Luxembourg: Death Of A Tax Haven?

It may be pushed into taxing foreign accounts

Little Luxembourg's longtime status as one of the world's most discreet tax havens has brought it fame and fortune. For decades, Belgian, French, and German depositors have brought suitcases of cash to the tiny principality. When the German government slapped a 30% withholding tax on investment income in 1992, this flow of money turned into a torrent.

Now internal and external pressures may force the pocketbook-size state to do the unthinkable and tax foreign accounts. Its European neighbors are doing the bullying. They are desperate for every mark and centime they are losing in tax revenue to help them bring down public deficits before monetary union. Some Luxembourg bankers and politicians, putting on a brave face, say a tax will help the country overcome its reputation as a tax shelter for the rich and criminally inclined. "Luxembourg's image has become bad for business," says Albert J. Ulrich, managing director of Banque Leu Luxembourg.

MONEY LAUNDERING. It's going to be a tough balancing act. Luxembourg will probably have to bend to its European partners, but it can't afford to scare off depositors and risk billions in capital flight. The compromise officials are considering is a 10% withholding tax. Says Luxembourg Treasury Director Yves Mersch: "I've done the models, and a 10% tax on the dividends and investment income of foreign accounts wouldn't hurt us."

Even if Luxembourg relinquishes its tax-free status, government officials say it will never give away its biggest advantage: secrecy. Luxembourg-based banks are legally forbidden to turn over information to any tax official except in cases of money laundering. Yet some bankers worry that even that won't be enough to satisfy the kinds of investors who have chosen Luxembourg. If a tax is imposed, money will leave Luxembourg overnight and pour into the world's remaining tax havens such as the Cayman Islands and Ireland, predicts Robert Milroy, editor of The S&P Micropol Guide to Offshore Investment Funds.

Meanwhile, infuriated neighboring governments are increasingly resorting to strong-arm tactics to frighten their citizens away from banking in the Grand Duchy. German tax authorities have repeatedly raided German banks suspected of hiding money in Luxembourg. Late last year, Belgian prosecutors hauled Kredietbank Luxembourg Chief Executive Damien Wigny into jail for a weekend. Although no charges were filed and he was quickly released, Belgian authorities suspected him of encouraging clients to evade taxes. Wigny declined comment.

Other methods of intimidation are also being used. According to officials in Belgium's Finance Ministry, rogue Luxembourg bankers had offered to provide them with lists of clients who are not paying taxes. A similar scandal occurred in Germany, where police recovered a list of clients at Commerzbank who were parking money in the Grand Duchy.

Luxembourg has a lot to lose if markets are disrupted. In less than a decade, the country has built up its mutual-fund marketing and administration activities from scratch. Today, more than $410 billion in fund assets are registered, administered, and marketed in Luxembourg. Although much of the money is managed elsewhere, the country has built up Europe's second-largest mutual-fund base. Since 1994, when Europe's single market first allowed citizens to buy insurance policies outside of their home market, a thriving insurance trade has emerged.

Even if a new tax is imposed, bankers are counting on new opportunities to compensate for some of the losses. Luxembourg-based financiers are predicting a surge in business once the euro is introduced next year. European pension management, for instance, will likely become one of the most competitive areas of financial services. Until now, multinationals such as IBM and Nestle were forced to manage separate pension funds in each European country where they operate. Centralizing pension operations will help companies save money. That's why Luxembourg rushed to introduce the first legislation allowing pan-European mutual funds and insurance policies. The law is likely to be in effect by the end of March, well before the rest of Europe passes similar bills. "Luxembourg has a big advantage because of its flexible legislation," says Jacques Clerc, director of Swiss Life Luxembourg.

"EASY TARGET." But these legal strengths depend on investor confidence--and it's here that Luxembourg remains vulnerable. With the tax police getting aggressive, many investors are staying away. Admits Banque Leu's Ulrich: "Many of my well-off clients are afraid to come see me." He favors a modest withholding tax "to restore confidence."

Luxembourg officials point out that beating up on the Grand Duchy won't reduce Europe's growing ranks of tax evaders. The only sure way to stop the problem is to lower Europe's punishing tax rates, which would eliminate investor incentive to hide money in Luxembourg. "We will remain an easy target" until the rest of Europe "stops using tax increases to resolve their public finance problems," says Treasury Director Mersch.

But given the unwillingness of Continental governments to cut spending and Luxembourg's insistence on preserving secrecy, Europeans aren't likely to bring their money back home anytime soon.

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