Its action follows an inquiry, which led to the Commission concluding that the tax system constituted illegal state aid, banned under EU law because it unfairly favours one European company over another.

Exempt Companies are financial services companies domiciled in Gibraltar that may not conduct any trade or business within the colony; they pay a fixed annual tax of between £225 and £300 and are exempt from any further taxation in Gibraltar; its standard company tax on profits is 35%.

The Commission has told the British government that it expects it to state publicly by next month how it will reform this system. If Britain refuses, the Commission could start legal proceedings that may end in the government being taken to the European Court of Justice.

Brussels has long been opposed to this offshore tax break, opening a formal state aid investigation in July 2001. This was scrapped this April, however, after the Gibraltar government persuaded the ECJ that the Commission had made procedural errors in the inquiry.