UK: The Application Of VAT To E-Commerce In The European Union

Co-written by Peter Jenkins (Ernst & Young)

The advent of e-Commerce – business transactions taking place through the electronic transmission of data over communications networks such as the Internet – has altered the business model in important respects, by creating new sources of revenue, new and much less cumbersome routes to market, new alliances and synergies between businesses, new and different supply chains and fulfilment models. It has also altered the traditional ways of valuing businesses, placing a premium on growth of the customer database and the potential of new ideas and technology, rather than more solid measures of profitability, though this may now be changing. Also it has created huge uncertainty about taxation, both sides of the Atlantic, particularly in the area of consumption taxes, which is the subject of this article. Can the existing tax base be maintained, particularly given the difficulty of tracking B2C sales over the Internet? Can offshore/out of State on-line providers of goods and services be made to account for consumption taxes? Can they be collected some other way?

Underlying this debate is a growing realisation among tax collectors that perfection in this area is just not attainable in the real world – there is no paradigm solution to all the problems. In the end, there are bound to be a series of compromises or trade-offs between the need to ensure "bricks and mortar" businesses do not lose out to unfair competition from the 'dot-com's and the need to maintain the revenue yield without placing wholly unrealistic compliance burdens on the new businesses whose concern is with growth and markets, not with paying taxes. There is also a strong concern to ensure that the basic integrity of the existing taxes is maintained, which means that whatever new rules are put in place have to be credible and realistic, that is to say enforceable in practice, at least against the bigger players. It is already the case that no consumption tax can be enforced and collected 100% or anything like it – the variable is always the relative size and competitive distortion caused by those choosing to trade in the black economy.

Perhaps the easiest way of describing this gap is by pointing out that, while in the US the debate is still about whether to tax the Internet and the new business it generates, in the EU it is purely about how to do so. The questions of jurisdiction, nexus and legitimacy that are still the subject of furious debate and proposals and counterparts in the US Congress are not regarded as open questions needing resolution in the EU. As the EC Commission put it in the working paper presented to the Council of Ministers on 8 June 1999 on the VAT aspects of e-Commerce:-

"Any long term business strategy which assumes on-line sales can be made in the Community without regard to VAT would be most injudicious."

In the EU, VAT is seen as a broadly based consumption tax on all types of consumer expenditure which is not specifically relieved by exemption and unlike most sales taxes, it applies equally to goods and services. Overall it raises one fifth of all tax revenues, and nearly half of "own resources" in the EU, making it a most important revenue earner for the Member States. All pleas for a moratorium on infant industry or other grounds against the application of VAT have been rejected from the beginning – as have proposals for replacing VAT on Internet sales with some other method of taxation (for example a bit tax).

The assumption has been that, with whatever adaptations are needed, VAT will be successfully imposed on e-Commerce sales, even those services which are supplied digitally on a B2C basis for downloading by the consumer in his own home. It is recognised that securing the cooperation and compliance of the greatest number of offshore operators may well require carrots as well as sticks, though a stark warning note is sounded:-

"For an operator, even one located outside the EU, to risk exposure to significant and unresolved tax debts in the world's largest market place cannot be considered prudent business practice…. The presence of such a liability is hardly likely to assist in access to legitimate capital or funding resources."

In the US, the scene was set by the Internet Freedom Act of October 1998. This provided for a three-year moratorium on Internet Access taxes, unless these taxes were in effect before 1 October 1998, and a similar three year ban on multiple or discriminatory taxes on electronic commerce. The Advisory Committee on Electronic Commerce was set up by Congress to conduct "a thorough study of Federal, State and local and international taxation and tariff treatment" of Internet transactions and access to it. Although the ACEC, chaired by Governor Gilmore has come up with simple majority resolutions in favour of extending the moratoria and prohibiting taxation of sales of digitised goods and products, these do not have force. By contrast, the approach favoured by Utah Governor Leavitt is to approach the issue on lines more familiar in the EU (how, not whether):-

His proposals include the development of uniform tax base definitions for e-commerce, accepted and uniform sourcing rules and uniform audit procedures, tax returns and use of technology (e.g. electronic filing). These proposals have been taken up in Congress by would-be reformers of sales and local taxation (SALT) whose belief is that a streamlined and standardised version of such taxes can be made to work. Three bills on these lines encouraging States to reach "compact agreements", clearer rules to determine State jurisdictional nexus and simplified sales and use tax rules and procedures are currently under consideration in the Judiciary Committee of Congress and its Sub-Committee. The potential trade-off between streamlining and reform of SALT and effective rules to require remote sellers to collect tax on consumer sales into a state is recognised as a promising way ahead: but it still has many opponents inside Congress who continue to argue for a permanent extension of the moratoria on Internet Access taxes and on new multiple and discriminatory taxes.

