The European Commission dealt Luxembourg's huge financial sector a bitter blow Wednesday by ordering the Grand Duchy to phase out nearly 80-year-old tax breaks for financial holding firms.
A top Luxembourg official was quick to downplay the importance of the decision however, claiming the sector had prepared for a clampdown which it had seen coming.
After a six-month in-depth investigation, the European Union's executive arm ruled that Luxembourg's tax rules on financial holding companies were unfair and distorted trade and competition in Europe.
"Today's decision to eliminate a scheme providing sizable tax advantages to Luxembourg's financial holdings will help to restore a level playing field in the EU's financial services industry", EU Competition Commissioner Neelie Kroes said.
Under a 1929 law, Luxembourg's corporate tax code encourages big foreign companies to set up special subsidiaries for internal financing and licensing operations by not making them pay taxes on earnings, dividends, interest and royalties. Although Luxembourg tightened the rules in 2005, the EU competition watchdog ruled that that was too little too late.
Therefore, it ordered Luxembourg to clamp down on the scheme by the end of this year while the advantages benefitting existing holdings must be phased out by the end of 2010.
However, Luxembourg Treasury Minister Luc Frieden said that Brussels' action would only have limited impact on the financial services sector, which is by far the Grand Duchy's biggest industry and thrives on favourable tax regimes for firms and individuals.
"It's wrong to say that the holdings are the foundation of the Luxembourg financial sector and that the industry relies on the survival of these holdings," Frieden said. "The holdings are no longer so important for Luxembourg" because they are now mostly used for managing the money of wealthy individuals, he said.
People in the industry say that they had largely seen the commission's decision coming after Luxembourg's EU partners urged it in 2003 to do away with the regime. Since then, many multinational companies that used to use 1929 holdings, as they are known in Luxembourg, have changed their status.
Nevertheless, lawmaker Laurent Mosar recently estimated the 1929 holdings to number as many as 15,000, although one tax expert said that 12,000 to 13,000 were used for individual's wealth management purposes. Eager not to see the financial sector lose some of its shine, Frieden said that a new "instrument" for wealth management would be proposed in the coming months without commenting on what that might consist of.
"Luxembourg will remain an attractive place for wealth management, which is one of the pillars of the financial sector," he said. The country's Statec data agency said on Monday that the industry generated three-quarters of the country's gross domestic product last year.
The Financial Sector Monitoring Commission claims that the Grand Duchy is Europe's biggest home for investment funds with 1.675 trillion euros (2.1 trillion dollars) under management at the end of March this year.