The taxman takes on cyberspace

A loophole that lets you buy goods on the Net, VAT-free is about to close. By Name

THE SOUND of tax loopholes slamming shut are being heard on the Net, emanating from Brussels. The European Commission has declared that EU consumers who buy and receive products or services over the Internet should pay VAT on them, even if ordered from a foreigner.

The EC policy paper released this month states that all Net transactions should be taxed as services, marking a "significant change" in EU and European tax practice. At present, private individuals or businesses who buy services from outside the EU do not usually have to pay VAT, which is applied at varying rates in each of the 15 constituent EU countries and can reach 20 per cent of the purchase price. Even online transactions within the EU and within the purchaser's country typically escape VAT for lack of enforcement.

CompuServe has exploited this loophole in the past. The online service (now part of AOL) claimed its services were delivered from its US-based head office and were therefore not subject to VAT. It worked for years but aroused the ire of European Internet service providers, who found themselves at a commercial disadvantage because they had to add VAT at the local rate to customers' bills. The EC has moved to close that loophole and now seems determined to go one better.

If someone in Europe buys software online today or gets access to a database or downloads some information in a file, that transaction escapes VAT, but the Euro-Vatman is now seeking to interpose himself between your credit card and your download. The Commission's position is that purchases sent directly to your PC or network that utterly escape VAT and import duties are unfair. Those purchases would attract VAT if they were bought in a box off a shelf locally or in another EU member state.

"The absence of such taxation would lead to unfair competition for EU operators who already have to tax their supplies of services for private consumption within the EU," the Commission's policy paper said. This stance, however, is a bit outdated. The future of the software distribution and the computing retail industry seems to be rapidly evolving beyond the traditional disk-in-box-on-shelf model.

In an alignment with the policies announced by the Clinton administration, the European Commission's proposed changes do not amount to a "new" tax. The US is operating under a "no new taxes for the Internet" policy for fear of damaging the rapid growth of electronic commerce.

The US House of Representatives recently voted to keep the taxman out of cyberspace. "Read my e-mail. No new Net taxes!" remarked Rep Christopher Cox, who sponsored the bill in the House. The bill must be passed by the Senate and then signed by President Clinton before it becomes law.

The bill creates a moratorium for state or local taxes on the access fees that are paid to online service providers such as America Online, CompuServe, or other Internet service providers. Under the proposed law, the eight states that currently impose a special tax on Internet access can continue only if they pass additional legislation, which would be difficult, given the strong "no tax" signal emanating from Washington.

The EC has restated its general agreement with the US stance that purchases made over the Internet or other electronic networks should not be subject to new taxes but it believes that Net commerce should not escape existing taxes such as VAT.

With the growth of electronic commerce, some consumers are already exploiting loopholes even when they take delivery of physical objects such as music CDs. In the UK, a purchase of CDs from the US-based Internet music shop CDNow that amounts to less than $35 is VAT exempt. Music lovers can still save money buying CDs from America, even when including shipping charges. Orders larger than $35 are presumably deemed to be worthy of the paperwork necessary to collect the tax. The EC paper proposes no changes to these national practices

However, the Commission's new angle is that goods downloaded electronically should be taxed as a service. The already prodigious enforcement challenge grows, however, when you consider that the EC policy paper goes on to say that VAT should not be applied when a customer from outside the EU orders something from an EU supplier. On the Net no one can tell you whether you are a dog, let alone whether you live in the EU or elsewhere.

The Commission acknowledges that the changes in the tax system will be difficult to implement practically but where there is a will, there will no doubt be a way and that has the ability to send a chill down the spines of users who might object to government sticking its nose into their Internet bit stream or auditing their credit card transactions.

The EC has committed itself to a round of consultation with national governments and business groups to find a way to make it work. Whatever system they come up with must be easy for businesses to implement and escape-proof if it is to work at all for the VATman.

This new policy paper is a step forward from the suggestions made in April 1997 by the EC High Level Expert Group to tax modems or levy a "bit tax" on all Internet traffic. Still, with the Internet's much-vaunted ability to route itself around any impediment, it doesn't take too much perspicacity to predict a "server flight" to jurisdictions that can provide their cyber goods or services beyond the reach of the Euro-Vatman. Given the clear "hands off" signal from Washington, the US could reap the profits of electronic commerce while Europe loses out. EU citizens are unlikely to be taxed without a fight. The Internet offers that choice.