Taxing Times Ahead: Digital Sales and The European Union
By, Torsten Fetzer, Director of Tax Research Department Taxware
On 1 July 2003, a new European Union Directive [Directive 2002/38/EC and Regulation No. 792/2002 amending the Sixth VAT Directive (77/388/EEC)] comes into force with regard to the levying of Value Added Tax (VAT) on digital sales within the European Union.
All companies outside the EU that are supplying certain specified digital goods and services to final consumers in the EU will be required to register with European tax authorities by July 2003 to collect value-added taxes (VAT). EU based suppliers of digital goods and services will no longer be required to levy VAT on their sales to final consumers based outside of the EU.
Although this Directive attracted considerable attention during its formative stages, many businesses, particularly in the United States, remain completely unaware of its content and implications for their business.
In this article we provide an overview of the Directive and discuss some of the issues raised by its introduction. Although every care has been taken to ensure that the information provided is accurate, it is strongly recommended that appropriate legal and financial advice is sought in order to better understand the ramifications for your business and engage in proper tax planning before contemplating any specific action in advance of the registration deadline of 1 July 2003.
Overview of VAT
Value Added Tax (VAT) is a general consumption tax assessed on the value added to goods and services and levied on every transaction during the process of producing, distributing and providing the goods and services in question. Although a consumption tax, because it is borne ultimately by the final consumer, VAT is not a sales tax.
Levied as a percentage of price, the actual tax burden is visible at each stage throughout the production and distribution chain. It is collected fractionally, via a system of deductions whereby taxable persons (i.e., VAT-registered businesses) can deduct from their VAT liability (the amount of VAT they have charged their customers, called output debit) the amount of tax they have paid (input credit) to other taxable persons on purchases for their business activities. This mechanism ensures that the tax (levied on the value added i.e., the difference between the input credit and the output debit) is made neutral, by the fact is passed on down the economic supply chain, regardless of how many transactions are involved.
Every Member State of the European Union has a Value Added Tax (VAT). Yet the laws establishing the VAT are national laws, each framed within certain parameters specified by the EU in the Sixth Council Directive 77/388/EEC (as amended) on the common system of VAT and the uniform basis for its assessment. This Sixth VAT Directive aims to ensure that each Member State has a broadly harmonized "VAT base" levied on the same transactions. Its subsequent amendments have attempted to remove anomalies. But VAT rates still vary widely from one Member State to another.
Table of current Standard VAT rates throughout the European Union
The Netherlands 19
United Kingdom 17.5
Place of Supply and Consumption
Generally, the place of supply of services in the European Union is considered to be the physical location of the service provider or operator. A number of exceptions have been made to this rule, including so-called Article 9(2)(e) services (referring to the Article in the Sixth VAT Directive), which include information services and telecommunication services, but up to now such services supplied from outside of the EU territory to final consumers in the EU were not specifically included. This explains why the purchase of goods and services delivered digitally currently remain tax free within the European Union if the supplier is based outside the EU, but are subject to VAT if the supplier is based within a Member State.
Under the new rules on digital sales, sales provided from countries outside of the European Union to non-taxable persons who are established, have their permanent address or usually reside in a Member State (i.e., final consumers in the EU) are no longer tax free because the place of taxation is shifted from the place where the service provider or operator is established to the place where the recipient of the services is deemed to consume those services.
The European 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.
More important perhaps, this Directive is an attempt to create a level playing-field between EU and non-EU based suppliers of digital services. At present, EU-based suppliers of digital services are at a competitive disadvantage compared with non-EU based suppliers because of the requirement on EU-based suppliers to charge VAT to consumers regardless of where they are based. Under the terms of the Directive, EU-based suppliers will no longer be required to charge VAT on sales to customers in countries outside the EU while non EU-based suppliers will be required to charge VAT on sales to customers based within the European Union.
Understanding Digital Sales
A Digital Good or Service is an item supplied wholly electronically, as opposed to physically, over the Internet and downloaded by the purchaser.
Annex L of the Directive provides examples of digital goods and services. These include:
- Distance maintenance
- News services
- Music, films and games
- Online gambling
- Distance learning
Companies considering whether this Directive applies to their business should note that business-to-business transactions are unaffected by this new Directive. The VAT rules for non-EU suppliers selling to business customers in the Union (which accounts for approximately 90% of the market), will remain unchanged (since the place of supply for such transactions is deemed to be the place where the customer has established his business or has a fixed establishment to which the service is supplies), with the purchasing company paying the VAT under existing self-assessment (or reverse charge) arrangements.
