The British and United States governments are on a diplomatic collision course after the US Department of Justice (DoJ) decided to initiate a formal investigation into allegations of corruption at BAE Systems, the defence company.

The DoJ investigation will scrutinise BAE’s dealings with Saudi Arabia and expose an account held by the Bank of England that is used to facilitate Saudi payments for arms. The British Government refuses to acknowledge the existence of this account.

Gordon Brown, who becomes Prime Minister today, could face a diplomatic crisis in the early days of his leadership if the DoJ demands information on the account. Turning down a DoJ request for help in a corruption inquiry could be embarrassing for Mr Brown and damage the reputation of the country.

Defence sources and government officials said yesterday that the Ministry of Defence (MoD), which runs the account, was seeking legal advice on how to proceed.

The decision by the DoJ to look into allegations of fraud and corruption against BAE is potentially devastating for the UK’s largest defence company. BAE gets 43 per cent of its business from the US and, if it is found guilty, the company could face enormous fines or be barred from winning new US defence contracts.

The company told the stock market that it had received notification of the DoJ investigation yesterday morning. Its share price fell 11 per cent in early trading and closed down 34½p at 407¾p, wiping £1.2 billion off its capitalisation.

The Times reported last month that the DoJ was assessing whether it had jurisdiction to look into BAE’s dealings with Saudi Arabia after a similar investigation by the British Serious Fraud Office (SFO) was shut down for reasons of national security. Allegations of corruption have dogged the £43 billion al-Yamamah oil-for-arms deal, with BAE accused of running a $100 million slush fund to entertain Saudi royals and rumours of backhanders to middlemen and officials. The DoJ is thought to be looking into payments of more than £1 billion made by BAE to Saudi officials, including Prince Bandar bin Sultan, a former Ambassador to the US.

However, these payments are understood to have originated from the escrow account held at the Bank of England and merely transferred through BAE’s financial system. Both BAE and Prince Bandar have denied that the payments were bribes and insist that the transactions were agreed by the Saudi and British governments.

Disclosure of the investigation came three days after the US cleared BAE’s $4.5 billion (£2.2 billion) takeover of Armor Holdings. It also came within hours of Tony Blair and President Bush countersigning a treaty promising greater defence cooperation.

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