Brussels is to sue the UK in Europe’s highest court over tax breaks for commodities traders, according to EU diplomats briefed on the plans, escalating a battle that Britain said risked damaging the post-Brexit competitiveness of the City of London.

The European Commission is bringing the case in the European Court of Justice just over two months before Britain is due to leave the EU, potentially without agreeing an exit deal. However, the withdrawal treaty that Theresa May has brokered with Brussels means the UK would have to abide by ECJ rulings in cases launched while it was a member or during a 21-month transition period.

Brussels’ move to try to limit how the UK applies value added tax exemptions escalates a dispute that began last year when Brussels challenged the UK on rules dating back to the 1970s.

Under the rules, Britain has a right to apply a zero VAT rate to commodities contracts traded on “terminal markets” such as the London Metal Exchange.

Brussels argues that the UK has stealthily widened the exemption over time, creating a tax loophole that unfairly boosts the City of London at the expense of other EU financial centres. London is one of the largest global centres for commodities trading.

The commission declined to comment but last year said the UK had “extended the scope of the measure considerably meaning that it is no longer limited to trading in the commodities as originally covered”.

Brussels contends that the UK has amended the original exemption at least eight times without seeking advice from the EU, so that it now includes trading commodity options and futures contracts.

Britain has consistently rebuffed the commission’s claims that the changes are illegal, saying its approach is in line with EU “standstill” rules that allow the zero rate because it was applied before a 1977 cut-off date.

The case comes at an acutely sensitive moment in Brexit talks, following the overwhelming parliamentary defeat of Mrs May’s deal and amid deep splits in the UK parliament over how to proceed. Mrs May is due to face a further crucial vote on her Brexit plans in the House of Commons next week.

It also underlines the complex task facing the UK Treasury to disentangle Britain and its businesses from an EU VAT system that has developed over decades.

While tax rates are mainly set at national level, Brussels tries to restrict how far governments can go in lowering VAT rates to lure business, while allowing countries to introduce specific carve-outs.

Brussels opened “infringement proceedings” against the UK on the issue last year, following talks between EU and UK officials dating back to 2015.

The UK government declined to comment but officials have previously said the VAT treatment was “vital” to ensure the City remained a world-leading hub for commodities trading.

- The Financial Times Limited