Luxembourg: Selected Issues

Abstract

Luxembourg: Selected Issues

Luxembourg Tax Policy Challenges1

Luxembourg’s predictable and generally low-rate tax system has helped establish it as a leading financial and commercial entrepôt and has supported its fiscal revenues. Its revenue base could, however, be susceptible to changes in the EU and global tax environment. While the various international tax initiatives that motivate this chapter remain in early stage, it would nonetheless behoove Luxembourg, as a sovereign with top credit standing and a track record of fiscal responsibility, to assess the challenges and formulate policy responses preemptively, where the effort should be to diversify revenue sources and strengthen the tax system over the medium term.

A. Introduction

1. This chapter considers features of the Luxembourg tax system that may be susceptible to changes in international tax transparency standards and surveys related policy options. Luxembourg has the lowest value added tax (VAT) rates in Europe; low excises for fuel, alcohol, and tobacco; and, as other countries, a range of deductions and exemptions that reduce its effective corporate income tax (CIT) rate. This system has helped make Luxembourg a hub for international financial and commercial operations while also stimulating cross border retail demand. Taxing the resulting activities brings in over one-quarter of general government revenue, where some portion could be susceptible to changes in EU and international tax standards, rules, and practices. This highlights the need for advance planning, including a careful exploration of options to make the tax system more robust, where Luxembourg’s upcoming tax policy review is thus timely.

B. Winds of Change

2. Potential challenges to Luxembourg’s tax base arise from various sources (Staff Report, Box 1). The OECD/G20 Base Erosion and Profit Shifting (BEPS) project and similar initiatives at EU level may lead to changes in tax standards that could reduce incentives for certain multinational corporations (MNCs) and banks to domicile their operations in Luxembourg. European Commission state aid probes in selected cases introduce additional uncertainty. Separately, proposed changes to U.S. federal taxation of unrepatriated past and future profits of U.S. companies could cause affected firms to repatriate some or all of their Luxembourg profits, with an impact on the collection of associated revenues in Luxembourg. Some estimates suggest U.S. firms booked up to $40 billion of profits in Luxembourg in 2013, or about 8 percent of their overseas total (Zucman, 2014). Finally, EU energy tax reform has been debated since 2011, and in early 2015 the OECD recommended that, to reduce carbon emissions, Luxembourg should increase taxes on petrol and diesel to gradually eliminate price differentials with neighboring countries (OECD, 2015).

3. Luxembourg has already responded to these challenges with many positive steps. It is among early adopter countries that have committed to implement the OECD Standard for Automatic Exchange of Financial Account Information in Tax Matters from 2017. Within the EU, Luxembourg has begun to share firm specific advance tax rulings (ATRs) on a bilateral basis on request, and has expressed support for EU proposals to make such exchanges automatic. A Grand Ducal decree adopted in December 2014 strengthened procedures for ATR approval by creating a legal basis, clarifying information requirements, and creating a special committee to review applications. In the area of bank secrecy for individuals, Luxembourg has adopted mandatory automatic exchange of information on interest payments under the EU Savings Directive, taking effect in 2015. It has also agreed to adopt an extension of that Directive covering account balances and other sources of income including dividends, effective from 2017. Finally, the Luxembourg authorities are fully engaged in the BEPS deliberations, where they stress the importance of synchronized action by all countries and ensuring a level playing field more broadly.

C. Selected Features of Luxembourg’s Tax System

4. Luxembourg’s VAT rates remain the lowest in the EU, and among the lowest in the OECD, even after the 2 percentage point rate increase that took effect on January 1, 2015 (Figure 1). The standard rate, now at 17 percent, is complemented by three reduced rates: an intermediate rate, now at 14 percent, on a range of financial services and wine; a reduced rate, now 8 percent, on gas and electricity; and a super reduced rate, unchanged at 3 percent, on water, pharmaceuticals, most food products, broadcasting services, some housing, and printed materials.

Figure 1.
Figure 1.

