The hidden cost of online shopping

From the air, the tiny circle of Guernsey sparkles from scores of greenhouses dotted in a quilt of small fields. Close up, the greenhouses lie derelict and trees rampage through their dilapidated timber frames. As these monuments to the island's tomato-growing industry – which collapsed in the 1970s – fall into disrepair, they are being replaced by the gleaming metal skeletons of new warehouses. Like the wealthy people who live tax-free lives on Guernsey, these warehouses are exceedingly discreet. HMV's depot is tucked down a tiny, unsignposted track. Moonpig's headquarters is not signposted from the main road. These shadowy buildings are an almost invisible tip of a new industrial boom on the Channel Islands: the euphemistically named "offshore fulfilment" industry.

If you buy a new CD or DVD, printer ink, camera memory cards or vitamins online this Christmas, they will probably be dispatched from the Channel Islands. Usually they will have been shipped from Britain first in bulk, before being individually packed and returned on the islands' ferries. A growing number of top retailers, including Tesco, Asda, Amazon, HMV, Play.com, and now Sainsbury's, use Guernsey or Jersey warehouses to take advantage of a little-known but perfectly legal tax arrangement that enables goods under the value of £18 to be shipped to UK customers VAT-free from countries outside the EU. Consumers are delighted to find internet bargains, but rarely realise they are not paying VAT. Critics argue that this lucrative way to avoid tax – which the Treasury is fully aware of – is a gross distortion of the market, which has put hundreds of small traders, particularly independent record shops, out of business. And offshore fulfilment is about to get bigger: from 1 January, VAT will rise to 20%, making it even more profitable for companies to move to the Channel Islands and take the daily ferry to the mainland.

Offshore fulfilment is a creature of happy accident and the ruthlessness of good entrepreneurs in exploiting tax advantages. When Britain began levying VAT in 1973, the Channel Islands – a "crown dependency", which is independent from the UK and has stayed outside the EU – were allowed to pre-pay VAT because fresh flowers and cream imports were perishable and filling in customs forms would catastrophically delay their entry. In 1983, these arrangements were superseded by an EU directive that established low value consignment relief (LVCR). This allowed member states to avoid collecting VAT on low-value imports where administrative costs were deemed excessive when set against tax receipts they generated. Britain set the bar at the highest possible figure, £18 – all goods below this price imported from outside the EU did not attract VAT.

VAT-free imports from the Channel Islands remained a cottage industry until 1998 when three bright 28-year-olds on Jersey, high-street sportswear retailers Richard Goulding and Simon Perrée and their computer-savvy friend Peter de Bourcier, started selling DVDs to UK mainland customers via Play.com. Envying the success of what is now one of the biggest dotcom businesses, the big boys belatedly waded in: Tesco set up its own web operation called Tesco Jersey; Asda, HMV and others followed. In 2006, the transfer of goods from the UK to Jersey so they could be shipped back VAT-free to the mainland was described by Jersey's then economic development minister as "a complete sham" and Tesco and others were expelled from the island. The VAT loophole was too lucrative to give up, though: Tesco switched its CD and DVD website to Switzerland before quietly returning to the Channel Islands via an outsourcing fulfilment firm, The Hut Group. In 2008, the VAT loophole trade was worth £110m according to the Treasury; critics allege it is now far higher, with greetings card business Moonpig and computer game retailers thriving offshore.

Every major music retailer now sells CDs and DVDs online using offshore centres because of the VAT loophole. "Do they really deserve a 20% advantage over high street retailers?" asks Graham Jones, author of Last Shop Standing: Whatever Happened to Record Shops? "I have witnessed the misery this loophole has created. Family businesses, many of which have been trading for years, are closing down, people are losing their homes, people are suffering nervous breakdowns, and in one case a customer of mine took his life, so depressed was he about losing his businesses."

According to figures produced for the Guardian by market research firm Kantar, an estimated 48m CDs were purchased online in the year to October. Of this number just 450,000 were bought for more than £18. Some 68.5m DVDs were bought on the web – 34% of the total market – while 20m games for computer consoles were sold online, representing 35% of the market. Unsurprisingly, more than 600 independent record shops have closed in the last five years, leaving just 269 standing, according to the Entertainment Retailers Association; high-street fatalities include Zavvi and Fopp.

