With a population of little more than 400,000, Luxembourg must be the smallest jurisdiction to have attracted the attention of the major international firms. With the exception of Freshfields Bruckhaus Deringer, the UK's magic circle have all established a foothold in the Grand Duchy in recent years and top-tier Dutch practice Nauta Dutilh, a 'best friend' of the UK's Slaughter and May, opened its doors there this month.

A member of the European Union, Luxembourg is not a typical 'offshore' jurisdiction. However, its long-established 'holding' company entity and the more recent investment fund form (UCI) are both exempt from all taxes.

Luxembourg has a substantial international banking sector, thanks to its relatively relaxed regulatory regime, its 'holding' company legislation, the growth of the Euro markets and the existence of the Luxembourg Stock Exchange and Europe's biggest investment fund industry. During the year 2000 alone, assets in funds domiciled in Luxembourg increased by $70bn to $817.3bn.

Private banking services are particularly strong, due to the absence of withholding tax on interest payments, the very wide range of financial products available and tight banking secrecy (this secrecy is protected by statute). The courts are likely to permit disclosure of information only where there is clear evidence of tax fraud or money-laundering activity.

"The investment banks are here, the major players are here. After a long learning phase, Luxembourg is firmly on the map," says Linklaters Loesch partner, Freddy Brausch. "The firms that are global and serve international clients will probably want to give some thought to whether they should have a Luxembourg office to support the international business of the firm."

Nauta Dutilh's move into Luxembourg may be consistent with its stated aim of creating a true full-service Benelux practice, but the firm's immediate interest in the Grand Duchy is tax driven. This follows recent legislation and anti-avoidance measures implemented in both Holland and Belgium, which has disadvantaged the use of Dutch holding companies and Belgian co-ordination centres for multi-national companies' tax planning.

With a tax-take of more than 41% of GDP, Luxembourg could barely be described as a tax haven, but its finance system (financial services account for 22% of the economy) does share some similar characteristics to the offshore centres, particularly with regard to banking secrecy, certain ring-fenced tax advantages for non-resident companies and favourable tax ruling practices.

Both are currently under attack, from the European Union's Savings Tax Directive and the Organisation for Economic Co-operation and Development's (OECD) campaign against 'harmful' tax practices respectively. The OECD's deadline for the reform of harmful tax practices is April and the first victim in Luxembourg is widely predicted to be the tax-exempt '1929 Holding Company'.

Nevertheless, according to Derk Prinsen, the partner leading Nauta Dutilh's new Luxembourg practice, Luxembourg will still be well placed to benefit from business migrating from Holland and Belgium through structures based around Luxembourg's other main form of holding company, the SOPARFI (Societe de Participation Financiere).

Unlike the 1929 vehicle, the SOPARFIs are not wholly tax exempt, but do benefit from Luxembourg's existing tax treaties and can receive dividends, and dispose of shares, tax free. In plain form, these companies can perform the function of Dutch holding companies in respect of intra-group financing. Used in conjunction with similar vehicles in other jurisdictions with which Luxembourg has tax treaties (for example Belgium and Ireland) they can replicate the role of co-ordination centres, which are used to provide services between the subsidiaries of multi-national companies in a tax efficient manner.

Prinsen is confident that these structures will survive the scrutiny of the OECD. "These structures are not in contravention of the 'level playing field' concept," he says. "They make use of existing tax treaties and conform to the normal characteristics of the tax regime. They are not opportunistic."

The spat with the EU may take longer to solve. While secrecy is an issue that primarily affects the private banking sector, Luxembourg's corporate lawyers say it is not something the corporate sector can ignore. The decision whether to list on a country's stock exchange is driven as much by image and perception as by practical or taxation matters – if the jurisdiction is seen as unco-operative, it has a negative effect on the business environment.

Lawyers in Luxembourg remain confident that it has a bright future ahead as an international financial centre. Its critical mass of banks, liquidity and expertise, they say, should sustain it beyond the tax and secrecy advantages that created it in the first place – as long as it retains the ability to innovate.

In June, Luxembourg announced that it was preparing legislation to ease its regulatory regime for hedge funds and venture capital funds, and – given the jurisdiction's market-leading position in investment funds – the prospect of pan-EU pension funds could provide a major opportunity for the future.

Ironically, the drive toward tax harmonisation across the EU, which so threatens Luxembourg's private banking industry, is paving the way for the creation of pan-European pension funds. In an era of constant external scrutiny and competition, every financial centre needs the flexibility and capacity for innovation to constantly re-invent itself, leverage off its existing strengths and capitalise on new opportunities.

Luxembourg may need all the lawyers it can get its hands on if it is to stay ahead of the game.