On the 4th of September 1996, Luxembourg signed its most recent tax treaty with the United States of America. According to that agreement, Lux-based ETFs pay a 30% withholding tax on income received from US securities, as opposed to the 15% paid by their Irish counterparts.
This withholding tax advantage on US securities has led to Ireland solidifying its position as the top domicile for Ucits ETFs in Europe. Given that US securities dominate financial markets, most Ucits ETFs with exposure to them seek a tax advantage in Ireland.
This poses a significant challenge for Luxembourg, as the growth of ETFs is outpacing that of mutual funds and could potentially replace them entirely. I am a convert and exclusively invest in ETFs, believing that as people become more financially literate, they will prefer ETFs over mutual funds.
I own four ETFs – Amundi (domiciled in FR), Lyxor (LU), SSgA (IE), and Vanguard (IE) – with only one domiciled in Luxembourg. The ETF market in Ireland is valued at $953 trillion, compared to $277 trillion in Luxembourg. There is a substantial gap that needs to be addressed.
Costs
The primary reason to invest in an ETF rather than a mutual fund is costs; ETFs are more cost-effective and can consequently offer higher returns than their mutual fund equivalents. The structure and operation of ETFs generally make them cheaper than equivalent mutual funds.
While cost is not the sole reason to invest in an ETF, other advantages include trading on a public exchange, allowing investors to buy and sell throughout the day, and providing a permanent up-to-date view of the fund's assets.
Mutual funds, Luxembourg's cash cow, cannot compete on these selling points.
Despite the absence of an immediate threat to the dominance of the Luxembourg fund industry, measures have been implemented to bolster competitiveness with Ireland. The subscription tax for passive ETFs has been waived, and the CSSF is more lenient with naming conventions than the CBI.
Renegotiate
Unfortunately, the only real solution is to renegotiate the tax treaty with the US, although it remains uncertain if the government is willing to do so.
Alarm bells should be ringing in Luxembourg, as Ireland is constructing a similar moat around ETFs as Luxembourg has around mutual funds. While there are overlaps, the expertise required to administer an ETF differs from that needed to run a mutual fund.
Although reluctant due to the lower margin’s ETFs offer, fund promoters are gradually entering the space, sometimes by converting existing mutual funds. Naturally, they will choose a domicile that best fits tax and operational considerations.
Currently, that choice is Ireland. Luxembourg would be mad to let this continue.
Gregory Kennedy is a columnist for Investment Officer Luxembourg. His columns appear every other week. He also works as a business development manager at Finsoft Luxembourg.
