Luxembourg, the tiny nation wedged between Belgium, France and Germany, is one of the world's top financial services centers. Reuters

By Tom Bergin

LONDON (Reuters) - "Life in Luxembourg is simply different," says its government website. The same could be said of tax in the Grand Duchy. It's known for its generous tax policies, but what's less familiar is a Luxembourg rule that lets companies cut their income taxes using costs that they haven't actually borne -- a break offered by almost no other state.

The rule, which dates back to World War II, helps companies save hundreds of millions of dollars in taxes each year, a Reuters analysis of the accounts of several major international corporations shows. The profits that escape tax have often not been earned in Luxembourg but rather in countries like Britain, the United States and Germany. Those countries may lose out.

New York-listed telecoms group Vimpelcom, U.S. Internet group AOL Inc., building equipment maker Caterpillar, and U.K. mobile telecoms group Vodafone are just four of those to have made use of the system, accounts for their Luxembourg subsidiaries show. Other firms have similar arrangements, tax advisers say, but they have not made them public.

What these firms can do that companies in most other countries cannot is use notional losses -- like a fall in the value of an asset that a business still holds -- to cut their corporate income tax. In other countries, such an asset would have to be sold, so that the loss is realized, before the company could use it to reduce its tax bill. The only other country to offer a similar tax break is Switzerland, according to 20 tax advisers from a dozen countries interviewed by Reuters; but they said the Swiss are more restrictive.

In the European Union, where some countries use tax incentives to attract corporate investment, Luxembourg's rule is a unique lure. Tax advisers say it has helped attract more than 40,000 holding companies and thousands of high-paying jobs for the population of nearly half a million.

"For a government that wants to collect taxes ... this is just a stupid idea," said Reimar Pinkernell, tax partner in Flick Gocke Schaumburg in Bonn. "But if you don't want to collect taxes, if you are just happy that the company is there, and employs some people, then this is a perfect system."

The leaders of the group of 20 biggest economies pledged in September to close some international loopholes in company tax, but their plans won't target country-specific practices like Luxembourg's. EU sources said in September that the European Commission, the executive arm of the EU, wrote to Luxembourg, Ireland and the Netherlands asking for details of tax deals they had cut with foreign companies, to see if they meet competition rules.

Tax advisers point out that other countries offer different tax breaks to attract investment. The Luxembourg Ministry of Finance said its tax rules are sensible, and not intended to help companies shift profits from other countries.

"A lot of countries use tax competition," said Heather Self, partner at law firm Pinsent Masons in London. "There's nothing wrong with it and there's nothing wrong with companies taking account of different tax rates. Tax is just another cost of business."

Spokespeople for the U.S., U.K., French and German finance ministries declined to comment or said it would be inappropriate to comment on another country's tax rules. A spokesman for the EU Commission said the issue was not one it has examined in detail.


Here's how the rule works. If a company makes an investment -- say, it buys another firm, and the business turns out to be worth less than it paid -- the company will follow international accounting rules to reduce, or write down, the value of the asset in its accounts. In countries like Britain and the United States, that impairment does not generate a tax saving. But in Luxembourg it does.

The case of Dutch-based Vimpelcom Ltd., one of the biggest phone operators in Russia with operations in Canada, Italy and North Africa, shows how firms can benefit.

At the end of 2012 a Vimpelcom subsidiary, a holding company called Weather Capital Sarl, made a 1.1 billion-euro ($1.51 billion) write-down in relation to some shares it held in a subsidiary, Weather Capital Special Purpose 1 Sarl, also a holding company. It also reported an 840-million euro decline in the value of a loan it had made to the holding company.

Under Luxembourg rules, those two losses could save hundreds of millions in tax.

But the loss doesn't give a saving on its own; it must be offset against profits. And Luxembourg's domestic market is too small to make much profit; Vimpelcom doesn't even have a telephone business there.

So the company found another way to benefit.

In January this year, it told investors at a presentation in London that it planned to establish an "internal bank" that would borrow money and lend it on to operating units around the world, to fund their investments.

Henk van Dalen, its chief financial officer at the time, said the company planned to route $13 billion to $15 billion of loans each year through the new financing unit. The in-house bank would generate large profits by charging more in interest than it had to pay. And these profits would escape tax because the financing operation would be based in Luxembourg, where Vimpelcom had big tax losses to use.

The "tax saving" would be $200 million to $250 million each year, van Dalen said.

Vimpelcom declined to comment or answer questions about its Luxembourg operations. Van Dalen did not respond to requests for comment.

It could go on indefinitely, van Dalen told the London meeting, a video of which is available on the company website. "Of course, at a certain moment you will run out of these tax losses and then there will be a new phase developed for the financing company," van Dalen said.

One investor on the video described the structure as "fairly ingenious."

But University of Connecticut School of Law Professor Richard Pomp said the system made no sense. "It's absurd," he told Reuters of the Luxembourg rule. "It gives the taxpayer too much control in managing their tax bill."


