Online retailers using a Channel Islands VAT loophole on the sale of entertainment products are under threat as Government looks into whether they are abusing the system.

Retailers such as HMV, Amazon, Tesco, WH Smith, Asda, Argos, and could all be affected if the Treasury was to clamp down on the practice.

Government has always insisted retailers that exploit the VAT relief on imported goods — mainly CDs and DVDs — sold for under £18 were not taking advantage of a loophole.

However, letters from the Treasury minister Stephen Timms, seen by The Observer, reveal that Government now believes UK retailers may be “abusing” the rules.

The Treasury estimates that VAT free sales to the UK from the Channel Islands grew to £620m last year, costing the Government £110m in lost tax.

To qualify for VAT-free sales, products destined for UK customers are shipped out to the Channel Islands and back again.

HMV said it was “confident it could not be challenged”.

A spokesman said the retailer holds a “significant amount of stock” in Guernsey.

He added: “It is not shipped there upon receipt of customer orders, se we do not ‘round-trip’.”