VAT and CIT Rates in the OECD, 2013

Citation: IMF Staff Country Reports 2015, 145; 10.5089/9781513546056.002.A001

5. Luxembourg’s CIT rate is among the highest in the OECD although, as in most countries, exemptions apply (also Figure 1). The statutory CIT rate, 29.2 percent, remains below statutory rates of 30.2–34.4 percent in neighboring Belgium, France, and Germany. Available tax exemptions, under domestic law, tax treaties, and the EU Parent-Subsidiary Directive, allow qualifying companies to reduce their effective CIT rates. Luxembourg also offers a favorable tax regime for intellectual property (IP) rights, where up to 80 percent of net royalties and capital gains derived from qualifying IP rights are excluded from taxation. Exclusions apply to patents, trademarks, designs and models, internet domain names, and software copyrights. The result is an effective CIT rate of about 5.8 percent for IP income, among the lowest in Europe (Evers et al., 2014). Qualifying IP assets are also exempt from net wealth tax (KPMG, 2012). Of note, Luxembourg is currently in the process of changing tax legislation applicable to IP.

6. In addition to low VAT rates, Luxembourg also maintains excise rates on certain fuel, alcohol, and tobacco products that are generally below those of its immediate neighbors (Table 1). Differences are particularly notable for specific excises on cigarettes and petrol, whereas for diesel two of the three neighboring countries have reduced rates on professional use. These Luxembourg excise rates, specific and ad valorem, are fully consistent with EU tax legislation, meeting or exceeding the applicable floors.

Table 1.

Selected Specific Excises in Luxembourg and Neighboring Countries, 2014

(Euros)

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Sources: EU, Excise Duty Tables on Alcohol, Energy and Tobacco, January 2015; and Luxembourg authorities.

7. As in other financial hubs, investment funds benefit from favorable tax treatment, which, together with other factors, creates incentives to domicile in Luxembourg. As in competing jurisdictions, benefits for funds in Luxembourg include exemptions from CIT, municipal business tax, and net wealth tax. Instead, such entities pay a Taxe d’Abonnement (subscription tax), currently set at 5 basis points of net assets under management annually for most funds, or 1 basis point for qualifying money market funds and special investment vehicles, with funds dedicated to certain socially important activities such as occupational retirement pensions and microfinance exempt from this tax (Elvinger and Le Sourne, 2013). Dividing receipts by average assets under management suggests an average effective subscription tax rate of about 2½ basis points in 2014.

8. In addition, MNCs and banks doing business in Luxembourg can benefit from its wide network of tax treaties. As of end 2014, Luxembourg had bilateral tax treaties with 75 countries and agreements with another 19 countries were under discussion (KPMG, 2015). This network covers all EU member states save Cyprus and almost all OECD countries. Intended to prevent double taxation, the agreements allow foreign companies with Luxembourg-sourced income to obtain certain exemptions from Luxembourg taxes on dividends, interest on profit-participating loans, and other operations if they are subject to taxation in other jurisdictions.

9. To provide legal certainty, Luxembourg’s tax authorities offer to qualifying taxpayers advance decisions concerning their envisaged operations per Luxembourg tax law. The authorities may approve advance price agreements (APAs) on intercompany transfer prices or ATRs that lay out the expected tax treatment of specific operations. An ATR is binding for five years (with the possibility of extension) and subject to the principles of good faith and compliance (Deloitte, 2013). According to a January 2011 administrative circular, ATRs may be obtained only by companies where the Board and a majority of directors are based in Luxembourg. APAs and ATRs are strictly confidential, mirroring similar practices in most other EU and OECD countries, being understood that they can be exchanged on the basis of EU and international instruments.

10. The combination of international rules and favorable national tax treatment has helped Luxembourg attract many large MNCs and banks. A number of the world’s largest and best known firms (including Microsoft and Apple’s iTunes) choose to conduct business through Luxembourg. Some (such as Amazon and Skype) have selected Luxembourg as the location of their European corporate headquarters. This has cemented Luxembourg’s role as an important jurisdiction for international financial and nonfinancial business.

D. Some Macroeconomic Effects

11. Luxembourg’s mix of fiscal stability, openness, conservative prudential oversight, and responsiveness to investor needs has served as a magnet for international financial business. Net assets of investment funds have more than doubled since 2008, reaching €3½ trillion, or over 70 times GDP. Bank assets amount to €750 billion, or more than 15 times GDP. Gross output (turnover before deducting the value of inputs used, a measure of underlying economic activity) of the financial and insurance sector (financial sector hereinafter) accounts for nearly half of overall gross output (Figure 2). The financial sector contributed about 15 percentage points to the 37 percent cumulative expansion of real overall gross output over 2005–13.

Figure 2.
Figure 2.

Gross Output by Sector, 2005–13

Citation: IMF Staff Country Reports 2015, 145; 10.5089/9781513546056.002.A001

Source: STATEC.

