Explainer: how tax engineering works in Luxembourg

A man in sunglasses taking a bath in euro coins
Alexia Barakou

The choice of the Grand Duchy is basically for tax reasons. The money enters the EU from tax havens without major obstacles and, after investing in real estate projects all over Europe, returns multiplied to the low-tax territories.

Christoph Trautvetter, from the German Tax Justice Network, recently carried out a study on Luxembourg’s role in tax engineering and explains it as follows: “Tenants in many European countries, especially in the biggest cities, are suffering from exploding prices for housing and rent. These price explosions are partly driven by professional investors from the global financial markets that discovered residential real estate as a lucrative investment. Many of them channel their profits from European real estate out of the EU virtually untaxed. To do so they often use intra-group interest payments routed via Luxembourg”.

Watch the animation or read on to learn how tax engineering woks in Luxembourg

But how does this fiscal engineering work? This explainer will explain it in five simple steps, taking as an example a project by Kronos, a group that claims to have managed 100,000 real estate units since its foundation in 2014. The Perrodo family, who made their money with oil, are one of its main shareholders.

Step 1: The business

Kronos uses Luxembourg as a base for its real estate investments in Spain and Portugal.

Luxembourg serves as a gateway for the money used in Kronos’ various businesses, coming from tax havens, and also plays a fundamental role in reducing the payment of taxes on the profits obtained.

Let’s see what happened with the H2O project, the construction of 252 homes, 372 garages and 18 commercial premises in the port city of Badalona, on the outskirts of Barcelona.

To start up the business, a company was set up in Luxembourg called Barkeno Sàrl, the sole owner of a subsidiary in Spain, Barkeno Developments SLU.

68.04% of the capital of Barkeno Sàrl belongs to the Perrodo family, one of the richest families in France thanks to its ownership of  Perenco.

The Perrodos’ investment was made from companies they owned in the Bahamas, which in 2021 were relocated to Guernsey, another favourable tax jurisdiction in the Channel Islands.

The rest of Barkeno Sàrl’s shareholding is held by companies based in the British Virgin Islands, Jersey, Guernsey and Switzerland, owned by the Perrodos’ partners.

All these territories are tax havens or low-tax jurisdictions

The H2O project was launched in 2015 and almost all of the homes, garages and premises were handed over to their buyers in 2020 and 2021. The last ones are scheduled to be sold in 2022.

Step 2: The money’s journey from the Bahamas to Spain

Barkeno Sàrl was incorporated on 30 July 2015 in Luxembourg.

In December 2015, Barkeno Sàrl received €15.8 million from a Bahamian company called Tchak Limited, which belongs to the Perrodo family.

To receive this money, Barkeno Sàrl relied on a financial product issued in Luxembourg: Convertible Preferred Equity Certificates (CPECs). This product is widely used for cross-border investments in Luxembourg.

The reason is that, for tax purposes, CPECs are considered as debt for the Luxembourg company receiving the money and as equity for the lender. This means that the interest paid by the Luxembourg company is fiscally deductible and, at the same time, is tax-free for the recipient of the money in another country until finally distributed.

In the same month of December 2015, Barkeno Sárl in turn lent €15.7 million to its Spanish subsidiary (Barkeno Developments SLU).

In short, the money travelled in a few days from the Bahamas to Spain with a stop in Luxembourg.

In the following two years, Barkeno Sàrl lent another €3.3 million to its Spanish subsidiary. The money also came to Luxembourg through loans from the Perrodos and their business partners.

Step 3: Loans at exorbitant interest rates

The Spanish company Barkeno Developments SLU received, in total, €19 million in loans from its Luxembourg parent company.

The agreed interest rate was 8%, an exorbitant percentage, between 2015 and 2017, when the loans were taken out.

The best proof of this can be found in the Spanish company itself. In addition to receiving €19 million from its Luxembourg owner, it asked for another €8 million from Banco Sabadell, one of Spain’s main financial institutions. The interest rate agreed in 2015 with Banco Sabadell was 3.08%, which was reduced two years later to 2.5%.

The H2O project in Badalona, Spain. | Credit: Kronos

In other words, Barkeno Developments was paying almost three times more in interest for the money it received from its shareholders in Luxembourg than for the money it borrowed from Banco Sabadell in Spain.

When questioned by Investigate Europe, a spokeswoman for the Kronos group defended the correctness of the transactions: ‘The interest rates used for intra-group loans in Kronos structures are defined by transfer pricing analyses, which are updated annually by independent experts following OECD guidelines. It is important to note that such interest rates cannot be compared to bank loans, as the latter are usually secured by a mortgage on a real estate asset, whereas an investor assumes a higher risk as his debt is subordinated and unsecured, which should consequently imply a higher return.”

Step 4: An income gap for the treasury

But why would a company decide to pay three times more for the money it receives from its shareholders than the market price set by the banks? The answer is simple: to pay less tax.

By the end of 2020, Barkeno Developments SLU had already paid back to its Luxembourg parent company all the money it had borrowed, plus €5.818 million in interest payments.

If the loans had been signed at the same interest rate as with Banco Sabadell, the Spanish company would have paid €1.995 million in interest to Barkeno Sàrl.

