Funding scandal from Sarkozy's past returns to haunt him

Investigation into misuse of cash from two decades ago threatens to derail re-election campaign

A two-decades-old financial scandal threatens to engulf the former French prime minister Edouard Balladur – to the deep embarrassment of his former lieutenant, Nicolas Sarkozy.

New evidence emerged yesterday linking President Sarkozy to an off-shore company created in 1994 to handle commissions on large French arms sales to Pakistan and Saudi Arabia.

The commissions, paid through a company in Luxembourg allegedly created by Mr Sarkozy as budget minister, were not illegal at the time. It is suspected, however, that cash kick-backs were paid on the contracts – secret commissions on commissions – to fund Mr Balladur's failed 1994-95 campaign for the presidency.

Investigations by two examining magistrates have crept closer to the retired Mr Balladur, 82, in recent days. Two former senior officials in his campaign have been arrested and questioned by magistrates. One, the former culture minister Renaud Donnedieu de Vabres, was placed under formal investigation for "embezzlement" just before Christmas.

Last September, two longstanding friends and associates of Mr Sarkozy, including Nicolas Bazire, the best man at his wedding to Carla Bruni in 2008, were accused of "receiving embezzled funds" as part of the same probe.

Yesterday, the transcript of a witness interview conducted by the magistrates was leaked to the newspaper Libération. A former senior official in the French naval dockyards, Philippe Menayas, told the magistrates that Mr Sarkozy, as budget minister, had authorised the creation in 1994 of an offshore company in Luxembourg called Heine. The equivalent of £18m was paid by the Direction des Constructions Navales to Heine in 1994-95 as commission on two large French arms sales to Saudi Arabia and Pakistan.

Payments of this kind were legal in France until 2000 but the magistrates suspect that part of the cash was illegally "kicked back" to the Balladur campaign. Mr Sarkozy was also the spokesman – and de facto manager – of Mr Balladur's unsuccessful presidential bid. No direct evidence has emerged, however, linking him to kickbacks or other illegal campaign funding.

The examining magistrates, Renaud van Ruymbeke and Roger Le Loire, are expected to extend their investigation to Mr Balladur, who has denied the allegations, in coming weeks.

With only months until the next presidential elections, the affair is potentially damaging for Mr Sarkozy. He has managed to distance himself from the financial and political chicanery long associated with Jacques Chirac and other figures on the French centre-right.

In the past two years, a series of allegations have surfaced connecting Mr Sarkozy to illegal campaign funding in the past. The Elysée Palace has dismissed all the allegations as baseless and politically motivated.

The accusations surrounding the Balladur campaign are especially explosive. After Mr Chirac won the 1995 presidential election, he froze the Pakistani and Saudi commissions, allegedly to punish his old friend Mr Balladur for running against him. It is alleged by two other magistrates that this led indirectly to a "terrorist" attack on a bus in Karachi in May 2002 in which 14 people, including 11 French submarine engineers, died.