Luxembourg's practice was actually inherited from Germany and dates back to the occupation of the Grand Duchy during the Second World War, said Ministry of Finance spokeswoman Veronique Piquard.

Indeed, Germany allowed companies to create such tax losses until 2001, althoughBerlin was less generous, German tax lawyers say.

Another difference was that while Germany gave deductions for write-downs, if a firm made a profit when it sold an investment, the company would be taxed on that.

In Luxembourg, if the investment goes up in value or is sold at a profit, the gain isn't taxable. Pomp, the University of Connecticut professor, calls that a "one way bet" for companies. "There should be symmetrical treatment," he said. "This is a pure tax incentive."

Tax advisers say Germany changed its approach because it stopped taxing capital gains, so it no longer made sense to give a deduction for losses. Piquard saidLuxembourg's treatment of write-downs was not a tax incentive and the tax authority only gave deductions for write-downs which were justified.

The deductions can be quite quickly arranged, as illustrated by the case of internet group AOL Inc.

AOL told investors in its 2009 annual report that it was experiencing weakness in its European display advertising business.

In 2010, it transferred ownership of several European advertising subsidiaries from a British to a Luxembourg-based company.

Months later, that company, AOL Europe Sarl, wrote down the value of the advertising units as part of a 27-million-euro impairment. It then offset this against royalty income totaling 6 million euros, which could otherwise have incurred tax of almost 2 million euros.

Had AOL left the units with the British holding company and taken the losses there, it would not have received any tax benefit.

Piquard declined to comment on individual companies' tax affairs. AOL also declined to comment.


Boosting the appeal of Luxembourg's rule is the fact that many takeovers -- more than half, according to some studies -- don't work out for the acquirer.

Take Caterpillar, which shocked investors in January by writing down almost all of the value of ERA Mining Machinery Ltd., a Chinese company it agreed to buy for more than $653 million in 2011. Caterpillar cited alleged accounting irregularities at an ERA subsidiary, and the write-down wiped out more than half its earnings for the fourth quarter of 2012.

However, there was some consolation for Caterpillar investors, because the deal was structured through a Luxembourg holding company.

The write-down generated a tax deduction of $445 million that could be used to offset Caterpillar's future income in Luxembourg.

Caterpillar declined to comment.


One of the most successful users of the Luxembourg rule is Vodafone. The losses it built up in Luxembourg are so big the Grand Duchy's approach to taxing write-downs has helped it save billions of euros in taxes over the past 13 years.

Vodafone became the largest mobile phone company in the world after a buying spree in the late 1990s, with deals such as the $180 billion takeover of Germany's Mannesmann AG. After the tech bubble burst, Vodafone had to write down these assets.

They were held in Luxembourg, which meant that the 70 billion euros in charges it reported could be used to offset future profits.

These have been significant. Since Vodafone's first write-downs in the year to March 2002, just four Vodafone Luxembourg subsidiaries have earned almost 30 billion euros.

Two have been like Vimpelcom's "internal bank." Vodafone Luxembourg 5 Sarl (VL5) made $15 billion in profits from lending to the group's U.S. arm, while Vodafone Investments Luxembourg Sarl (VIL) made 18 billion euros lending to affiliates such as Vodafone's German arm. Interest payments are tax deductible in the United States and Germany, so the U.S. and German units' taxable income, which could have exceeded 60 billion euros, was also reduced by this arrangement.

More recently, two other Vodafone subsidiaries have gone beyond lending, to start business operations in Luxembourg. The firms -- Vodafone Procurement Company Sarl (VPC) and Vodafone Roaming Services Sarl (VRS) -- trade phone equipment and telephone bandwidth between affiliates and external suppliers. Their 300 staff generated an average 1.7 million euros per head in profit in the year to March 2013, compared with a group average of around 44,000 euros per worker.

Combined, these arrangements mean Vodafone reports more profit in Luxembourg than it does in any other country apart from the United States, group accounts show.

And thanks to the tax losses it has built up in Luxembourg, it has paid only around 100 million euros in tax since 2001. If Vodafone had paid the headline tax rate on this profit, it would have faced a bill of almost 9 billion euros.

Vodafone said it did not use contrived arrangements to shift profits. "Vodafone acts with integrity in all tax matters and operates under a policy of full transparency with the tax authorities in every country in which we operate," the company said in a statement.

Head of Group Media Relations Ben Padovan said the profits reported inLuxembourg reflected genuine economic activity there and the arrangements had no impact on Vodafone's U.K. tax bill.

Vodafone added that the decision to hold its investments and base its inter-company financing in Luxembourg reflected a variety of factors including the country's location within the euro zone, "the stability and predictability of the tax, regulatory, social and political environment and the availability of relevant skills within the labor market."

If companies do use Luxembourg's rules to avoid taxes in other countries, saidLuxembourg tax lawyer Thierry Lesage, then it was up to other countries to change their systems.

The system is "really part of the DNA of the Luxembourg holding (company) taxation system," he said. "As a sovereign state Luxembourg is allowed to determine its fiscal policy."

($1 = 0.7283 euros)

(Edited by Sara Ledwith and William Waterman)