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On July 1, 2003, new legislation [FOOTNOTE 1] concerning the application of value-added tax (VAT) to sales of digital goods within the European Union will come into force. While the legislation is European, it will have important implications for companies based outside of the EU to the extent that such companies sell digital goods to consumers based in one of the EU countries. As a result of this legislation, such companies will be required to register with European tax authorities and levy, collect and remit VAT based upon their supplying digital goods within the EU. Clearly, such legislation may have important implications for all companies engaging in e-commerce on a cross-border basis. SCOPE OF LITIGATION The legislation has a very broad scope. The “electronically supplied services” that are the subject of the new rules encompass a vast selection of information services, including the electronic supply of cultural, artistic, sporting, scientific, distance teaching, entertainment and similar services, software (including updates), computer games, downloadable music, database access, Web site hosting, subscription-based and pay-per-view radio and TV broadcasting. [FOOTNOTE 2] Virtually all kinds of goods and services provided electronically will fall under the new rules. [FOOTNOTE 3] One of the most significant changes brought about by the legislation concerns the fact that sales of electronically supplied services from companies based outside of the EU to end users based within the EU will no longer be free of VAT. This is because, under the new rules, the location that is used in determining taxation will shift from the place the service provider or operator is established to the place where the recipient of the services is located. At the same time, under the new legislation, suppliers that are based within the EU will no longer be obligated to levy VAT when selling electronically provided services to end users based outside of the EU. These fundamental changes in the application of VAT to electronically provided goods and services were clearly brought about as a result of European desires to ensure that EU and non-EU vendors could compete on a more even playing field. There have long been concerns that EU-based enterprises were at a disadvantage as compared with enterprises based outside of the EU in terms of selling digital goods since the EU-based enterprises would be required to account for VAT when the non EU-based enterprises would not have such a requirement. This belief that European enterprises have been at a disadvantage when compared with overseas enterprises is evident in the statement made by European Commissioner Frits Bolkestein when welcoming the approval of the legislation. I welcome the decision of the Council (of ministers) 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. [FOOTNOTE 4] With the enactment of the legislation, enterprises based outside of the EU will no longer be able to avoid paying VAT on sales of electronically supplied services into the EU. At the same time, entities established within the EU will be able to cease paying VAT on sales of electronically provided services to parties based outside of the EU. European supporters of the legislation suggest that these two changes might enable European suppliers of electronically supplied services to be in a better position to compete with their foreign counterparts. COMPLIANCE OPTIONS The legislation requires non-EU suppliers of electronically supplied services to register with a single VAT authority in a EU Member State of choice. However, it must be emphasized that companies will not be permitted to take advantage of the disparities that exist between the different European Member States with respect to VAT rates. Currently, VAT rates range from 12 percent in Madeira to 25 percent in Sweden. Under the legislation, the VAT rate that is chargeable will be the rate applicable in the Member State where the consumer is resident, irrespective of the jurisdiction of the VAT registration. This means that the VAT rate that non-EU companies will be required to charge for the supply of digital goods and services to consumers will be based solely on the location of the consumer. Alternatively, such non-EU enterprises may consider exploring other options. For instance, suppliers of digital goods that are based solely outside of the EU may wish to consider establishing a company in one of the EU Member States that has a low VAT rate. For companies established in the EU, the VAT rate will be the rate applicable in the jurisdiction from where the goods are delivered. While the specific requirements are to be established at the national level, generally, non-EU companies will be able to use a simplified system to register. Such system will permit enterprises to register online. Of course, this, along with the fact that digital goods can be difficult for tax administrators to trace and monitor, raises questions about the enforceability of the new rules. Generally, VAT is a self-assessment tax, and its collection involves a high degree of voluntary compliance. European tax authorities may face particular challenges in ensuring that the VAT is collected and submitted. In addition to monitoring how EU tax authorities will deal with the challenges of enforcement, it will also be interesting to monitor whether other countries will attempt to retaliate against the EU’s new rules by enacting new legislation designed to extend the reach of their taxation authorities. If that should occur, it will offer greater support for the argument that there should be a singular internationally accepted regime that would be applicable to the taxation of digital goods. CRITICISM AND FUTURE ISSUES Despite the perception that the legislation might lead to the development of a more level playing field for European suppliers of electronically provided goods and services, a number of