12. Strong growth of intermediary operations in the financial sector, however, limits the sector’s value added and thus its contribution to GDP. The sector contributed just over 1 percentage point to the 15 percent cumulative expansion of real overall value added (gross output less intermediate consumption) in 2005–13 (Figure 3). Over the same period, the share of value added in financial sector gross output (a proxy for the margin) fell from an already low 20 percent to about 15 percent (Figure 4). In comparison, the share of value added in financial sector gross output in other European and Asian countries with large and internationalized financial sectors ranges from about 40 percent in Ireland to some 60 percent in Switzerland (Figure 5). The relatively low margin in Luxembourg likely reflects the dominance of fund related operations where value added—and thus the taxable base—is lower than for banks. These comparisons are blurred by measurement difficulties (Haldane, 2010). In any event, comparing Luxembourg’s city state economy to that of larger countries (rather than the financial centers within them, say, London or Frankfurt) can yield biased results.

Figure 3.
Figure 3.

Value Added by Sector, 2005–13

Citation: IMF Staff Country Reports 2015, 145; 10.5089/9781513546056.002.A001

Source: STATEC.
Figure 4.
Figure 4.

Shares of Value Added in Gross Output by Sector, 2000–13

(Percent)

Citation: IMF Staff Country Reports 2015, 145; 10.5089/9781513546056.002.A001

Sources: STATEC; and IMF staff estimates.
Figure 5.
Figure 5.

Luxembourg Financial Sector in Perspective, 2000–14

Citation: IMF Staff Country Reports 2015, 145; 10.5089/9781513546056.002.A001

Sources: Haver Analytics; Luxembourg authorities; Etude d’impact (2012); and IMF staff estimates.

13. In contrast, the real gross output of Luxembourg’s commercial sector has more than doubled in the last eight years, with the impact on overall value added varying by subsector. Gross output of the retail trade subsector increased by an estimated 270 percent in real terms over 2005–14. This expansion far outstripped real domestic demand growth over the same period, reflecting increasing cross border trade. In terms of real gross value added, the commercial sector as a whole grew by 25 percent over 2005–13. The sector thus contributed more than 2 percentage points to the 15 percent cumulative expansion of real overall gross value added over the period. In retail trade, however, gross value added stagnated despite strongly growing gross output.

E. Luxembourg’s Revenue Receipts

14. The financial sector’s share in revenues is smaller than its share in value added (Figure 5). Counting direct and estimated indirect revenues (following Etude d’impact, 2012, where indirect revenues include those from ancillary industries and employees’ PIT), the sector generated more than 8 percent of GDP in revenues in 2014, or about 18 percent of general government revenues. This is well below the sector’s 27 percent share in overall value added (and far below its 50 percent share in overall gross output). The sector’s share in total revenues is down significantly from its pre crisis peak of about 21½ percent in 2007, and has remained broadly stable over the last three years. By revenue head, the largest contribution was CIT, followed by PIT, then subscription tax. Banks remain the largest source, although their share in total revenue receipts from the sector has slipped while that of Soparfis (financial management companies) has increased steadily (Table 2).

Table 2.

Tax Revenues from Financial Sector, 2011–14 1/

(Percent of total)

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Sources: Luxembourg Ministry of Finance; and IMF staff estimates.

Sum of sector contributions to CIT, net wealth tax, and local business tax, plus PIT of employees; excludes subscription tax on investment funds and estimated revenues from ancillary activities.

15. Luxembourg’s ratio of overall CIT revenues to GDP is above those of its immediate neighbors, although the excess is gradually diminishing. Luxembourg collected CIT worth about 4.9 percent of GDP in 2013, among the highest ratios for advanced economies and well above the 1.8–3.1 percent of GDP range for Belgium, France, and Germany (Table 3). At the same time, the statutory CIT rate in Luxembourg is somewhat lower than in those three countries (recall Figure 1), and the effective rate may be lower still. Taken together, these observations suggest that the higher CIT yield to a large extent reflects MNCs’ and banks’ decisions to set up their European headquarters in Luxembourg, although other country specific factors may also be at play given the small open city state economy. The positive differential in CIT collections between Luxembourg and its neighbors is gradually diminishing (Figure 6). Steady declines in both the ratio and its excess over the three neighbors since 2002 may in part reflect falling CIT rates (statutory and effective) in all four jurisdictions, as well as possible larger declines in the effective rate in Luxembourg.