The underlying difference in the US is that State and local tax collectors already have a huge difficulty in collecting sales and use taxes from sellers (whether conventional mail-order or on-line) who supply consumers from out-of-state locations and have no presence there sufficient to create nexus. This arises from a fundamental conflict between the principle in the US Constitutions 14^th Amendment (which gives a State the right to impose its tax powers on a person who "purposefully directs its business activity into a state") and the Commerce Clause which prohibits a State from extending its tax jurisdiction to persons that do not have a "substantial nexus" with that State – which the Supreme Court has established means the taxpayer must have physical presence in that State. The case of Quill v. North Dakota in 1992 established that businesses are not responsible for collecting a use tax unless they have a physical presence or nexus in a customer's home State. Where there is still room for debate is how far the Quill tests – derived from mail-order transactions – read across to Internet sales, where the presence and use of www sites accessible to persons in the State, the use of ISP's and servers located in the State, and the use of service providers for transmission of information and of local affiliates for marketing and sales raise new points which will sooner or later be put to the test as States try to defend their tax base. However, new Federal law on this whole subject, whether on the basis of a trade-off between simplicity/reform and compliance or some other basis seems a long way off. As the October 2001 Internet Moratorium deadline approaches, the newly convened 107^th Congress will want to find some way of resolving these issues – which boil down in the end to those which exercise the tax collectors in the EU, how to collect consumption taxes on remote "no substantial nexus" transactions with final consumers.

However, the issues still outstanding in the EU VAT context are far more narrowly defined than is the case with US SALT. Fundamentally the issue boils down to the narrow (but not easy) issue of how to enforce VAT collection on supplies of digitised products from remote (i.e. non-EU) on-line sellers to final consumers resident in the EU where the supplies are down-loaded on their home PC's or other equipment. This is because supplies of goods, being physical events requiring an importation into the EU, and B2B supplies of services do not raise nexus or enforcement issues of the kind raised in the US.

In the case of physical goods, it makes no difference if the Internet is used to trigger a mail-order delivery: tax will be collected, if necessary from the delivery agent and by him from the customers, when the goods pass the frontier on importation, the only exemption being postal deliveries under a threshold (which varies from EUR 22 in some Member States to only EUR 10 or even nil in others, especially for mail-order sales). In any case those trying to set up and operate "remote" mail-order businesses from outside the EU soon find they run into severe practical and logistical problems, and end up having to set up at least one local distribution centre.

In the case of B2B supplies of services, the EU answer is simple – apply the reverse charge so that the responsibility for remitting the tax passes from the supplier to the tax registered business customer, who treats it like any other intermediate transaction in the supply chain (i.e. he deducts the tax as a credit and passes it on to the next person in the chain – only suffering a restriction if he makes "exempt" supplies, e.g. financial services or healthcare). The problem at present is that "reverse charging" does not apply to the full range of services which can potentially be provided via the Internet, so the first change to the existing VAT rules needed is to widen the scope for reverse charging, making it in effect co-extensive with Internet deliveries. The other more practical requirement is to deal with the question of identification of business customers – how can the on-line service provider determine that the person he is dealing with really is a business customer and not a final consumer masquerading as one to obtain a VAT-free delivery? The Commission's answer is to recognise the need for an on-line 24 hour verification system to check the existence and validity of VAT registration number, the assurance being that if the supplier makes the necessary check before completing an on-line transaction, his liability will be at an end, and tax will be collected by self-assessment from the business customer.

One criticism with this approach is that by removing the need for compliance in the case of B2B suppliers, the EU is placing a psychological bar in the way of compliance for B2C supplies, particularly if they are in the minority.