These closures have been shrugged off as the inevitable consequence of downloads and the digital revolution. In fact, UK sales of hard-copy CD albums have seen some of the slowest declines anywhere in the world. And independent online retailers on the UK mainland have suffered as well as the high street: three years ago, Richard Allen was forced to shut The Freak Emporium, his British-based online business, because, he says, of the VAT loophole. "The only reason we're suffering is that we have to pay VAT," he says. "Every CD that is sold is a tax advantage to the purchaser at the expense of other taxpayers. It's a nonsensical arrangement that makes a mockery of VAT and a mockery of the EU."

The corporate beneficiaries of this arrangement are extremely reluctant to comment. There are around 15 offshore fulfilment companies based on Guernsey, providing 600 full-time jobs (and many more temporary posts). Moonpig turned away our inquiries. MBL Group – fulfilling for Sainsbury's – and The Hut Group also refused to comment, as did HMV and vitamin retailed Healthspan. The one business happy to open up its warehouse, however, makes a robust defence of these VAT arrangements.

Guernsey born-and-bred business partners Jon Sandilands and Chris McQuaigue set up internet retailer 7DayShop.com when they noticed lithium camera batteries cost £12.95 in shops when they could sell them for £2.25. "That's not just about VAT, is it?" points out Sandilands. An antidote to "rip-off Britain", they argue they offer genuinely cheap gadgets from around the world. "We've not moved here to take advantage of anything – we just live here," says McQuaigue.

After back-of-a-shop beginnings, 40 local people now bustle between rows of shelves picking and packing more than 4,000 different products – from USB drives to camera straps – in their immaculate 32,000sq ft building. Christmas is boomtime for offshore fulfilment. Some warehouses are staffed 24 hours a day; 7DayShop's employees are currently working overtime. Their latest success is framed canvas prints of customers' favourite photographs uploaded via website snapmad.com, which again falls under the VAT threshold. Sandilands and McQuaigue do not want to reveal their turnover or quantities shipped, but they seem to be thriving: nestled between boxes in their warehouse is their collection of nine classic cars, including a Lamborghini.

"We're not breaking the Treasury," says Sandilands. "We're not a VAT loophole scam. We're passionate about every little thing that goes out of the door. I'm proud of employing 40 local people." 7DayShop doesn't do "fulfilment" for anybody else. "It would be a very sad day when we dispatched stuff for other people," says Sandilands. In fact, they were furious when HMV moved its online sales to Guernsey. "We weren't pleased when HMV came to Guernsey because we felt it would rock the situation a bit," says McQuaigue. "There's a certain obviousness to what's going on and that doesn't seem particularly right does it?" Then again, as entrepreneurs, 7DayShop's founders recognise that the big boys are simply "taking advantage of a situation".

LVCR is an EU-wide tax relief. But it is optional: member states can exclude mail-order goods, and set the limit at £8 instead of £18, which would vastly reduce loophole trade. John Whiting, tax policy director of the Chartered Institute of Taxation, explains that there is a sound principle behind it: to provide administrative simplification. The arrival of internet shopping, however, appears to have tipped the balance too far. "The relief does distort the market. And with a rise in VAT that issue may become even more problematic," he predicts. Richard Allen, who now heads a small pressure group, Retailers Against VAT Avoidance Schemes, has met EU officials who he says have made it "pretty clear" they believe the UK is breaching its obligations to stop market distortion. "It's getting out of control now and people are starting to notice, including the EU," says Allen. "If offshore fulfilment is legitimate then VAT is a farce. There's a credibility issue here – the credibility of the entire UK taxation system."

As the fire crackles in the grate of the Old Government House Hotel, Carla McNulty Bauer, Guernsey's commerce and employment minister, downplays offshore fulfilment. Guernsey has constantly adapted since the days when its exported granite made the steps of St Paul's Cathedral. These days 40% of GDP comes from financial services; offshore fulfilment's 600 full-time employees make up just 1.9% of the island's 32,000-strong working population. If offshore fulfilment is such a trifle, why is Guernsey so keen to protect it? McNulty Bauer argues that it sustains a "diversified economy" providing low-skilled jobs (and ample seasonal, temporary work). If the VAT loophole was closed, would all offshore fulfilment jobs vanish? McNulty Bauer says it depends on companies and consumers. "The likelihood is yes, and yes it would have an impact on our local economy," she says.

