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By Tom Bergin
LONDON, Dec 17 (Reuters) - "Life in Luxembourg is simplydifferent," says its government website. The same could be saidof tax in the Grand Duchy. It's known for its generous taxpolicies, but what's less familiar is a Luxembourg rule thatlets companies cut their income taxes using costs that theyhaven't actually borne - a break offered by almost no otherstate.
The rule, which dates back to World War Two, helps companiessave hundreds of millions of dollars in taxes each year, aReuters analysis of the accounts of several major internationalcorporations shows. The profits that escape tax have often notbeen earned in Luxembourg, but in countries like Britain, theUnited States and Germany. Those countries may lose out.
New York-listed telecoms group Vimpelcom, U.S. internetgroup AOL Inc., building equipment maker Caterpillar and UKmobile telecoms group Vodafone are just four of those to havemade use of the system, accounts for their Luxembourgsubsidiaries show. Other firms have similar arrangements, taxadvisers say, but have not made them public.
What these firms can do that companies in most othercountries cannot is use notional losses - like a fall in thevalue of an asset that a business still holds - to cut theircorporate income tax. In other countries, such an asset wouldhave to be sold, so that the loss is realised, before thecompany could use it to reduce its tax bill. The only othercountry to offer a similar tax break is Switzerland, accordingto 20 tax advisers from a dozen countries interviewed byReuters; but they said the Swiss are more restrictive.
In the European Union, where some countries use taxincentives to attract corporate investment, Luxembourg's rule isa unique lure. Tax advisers say it has helped attract more than40,000 holding companies and thousands of high-paying jobs forthe population of nearly half a million.
"For a government that wants to collect taxes ... this isjust a stupid idea," said Reimar Pinkernell, tax partner inFlick Gocke Schaumburg in Bonn. "But if you don't want tocollect 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 inSeptember to close some international loopholes in company tax,but their plans won't target country-specific practices likeLuxembourg's. EU sources said in September the EuropeanCommission, the executive arm of the EU, wrote to Luxembourg,Ireland and the Netherlands asking for details of tax deals theyhad cut with foreign companies, to see if they meet competitionrules.
Tax advisers point out that other countries offer differenttax breaks to attract investment. The Luxembourg Ministry ofFinance said its tax rules are sensible, and not intended tohelp 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 nothingwrong with it and there's nothing wrong with companies takingaccount of different tax rates. Tax is just another cost ofbusiness."
Spokespeople for the U.S., UK, French and German financeministries declined to comment or said it would be inappropriateto comment on another country's tax rules. A spokesman for theEU Commission said the issue was not one it has examined indetail.
AN "INTERNAL BANK"
Here's how the rule works. If a company makes an investment,say it buys another firm, and the business turns out to be worthless than it paid, the company will follow internationalaccounting rules to reduce, or write down, the value of theasset in its accounts. In countries like Britain and the UnitedStates, that impairment does not generate a tax saving. But inLuxembourg it does.
The case of Dutch-based Vimpelcom Ltd, one of the biggestphone operators in Russia with operations in Canada, Italy andNorth Africa, shows how firms can benefit.
At the end of 2012 a Vimpelcom subsidiary, a holding companycalled Weather Capital Sarl, made a 1.1 billion-euro ($1.51billion) write-down in relation to some shares it held in asubsidiary, Weather Capital Special Purpose 1 Sarl, also aholding company. It also reported an 840-million euro decline inthe value of a loan it had made to the holding company.
Under Luxembourg rules, those two losses could save hundredsof millions in tax.
But the loss doesn't give a saving on its own: It must beoffset against profits. And Luxembourg's domestic market is toosmall to make much profit; Vimpelcom doesn't even have atelephone business there.
So the company found another way to benefit.
In January this year, it told investors at a presentation inLondon that it planned to establish an "internal bank" thatwould borrow money and lend it on to operating units around theworld, 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 ofloans each year through the new financing unit. The in-housebank would generate large profits by charging more in interestthan it had to pay. And these profits would escape tax becausethe financing operation would be based in Luxembourg, whereVimpelcom had big tax losses to use.
The "tax saving" would be $200 million to $250 million eachyear, van Dalen said.
Vimpelcom declined to comment or answer questions about itsLuxembourg operations. Van Dalen did not respond to requests forcomment.
It could go on indefinitely, van Dalen told the Londonmeeting, a video of which is available on the company website."Of course, at a certain moment you will run out of these taxlosses and then there will be a new phase developed for thefinancing company," van Dalen said.
One investor on the video described the structure as "fairlyingenious."
But University of Connecticut School of Law ProfessorRichard Pomp said the system made no sense. "It's absurd," hetold Reuters of the Luxembourg rule. "It gives the taxpayer toomuch control in managing their tax bill."
AOL'S LUXEMBOURG MOVE
Luxembourg's practice was actually inherited from Germanyand dates back to the occupation of the Grand Duchy during theSecond World War, said Ministry of Finance spokeswoman VeroniquePiquard.
