Jan F Wagner examines Luxembourg’s options for maintaining a competitive edge as the end of its tax-free status looms.

In Germany, Luxembourg is known for one thing only: it’s where rich Germans put their savings to shelter them from tax. This may sound overly simplistic, but it’s easy to see why the tiny country has gained that reputation.

Since Luxembourg became a tax haven in the 1980s, several dozen German banks have established subsidiaries there, mostly for private wealth management. Today, 49 German banks represent the largest single group of foreign financial institutions in Luxembourg.

The Grand Duchy’s existence has been very convenient for rich Germans, most of whom made their fortune during the nation’s post-World War II economic boom. True, they had the choice of putting their savings in intensely-secret and tax-free Switzerland, but the odds were that their “house bank” back home had a presence in Luxembourg. This way, they could enjoy all the benefits of Switzerland without the hassle and cost of opening a new account.

Of course, wealthy Germans are not the only ones taking advantage of what Luxembourg has to offer. Beyond German banks, there are another 120 institutions, almost all of which are foreign and in some way involved in administering the savings of high net-worth individuals. This larger group even includes 13 Swiss banks.

Having positioned itself as the alternative to Switzerland, Luxembourg has become a big success in terms of financial centre competition. Although there are no hard statistics, due to the strict confidentiality of private banking, Luxembourg claims to be Europe’s second-largest private banking centre after Switzerland.

Closing in on Switzerland

According to Lucien Thiel, director of the Luxembourg bank association Association des Banques et de Banquiers, Luxembourg (ABBL), Luxembourg is closing in on Switzerland’s lead. “The private banking assets held by Swiss banks used to be twice ours. The gap is shrinking, though, and I would guess that today, the Swiss may have just 50% more assets than us,” he says.

While they do not confirm Mr Thiel’s statement, statistics from the ABBL shed some light on how Luxembourg’s banks compare with Swiss ones. ABBL says that in terms of so-called “Aktiva” (fixed and floating assets), Swiss banks have $805bn, putting them seventh in the world. Luxembourg banks, meanwhile, have $641bn in Aktiva, putting them a close eighth.

Luxembourg’s track record so far is impressive, but recent events suggest that it will have a hard time maintaining that performance in the future because it will lose its status as a tax haven in 2005 by agreeing to impose a withholding tax on revenue from interest-bearing accounts. The tax rate will be initially set at 15%. In 2008, it will rise to 20% before hitting a peak of 35% in 2011.

The move follows years of acrimonious negotiations between Luxembourg and EU governments incensed at the loss of considerable tax revenue caused by the Duchy’s existence. For obvious reasons, the German government was particularly adamant that Luxembourg’s special tax status be ended.

Smartly, however, Luxembourg’s government insisted that if it went ahead with the measure, its rivals in private banking had to follow suit. From next year then, a withholding tax will also apply in Switzerland, Andorra, Monaco, Liechtenstein, as well as the Cayman Islands and the Channel Islands.

Dire consequences

Even so, the emergence of a withholding tax could have dire consequences for the Duchy’s competitiveness as a financial centre. For example, Boston Consulting Group in Singapore estimates that the new levy will cause E1000bn to flow out of Luxembourg and Switzerland and in to Asian tax havens like Singapore and Hong Kong.

Luxembourg bankers acknowledge that the withholding tax will have a negative impact, but they stress that it will be marginal. This, they say, is mainly due to the strong cultural and linguistic ties between Luxembourg banks and their clients. Indeed, everyone in Luxembourg’s financial industry speaks the main business languages of English, French and German, and many speak Italian.

“The new EU withholding tax will no doubt have an impact on Luxembourg’s financial centre, as any tax is part of the overall return of an investment. It will thus influence the customer’s decision for a banking location,” admits Jean Meyer, chief executive of Banque Générale du Luxembourg (BGL), which is the Duchy’s largest bank.

“But return, although an important consideration, is obviously not the only one. Considering its European customer base, Luxembourg will, in particular, continue to profit from major advantages over Hong Kong or Singapore. The most important of these is cultural and linguistic proximity to its customers, and with that, personalised customer relationship management,” he says.

Another factor in Luxembourg’s favour, adds Mr Meyer, is that most private clients in Europe are wary of “expatriating their money to foreign jurisdictions so far away from their homes and habits”.

In some cases, Luxembourg banks also may get around the withholding tax. Since a savings portfolio with less than 40% in bonds is exempt from the withholding tax, it is possible that some banks, client permitting, will simply shift assets from bonds to stocks.

Competitive advantage

Although it has agreed to a withholding tax, Luxembourg and its competitors have not abandoned their banking secrecy, another crucial incentive for wealthy individuals to bank with them. Interestingly, Luxembourg’s banking community believes that since a level playing field has been maintained, the Duchy is better positioned than its rivals, particularly Switzerland.

Mr Meyer observes that Swiss banks are at a significant competitive disadvantage owing to the country’s decision to stay out of the EU. “We have the freedom to deliver services across the EU, which has just grown to 25 members from 15. This is not the case for Swiss banks.”

Switzerland also cannot lure finance professionals from around the EU as easily as Luxembourg, as its non-member status means the professionals need a work permit, adds Hermann Beythan, a partner at the law firm Linklaters who advise major Luxembourg banks.

The Swiss banking association (SBA) in Basel counters that for all of Luxembourg’s apparent advantages, Switzerland has several unique advantages of its own. Not only do Swiss bankers speak the same languages as those in Luxembourg, they speak more of them, including Arabic, Russian and Chinese. Moreover, unlike Luxembourg, Switzerland has several hundred years of experience in private banking, which is probably one of the reasons why it is still ahead of the Duchy, says the SBA.

Mr Thiel of ABBL admits that while Luxembourg has done amazingly well in private banking and even better in mutual funds, relying on these businesses alone will not ensure its competitiveness as a financial centre. He is thus clamouring for the Duchy’s banks to develop other niche businesses. These include: servicing small and medium-sized enterprises (SMEs), especially as they come under pressure following implementation of Basel II; encouraging multi-national companies to base their pension funds in Luxembourg; creating innovative products like Sicar, a new private equity vehicle that permits investment across Europe with few restrictions; and promoting securitisation products like lettres de gage, a covered bond similar to Germany’s Pfandbriefe.

“Until now, Luxembourg has only been seen as a tax haven. If we want to compete in the future, we have to give it a makeover and convince investors that what we’ve done is not superficial but is underpinned by a concrete offer,” he says.


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