The beauty of VAT for EC outsiders

Exempt supplies are the only stain on the theory of the tax. The practice is a different matter. Knowing where the tax charge falls and getting the money are not the same thing. E-commerce presents new challenges, and the European Commission’s response is not the complete solution.

The commission published its proposal on 7 June. It will be debated in the council of ministers over the coming months. It is directed at sales of digitised products, such as software and music, downloaded over the Internet by private consumers. At the moment, such a sale from outside the EC is not subject to VAT. A community business does have to charge VAT even if the consumer is outside the community. This gives non-EC businesses an advantage. The position is the opposite to that for goods: imports of goods do suffer VAT, while exports are zero-rated.

The commission’s proposals fit with the theory of VAT. Sales of digitised products to consumers within the community will suffer VAT, but sales to non-community consumers will become zero-rated. The hard bit will be applying these rules.

The biggest problem is that a non-community business will be outside the reach of community tax authorities. When goods are imported, VAT is easy to collect: if the money is not handed over, the goods stay at the docks. But digitised products cannot be held up, and the business does not need to have any assets within the community which the authorities might seize.

Thus when a non-community business is told that it must charge VAT and hand it over, it can simply refuse. If it does not care about reputation it might well do so, in order to keep a competitive advantage. The community’s main hope is that large businesses will want to keep their good record for compliance with local laws, and will voluntarily pay VAT.

Suppose that they do not comply. The commission suggests another weapon.

Businesses selling software and music need to be able to enforce copyright law. If they could not, there would be even more pirating than there is now. The commission hints businesses which do not pay their taxes might not get help.

If this threat could be used, it would be serious. But there are international agreements to enforce copyright. Neither the EC nor member states could break those agreements just to enforce tax law.

Recognising enforcement is going to be difficult, the commission has set out to make voluntary compliance easy. A non-community business will only have to register in one member state, to cover sales to consumers in all 15 states. But this labour-saving measure will not be implemented.

The reason is that it would lead to some member states being more popular than others as places to register. Sweden and Denmark, with their 25% VAT rate, would attract few businesses. Luxembourg, with a 15% rate, would be very popular.

The UK, with a 17.5% rate, the English language and a comparatively sensible regulatory regime, should do well. Member states not attracting businesses would see VAT on sales to their consumers going into other states’ treasuries.

There is no provision for re-allocating the money. Member states losing out will vote against allowing a business to register in just one member state, so this will be rejected. The chance to make compliance simple for non-EC businesses will be lost.

There will be another burden on non-community businesses. They will be asked to charge VAT on sales to community consumers, but not on supplies to community businesses (which will pay the VAT themselves). To do this, they will have to check whether their customers are businesses. The commission expects them to check the VAT numbers which businesses will supply in order to prove their status. They may or may not care enough to bother.

So the commission is thinking along the right lines, but there is a lot of work to do. The EC will have to rely on the goodwill of non-EC businesses.

It had better make life as easy for them as it can.

• Richard Baron is deputy head of the policy unit at the Institute of Directors.