The current system in the EU for direct and indirect taxation creates harmful tax competition, which must be eliminated if EU businesses are to retain their competitive edge in the new online environment. This is particularly the case with the current VAT regime, under which EU companies have to pay VAT on online sales irrespective of where these are consumed, when their third country counterparts escape tax on sales to both their home and export markets. Unchecked, these fundamental inconsistencies are creating a major distortion of competition.
Towards the level playing field Most states recognise that tax competition between jurisdictions can be damaging. Some forms of tax competition are sometimes regarded as legitimate whilst others tend to undermine states’ ability to levy particular taxes. Methods for addressing the issue have been subject to considerable debate within the EU and the international community at large.
This has resulted, at the EU level, in a general consensus in favour of adapting the existing VAT regime to move towards consistency in the treatment of electronic and conventionally delivered products, rather than in favour of creating a new framework.
With regard to direct taxation, the EU has been largely content to participate in the efforts of the Organisation for Economic Co-operation and Development (OECD).
So, what proposals are now emerging at an EU level for the taxation of electronic products? For direct taxation of the profits of Internet businesses, the difficulty had always been the identification of the “permanent establishment” for companies able to operate in one country but which locate the servers that host their websites elsewhere.
This ambiguity has now been resolved by the OECD’s recent agreed definition for “permanent establishment”, which means that the location of a server in a country, where the purpose of the server is significant and an essential part of the company’s business (e.g. it takes orders from online customers or processes credit card details), is likely to lead to a tax liability in that country, whereas merely having a website or ISP will not.
For indirect taxation, the EU announced proposals in June last year for a Directive to modify the rules for applying VAT to certain products supplied by electronic means, such as software, music and video, as well as to subscription-based and pay-per-view radio and TV broadcasting services. The intention here is to create a “level playing field” in accordance with the Ottawa Taxation Framework Conditions, a set of international principles for taxing e-commerce agreed at the OECD Ministerial Conference in 1998.
With the aim of adopting this by 2002, the proposed compliance model depends on the tax status and location of the recipient of the product. Basically, online sales to business consumers within the EU will be supplied without VAT, irrespective of the location of the supplier, since VAT will be paid by the business customer on a self-assessment basis under the so-called “reverse charge mechanism”.
In this respect, there will be no change to the current position. However, the significant change will be for non-EU operators undertaking business to consumer transactions, which are currently not charged to VAT.
Under the proposal, non-EU operators with annual sales to consumers within the EU exceeding a minimum turnover threshold of euro 100,000, will be required to register and account for VAT in one of the Member States in which they supply online services. In that way, non-EU operators would only have to deal with a single tax administration within the EU. It is argued that a requirement to register with all Member States in which trade takes place would constitute a trade barrier.
Level for whom?
Whether either development w ill benefit the EU remains to be seen. With regard to the OECD developments on direct taxation, the more likely consequence is that online businesses will establish themselves outside the OECD and the developed world will lose out as a result. To safeguard against such an eventuality, the OECD is proposing what it calls “defensive measures”, but these will only be against Member States and the extent of them remains unclear.
Commissioner Frits Bolkenstein himself believes that there is a strong culture of compliance which might indicate that effective enforcement may not be critical.
With regard to indirect taxation, the US has expressed serious concerns about the Commission proposal which, if introduced, will require US companies to pay VAT if they sell in Europe, while European companies will continue to escape paying sales tax in the US. Given the fact that President George Bush has just backed a five-year extension to the US Internet Tax Freedom Act, which prohibits new taxes on e-commerce, it leaves open to speculation whether the US/EU trade wars will end with bananas.
As well as exposing the EU to complaints of a ‘fortress Europe’ isolationism, requiring non-EU operators to register for VAT in just one Member State is likely to create distortions and competition questions arising from differences in Member State VAT rates. Currently VAT rates within the EU must be set within the 15% to 25% band, and it is not hard to imagine that non-EU operators will be forming queues outside the Luxembourg Customs Office to register for VAT at the lowest rate. This has led to a call from Belgium to share VAT revenues on online sales, and a counter-proposal from France, which wants any business selling online to EU consumers to be registered in all fifteen member states.
Both have been ruled out as impractical, with the implication that, if this proposal becomes law, the resulting distortions will only be reversed in the unlikely event that the EU achieves a uniformity of rates.
Order within the EU?
It might be postulated that the EU should put its own tax house in order before venturing on the dubious project of attempting to tax e-traders in third countries. For VAT, the EU has accepted the OECD principle of taxation in the country of consumption, but only for the EU as a whole, failing to recognise that each Member State constitutes a separate country, or tax jurisdiction, for this purpose. The general EU VAT law on the supply of goods and services is blind to this fact and, for most purposes, sales to consumers are accounted for in the Member State of the supplier – quite contrary to the OECD principle. Excise duty, the consumption tax that everyone tries to forget, does follow the OECD for distance sales, though the Commission’s original proposals favoured an origin system. If a massive distortion of trade is to be avoided, taxation in the country of destination remains crucially necessary where tax rates diverge very widely. But even the system of excise duty will perhaps crumble under the reality of e-commerce, where websites make it easy for customers to arrange their own delivery and transport.
Suppliers cannot account for tax in a country of destination of which they are unaware.
Does it matter anyway?
Before rushing to ostracise Luxembourg on scooping the pot, it is worth sparing a thought for whether any of this is likely to work in practice. After all, a taxation regime that cannot be enforced is no tax regime at all, and this one will have a less than auspicious start given its reliance on a high degree of voluntary compliance. Although the requirement to register for VAT will be a legal obligation, and failure to do so will result in a tax debt, how will such a debt be recoverable?
One unlikely suggestion from the Commission is that auditors, when preparing the accounts of the non-compliant ven dor, must insist on a provision in the accounts for liability to account for VAT. That is assuming, of course, that non-EU auditors keep abreast with changes to tax law. Another suggestion is that a non-compliant vendor who seeks redress in the EU courts may have problems in doing so. However, it remains to be seen precisely what is meant by this. In any event, if cowboy traders enter the market on a tax free basis, how long will voluntary compliers be able to compete?
Whilst there is some way to go for the law to catch up with e-business, the Commission is certainly making an effort to close the gap. The proposed changes will be good news for EU vendors, who will now be able to develop their business strategy without having to pay tax for which there can be no justification, but significant distortions will remain. Furthermore, it is inevitable that some people will not comply. An increasingly fluid global economy exposes the weaknesses of tax and enforcement systems based on local jurisdictions, and this is true even within the EU itself where tax competition between Member States continues unabated.
Martin Rees, is partner and Janice Collino is professional support lawyer at DLA, a leading UK and international law firm.
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