HMV is extending to its high-street stores a controversial VAT-avoidance scheme that it currently operates solely through the group’s website, which is based offshore. The move will offer shoppers discounts and free delivery on out-of-stock titles, at the expense of Treasury coffers.

The retailer is planning to install instore “HMV Delivers” kiosks in its 250 stores. Customers will be able to place orders for CDs, DVDs, Blu-ray Discs and console games and avoid the 17.5% VAT charged on conventional instore purchases.

The terminals bring a ballooning offshore tax ploy, already exploited by major music and DVD websites including HMV.com, to Britain’s high streets. The ploy is a fundamental challenge to the government’s direct taxation regime. If copied by other high-street chains and supermarkets, it could divert hundreds of millions of pounds from the Treasury. Woolworths is also testing similar terminals in three stores.

HMV’s new terminals offer “free home delivery” not from the group’s London distribution centre, but from its base on the Channel Islands tax haven of Guernsey. The extra expense of postage is paid for many times over by avoiding VAT.

HMV initially refused to answer questions on its Guernsey operations, telling the Guardian that VAT-free transactions were blocked on all store terminals. But sample purchases at a number of stores showed this was not the case. HMV then said that after trials of various pricing strategies in a few stores, it planned to restrict VAT-free purchases on terminals to products the customer is unable to find on shelves because they are out of stock. This will “remain a convenient, but very marginal channel for customers and sales,” a spokesman said. He added the main function of the terminals in the future would be to offer digital downloads.

The tax ploy, which is not unlawful, works by exploiting a VAT exemption on goods priced below £18 that are imported by individuals into the UK from outside the European Union. Known as “low value consignment relief”, it has been enshrined in European law for 15 years. But the arrival of online retailing has seen the relief, originally designed to ease the administrative burden on marginal trade, exploited on a scale that was never anticipated.

Initially, HMV was slow to exploit the VAT ploy on the web, seeing cut-price internet retailers as a threat to its stores. In recent years, however, the group has been catching up fast with the pioneers of the VAT relief scheme, such as Jersey-based Play.com. HMV.com gets 1m hits a week.

In March 2007, new chief executive Simon Fox put HMV Guernsey at the heart of his strategy to turn around the struggling retailer. He pledged to expand online sales through the group’s Channel Islands base from 6% of HMV’s UK sales, to 20% by 2010, and promised to double spending on marketing the website.

HMV told the Guardian its VAT-free sales for the last financial year amounted to about £50m. The loss to the Treasury in unpaid VAT was £8.75m.

HMV’s parent company, HMV Group, incurred a total UK corporation tax bill for the same 12 months of £11.4m. More than £8 in every £10 of sales from HMV.com for the last financial year related to VAT-free purchases. Of the 200 bestselling CDs and DVDs available on HMV.com, 196 titles qualify for VAT exemption.

Analysts at Lehman Brothers, the group’s corporate broker, have suggested HMV will have to grow web sales to more than £200m by 2010 if Fox is to meet his target of generating 20% of earnings online. The Guardian estimates HMV’s Guernsey website may be costing the Treasury more than £30m a year in lost revenue in two years’ time.

The British government has put pressure on authorities in Jersey, who have taken actions against a small number of operations deemed to have set up in the island purely for the purposes of exploiting the relief. Officially, ministers and the tax authorities have for years had VAT relief operations under “close review” and have said they will consider cutting the £18 threshold or removing exemption from CDs and DVDs.

Last month, the Treasury’s financial secretary, Jane Kennedy, was asked in parliament to clarify the scale of low value consignment relief not just on CDs and DVDs, but on health food supplements, contact lenses, flower deliveries and all product categories. She pointed to official estimates in 2006 of around £90m a year in unpaid VAT – a figure tax campaigners believe is out of date, and too low.

Nevertheless, home delivery exports to the UK have become a major industry in the Channel Islands. Retailers are struggling to find staff and warehouse space on the islands to meet demand. Of the seven CD-selling websites most visited on the internet in the UK, as defined by web traffic monitoring firm Hitwise, all exploit import VAT relief.

Better offshore

HMV does not advertise the difference between many of their store prices and those available in VAT-free, home-delivery web deals. Here are examples:

Desperate Housewives
Series three DVD: instore, £27. HMV.com, £17.99. (All HMV.com prices include home delivery).

Prime Suspect
10 DVD boxed set: instore, £25. HMV.com, £17.99.

Brothers and Sisters
Series one on DVD: instore, £30. HMV.com, £17.99.

There Will Be Blood
DVD: instore, £14.99. HMV.com, £12.99.

Harry Potter: Years 1-5
10 DVDs. Instore, £25. HMV.com, £17.99.

Coldplay: Viva la Vida
CD: instore, £10.99. HMV.com, £8.99.

Duffy: Rockferry
Instore, £10.99. HMV.com, £8.99.

Paul Weller: 22 Dreams
Instore, £9.99. HMV.com, £8.99.