Taxing times on the web

Directors at internet service provider Freeserve will be toasting the European Union this week while their counterparts at rival AOL will be gritting their teeth in anticipation of paying an estimated £40m a year in extra tax.

The reason for this is the EU’s adoption of new rules last week that will force non-EU suppliers of what are known as ‘digital’ goods to charge VAT to their European consumers.

By 1 July next year, member states will have to ensure businesses based outside the EU which sell music, computer services, software and similar products which are provided or can be downloaded over the internet, charge VAT on their services.

The rules deal with sales to private consumers and will apply for three years, after which they will be reviewed. The idea of the changes which, as is usually the case for EU tax changes, have had a long and controversial gestation period, is to provide a level-playing field for EU businesses.

Expansion in web services
As the provision of services over the internet has expanded, European suppliers of downloadable music and internet services have become increasingly annoyed that their non-EU rivals can provide the same services without having to add on VAT, giving them a substantial competitive advantage as far as pricing is concerned.

While few would agree that the new rules are perfect, most agree they will, in broad terms, achieve their objective of making things more equitable.

Freeserve has conducted a long and vitriolic campaign against the UK government’s refusal to impose VAT on rival AOL’s activities in the UK.

US-based AOL, it says, has much greater freedom than its competitors in the setting of prices, which it can channel into promotions and advertising – which are of particular importance in the young and competitive online market.

According to Freeserve, AOL saves itself £40m a year as a result of this ‘illegitimate competitive advantage’.

It bases this calculation on the assumption that AOL has 1.5m customers in the UK, and assumes that AOL will absorb the whole of the VAT charge itself, rather than raise its prices by 17.5%. An AOL spokesman refused to talk figures, instead saying simply: ‘We comply with the law.’

Bittersweet victory for Freeserve
Freeserve has even gone so far as to issue judicial review proceedings against Customs & Excise over the issue. While Freeserve is of course pleased that AOL will have to start charging VAT on its services as a result of the new EU rules, the victory is somewhat bittersweet.

In a terse statement issued last week, it said: ‘This means AOL will have to establish themselves in the EU for the purposes of accounting for VAT. However, Freeserve maintains that AOL could and should be paying VAT today. The new directive won’t take effect until 2003, by which time AOL will have saved itself yet another £40m-£50m.’

It is not dropping its judicial review, which argues that AOL’s services should be subject to VAT under current UK law, irrespective of next year’s European-level changes.

The way the EU is enforcing the new rules is by requiring affected non-EU businesses to register in a member state of their choice, but levy VAT at the rate of the consumer’s resident country – meaning one set of forms but numerous different VAT rates.

VAT experts say this will mean unnecessarily complex VAT returns, although one or two conceded it would bring in more work to the VAT practices of international accountancy firms.

Winners: European operators
KPMG indirect tax partner Stuart Hindle says the winners will be European operators, such as music providers, who are becoming increasingly concerned about non-EU competition in the growing market for downloadable music.

The losers, he says, will be non-EU businesses who now face the cost and time burden of setting up some sort of VAT administration in the EU.

The complexities of the rules led UK chancellor Gordon Brown to suggest a VAT ‘moratorium’ as they were being developed – he suggested VAT on all ‘digital’ goods, EU or not, should be suspended while the issue was debated. He has since withdrawn his objections.

Chas Roy-Chowdhury, head of tax at the ACCA, argues the whole debate is rather theoretical. He concedes that some big players such as AOL will be hit, but says most affected businesses are much smaller and the rules will be impossible to enforce.

Operations run out of garages or spare rooms in backwaters of the US, he argues, will have never heard of VAT, let alone any changes to the way it works.

The EU, he argues, faces a near-impossible task in trying to impose its rules on such operations.

The whole issue is a case of the realities of business changing and tax law being left behind.

VAT rules are particularly complex. Some tax experts are hoping that the headaches lawmakers have had in developing this latest piece of legislation will encourage movement towards a clearer and simpler VAT system for the EU as a whole.

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