This article originally appeared in the Summer 2000 issue of the New Rules journal. It was authored by Simona Fuma Shapiro
Webretailers in the U.S. are largely exempt from collecting state and local sales taxes. In allowing this exemption, Congress agrees to give out-of-state businesses a 5 to 7 percent price advantage over local stores. Proponents of the exemption argue internet-based suppliers would stagger under the administrative burden of collecting thousands of different state and local sales taxes; opponents of the exemption argue that the electronic commerce companies don’t need help siphoning business away from already-struggling downtowns.
Unlikethe United States, the European Union never considered making the internet a tax-free zone. The difference in approaches can be traced to the treatment of mail-order goods. Mail-order goods present a problem for taxation authorities because a taxing jurisdiction must either collect taxes from a supplier outside its borders (hard to administer)or tax the consumer within its borders as soon as she receives the product (hard to enforce). European countries figured out a way to tax these items. The U.S. exempted them. 1
ForEurope, then, a system was already in place to handle the taxation of physical goods purchased on the internet. To exempt goods sold on the internet, in the European view, would be to violate the principle of neutrality.
E.U. and U.S. Views Differ
In1998, E.U. tax authorities voiced their concerns that, “aside from revenue considerations, it would be essential to be able to apply VAT(value-added tax) to trade over the networks in order to avoid distortion of competition with conventionally traded products.” In October of that year, an international conference on the subject of e-commerce was held in Ottawa, Canada. Participants included ministers and high-level officials from all 29 OECD (Organization for Economic Cooperation and Development) member countries, as well as participants from 12 non-member countries, representatives of international business organizations and various trade unions, consumer groups and other non-governmental organizations. The OECD issued a report on “framework conditions” for the taxation of e-commerce. The first principle cited is that of neutrality:
Taxation should seek to be neutral and equitable between forms of electronic commerce and between conventional and electronic forms of commerce. Business decisions should be motivated by economic rather than tax considerations.
Taxpayersin similar situations carrying out similar transactions should be subject to similar levels of taxation. This approach is in stark contrast to the Clinton administration’s December 1997 policy paper, “A Framework for Global Electronic Commerce,” which argued that the internet be tariff-free.
Point of Collection
All E.U. purchases are subject to a value-added tax, or VAT, which is similar to U.S. states’ sales taxes on retail goods. Each of the 15 E.U. member states has its own VAT rate, ranging from 15-25 percent of the price of the good sold. (In many member states, reduced or even zero rates are applied to “essential” products – such as food, fuel and children’s clothes – and to products of cultural or educational significance, such as books and newspapers.) One difference between VAT and state sales taxes, however, is that VAT is collected at the final destination where consumption occurs (usually the vendor in the consumer’s own country), while U.S. states’ sales taxes are charged where the product is purchased. Thus, a visitor to a European country can be refunded the VAT he paid on a product purchased in that country if he carries that product with him across the border. In addition, products entering international trade do so free of VAT. However, a foreign tourist visiting Minnesota is not refunded the sales tax on her purchases once she leaves the state.
VATcollection becomes logistically more difficult when an individual makes mail-order purchases across European borders. Which country has the right to collect tax on the transaction? Is this practical? If not, can one country collect the tax and remit it to the other ? How can this be accomplished? According to European rules, if I live in E.U. member state A and buy a product from E.U. member state B, it is state A that has the right to charge VAT on my purchase, since VAT is collected at the point of consumption. But because the vendor is the best place for the tax authorities to intercept my purchase, the E.U. nations early on developed a framework whereby the vendor in state B must collect VAT and remit it to state A.
Physical Presence vs. Economic Influence
Both the U.S. and Europe use a similar test to decide whether a tax can be imposed on remote suppliers. In the United States “nexus” occurs when the seller has a physical presence in the state (e.g. a store or warehouse or agents).
InEurope, what corresponds to nexus occurs when a seller has a sufficiently large economic presence that it can affect local enterprises. According to Arthur Kerrigan, head of the Section of International Services-Taxation at the European Commission, “if a merchant is transacting a material level of business in a particular jurisdiction, they should do so on the same terms and conditions as a local merchant.” The threshold for registration for distance sales is set out in European Commission (EC) legislation and is generally 100,000 Euro a year (about $90,000 USD), with some exceptions.