The big question is: why has the UK government not closed this loophole? Judging from Guernsey officials' accounts of their dealings with the Treasury, its policy has been to privately urge the Channel Islands to stop the loophole getting any wider. Responding to this pressure, Guernsey created a code of conduct for offshore fulfilment to stop "circular shipping" in 2008. "We've actively discouraged this circulation of goods coming in and going straight out again," says McNulty Bauer. "We are not a letterbox for those sorts of goods." Officials claim the voluntary code is honoured because the island is such a small community where everyone knows each other's business. Other restrictions on offshore fulfilment include tough land-use rules limiting warehouse construction and almost full employment. This means new companies cannot easily find workers and they cannot import labour because of a strict housing licence scheme.

According to Jon Buckland, Guernsey's chief civil servant in commerce and employment, the island has "regular contact" with Treasury officials and has "addressed their concerns". "I'm particularly pleased that the latest figures show there is no growth expected in CDs and DVDs in 2010 and we are successfully restraining that activity." With the 20% VAT hike, has the Treasury – and the coalition government – reminded Guernsey to constrain growth? "Not at a political level," says McNulty Bauer carefully. "It is something they are monitoring."

In opposition, senior Conservatives and Liberal Democrats were outraged by the loophole. In April, the now business secretary Vince Cable described big supermarkets selling CDs and DVDs through the Channel Islands as "extraordinary and seriously unwise". As shadow chancellor, George Osborne said of the VAT loophole: "The Conservatives intend to hold the government to account for the effect on domestic business if nothing is done." These crusaders have fallen silent in government. This week the government announced plans to claw back some of the £7bn of lost tax revenues, but its failure to mention reform of LVCR caused an outcry from the Forum of Private Business. "The Channel Islands VAT loophole distorts competition and leads to VAT abuse," says Jane Bennett of the forum. "Clearly it was not created to allow large retailers to undercut their smaller, mainland competitors, which is what is happening now on a worrying scale, forcing many to close."

A Treasury spokesman insists that the government is "actively reviewing" the LVCR. But the answer David Gauke, exchequer secretary to the Treasury, gave to the House of Commons earlier this year is telling. He said the government would "take into account the need to balance often conflicting considerations including the impact on consumers, UK businesses and Royal Mail and other parcel operators, as well as the overall fiscal position and the practicality and cost of enforcing any changes to the operation of the relief". The Royal Mail and other parcel operators are major beneficiaries of the loophole. A clampdown would certainly hurt the soon-to-be-privatised Royal Mail, which has seen small packages make up an increasing proportion of post bags in recent years.

Independent experts believe that offshore fulfilment would vanish from the Channel Islands without the current loophole. "If you remove the relief, you potentially remove the value of ordering goods from Jersey or other places outside the EU," says Whiting. "It would potentially lead to a big drop in that trade – although nobody knows by how much. Certainly, you would imagine that decisions about where to locate a business would be driven by logistical considerations rather than considerations of tax. There are a lot of costs involved in sourcing goods in the UK, shipping them out to Jersey, and then posting them back to customers in the UK."

Both Guernsey's government and 7DayShop argue that if you closed the VAT loophole on the Channel Islands, businesses would simply relocate to Gibraltar or Hong Kong. "It's very easy to point the finger at Guernsey and Jersey because we're close to home," says McQuaigue. "Look on eBay and Amazon – there are sellers around the world selling these products. You can get rid of us but don't imagine it's not going to happen from somewhere else in the world." The argument that tax loophole trade would simply relocate infuriates Richard Allen. "That's like saying if you stop house burglaries, street crime will increase," he says. "You make sure you shut it down elsewhere."

In the Channel Islands, there is an insistence that the loss of independent high-street traders in the UK has little to do with them. They hope that placating the Treasury by ensuring there is no flagrant growth – good old Guernsey discretion – will save their blossoming offshore fulfilment industry. "I'm sorry to see that a lot of smaller shops in smaller towns are moving. But it's down to the customer seeking lower prices," says McNulty Bauer. "It is a much bigger issue than little old Guernsey with a population of 60,000, nine miles by three miles, sending goods off to the UK. It's a much bigger picture in a changing world."