With the EU's new VAT directive requiring non-EU businesses to register in an EU member state in order to supply digital services to EU consumers, it's time for such businesses to take a long, hard look at exactly what's involved. Torsten Fetzer, Director of International Tax Research at tax software solutions provider Taxware (www.taxware.com), says that the new rules present multiple difficulties. Here is his analysis of the situation.
Businesses selling electronic services into the European Union should now begin preparing for changes in tax legislation. With the passage in May of Directive 2002/38/EC and Regulation No. 792/2002 amending the Sixth VAT Directive (77/388/EEC) digital services providers located outside of the EU will be required to register with European tax authorities by July 2003 to collect value-added taxes (VAT). With this new legislation, which was developed to help create a more level playing field for EU businesses engaged in sales of electronically supplied services, foreign firms that were previously exempt from charging taxes will now be required to comply.
Under the new rules, sales provided from countries outside of the European Union to non-taxable persons in the EU no longer are tax free because the place of taxation is shifted from the place the service provider or operator is established to the place where the recipient of the services is located. That means that while non-EU suppliers are allowed to register in a single Member State under a "special scheme" they will have to be able to account for VAT in all of the EU Member States in which they have customers who are final consumers.
While the rules do place new burdens on some foreign firms, Frits Bolkestein, the European Commissioner for Taxation, believes that ultimately, everyone's interest will be served by the legislation.
"I welcome the decision of the Council to adopt these rules on applying VAT to digital products. They will remove the serious competitive handicap which EU firms currently face in comparison with non-EU suppliers of digital services both when exporting to world markets and when selling to European consumers" (IP/02/673).
The Commission
argues that these new rules put into practice the Framework Conditions agreed
to by the Organization for Economic Cooperation and Development (OECD) in Ottawa
in 1998, which state that ecommerce should be taxable at the place of consumption
and that digitized goods should be treated as a supply of services.
The list of services subject to these rules encompasses information services,
including the electronic supply of cultural, artistic, sporting, scientific,
educational, entertainment and similar services. Software (including updates),
computer games, downloadable music, website supply and hosting, distance maintenance
of programs and equipment, subscription-based and pay-per-view radio and TV
broadcasting are also included in the list of services subject to the new rules.
The rules applicable to EU businesses supplying the same types of services to final consumers in the EU remain the same. By these rules, EU businesses charge VAT at the place where the operator is established when making sales to final consumers. In other words, rather than having to keep track of the various rates in the Member States in which their customers are located, they only need to keep track of the rate of the Member State in which they are headquartered. For example, if they are established in Great Britain and they make sales to France, Germany and Sweden, all they would need to worry about is the British VAT rate of 17.5%.
While this proposal sounds unassuming at first, there are several potential concerns.
Since VAT rates differ according to EU member states, the accounting becomes a bit tricky. The standard VAT rates currently range between 15% in Luxembourg to 25% in Denmark or Sweden. Thus, any non-EU firm providing services to EU residents must keep track of their customers' locations in order to properly assign taxes. For example, if a non-EU operator decides to register in Great Britain and makes sales to individuals in France, Germany and Sweden, then the operator will need to know that the rates to be applied at the customer location are 19.6%, 16% and 25% respectively.
Whether or not the special scheme will be effective is an open question. A letter from the U.S. Council for International Business to Commissioner Bolkestein on February 7 spelled out some of the concerns expressed on behalf of businesses:
Proving a customer's location is difficult: the most impartial way is to allow the customer to self-declare. Unfortunately, EU member states might not agree to such a policy due to the likelihood that customers can evade the VAT altogether, merely by declaring that they are in a non-EU country.
Another risk involves the increase in costs for foreign firms. Non-EU providers will undoubtedly face administrative burdens due to the VAT. Making the situation all the more hazardous is that the value of these costs is yet unknown. Businesses must plan their taxes in such a way that their compliance burdens are kept to a minimum. If the cost of being compliant under the special scheme outweighs the cost of registering normally in the European Union, businesses will probably want to opt for registering normally. This will allow them to benefit from the regular input tax recovery system that is disallowed under the special scheme. Special scheme operators will only be allowed to recover input taxes by means of a so-called 13th Directive refund, which may constitute a risk and further compliance costs.
What businesses will actually be affected? Only those non-EU businesses that perform more than EUR 100,000 (about USD 90,000) in electronic services sales to final consumers in the European Union will "qualify" for the special scheme. It is important to make clear that only those activities for which a sales price is charged will be affected, since only those may have a tax attributed to them. In effect, that means that a large number of supplies of electronic services will continue to be free of tax.
In 2000, Forrester Research valued 2002 Internet ecommerce at USD 2.2 trillion. More than 50% (USD 1.4 trillion) of that share relates to sales in North America, compared to less than 20% in Europe (USD 422 billion) and Asia-Pacific (USD 287 billion). Given that 67% of European consumers will be online by 2006 (over 200 million regular users), this is not an insignificant amount of money, even when less than 10% of digital service sales are business-to-consumer (B2C) sales.
Finally, there is the issue of compliance. How the EU expects non-EU firms to adhere to these new rules is the most glaring question. The language of the Directive is soft, stating that electronic services providers "may opt" for identification. The EU has made it clear that it will rely on voluntary compliance. The Commission believes that operators that qualify for the special scheme are very likely the ones who would want to honor it in order to ensure that "others respect their [the operators'] obligations in respect of the operators' rights, for example as regards copyright or other intellectual property rights" (MEMO/00/31). This conclusion may turn out to be a faulty one.
Knowing that there are a large number of open questions with regard to the practicality of the special scheme adopted by the European Union, there is one thing to be said in favour of the European Union policy: the Directive on electronic services has revived the sense of urgency required for an effective solution with regard to the taxation of digital goods at an international level. This step may indeed prove to be a good test case for a future single global place of identification for taxpayers and automation of tax collection. As the EU attempts to put its new rules into practice, the OECD and other international associations will continue their efforts for an internationally acceptable solution which will not be an unnecessary burden to businesses and will guarantee a new source of income to taxing authorities.
If your business sells electronic services into the EU, it is imperative that you begin monitoring the legislation of the EU Member States as they transpose the Directive into national legislation. In addition, it is advised that you seek professional advice in order to better understand the ramifications for your business and engage in proper tax planning before contemplating any specific action.
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