The Channel Islands are urgently challenging the legality of proposals they fear could "devastate" a thriving internet trade in VAT-exempt goods, including CDs and DVDs.
They are asking a High Court judge in London to block Government plans to end exemption for low value imports from the islands.
The exemption under EU law has led to the growth in the last decade of a multi-million pound business in which low value items are ordered over the internet by UK consumers.
The exemption was introduced to expedite trade involving "distance selling" and to ensure items were not held up in the postal system.
It currently applies to goods purchased outside the EU for less than £15 under a tax rule called low value consignment relief (LVCR).
UK retailers have condemned the waiver, in the case of the Channel Islands, as an unfair loophole which is costing them trade and jobs.
But lawyers for Jersey and Guernsey argued in court that abolition would be unlawful and lead to devastating consequences for the local economy and employment.
David Vaughan QC, applying for judicial review on behalf of Jersey, said there were fears that if the islands lost today's case it might lead "to the whole trade leaving and going to Switzerland or some other place" outside the EU.
Mr Vaughan argued the exemption did not amount to an abuse or evasion of tax, and the UK had no power under EU law to remove it.
Sam Grodzinski QC, for Guernsey, said at the heart of the case was the simple proposition that the UK could not lawfully allow an exemption on the importation of goods "from every country in the world outside the EU - except for Guernsey and Jersey".
The Channel Islands qualify for the exemption because they are not considered as part of the EU for VAT purposes.
The court heard the chancellor and HM Customs and Revenue plan to introduce legislation removing the Channel Islands exemption in the Budget on March 21.
Mr Vaughan urged Mr Justice Mitting to give a ruling before budget day.
He told the judge that, if the court ruled against the Government, the proposals would not be put forward as part of the Budget.
Retailers Against VAT Avoidance Schemes (Ravas), which represents about 80 UK mainland internet and high street retailers, are submitting to the court that the exemptions amount to an unfair loophole that should be closed.
Ravas solicitor David Greene, partner with law firm Edwin Coe, said ahead of the hearing: "Ravas and its members have been campaigning for the past ten years to abolish the loophole that allows retailers based in Jersey and Guernsey to avoid VAT on low value goods ordered over the internet by UK consumers.
"As a result of Ravas's pleas to the European Commission the UK Government has at last clamped down on this abuse.
"Jersey and Guernsey are saying that this will affect employment in the Islands but this VAT avoidance scheme has already seen businesses close and job losses in the UK.
"All that retailers here are seeking is an even playing field."
The hearing continues tomorrow.
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