According to the documentation, the Databricks extension for Visual Studio Code supports the %sql magic command.

However, there are limitations to this support:

• The notebooks magics %r and %scala are not supported and will display an error if called.
• The notebook magic %sql does not support some DML commands, such as Show Tables.

Given your setup (Databricks Connect: 13.3.2, Databricks Runtime: 16.0, Databricks Extension for VS Code: v2.5.0), it appears that the %sql magic command should be supported.

Do you have option to open support case so this can be reviewed further and possibly engage engineering if a bug is detected?