As mentioned above, services are "vatable". In addition, a product, which is delivered digitally (such as a book or record), is considered a "service". Because the service rules were drafted under the assumption that the supplier knows his customer and they are relatively close to each other, there is an anomaly in the EU as to e-commerce. This problem is stated in a Working Paper produced by the European Commission dated 8 June 1999:

"The basic rule [for supply of services] is set out in Article 9.1 and applies where no other provisions are elsewhere in Article 9. It was enacted at the time when there was a natural supposition of direct personal contact between the supplier of the service and the customer. Accordingly, it establishes the place of supply as the place where the supplier is located.

If this measure were taken in isolation, the result would be that, unless otherwise provided, where the supplier is based outside the EU, no VAT on services to customers within the EU. Operators registered for VAT within the EU are, however, required by Article 9.1 to charge VAT at the effective rate in their Member State to customers [inside of and] outside the EU. …" (Emphasis supplied).

The general rule under Article 9.1 determines that the place of supply is the place where the supplier is located. The problem is that under e-commerce, the place of supply (should be) the place where the customer is located. But, in the Internet, how can the supplier know where the customer is located?

Under the general rule under Article 9.1 (which covers digitally delivered services unless there is an exception), a supplier outside the EU supplying a service inside the EU would not charge VAT on the service. However, a supplier inside the EU would charge VAT on the digitally delivered services both to customers inside and outside the EU. The Working Paper states:

"In the absence of other provisions, this would have the potential to constitute a major distortion of competition and place EU service providers at a competitive disadvantage to non-EU suppliers".

As a result, either the rules are changed or the European suppliers will move outside of the EU to supply customers inside the EU.

The European Commission's solution to this problem is to change the law (the rules) so that digitally supplied services are taxed where they are consumed. This rule change solves the problem for European suppliers (they charge VAT to customers within the EU and they don't charge VAT to customers outside of the EU). However, the rule change would have a significant negative effect on non-EU suppliers because they would be required to charge VAT for customers inside the EU, thus increasing their prices and collecting a tax for a customer that is not in their jurisdiction. They would also have the administrative burden of registering and complying with a tax that is completely different (for American suppliers) from the sales tax in their jurisdiction.

This idea is exactly the opposite of the rule in the United States where a supplier of goods in one state (that does not do business in the other state) has no obligation to impose and/or collect sales tax from the customer in the other state. (There is generally no sales tax on services in the United States.) The ideas are also against the general rule of international law that no one sovereign state will collect the taxes of another sovereign state.

The Commission envisages that a non-EU supplier would either register for VAT in one central location (for which there is no provision in the law) and/or in all the jurisdictions where the supplier delivers the digitally supplied services. The supplier would apply VAT to the digitally supplied service at the appropriate rate to the appropriate customer. The Commission also envisages that the supplier would verify that the customer has a "valid" VAT number so that the supplier can supply the service without VAT and the customer can apply the reverse charge to the service. The supplier would have to file VAT returns and remit the appropriate tax, but the supplier would be unlikely to have an "inputs" to reduce the tax paid.

It is likely that the Commission will propose this rule change in the fall of 1999 to the member states. Five member states (France, Italy, Denmark, Sweden and Portugal) have already gone ahead and, in effect, imposed the rule change in their jurisdictions under the "use and benefit" provisions of the rules (similar to the use tax provisions for sales tax in the United States) without consideration of whether the change is administratively feasible and/or enforceable.

If the Commission does not impose the rule change, then it is likely that more member states will follow the "use and benefit" provisions of Article 9.3(b) (but not the United Kingdom) and even more confusion will result in the market.

Problems