Starting July 1, 2003, the European Union will require US and other non-European business to collect and remit value added tax on internet sales of software, music, films, games, other digital products and services to EU consumers. The new requirement, known as Council Directive 2002/38/EC does not apply to business-to-business sales. U.S. companies that do not collect and remit VAT on such sales should begin to develop compliance programs and take the steps necessary to implement those programs by July 1st.
What is VAT?
VAT is a consumption tax that each EU member levies on the sale of goods and services within its jurisdiction. The electronic delivery of digital products is regarded as a service for VAT purposes.: Under current law, the place where the service is rendered is the place where the supplier resides if the digital product or service is sold to an EU consumer.
VAT is collected and paid by each business in the production and distribution chain. The VAT burden is transferred to the consumer through a credit mechanism under which each business in the chain is given credit for VAT paid on its purchases. For example, France has a VAT rate of 19.6%. Assume a French software developer sells a copy of its personal financial planning software to a French retailer (a business to business sale or “B2B sale”) for €60 who in turn sells that software to a French citizen (a business to consumer sale or “B2C sale”) for €100. The developer is required to collect VAT of €11.76 from the retailer (i.e., 19.6% of €60), and the retailer in turn collects VAT of €19.60 from the French citizen. When the retailer files its French VAT return, it shows VAT collections of €19.60 and claims a credit for VAT paid of €11.76, so that the net amount it remits to the French tax authorities is €7.84. The total amount paid by the French citizen for the software, including VAT, is €119.60.
Why the change?
If, in the above example, the developer is a U.S. company the cost to the French retailer and the French citizen are the same because the French retailer must still charge €19.60 of VAT on the sale of the software, and the French retailer must self-assess VAT of €11.76 at the time it purchases the software from the developer (which it claims as a credit as set forth in the example). If however, the retailer is also a U.S. company and the software is sold to the French citizen over the internet, the sale is not subject to VAT because the U.S. retailer is not rendering the service within France (or within an EU member country). As a consequence, the French citizen would pay only €100 for the same software. Because the place where the seller resides is the place where the service is rendered and the basis on which VAT is levied, US business have enjoyed an advantage over their European competitors who must charge VAT on B2C sales of digital products and services delivered to locations both within and without the EU.
Changes made by the Directive
To eliminate this competitive advantage, the Directive treats the service, i.e. the electronic delivery of digital products and services, as occurring at the place where the consumer resides. As a consequence, US companies will be required to charge VAT on B2C sales of digital products and services delivered to locations within the EU, while EU companies will no longer charge VAT on B2C sales of digital products and services delivered to locations outside the EU. The Directive applies to the sale of digital goods and services that fall within the following categories: (i) website supply, web-hosting, and distance maintenance of programs and equipment; (ii) software and software updates; (iii) images, text and information, and making databases available; (iv) music, films, games (including games of chance and gambling games), and political, cultural, artistic, sporting, scientific and entertainment broadcasts and events; and (v) distance teaching. Because the implementing legislation of each member country may differ slightly with respect to the digital products and services included in these categories, it may be necessary to review the implementing legislation of member countries to determine if the sale of a particular good or service into a particular country is subject to VAT.
In order to give EU countries and taxpayers guidance, the VAT Committee issued the so-called Annex L guidelines in early April. That Annex aims to clarify the scope of the above categories by giving general criteria as well as by mentioning various examples in each category. The general criteria define an "electronically supplied service" as a service that (i) in the first instance is delivered over the Internet or an electronic network; and then (ii) the nature of the service in question is heavily dependent on information technology for its supply (i.e. the service is essentially automated, involving minimal human intervention and in the absence of information technology does not have viability). The Directive, including Annex L, is attached for purposes of reference.
Special Registration Regime
A special registration regime allows non-EU businesses to register and pay VAT in only one EU member country (under the traditional regime it would be necessary to register in each member country where the non-EU business has B2C sales and pay VAT on both B2C and B2B sales). Under the special regime, it will be necessary for non-EU business to (i) register and obtain a tax number from the country of registration (ii) distinguish between B2B and B2C sales, (iii) identify the country of consumption for B2C sales, (iv) charge and collect VAT at the applicable rate (rates vary from 15% to 25%) on B2C sales, (v) file a tax return 20 days after the end of each quarter with detail establishing the VAT on sales in each country, (vi) pay into a euro denominated account in the country of registration, the VAT due, and (vii) maintain transaction records for 10 years that are sufficient to allow each state of consumption to determine the VAT that was due and paid. A non-EU business that qualifies for the special regime will be entitled to claim a credit for VAT paid, if any, on its purchases of goods and services.
Special attention should be given to the fact that the non-EU supplier is responsible for the correct application of VAT legislation. In other words, the non-EU supplier should audit the information provided by the EU consumers for correctness, and is liable if the use of incorrect information leads to a lower VAT charge being applied than actually should have been charged. It is, as yet, unclear how non-EU suppliers can adequately protect their position.
Before opting for the traditional regime or the special regime, a US company should determine whether it may be more advantageous to establish a Luxembourg subsidiary through which it would make its B2C sales. The benefits to such an arrangement would be twofold. First, B2C sales would be subject solely to Luxembourg VAT at a 15% rate, the lowest VAT rate within the EU. Second, the administrative burden would be minimal when compared to the traditional regime and special regime. The benefits would of course, need to be balanced against the costs of such an arrangement which would include: (i) € 2,500 excluding VAT for professional fees to organize the Luxembourg subsidiary, (ii) a capital tax equal to 1% of the initial capital invested in the subsidiary (which should be minimal), (iii) € 30,000 estimated annual costs which includes the cost of a resident director, net worth tax, filing of statutory financial statements, preparation of VAT returns, preparation of income tax returns, etc., and (iv) Luxembourg income tax (levied at roughly a 30% rate) on income deemed equal to 10% of the costs incurred by the Luxembourg subsidiary (excluding cost of goods sold and license fees). A company that pursues this alternative should allow a minimum of four weeks to organize its Luxembourg subsidiary.
In lieu of a wholly owned Luxembourg subsidiary, it may be feasible to sell digital products and services through a “shared Luxembourg company” and thereby further reduce the costs associated with the sale of these products and services. Under this approach, a Luxembourg company would be organized and owned by a Luxembourg trust company and function as a quasi distributor for non-EU companies. We are currently in the process of evaluating the feasibility of the shared Luxembourg company approach.
If you have questions regarding the Directive or need assistance in developing or implementing a compliance program please contact firstname.lastname@example.org.
 The US is an advocate of the position that digital products such as software that are delivered electronically should be classified as “goods” and thus benefit from the protections of GATT. The EU position is that digital products delivered electronically should be classified as “services” and thus benefit from GATS. This issue has not been resolved. It is important because the Directive is more likely to violate the anti-discrimination provisions of GATT than those of GATS.