Whilst reading our various articles about the business of Formula One many of you may have been wondering why a lot of the companies which run the sport are based in offshore locations such as Jersey. It is of course no accident. These locations have favourable tax regimes for companies and the lower the amount of tax paid, the higher the net profits. However, with Bernie Ecclestone, undoubtedly F1's sharpest business brain, in charge it is no surprise to learn that this isn't the only benefit from having companies located offshore.

An article in today's Telegraph, written by Pitpass' business editor Christian Sylt, reveals that F1 pays less than 5% tax on its annual profits of nearly £320m ($500m). It is thanks to a series of loans from F1's offshore companies to those based in the UK. Unsurprisingly, it is fiendishly complex but it is completely legitimate.

Don't go thinking Ecclestone or F1's controlling shareholder, the private equity firm CVC, have done anything underhand here to extract more money from the sport because they haven't. Sylt's article reveals that the UK's tax authority, HM Revenue and Customs (HMRC), knows all about the loans and has given its blessing to them. Indeed, the principle of using loans in this way to reduce tax is not F1's creation but is set out in HMRC's own guidelines. If companies want to take advantage of it all they have to do is get HMRC's agreement.

F1's low tax rate is a big selling point for investors considering buying shares in the planned £6.4bn ($10bn) flotation of the sport on the Singapore stock exchange. Lower tax means higher profits which can ultimately be paid out to shareholders so in turn this contributes to the valuation of the business which Sylt revealed way back in March.

F1's tax rate hovers between 3% and 5% giving it a tax bill of around £8.9m ($14m) on its underlying profits, known as earnings before interest, taxes, depreciation, and amortization (EBITDA), which came to £302m ($474m) last year. This is despite F1's key revenue generating company, Formula One World Championship (FOWC), being located in the UK along with another 13 of the 30 companies in the group. UK companies have to pay corporation tax on their profits and this comes to around 24%. FOWC is no exception to this so how is its tax bill reduced? The answer is simple: it makes a huge loss.

F1's revenue was up 6% to £973m ($1.5bn) in 2011 and FOWC makes the lion's share of it. This includes around £325m ($510m) from race promoter fees as well as £313m ($490m) from TV rights. The remainder is divided between other UK and offshore companies (see box).

After paying all its costs, including the team prize money which came to £438m ($686m) last year, FOWC is left with a huge profit but it then has to pay far more than that in interest to the F1 companies which are located offshore since they have loaned billions of dollars to it. Interest has to be paid from a company's profit and since the interest in this case comes to more than FOWC's profit it is pushed into loss. And voilà: FOWC ends up with a loss and so does not have to pay tax.

The same process occurs with many of F1's UK based companies and since the interest they pay ends up in the coffers of the offshore companies very little tax is charged on it there. The interest received by the offshore companies is paid from the profits of the UK companies so although it is earned in a country where tax is around 24%, it ends up in a country with a much lower rate and can be paid out to shareholders from there.

The loans from F1's offshore companies put the UK companies into a loss on paper (i.e. on their accounts) but when F1 is floated it will show a healthy profit. On 18 May F1 registered a new Jersey-based parent company, Formula 1 plc, and it is shares in this which will be floated in Singapore. Each share will come with the right to interest in the loans from the offshore companies so the profits from the UK companies will go straight to shareholders.

This all explains why F1's tax rate is below 5% and why investors in the float should be very thankful for it. HMRC allows interest on intra-group loans to be tax deductible and it has given its agreement to F1 doing this so the transactions could not be more legitimate. There is no reason whatsoever why HMRC won't continue to agree to this in future.

If HMRC had not given its agreement F1 could easily have got round the hurdle by moving its tax base offshore. Many other businesses have done this including advertising group WPP, which is run by one of F1's non-executive directors Martin Sorrell. In 2008 WPP moved its tax base to Dublin although Sorrell didn't need to move with it. It is not something F1 needs to do.

F1 directly employs over 300 people and in 2010, the most recent year where a complete set of data is available, the eight teams which are based in the UK paid no corporation tax. However, along with F1 itself they are a significant engine for the UK economy and employ around 4,000 people. It is no wonder that HMRC wants to ensure that F1 doesn't look into moving any of its bases abroad.

BOX: F1's racy results