criticisms have been asserted against the legislation. For instance, the legislation may lead to unduly high compliance costs for non-EU entities. As discussed, such non-EU entities will need to become familiar with the requirements of the jurisdiction in which they are registered. Entities that do not register will, of course, be obliged to become knowledgeable of all of the jurisdictions in which they distribute electronically provided services to end users. Furthermore, non-EU enterprises may also incur substantial costs as a result of the legislation’s considerable record-keeping requirements. The compliance costs associated with the legislation may be particularly burdensome for small and medium enterprises. Furthermore, if other jurisdictions follow the EU’s lead and implement similar proposals, companies’ compliance costs may increase exponentially. The legislation can also be criticized for “jumping the gun” before global consensus was reached on Internet taxation. A number of international bodies including, notably, the Organisation for Economic Cooperation and Development, have been working on efforts to achieve international agreement on the application of VAT and other taxes to goods and services distributed through electronic means. By taking action before the possibilities of a global consensus could be examined fully, EU legislatures may have reduced the likelihood that international agreement on this issue will ever be achieved. The legislation may also have the effect of discouraging sales of digital goods and services to consumers based within the EU. The costs and burdens of complying with the new rules may actually dissuade suppliers based in the United States and other countries outside of the EU from selling their products and services into the EU. Over the long term, this may have the effect of impeding the growth of online commerce. Finally, there are also questions about whether the legislation can actually be enforced as drafted. Pursuant to the legislation, the enforcement of the rules of taxation will hinge upon the online identification of consumer location. Present technologies do not permit an online seller to verify the location of a consumer with a high degree of accuracy. If such technology does not become available in the near future, the enforceability of the legislation will become even more questionable. EU Member States are required to implement the legislation before July 2003. The new rules will be applicable for three years. After such time period, they may be extended or modified. Enterprises based outside of the EU including, specifically, those that engage in any e-commerce with end users residing within the EU, should consider using the time prior to implementation to familiarize themselves with the requirements of the legislation as well as the measures that are adopted at the national level in order to implement it. At the same time, non-EU companies should consider whether they should register in one of the EU countries and, if so, begin taking steps in that direction. In enacting the legislation, the EU has become “the first significant tax jurisdiction in the world to develop and implement a simplified framework for consumption taxes on e-commerce.” [FOOTNOTE 5] It is unlikely, however, to be the final jurisdiction to do so. It will be interesting to monitor developments in this area to determine whether other jurisdictions will enact similar legislation, either in retaliation, or as a means of following the approach established in it. CONCLUSION The new legislation marks a significant change in the taxation of electronic goods and services provided on a cross-border basis. Given the scope of electronically provided goods and services that are covered by the legislation, it will be extremely important for all enterprises engaging in e-commerce to consider whether the requirements will apply to their particular activities. Non-EU companies falling under the requirements of the act will have to either: (i) establish a physical presence in an EU Member State, in which case the company will be required to levy VAT at the rate applicable in that member state; or (ii) register pursuant to the special scheme established by the legislation, in which case the company will be required to levy VAT at the rate applicable in the Member States of the customer. Regardless of the option that is selected, companies will have to undertake significant changes, including changes in their online transaction processing systems, in order to comply with the new requirements. William C. Hwang is a partner with Goodwin Procter (www.goodwinproctor.com). Jacqueline Klosek is a senior associate at the firm and author of “Data Privacy in the Information Age” (Greenwood, 2003) and “The Legal Guide to e-Business” (Greenwood, 2003). ::::FOOTNOTES:::: FN1 The key measures at issue are: Council Directive 2002/38/EC of 7 May 2002 amending and amending temporarily Directive 77/388/EEC as regards the value added tax arrangements applicable to radio and television broadcasting services and certain electronically supplied services (Directive 77/388/EEC) and Council Regulation No. 792/2002 of 7 May 2002 amending temporarily Regulation (EEC) No. 218/92 on administrative cooperation in the field of indirect taxation (VAT) as regards additional measures regarding e-commerce (Regulation 792/2002). FN2 See Directive 77/388/EEC, supra note 1, at Annex L. FN3 Furthermore, the list of “electronically supplied services” that is attached as Annex L to Directive 77/388/EEC is only an “illustrative” list. FN4 Quoted in, “Europe Approves Net Tax Law,” Wired, May 7, 2002, available on the Internet. FN5 European Commission, Taxation and Customs Union, VAT on Electronic Commerce, available on the Internet (visited May, 20, 2003). If you are interested in submitting an article to law.com, please click here for our submission guidelines.

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