Therefore, it has paid €3.823 million more than it owed.

As this money is an expense for the Spanish company (financial costs), this means that the profits of Barkeno Developments SLU have been reduced by the same amount: €3.823 million. And given that in Spain companies pay 25% of their profits in taxes, the Kronos group has avoid paying €955,876 to the Treasury thanks to this tax engineering.

International tax rules state that intra-group operations (between companies controlled by the same shareholders) have to be carried out at market prices (“at arm’s length” in the judicial jargon). The interest rates on the loans were not 8% between 2015 and 2020. Are we then faced with an irregularity? Fiscal engineering is not a priori illegal, but it sometimes plays at the limits of the regulations. It is up to the tax authorities in each country to determine whether or not the law is being complied with.

The Kronos spokesperson said the purpose of the intra-group loans is not “to incur in cost overruns” to reduce the tax bill and stressed that the group “is subject to many controls, both internal and external (i.e. tax authorities), with all our records being in order.”

Step 5: Money travels back to tax havens

The money that arrived in Spain in 2015 will return to tax havens multiplied and after having paid as little tax as possible in the country where Kronos actually did the business, as the Luxembourg structure has mainly a financial purpose. There are two ways for the money to return.

The first we have just seen: the payment of interest on the loans received from the parent company. In total, almost €5.82 million, of which more than €3.82 million can be considered as profit irregularly transferred in the form of interest payments.

The second is the payment of dividends. In 2020 and 2021, the Spanish company paid dividends to Barkeno Sàrl of €12.66 million.

In total, €16.48 million of profit was transferred to Luxembourg in a single real estate operation.

But the Grand Duchy is not the final destination of the money. Exactly the same system used by the Spanish company to transfer its profits to Luxembourg is used by Barkeno Sàrl to move the money to the offshore companies of its shareholders.

Firstly, the payment of interest on the loans received: Between 2015 and 2021, Barkeno Sàrl paid its shareholders’ companies more than €4.5 million in interest and financial costs (money paid on CPECs, on a very similar financial product called PEC and on direct loans by the shareholders).

Secondly, Barkeno Sàrl paid its shareholders’ companies €13.2 million in dividends in 2021.

Guernsey viewed from the air | Credit: Bob Embleton, CC BY-SA

The companies that received the payments are located in countries considered tax havens or low-tax jurisdictions. In the case of Barkeno Sárl’s majority shareholders, the Perrodo family, their companies are now in Guernsey (after moving from Bahamas). What happens in those tax havens, when the investors get the money, usually remains a secret. Investors should declare it in their income tax declaration, which they are obliged to make in the country of residence, but it is difficult to control because of the lack of transparency in low-tax jurisdictions.

And how much tax did Barkeno Sàrl pay in Luxembourg? Between 2017 and 2021, just over €37,000 in total, according to the annual accounts filed by the company.

In a nutshell, the H2O balance sheet can be summed up as follows: an investment of just over €19 million has generated dividends of €13.2 million. Or, in other words: investors achieved a return of 69%. And these figures will increase because a small part of the homes in Badalona were sold in 2022, so it is foreseeable that the Spanish company will also pay dividends this year.

Luxembourg and the phantom investment

Tax avoidance structures in Luxembourg are used widely by wealthy people. Intra-company loans are a popular way –but not the only one – of shifting profits earned in real estate businesses to places with 0% corporate tax rates. “By using hybrid structures and by allowing complete anonymity they finally ensure that the final (usually very wealthy) investors pay less tax than normal employees in their home countries or even evade taxes and scrutiny completely,” explains Christoph Trautvetter in his study.

An IMF publication, The Rise of Phantom Invesments, highlighted that “according to official statistics, Luxembourg, a country of 600,000 people, hosts as much foreign direct investment (FDI) as the United States and much more than China. Luxembourg’s $4 trillion in FDI comes out to $6.6 million a person. FDI of this size hardly reflects brick-and-mortar investments in the minuscule Luxembourg economy.”

The authors explained that FDI “is often an important driver for genuine international economic integration, stimulating growth and job creation and boosting productivity through transfers of capital, skills, and technology”. However, they added, much of FDI “is phantom in nature—investments that pass through empty corporate shells. These shells, also called special purpose entities, have no real business activities”. Rather, the goal is to minimise the tax bill through tax engineering.

The study added: “Interestingly, a few well-known tax havens host the vast majority of the world’s phantom FDI. Luxembourg and the Netherlands host nearly half. And when you add Hong Kong SAR, the British Virgin Islands, Bermuda, Singapore, the Cayman Islands, Switzerland, Ireland, and Mauritius to the list, these 10 economies host more than 85 percent of all phantom investments.”

The investments may be phantom, but those who get the money at the end are not. They have names and surnames, but that does not mean that they are always known. Sometimes, by consulting the Register of Ultimate Beneficial Owners, which was available in Luxembourg until a European Court of Justice decision decided to close it to the public at the end of last November, some of these names could be discovered. This is how Investigate Europe found most of the Kronos companies in Luxembourg and connected them to the Perrodo family.

Research on Perenco is supported by the IJ4EU Investigation Support Scheme