Table 3.

Corporate Tax Revenue in Selected Countries, 2013

(Percent of GDP)

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Source: OECD.
Figure 6.
Figure 6.

Corporate Tax Rates and Revenues, 2000–13

Citation: IMF Staff Country Reports 2015, 145; 10.5089/9781513546056.002.A001

Sources: OECD; Eurostat; and IMF staff estimates.

16. Low VAT and excise rates on fuel have helped induce cross border demand for petroleum products. Retail fuel prices are generally lower than in neighboring countries. This creates incentives for nonresidents, particularly those who already commute to Luxembourg for work, to purchase their fuel in Luxembourg. According to estimates presented by Luxembourg’s Cour des comptes (Court of Auditors) in its assessment of Budget 2015, residents contribute only about 17 percent of excise and VAT on fuel, with the rest paid by professional transit operators and other nonresidents (Table 4). In 2013, Luxembourg collected 2 percent of GDP in fuel excises, about 1½–2 times the levels in Belgium, France, or Germany (Table 5). From a peak in 2004, Luxembourg’s total excise receipts have declined by more than those of its three immediate neighbors (Figure 7).

Table 4.

Luxembourg Fuel Taxes Paid by Residents and Nonresidents, 2014

(Millions of euros unless otherwise indicated)

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Sources: Cour des comptes, 2014; and IMF staff estimates.
Table 5.

Petrol and Diesel Prices, Excise Rates, and Fuel Excise Revenues in Luxembourg and Neighboring Countries, 2013

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Sources:

Price of Unleaded 95 RON and Diesel as of April 3, 2015;

EU, Excise Duty Tables, January 2015; and

EU, Excise Duty Tables (Tax receipts – Energy products and Electricity), July 2014; Eurostat; and IMF staff estimates.

Figure 7.
Figure 7.

Excise Revenues, 2000–12

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 145; 10.5089/9781513546056.002.A001

Sources: OECD; Eurostat; and IMF staff estimates.

17. Excise rates on tobacco products are also set at a relatively low level, with a similarly positive demand effect. For these products too, retail prices in Luxembourg tend to be generally lower than in neighboring countries. According to rough estimates by the Ministry of Finance, Luxembourg residents contribute about 20–25 percent of the combined excise and VAT revenues on all tobacco products combined, with the balance paid by nonresidents. Excises on tobacco net Luxembourg some 1.2 percent of GDP annually, more than double the comparable levels in the three neighboring countries (Table 6).

Table 6.

Tobacco Excise Revenues in Luxembourg and Neighboring Countries, 2013

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Sources:

EU, Excise Duty Tables (Tax receipts – Manufactured Tobacco), July 2014; Eurostat; and IMF staff estimates.

18. In addition, VAT collected on electronic commerce contributed increasingly to Luxembourg’s VAT receipts in the decade up to 2014. Under streamlined EU rules governing e-VAT as implemented in 2003, e-commerce within the EU was taxed at origin rather than at destination for firms established in the EU (whereas firms selling from outside the EU had to determine the final destination to apply the correct VAT rate). These rules incentivized major non EU firms such as Amazon and Apple’s iTunes to establish in the Luxembourg, which offered the lowest VAT rate in the EU. Luxembourg’s revenues from e-VAT thus increased from about 0.4 percent of GDP in 2005 to an estimated 2.3 percent of GDP in 2014 (Figure 8).

Figure 8.
Figure 8.

Retail Trade and e-VAT, 2005–19

(Index, 2005 = 100; right scale in percent of GDP)

Citation: IMF Staff Country Reports 2015, 145; 10.5089/9781513546056.002.A001

Sources: STATEC; Ministry of Finance; BCL; and IMF staff estimates.

19. New EU rules, however, will sharply reduce e-VAT receipts that may be retained by Luxembourg going forward. Under EU Directive 2008/8/EC, e-VAT shall accrue to the country of domicile of the purchaser not the seller. Under the legislated transitional provisions, Luxembourg’s share of the affected e-VAT revenue would fall to 30 percent in 2015–16, 15 percent in 2017–18, and zero thereafter. Thus e-VAT revenue retained by Luxembourg is projected to fall by more than half, to about 1 percent of GDP in 2015, and to halve again by 2018. Exact amounts, however, will depend on the behavioral responses of affected firms, some of which could relocate out of Luxembourg.

