luxembourg Finance Minister announced in March 2015 that the current IP regime would be discontinued.
The current system under Art 50bis Income Tax Law grants a 80 per cent exemption on all returns on many classes of intellectual property, including patents, trademarks, and software. The result is an effective tax rate below six per cent on net royalty income and capital gains. Following the ‘nexus approach’ put forward by Germany and the UK and endorsed by the G20 countries and the OECD in the context of Action 5 of the BEPS project, a favourable tax regime for IP will be available only to the taxpayers who can prove that they incurred R&D expenditures giving rise to the relevant IP income and gains.
As a result, the new regime will be limited to patents and equivalent technical IP but not to purely commercial IP such as trademarks. Similarly to the intended provisions for all the ‘patent box’ systems currently available in Europe, a grandfathering rule should provide that after 30 June 2016 no new entrants will be admitted to the existing regime, which will stay in force until 30 June 2021. It should be noted that at the time of writing this was simply a media announcement and no legislative activity is known to be under way to this effect.
Action 6 of the BEPS project may bring further changes to corporate tax planning in the form of some limitations to the use of double tax treaties for tax avoidance purposes. Meanwhile, the amendment adopted by the Council of Europe on 27 January 2015 in respect of the EU Parent – Subsidiary Directive may introduce new constraints to the use of Luxembourg companies as international holding vehicles. The amendment, which must be implemented in all member States by the end of 2015, precludes the application of the Directive to any “arrangement or series of arrangements [that] are not put in place for valid commercial reasons which reflect economic reality”. This will at least translate into enhanced ‘substance’ requirements for Luxembourg holding companies – and for that matter, any holding company incorporated in a EU member state. It is worth mentioning that Luxembourg revenue authorities had already indicated some ‘substance’ criteria in respect of ’’financing companies’, ie Luxembourg companies that carry on infra-group financing, in the Tax Circular no. 164/2 of 28 January 2011. The relevant substance requirements in this case boil down to at least 50 per cent of the company directors residing in Luxembourg, all key management decisions being taken in Luxembourg, and an adequate degree of risk-taking such as a one per cent ratio of equity to outstanding debts (or at least €2million equity). These criteria are adequate for a special purpose vehicle in a cross-border financial arrangement. It is hoped that the 2011 Circular can be used as valid guidance also for the future.
Reviving Luxembourg’s Ingenuity?
By way of conclusion, the financial industry is by far the leading sector of the Luxemburg economy. Its prominence in certain areas such as investment funds do not appear to be materially challenged and on the contrary it shows clear signs of resilience. Luxembourg is holding to its position as first financial centre in the Eurozone, with an increasingly diversified geographic reach. It hosts the European headquarters of the major Chinese banks and on 29 April 2015 the People’s Bank of China announced that Luxembourg was granted an initial quota of RMB50 billion (ca €7 billion) in the RMB Qualified Foreign Institutional Investor scheme (RQFII), allowing FQIIs to directly reinvest offshore RMB into the capital markets of mainland China, with a clear advantage for Luxembourg funds investing in the Chinese market. Some breakthroughs in the context of Islamic finance were attempted as early as 2010 with two Tax Circulars clarifying the tax treatment of several shari’a compliant financial arrangements.
On the other hand, the long-term sustainability of the Luxembourg economic model is heavily influenced by the ability of some other sectors, such as private banking and corporate tax planning, to ‘re-invent themselves’ in the context of a violently changing global environment. The same vision and innovative ability that built Luxembourg’s fortune in the ‘80s and in the early years of this century should be revived in this era of unprecedented changes.
 Quote in the daily Luxemburger Wort on 20 June 2015.
 OECD, Economic Surveys – Luxembourg. Remarks by Secretary General Angel Gurría, 27 March 2015.
 Source: Association of Luxembourg Investment Funds (ALFI).
 Directive 2011/61/EU.
 Administration des Contributions Directes, Circulaire LIR n. 14/4.
 Administration des Contributions Directes, Circulaire LG - A n. 61.
 Directive 2014/91/EU.
 Directive 2011/16/EU as amended under the Directive 2014/107/EU and the proposal for a further amendment published by the European Commission on 18 March 2015.
 Luxembourg Banking Association (ABBL), Private Banking Group, information published at the members’ meeting of 12 June 2015.
 Bill n. 6595 on “patrimonial foundations” was filed with the Luxembourg Parliament on 22 July 2013.
 Directive 2015/849/EU.
 Directive 2011/96/EU.
 The implementation of this anti-avoidance provision under Luxembourg law is amongst others the subject matter of Bill N. 6847 which was introduced by the Minister of Finance on 5 August 2015.
 Circular LG-A 55 of 10 January 2010 of the authority in charge of income tax (Administration des Contributions Directes) and Circular 749 of 17 June 2010 of the administration in charge of stamp duties and VAT (Administration de l’Enregistrement et des Domaines).
Paolo Panico is a solicitor in Scotland and a director of Private Trustees SA, an independent trust company in Luxembourg, and of Teton Trust Company LLC, a regulated trust company in Wyoming (USA). Paolo is chairman of the STEP Europe Region and a member of the Council and Board of STEP Worldwide as well as deputy chairman of the International Tax Planning Association (ITPA). Paolo teaches at the Master in Wealth Management of the University of Luxembourg and at the LLM of the University of Liechtenstein. His publications include: Private Foundations. Law and Practice (Oxford University Press, 2014), International Trust Laws, 2d ed (Oxford University Press, 2017), and as editor Beneficial Ownertship Registers: The STEP Handbook for Advisers (Globe Law and Business, 2021) and Trust Laws in Cyprus: An International Perspective (Globe Law and Business, 2022).