Luxembourg has built a reputation for quality in the global fund industry. It is one of the few remaining eurozone countries with a AAA rating. Its lengthy history as a fund domicile has brought the infrastructure to cope with the increasingly complex demands of fund administration, and it has proved itself both pragmatic and rigorous in adapting to regulatory changes. But might its competitiveness wane as the European Union imposes increasingly stringent legislation on the mutual fund sector, including – potentially – a Financial Transaction Tax?
Last year was a weak period for Luxembourg relative to its main competitor, Dublin. The jurisdiction had €2,059bn ($2,718bn) under management in locally-domiciled investment funds at the end of November 2011, according to the Association of the Luxem¬bourg Fund Industry (ALFI).
New situation
This represented a decrease of 6.35% since January 2011, and was a similar level to that seen in 2007. While locally-domiciled funds were almost double the size of those in Dublin, which has just €1,055bn under management (though around €820bn is administered in non-Irish funds), Dublin grew its fund base by some 9.5% over the same period, Irish Funds Industry Association data shows.
It is a new situation for Luxembourg, which had recorded near-uninterrupted growth in its funds industry, barring an understandable blip in 2008. Its regulator, the Commission de Surveillance du Secteur Financier, is regarded as business-friendly and in tune with the needs of the financial sector.
The funds industry also has an effective representative body in ALFI, which has done much to embed Luxembourg at the heart of the European asset management industry. Addit¬ionally, the country has built one of the most specialised fund administration infrastructures in the world.
It has used this capability to full advantage. Much of the growth in recent years has been in specialist investor funds. Ucits-compliant hedge funds have also chosen to domicile themselves in Luxembourg, thanks to the sophistication of its fund administration base. The jurisdiction also has long-standing strength in specialist areas such as property and private equity.
Its recent weakness is partly a reflection of the nature of fund providers that choose to domicile there. Brian Dillon of legal practice Dillon Eustace says: “Dublin is predominantly US and UK fund providers, because it is English-speaking and has cultural similarities. In contrast, French, German and other continental European fund managers will tend to look at Luxembourg first because it is multi-lingual.”
French fund managers in particular suffered significant outflows from their funds as investors fretted about the economy. Morningstar recently reported that BNP Paribas Investment Partners and Amundi each saw around €22bn wiped off their asset bases in 2011.
There are other considerations, however. Luxembourg has been perceived as more expensive, which may partly be as a result of the economic crisis in Ireland, which has depressed prices there, but is also because Luxembourg’s skills base comes at a price.
Regulation issues
European Union fund jurisdictions face some considerable regulatory challenges over the next few years, and while Luxembourg has a reputation for pragmatic and speedy implementation of EU legislation, these may tax even its regulatory processes.
Ucits IV is now largely embedded, with only the introduction of Key Investor Information (due at the end of June) outstanding.
There is already talk of Ucits V, which will address the remuneration of asset managers, and the role and liability of depositary banks. It will also look at a harmonised European framework for sanctions.
In practice, some of the changes to Ucits should present opportunities for fund managers in Luxembourg and, by extension, channel new business to the country.
Sébastien Danloy, the managing director for RBC Dexia in Luxembourg, says: “Asset managers are increasingly starting to look at the opportunities created by Ucits IV and other legislation, rather than simply seeing them as hurdles to be overcome.”
However, Charles Muller, KPMG partner and deputy director general of ALFI, suggests there is not yet a lot of activity in using these new freedoms.
Meanwhile, Dermot Butler, chairman of the Custom House group, says the trend of hedge funds establishing Ucits-compliant funds in Luxembourg may slow.
“The reason many people went into Ucits was they thought they would avoid the AIFM [Alternative Investment Fund Managers] directive. But they are now finding the Ucits frame.
work is quite restrictive anyway.”
Those hedge funds that have launched as Ucits have not been a universal success. Butler adds: “Some have done very well and raised a lot of assets. Some have been awful.”
There have also been calls to rein in Ucits, as some believe the funds reaching retail investors may be too complex. Certainly, there may be restrictions on the way some funds are sold in the future.
The AIFM directive is also introducing uncertainty. The legislation will be implemented from mid-2013 in two phases, starting with EU funds and then non-EU funds. It was initially thought the directive might bring new funds to the region, where they had previously been based in the Cayman Islands or other locations, as fund managers and promoters sought a compliant domicile from which to distribute to European investors. However, Muller believes this is now unlikely.
“These companies are likely to remain based in the Cayman Islands, but they might set up a compliant ‘little sister’ fund, specifically for EU investors.”
Danloy agrees funds are likely to be co-domiciled rather than re-domiciled.
“Companies are thinking about third-party fund management, rather than launching a Luxembourg product,” he says. “They will simply replicate a strategy that already exists.”
| VAT: The management and distribution of Commission de Surveillance du Secteur Financier-recognised investment funds (Ucits and non-Ucits) is exempt from VAT in Luxembourg. Legal and audit services pay VAT at 15%. Depositary services are partially exempt from VAT. |
| Subscription tax: An annual subscription tax of 0.05% of net assets is payable and calculated quarterly, based on an undertaking for collective investment’s (UCI) net asset value at the end of each quarter. The rate is reduced to 0.01% per year for UCIs invested solely in money market instruments and bank deposits. This reduced tax of 0.01% per year is also levied on the total net assets of UCIs which are governed by the SIF Law and of institutional sub-funds and share classes. |
| Income/CGT: Luxembourg investment funds (Ucits and non-Ucits) are not subject to income/capital gains taxes in Luxembourg. |
| Withholding taxes: Withholding taxes levied at source on income received by a Luxembourg fund are normally not refundable unless a relevant tax treaty applies, but there are currently 36 double taxation treaties possibly applicable to a Luxembourg Sicav/Sicaf. |
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Tax on distributions: Distributions by investment funds, whether paid to resident or non-resident investors, are not subject to any Luxembourg withholding tax. Source: PricewaterhouseCoopers |
Admin hurdles
Muller adds that the directive may make fund administration more expensive. He suggests there are a lot of “airbags” in the legislation that will create administrative hurdles for companies.
Other legislative initiatives loom large. Muller points to Mifid II and its impact on commissions and retrocessions. America’s Foreign Account Tax Compliance Act is also likely to have an effect, while the Retail Distribution Review in the UK may also prove indirectly important.
However, the proposed Financial Transaction Tax is the big unknown for the Luxembourg fund industry. Muller says: “If the Financial Transaction Tax is implemented in its current state, it will generate billions of euros in revenue for Luxembourg. Considering the whole budget is around €12bn, it could make Luxembourg tremendously rich. However, it might be short-lived as the business could go elsewhere.
“The Luxembourg Government has said it is against the tax unless everyone levies it, including the UK, Hong Kong, Singapore and others. As a result, I suspect it will never happen.”
Future growth
Future growth in the Luxembourg fund industry may rely on the extent to which the country can promote its wares to emerging market fund promoters and investors. The weakening economic situation in Europe will continue to constrain fund flows.
Danloy says the Luxembourg fund industry is starting to see entrants from the Middle East, Latin America and Asia. In this, Luxembourg’s more international reputation may give it an advantage over competitor jurisdictions.
“Luxembourg has a more international client base and many fund managers distribute their Luxembourg funds globally,” he says.
Luxembourg has so far traded on its reputation as a well-governed, financially secure jurisdiction with a strong skills base, but it may need more than this to deal with challenges presented by the regulatory and economic environment in Europe over the next few years.
However, its international outlook and flexibility should help it weather the likely weakness in Euro¬pean fund markets.