F. Conclusion

20. In summary, as in other small open economies, a material share of Luxembourg’s tax base could prove susceptible to changes in EU, OECD, and U.S. tax practices or standards (Table 7). The remaining dwindling sums of retained e-VAT will depend on firms’ behavioral responses to new EU rules for cross border e-commerce. Over three-quarters of excise and VAT revenues on fuel and tobacco products are generated by nonresident demand. The financial sector generates some 18 percent of total revenues (counting ancillary industries’ contributions and employees’ PIT). Within these, revenues from the subscription tax on funds’ assets under management are importantly a function of market valuations. Separately, MNCs’ decisions to route corporate treasury operations through Luxembourg likely lift CIT receipts, although here effects are especially difficult to quantify.

Table 7.

Selected Luxembourg Fiscal Revenue Sources, 2014

(Estimates for 2014 unless otherwise indicated)

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Sources: Luxembourg authorities; and IMF staff estimates.

21. The precise triggers, magnitudes, and time horizons of challenges vary by type of revenue, are difficult to predict, and reflect many factors outside of Luxembourg’s control. This situation is not unique to Luxembourg, in many respects being common to other small open city state economies. Such economies’ macroeconomic prospects and revenue trajectories tend to be especially tightly linked to the policies of larger neighbors as well as developments more broadly. Nonetheless, it is important that the tax challenge that could now face Luxembourg is monitored, understood, and quantified as details evolve. Here, Luxembourg’s tax policy review scheduled to begin this year provides a timely opportunity to assess options.

22. To address potential challenges to Luxembourg’s revenue base, the tax policy review should explore selective rate increases and base broadening measures:

  • Review options to marginally increase the tax take from the burgeoning investment fund industry. The doubling of assets under management over 2005–14—with a half trillion euro increase in the last seven months alone—has not resulted in a proportional increase in revenues from this sector. Yet, with ECB monetary policy settings likely to remain exceptionally accommodative for an extended period, balanced by expectations of U.S. rate hikes, it is possible that search for yield dynamics will continue to drive strong asset growth going forward. With assets under management already at €3½ trillion, efforts to modestly increase collections from the sector would be wholly consistent with “following the money.” Options would need to preserve Luxembourg’s appeal internationally, with due consideration for tax arrangements in major competing investment fund jurisdictions.

  • Increase taxes on real estate and motor vehicles, where rates are currently set at relatively low levels. Strikingly, the last round of comprehensive real property revaluations for tax purposes took place in 1941. While a large jump in official real estate values and attendant tax obligations on old properties may be politically challenging, ample scope exists for gradual upward adjustments. Regarding taxes on motor vehicles, there may be scope to increase rates, including through CO2 levies, which could also reduce street congestion and pollution. Current low oil prices make the timing propitious for any such adjustments. In addition to positive revenue effects and relative ease of collection, these and other similar taxes offer the advantage of strong progressivity.

  • Revisit the scope and level of reduced VAT rates, which remain among the lowest in the EU even after the recent rate increase. The super reduced 3 percent slab deserves particular attention, where any future revisions would build upon the reforms adopted in 2014 and effected on January 1, 2015, which moved real estate investments (other than primary residences) and the consumption of alcoholic beverages from the super reduced rate to the standard 17 percent VAT rate.

  • Review CIT rates and rationalize exemptions. The objective should be a modernized system with competitive rates, a broad base, and simplicity with fewer exemptions. Detailed analysis is already underway in view of the envisaged tax reform. In particular, Luxembourg is adapting its tax legislation regarding IP, where the new tax treatment should narrow eligibility conditions for IP related exclusions. Other simplifications may also apply.

23. Finally, Luxembourg’s tax practices should seek to avoid encouraging unnecessary complexity in corporate ownership structures and intragroup financial contracts. Demand for firm specific cross border rulings often reflects the lack of harmonization across national tax regimes, and there are benefits in providing certainty to firms. Recently, however, it has become apparent that some rulings could give rise to layers of holding companies transacting with each other in hybrid instruments, which in the financial sector can multiply challenges for regulators and supervisors. Therefore, even as information sharing increases, the procedures for issuing ATRs and APAs should seek to promote simplicity in group structures, especially in the financial sector.

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Prepared by Michael Gorbanyov, with inputs from Piyabha Kongsamut (both EUR). Detailed comments from the Luxembourg authorities on an early draft are gratefully acknowledged.

Luxembourg: Selected Issues
Author: International Monetary Fund. European Dept.