Brussels Decrees an E-VAT

A Spanish fan downloads the latest Prince album from the artist's U.S.-based website. A Swedish schoolboy has his mother buy him a Japanese on-line Pokmon game. An American expat in London orders personal finance software from the U.S. Where should the sales tax go? In most of the world today, the answer is "Nowhere." In Europe, however, Luxembourg may be the lucky recipient at least if the European Commission has its way.

Last week, the Commission issued a directive calling for value-added tax the consumption levy that provides 44% of the E.U.'s budget to be collected from non-E.U. firms that sell "Internet-based services" to anyone in the 15 member states. Under the proposal, a firm selling more than about $100,000 a year-worth of software, games, prepaid television or music for electronic delivery in the E.U. would be obliged to register with one of the 15 member states' tax authorities and levy VAT on all European online sales. Because Luxembourg has the lowest such tax in the E.U. 15% versus as much as 25% in Sweden and Denmark the Grand Duchy would be the obvious place to register, and would hence reap the tax revenues.

The new directive aims to create that most subjective of trade objectives, a level playing field. As matters now stand, Commission rules force E.U. companies that sell services online to charge VAT to their customers wherever they are, while non-E.U. firms do not. Brussels has been under pressure from member states and European content providers to correct that obvious flaw in the E.U.'s tax regime.

But the proposal might create as many problems as it solves. The plan brought swift criticism from its intended target, the U.S. Stuart Eizenstat, Deputy Secretary of the Treasury, voiced "serious concerns with both the substance and process" of the directive, arguing that "the unintended implications of the ... proposal are not worth the short-term tax revenues that may result." Ken Wasch, president of the Software and Information Industry Association, called it "fatally flawed" and "simply unenforceable."

According to Guido De Wit, VAT tax expert with the Brussels office of the law firm Linklaters and Alliance, the Commission proposal doesn't solve the fundamental problem of how you locate a consumer in a virtual world; the Commission's idea to use credit card billing addresses is likely to run afoul of credit card companies who want no part in releasing information for tax purposes. Nor is it at all clear how European tax authorities could audit the flow of international e-commerce, or sanction those that don't levy the tax.

The good news is that, Brussels being Brussels, it could have been worse. De Wit says it is a "big novelty" for the E.U. to take regulatory burdens into account, in this case by requiring vendors to register in only one E.U. state rather than all of them. But that won't make the proposal any more palatable to member states with high VAT rates. Their vendors will still have to charge more than American competitors that registered in Luxembourg or Germany, whose basic VAT rate is 16%.

The even better news is that, like all tax matters, the directive requires the unanimous approval of the member states, and is unlikely to survive unchanged through the legislative process. But at the very least, the Commission's proposal will go down as a first attempt to grasp the nettle of taxing an increasingly intangible economy. It won't be the last.