So far as B2B supplies are concerned, therefore, the main problem identified in the EU is widening the scope of the reverse charge to cover the potential range of services and products capable of being delivered via the Internet, at the same time putting in place the on-line systems needed to enable the supplier to distinguish between business and non-business customers.

In the case of services, there are also problems of nexus to be resolved when the supplier is offshore. The basic rule in Article 9(1) does require the supplier to have his seat of business or a fixed establishment in the EU before VAT can be applied. For certain types of supply, for example those in Article 9(2)(e), the VAT liability will rest with the customer under the reverse charge where he receives a supply from a supplier based in another country, but only if he is in business. This is precisely the problem at present – while most B2Bsupplies can in practice be picked up under the reverse charge principle, so that VAT is accounted for by the customer, B2C supplies from third country suppliers of on-line services cannot effectively be taxed.

Supplies within the EU between the Member States will be treated broadly as now – B2B will be VAT-free from the Member State of export, but subject to the reverse charge in the hands of the business customer at the rate in his own Member State, and B2C supplies will be taxed in the Member State of origin, the supplier charging the customer his rate of VAT and paying it over to his taxing authority. The preservation of these intra-EU arrangements in the e-commerce environment is of some importance – it is also implicitly under threat.

The core of the EU's current legislative proposals is therefore intended to deal with the problem of B2C supplies of digitised products to final consumers in the EU.

The Commission has recognised that any system of self-assessment based on a reverse charge system extended to final consumers would lack any credible means of enforcement and would bring the tax swiftly into disrepute – exactly the problem experienced with use taxes in the US, where taxpayers have persistently failed or refused to recognise their obligations, and with GST in Canada. The Commission has also rejected ideas put forward for an alternative avenue of collection, for example a withholding tax collected by the banks issuing payment cards and/or by the clearing and payment systems used to manage these transactions, because of the lack of tax critical information available, the sheer practical difficult of distinguishing between taxable and non-taxable transactions, and dealing with multiple VAT rates. The only alternative, inevitably, is to "lasso" in the off-shore on-line supplier, by compelling him to register and account for VAT on his sales to EU final consumers, even if he has no "substantial nexus" with the EU (in the sense of the presence of people and equipment) but only a website accessible to those consumers.

The Commissions' proposals, in the form of a draft Directive amending the Sixth Directive published on 8 May 2000, recognised that to achieve this objective in the real world would require a good deal of persuasion and cooperation as well as legal certainty (largely lacking under the existing rules) and means of practical enforcement. In short, carrots as well as sticks. The Commission's scheme had three main carrots on offer:-

• A single place of registration enabling the operator to discharge all obligations for EU VAT with a single administration. This would normally be the first Member State where the first taxable supply is made – it would not require a fixed establishment to be present.
• An exemption from registration for non-EU businesses whose annual level of sales within the EU is below EUR 100,000
• The facility of completing electronically all procedures in relation to registration and making of tax return, together with electronic invoicing.

Under the EU legislative system, the Commission alone can propose legislation, but the Council of Ministers representing the 15 Member States must agree unanimously (in the case of tax) to adopt it before it can be implemented in the domestic law of the Member States. The Council can, to an extent, modify the Commission's draft in order to reach an acceptable proposal. In this particular case, the modifications since May 2000 have been extensive – and involve the removal of the most important carrots, while leaving the sticks. In particular under a "compromise" proposal drawn up by the French Presidency, the single place of registration idea has disappeared altogether, leaving a requirement that an on-line service provider should register and account for VAT in all the Member States in which he trades – subject to a much reduced registration threshold of only EUR 5000 per Member State (that is up to only EUR 75,000 in the EU as a whole).

Belgium, supported by the Commission, has proposed an alternative formulation of the earlier proposal – central registration in a single Member State with breakdown of receipts on a macro-economic basis between those Member States where actual consumption of services from that operator takes place.

This harks back to earlier ideas put forward by the Commission for a single place of registration for EU business with a clearing system to direct tax receipts to the Member State of consumption. This was rejected by the Council of Ministers as impractical and open to abuse; there is little reason to believe a lesser version of this rejected idea for non-EU operators would be likely to achieve unanimous approval.