The European Union (which does not include all European countries) is currently comprised of fifteen countries:
- The Netherlands
- United Kingdom
However, the European Union is currently undergoing a period of expansion and the following countries may join the European Union during 2004 or soon thereafter. Selling to consumers in these countries will automatically expose companies to the new Directive upon their accession to the European Union. In addition, there are three countries (Bulgaria, Romania and Turkey) that may join the EU in future accession rounds.
- Czech Republic
Companies that currently sell, or intend to sell, digital goods and services to final consumers in the accession countries should maintain a very close watch on developments as they will come under the terms of the Directive immediately a country into which they sell joins the EU. Note that free downloads are considered out of the scope of the Directive since there is no taxable consideration.
More Complex Still
The amendment to the Sixth VAT Directive means that companies are treated differently, depending upon whether they already have a physical presence or fixed establishment in the European Union.
Companies with a physical presence or fixed establishment in the EU will be required to levy VAT on digital sales to EU consumers at the standard rate applicable in the country in which they already have a physical presence or fixed establishment.
Companies without a physical presence or fixed establishment in the EU are required to register in a single Member State under a "special scheme" established for the purpose and will have to levy and account for VAT in all of the EU Member States in which they have customers who are final consumers.
In other words, companies with a presence in the EU will only have to charge one rate of VAT to all their final consumers, whereas companies without a presence in the EU will have to charge the standard rate applicable in their customer's "Member State of consumption."
The existing 15 Member States of the EU charge 10 different standard rates. ) Companies will need to consider whether establishing a physical presence in an EU Member State outweighs the challenge – and investment required – in making their online systems sufficiently flexible to manage multiple VAT rates.
Companies that register under the terms of the "special scheme" established by the Directive, will need to ensure that their online systems can identify EU-based consumers and levy the correct rate of VAT applicable to the country in which the supply of the electronic services is deemed to take place ("Member State of consumption").
Since VAT rates vary across the EU, online vendors must ensure that their systems are capable of levying different rates of VAT depending upon the location of the customer.
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.
However, compliance may prove even more difficult than this.
According to the Directive, the seller will also have to comply with "any relevant existing provision in the Member State where the services are consumed." To ensure compliance, sellers should familiarize themselves with the rules pertaining to all Member States in which they have customers.
In addition, the Directive requires that, "The non-established taxable person shall keep [electronic] records [for a period of ten years] of the transactions covered by this special scheme in sufficient detail to enable the tax administration of the Member State of consumption to determine that the value added tax return … is correct."
This suggests that the consumer's Member State may request to audit a seller's VAT compliance in addition to the Member State in which the seller is registered.
Fortunately, companies that register under the terms of the "special scheme" are not required to report and remit their VAT output tax to each appropriate Member State individually. Non-EU based companies will report and remit their VAT tax liabilities to the EU Member State in which they are registered. The registration country will then redistribute VAT to the EU States in which the sale was made.
Automated VAT Calculation and Reporting tools (such as Taxware's WorldTax® solution) do exist to help alleviate wholly or substantially the additional compliance burden this Directive places on business. However, these solutions may be considered "overkill” by small companies with very limited sales to final consumers in the EU. The result may be the loss of sales – and tax revenue - or companies may be tempted to ignore the terms of the Directive.
The Directive is an attempt to iron out a plain discrepancy between the VAT treatment of companies based within and outside of the EU and the competitive advantage/disadvantage that results. Unfortunately, the Directive introduces new anomalies in the process of addressing old ones and fails to address others.
As explained earlier, VAT is a neutral tax because companies can deduct tax paid on purchases (output tax) from tax levied on sales (input tax). However this is denied to companies under the Directive that register under the terms of the "special scheme". There generally is an exception for non-EU taxpayers - the 13th Directive refund - but this may carry further compliance cost and risk for business.
A further anomaly that already exists is not removed by the new Directive. The VAT rate for a digital good or service may differ from that which applies to the same product or service when physically delivered. For instance, a book delivered electronically will be subject to the standard rate, whereas the same book delivered in physical form may be subject to a reduced rate or even a "zero" rate.
Finally, rate discrimination results from the fact that non-EU operators' tax burden will be greater than that of EU operators who can charge a lower rate of VAT to EU customers if they are tax registered in a low-tax jurisdiction (e.g., Luxembourg).
Is the Directive workable?
There are two primary concerns.
The first is that 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.
The second is that it remains unclear how the EU will enforce compliance. 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).
Regardless of the perceived rights and wrongs of the Directive, 1 July 2003 presents a very real deadline for non-EU based companies selling digital goods and services to final consumers in the European Union. Clearly, now is the time to seek professional advice and review your organization's ecommerce systems with regard to their ability to calculate and levy VAT.
By, Torsten Fetzer, Director of Tax Research Department
Taxware, a division of govONE Solutions, LP