August 3, 2004 -- LONDON -- To understand how Britain's financial district, the City of London, has attracted so many European headquarters of international banks, check out a 200-year-old loophole in the British tax code.

It allows foreign bankers in the United Kingdom who work for a non-British company to pay much less in taxes than the vast majority of Britons and their counterparts elsewhere in Europe. U.S. bankers generally aren't among them; they usually can't take advantage of the tax provision because the U.S. taxes earnings regardless of where they are made or where the earner lives.

While the loophole is little known outside elite business circles, tax authorities here have been examining it lately. It remains intact largely because of the role it is believed to play in maintaining London's pre-eminence in European finance against challenges from, in particular, Frankfurt, home of the European Central Bank.

Take Spanish banker Claudio Aguirre, the former head of investment banking for Merrill Lynch & Co. for Europe, the Middle East and Africa. For more than a decade until he left last year, Mr. Aguirre used London as his base while he spent at least 30% of his time working elsewhere. In some years he would make $3 million (€2.5 million), according to people familiar with the matter. Tax on that could theoretically have been charged at 40%, Britain's standard rate.

But Merrill Lynch employed him on what is known as a "dual contract," meaning he had two separate employment agreements with Merrill. As a result, Merrill sent compensation for the 30% of his time that he spent elsewhere to an offshore account, and that wasn't taxed. The rest of his compensation was taxed at the standard rate. By hiving off 30%, or $900,000, the banker would have paid an overall tax rate of 28%, a savings of as much as $360,000 a year. The loophole can cover as much as 50% of a banker's pay.

There are no clear numbers on how many expatriates benefit. But bankers, accountants and human-resources executives put it in the range of at least several hundred across the city, as banks including Goldman Sachs Group Inc., Morgan Stanley and BNP Paribas SA also provide dual contracts for some of their non-British bankers. Accounting firm KPMG estimates that just under 10% of expatriates in the city receive some type of tax relief. Officials at all the banks declined to comment.

The tax loophole dates to the 1800s, when people would leave the country on ships for years. Because the law requires the duties in the two employment contracts to be "made distinct," says Rob Gell, a senior tax manager at Ernst & Young in London, its application is increasingly difficult today with modern communications. "If a European client calls you on our cellphone or e-mails you in London and asks for advice, what are you going to say? 'Wait until I am in Calais and I'll call you back'?"