Taxing Distant Purchases
On a practical level, VAT collection in E.U. countries on distance(i.e., mail-order or internet) sales is carried out as follows:
Situation 1: A supplier in E.U. member nation A sells a product to a business customer in E.U. member nation B. The supplier checks the validity of the VAT registration number the customer gave him against a central database, which is maintained by the national tax authorities of nation B. The supplier quotes the customer’s VAT registration number on the invoice and dispatches the goods (without charging VAT). Businesses are charged VAT on their purchases, but this is a provisionary tax, which is reimbursed once they sell the product.
Situation 2: A supplier in nation A sells a product to a private individual or organization in nation B that does not have a VAT registration number. If the value of the supplier’s sales in country B exceeds a certain pre-determined limit (usually 100,000 Euro a year) that supplier must register with the VAT authorities in state B, charge local VAT and file returns there.
Situation 3: A customer living in an E.U. nation buys goods from outside the E.U. These goods are considered imports, and are subject to customs duty and VAT upon being imported. However, there is a key exception. Goods worth under UK18Pd(about $27 USD) such as CDs or books, are not subject to either VAT or customs duty. Small items are apparently considered not worth the customs paperwork.
Situation 4: A U.S. customer buys a product over the internet from a European vendor. No VAT is paid. However, if she visits the E.U., she pays VAT on an item purchased there, but then is reimbursed upon leaving European territory.
Situation 5: A customer in European countr y A purchases downloadable music or software over the internet. The European Union treats these transactions as services for tax purposes. Under VAT rules, services(unlike goods) are taxed at the place where they are provided. Thus, the European operator is often obliged to charge tax on all such sales, no matter where the customer is located. On the other hand, a non-E.U. supplier can sell to European customers free of tax, since at present it is logistically impossible for the tax authorities to monitor such transactions.
TheEC is currently working on ways to change this. One suggestion by staff at the German finance ministry has been that banks and credit card organizations retain the tax and transfer it to the tax authorities. This is similar to the trusted third party proposal suggested by the National Governors Association in the U.S. (See “Local Retailers Hit the Web,” The New Rules, Winter 2000). This has met with stiff opposition in the European financial sector, however, where it is argued that the huge administrative costs would be involved in distinguishing between conventional payments and purchases subject to VAT, and correctly applying the right rates of tax.
Anotherpossibility is to extend the notion of an origin-based (as opposed to a destination-based) tax on services to countries outside the E.U., and require any foreign vendor (outside the E.U.) with a certain threshold of business in the E.U. to register and remit taxes to Europe. This is similar to what already occurs between E.U. countries. Such a system would be easier to implement, but not problem-free (because, for example, of the difficulty in monitoring sales bought with unaccounted money.)
Saving Retail in the Digital Age
One complaint of those who oppose e-commerce taxation in the United States is that with so many taxing jurisdictions (approximately 7600, each of which has the right to impose its own sales tax rate), collecting and remitting taxes to the appropriate authority would be impracticable. The European system, while encompassing far fewer taxing entities, offers a model of how interstate taxation can be achieved when there is a political will to do so. Indeed, a larger number of taxing jurisdictions makes it that much less likely for a truly small-time operation to achieve nexus in any one of them. Internet vendors of jam and maple syrup will not likely have to register in many jurisdictions. It is the internet giants like Amazon.com and eBay that would have to remit taxes in those areas where their business was sufficient to establish “nexus.”
Whilewe have been busy undermining our traditional retail sector, the Europeans have been devising ways to treat theirs fairly. We should learn from them in developing tax policies for the digital age.
1. In 1967 the U.S. Supreme Court (National Bellas Hess Inc. v. Department of Revenue of Illinois)concluded that states cannot compel out-of-state mail order firms to collect sales taxes. The court said that state taxation on remote business is justified only where the tax is necessary to make the business bear its fair share of the cost of the government whose protection it enjoys. Thus, it conditioned nexus upon finding that the retailer had a physical presence in the state. In 1998 Congress extended the exemption for mail-order merchants to e-commerce. The 1998 Internet Tax Freedom Act imposed a three-year moratorium on any new taxes on electronic transactions and created a commission to study this issue.
This article was originally authored by Simona Fuma Shapiro
Research Associate, Institute for Local Self-Reliance