The European Commission has called on the UK government to phase out a tax break for offshore companies based in Gibraltar by 2010.
Gibraltar's low taxes have attracted several firms to the territory
The Commission, which said the practice flouted EU competition rules, gave the UK a month to agree or else face possible legal action.
Under Gibraltar's Exempt Company programme, more than 8,000 offshore firms do not have to pay income tax.
Instead, they pay a small fee. The scheme is a life blood for Gibraltar.
While Gibraltar only gets a fixed annual payment of between £225 and £300 from each company, the programme has encouraged some 8,500 overseas companies to invest in the British territory on the southern tip of Spain.
The presence of these companies has helped fuel Gibraltar's service economy.
'Illegal state aid'
Companies qualify if they register in Gibraltar but do not conduct any business there or have any Gibraltarian shareholders.
Other firms trading in the territory must pay a standard 35% tax on their profits.
"This advantage is clearly selective, is financed from state resources, and is liable to distort competition," the European Commission said in a statement.
"The regime satisfies none of the criteria set out in (EU law) under which state aid may be authorised," it said.
Commission spokesman Jonathan Todd said he was confident that the UK government would stop the programme.
"We are now very optimistic that this measure will be withdrawn once and for all," he said.
Under the Commission's direction, the Exempt Company scheme will close to new entrants in July 2006 before being withdrawn in 2010.
Britain captured Gibraltar in 1704, with Spain formally ceding control in 1713.
Recent talks between the UK and Spanish governments over the future of the territory have failed to lead to any agreement.
While Spain wants to regain sovereignty over the territory, this is almost universally opposed by the people of Gibraltar, who in a 2002 referendum voted 99% in favour of remaining solely British.