So what is the great concern? It has to be remembered that VAT rates vary from as low as 15% in Luxembourg to 25% in Denmark and Sweden, and the higher rate Member States fear that third country operators will contrive to register in mass where the rates are lowest, and may even opt for the special status of registration in Madeira, where the rate is only 12%. Such registration would give them, in effect, "Community privileges", i.e. the right to supply final consumers all over the EU at the rate of VAT in the Member State in which they now have their base – leading to feared loss of revenue and "unfair" competition.

At risk in this debate is the survival of the intra-EU place of supply rules for all e-Commerce supplies in the EU, not just the third country ones. The high rate Member States would clearly like to remove the "arbitrage" advantage that on-line service suppliers already based in the EU enjoy – by moving to a general "place of consumption" test. Fortunately this would require a change to the long-established place of supply rules in the Sixth Directive, which is unlikely to win unanimous support from the Member States.

It is important to remember that the proposed changes only affect certain supplies of services delivered by electronic means – wider reform of the place of supply rules for other services (which is clearly necessary as the rules are over-complex and lead to confusion and anomalies) is promised as the next step in the Commission's programme to modernise the Single Market's VAT system. The affected services are:

• Cultural, artistic, sporting, scientific, educational and entertainment services
• Supplies of software
• Data-processing
• Information
• Computer services (such as web-design and hosting)
• Satellite broadcasting

The proposals do not affect these services if delivered other than by electronic means, genuinely "free of charge" services such as free downloads or free access to information, or supplies of other types of services such as basic telecommunications and use of the Internet just as a means of communication between parties.

How soon are the changes likely to be adopted? Given that the most controversial aspect put forward by the Commission – the right to register in only one Member State – has disappeared under the compromise proposal drawn up by the French Presidency, the proposals arguably have a greater chance of early adoption than before, and the French Presidency is pressing hard for agreement on adoption of its compromise proposal at the 27 November 2000 Council of Finance Ministers (ECOFIN) with a view to early implementation. At present, the betting is against this, because of the difficulty of getting unanimous agreement, but much will depend on how far the VAT authorities see their revenues becoming genuinely threatened by third country suppliers over the coming months.

Finally, on the question of registration in one Member State, non-EU on-line service providers should keep one important point in mind. If they want to "come out of the cold" and register for VAT in the EU, they can already do so by setting up a fixed establishment in one Member State of choice and conducting their EU trade from there – they will then have the Community privileges already referred to. Although this will require putting people and technical resources in place – as well as careful consideration of the direct tax effects of having such a permanent establishment – it may well be a better option than registering separately in each Member State once the EUR 5000 threshold has been exceeded, and Madeira, with its Treaty of Accession protected 12% VAT rate and much improved business infrastructure may be an attractive option for an EU 'dot-com' headquarters.

Madeira, a full EU Member State, has many benefits in addition to the VAT rate. As well as having good communications, labour and transport infrastructure, it also has preferential tax regime as part of a EU State Aid funding structure. This was approved by the EU to stimulate inward investment and reduce Madeira's dependency on tourism. As part of this financial commitment by the EU (which also includes a programme to increase the GDP per capita), the EU recently provided, through the EUREGIS and Cohesion funding, the financing structure for the new £300 million rebuilding of the airport which can now handle Boeing 747's and 3.5 million passengers a year. The days of buying a shelf company in an offshore tax haven location (or any location) and putting up a brass nameplate have finished. An operating presence, with the management powers is a necessity for the Tax Authorities to accept that the company is resident in that location. On the 11th April 2000, the Director of the UK Inland Revenue's International Division, Gabs Makhouf, said in his Lisbon speech:

Permanent Establishment is the rule that Governments use to decide where companies should be taxed. It is not, therefore, a viable proposition for a UK company to set up a server in Madeira, Luxembourg or the United States, whilst effectively managing the business from the UK, as the basis of operating in a low VAT EU jurisdiction or outside the EU. Similarly, setting up a server in the Cook Islands does not solve the problem unless substance and management can be demonstrated in that jurisdiction. As a guidance, the EU Commission announced on the 28 June 2000 and new aid scheme IP/00/670 as a State Aid under Article 87 of the Treaty. This was in the form of tax-free allowances. An eligible firm (who would receive tax-free allowances) was defined as requiring to have, amongst other matters, their registered office, centre of management or stable establishment in the jurisdiction to which this State Aid applied.