Indeed, Germany allowed companies to create such tax lossesuntil 2001, although Berlin was less generous, German taxlawyers say.
Another difference was that while Germany gave deductionsfor write-downs, if a firm made a profit when it sold aninvestment, the company would be taxed on that.
In Luxembourg, if the investment goes up in value or is soldat a profit, the gain isn't taxable. Pomp, the University ofConnecticut professor, calls that a "one way bet" for companies."There should be symmetrical treatment," he said. "This is apure tax incentive."
Tax advisers say Germany changed its approach because itstopped taxing capital gains, so it no longer made sense to givea deduction for losses. Piquard said Luxembourg's treatment ofwrite-downs was not a tax incentive and the tax authority onlygave deductions for write-downs which were justified.
The deductions can be quite quickly arranged, as illustratedby the case of internet group AOL Inc.
AOL told investors in its 2009 annual report that it wasexperiencing weakness in its European display advertisingbusiness.
In 2010, it transferred ownership of several Europeanadvertising subsidiaries from a British to a Luxembourg-basedcompany.
Months later, that company, AOL Europe Sarl, wrote down thevalue of the advertising units as part of a 27-million-euroimpairment. It then offset this against royalty income totaling6 million euros, which could otherwise have incurred tax ofalmost 2 million euros.
Had AOL left the units with the British holding company andtaken the losses there, it would not have received any taxbenefit.
Piquard declined to comment on individual companies' taxaffairs. AOL also declined to comment.
CATERPILLAR'S CONSOLATION
Boosting the appeal of Luxembourg's rule is the fact thatmany takeovers - more than half, according to some studies -don't work out for the acquirer.
Take Caterpillar, which shocked investors in January bywriting down almost all of the value of ERA Mining MachineryLtd., a Chinese company it agreed to buy for more than $653million in 2011. Caterpillar cited alleged accountingirregularities at an ERA subsidiary, and the write-down wipedout more than half its earnings for the fourth quarter of 2012.
However, there was some consolation for Caterpillarinvestors, because the deal was structured through a Luxembourgholding company.
The write-down generated a tax deduction of $445 millionthat could be used to offset Caterpillar's future income inLuxembourg.
Caterpillar declined to comment.
VODAFONE'S PROFITS POWERHOUSE
One of the most successful users of the Luxembourg rule isVodafone. The losses it built up in Luxembourg are so big theGrand Duchy's approach to taxing write-downs has helped it savebillions of euros in taxes over the past 13 years.
Vodafone became the largest mobile phone company in theworld after a buying spree in the late 1990s, with deals such asthe $180 billion takeover of Germany's Mannesmann AG. After thetech bubble burst, Vodafone had to write down these assets.
They were held in Luxembourg, which meant that the 70billion euros in charges it reported could be used to offsetfuture profits.
These have been significant. Since Vodafone's firstwrite-downs in the year to March 2002, just four VodafoneLuxembourg subsidiaries have earned almost 30 billion euros.
Two have been like Vimpelcom's "internal bank". VodafoneLuxembourg 5 Sarl (VL5), made $15 billion in profits fromlending to the group's U.S. arm, while Vodafone InvestmentsLuxembourg Sarl (VIL) made 18 billion euros lending toaffiliates such as Vodafone's German arm. Interest payments aretax deductible in the United States and Germany, so the U.S. andGerman units' taxable income, which could have exceeded 60billion euros, was also reduced by this arrangement.
More recently, two other Vodafone subsidiaries have gonebeyond lending, to start business operations in Luxembourg. Thefirms - Vodafone Procurement Company Sarl (VPC) and VodafoneRoaming Services Sarl (VRS) - trade phone equipment andtelephone bandwidth between affiliates and external suppliers.Their 300 staff generated an average 1.7 million euros per headin profit in the year to March 2013, compared with a groupaverage of around 44,000 euros per worker.
Combined, these arrangements mean Vodafone reports moreprofit in Luxembourg than it does in any other country apartfrom 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. IfVodafone had paid the headline tax rate on this profit, it wouldhave faced a bill of almost 9 billion euros.
Vodafone said it did not use contrived arrangements to shiftprofits. "Vodafone acts with integrity in all tax matters andoperates under a policy of full transparency with the taxauthorities in every country in which we operate," the companysaid in a statement.
Head of Group Media Relations Ben Padovan said the profitsreported in Luxembourg reflected genuine economic activity thereand the arrangements had no impact on Vodafone's UK tax bill.
Vodafone added that the decision to hold its investments andbase its inter-company financing in Luxembourg reflected avariety of factors including the country's location within theeuro zone, "the stability and predictability of the tax,regulatory, social and political environment and theavailability of relevant skills within the labour market."
If companies do use Luxembourg's rules to avoid taxes inother countries, said Luxembourg tax lawyer Thierry Lesage, thenit was up to other countries to change their systems.
The system is "really part of the DNA of the Luxembourgholding (company) taxation system," he said. "As a sovereignstate Luxembourg is allowed to determine its fiscal policy."
