The European Commission is set to begin a formal probe into allegations that Luxembourg allowed Inc to benefit illegally from state subsidies for its European operations for almost 10 years, the Financial Times reported on Monday.

The investigation relates to favorable terms given to Amazon under a 2003 tax ruling, which cap its tax exposure to the Grand Duchy and limit the overall cost to less than 1 percent of the company's European income, the FT reported, citing people familiar with the case.

The commission contends that Luxembourg permitted Amazon to misallocate gains within its corporate structure, in a way that fell short of standards expected of an arms-length transaction between corporate subsidiaries, the FT said.

This allowed the company to reduce artificially its tax bill on a selective basis, the FT reported citing sources familiar with the initial investigation.

If the charges are proven, the commission can ask Luxembourg to recoup the substantial state subsidy from the firm, the newspaper reported.

Amazon minimizes its tax bill by having the U.S. unit that owns its technology licenses lease the rights to re-license the technology to a tax-exempt partnership based in Luxembourg.

The amount the company reports through a tax-exempt vehicle in Europe has dropped sharply in the past two years, even as European sales jumped, after the U.S. tax authority tightened rules it felt were being abused to shift profits.

Representatives at the European Commission were not immediately available for comment. Amazon did not respond to requests for comment.

Luxembourg's Ministry of Finance could not be immediately reached for comment.

(Reporting by Shivam Srivastava in Bangalore; Editing by Cynthia Osterman)