Application of the EU Value Added Tax to E-Commerce Transactions

By Dr. Reimar Pinkernell, LL.M. (Int'l Tax, NYU),

Partner, Flick Gocke Schaumburg, Bonn/Germany.


While income tax issues and in particular the application of double tax treaties are at the center of the academic debate on electronic commerce, in practice tax attorneys are more often confronted with consumption tax issues raised by Internet based business models.  The reasons for this are very simple:  Income tax returns are filed annually, and a tax audit may take place several years later - if at all.  By contrast, VAT returns are filed on a monthly basis, and, pursuant to the European self assessment system, businesses are required to compute VAT tax liabilities at the time they account for their e-commerce transactions.  As a result, VAT attorneys found themselves at the forefront of electronic commerce taxation and it was their task to devise solutions before other tax lawyers had even begun to understand the issues.  In addition, Internet start-ups are rarely profitable so the fiscal authorities focus on VAT compliance issues, whereas income tax aspects are less important.

The rapid expansion of the "New Economy" left not much time for an in-depth discussion of tax issues.  Meanwhile, the situation has changed.  We now understand the issues more clearly, and a consensus is emerging on how to apply the existing rules and how to amend them so as to reflect the changes brought about by the implementation of Internet based business models.  The objective of this article is to reflect the current VAT discussion within the EU.  Part one deals with the political compromise reached by the US and the EU.  Part two explains a few basic concepts of the EU VAT in order to lay the ground for the more advanced issues of electronic commerce.  In part three, the different VAT rules applying to B2B transactions and B2C transactions are discussed.  Finally, part four is dedicated to the proposed amendments to the EU VAT Directive,[1] which were adopted by the EU Council of Ministers on February 12, 2002, and are scheduled for implementation by July 1, 2003.

I. Dissent and Consensus within the OECD

When the OECD first started examining the subject of electronic commerce about four and a half years ago,[2] it soon became clear that the US and the EU had opposing economic interests and therefore opposing views on the taxation of electronic commerce:  The US, being a net exporter of digital products, demanded a "tax moratorium" for electronic commerce transactions.[3]  The rationale of that policy was obvious:  The Clinton administration planned to maximize worldwide US business opportunities by taking advantage of the US's technological and economic lead.  The EU, on the other hand, found itself in the uncomfortable position of being a net importer of digital goods and services.  It quickly realized that foreign taxpayers no longer had to maintain a physical presence in the EU to do business on European markets.  Not surprisingly, several member states of the EU voiced serious concerns about dwindling tax revenues. Ironically, it seemed that the very tax treaty mechanism that had been designed to limit the source taxation of developing countries now turned against its European inventors who had to protect their shrinking tax bases against the economic power of the US.

For a while, it seemd that some European countries would tighten their source taxation rules in an attempt limit future revenue losses to a minimum.  Some even considered repealing or reducing tax treaty benefits for e-commerce income.  In the end, however, the US prevailed, and the OECD decided unanimously to keep the current treaty system of reduced source taxation under Articles 7 and 12 OECD Model Convention.  Fortunately, the EU did not leave the negotiating table with empty hands:  It reasserted its right to impose VAT on US. based businesses, and it received a mandate from the OECD to amend existing consumption tax rules so as to level the playing field for European businesses that are subject to VAT when they supply goods or services on their home markets.

The consensus on consumption taxes reached by the OECD and the EU consists of five central demands:[4]

·      Demand for "fair taxation" of e-commerce transactions, i.e. prevention of double taxation but also of double-nontaxation and tax evasion.

·      Demand for "neutrality", i.e. no preferred treatment of e-commerce transactions but equally no discrimination against such transactions.  In other words, e-commerce transactions should be subject to taxation if their "physical equivalents" are subject to taxation.  However, cost advantages of Internet business models over "brick and mortar" businesses would not be taxed away meaning that businesses could still reap the rewards of adopting more cost efficient technologies.

·      Demand for taxation at the place of consumption.  This demand is to ensure a level playing field for domestic and foreign businesses supplying goods and services on the same national market.  It is also consistent with the VAT's characteristic as a consumption tax.

·      Demand for simplicity and certainty.  While this fairly general demand applies to any tax, it is of particular importance to foreign businesses, which will be required to comply with VAT rules they are not familiar with.

·      Demand to keep the costs of compliance and administration low.  This demand, while being perfectly reasonable, is merely a selling point.  Any professional dealing with VAT issues knows that this demand is unrealistic because the VAT has reached a level of complexity that defies simple compliance solutions.  Ultimately, it will be the businesses alone which will bear the cost of applying complicated VAT rules, while tax administrations will limit their activities to mere audit functions.

II. General Characteristics of the EU VAT

1. VAT Harmonization

The EU has established an "internal market" regime that provides for the free exchange of goods and services.  The internal market requires, among other things, a uniform consumption tax.  While member states retain their tax jurisdiction under the EU treaty, the EU is authorized to promulgate VAT directives and regulations that are binding on member states.  In particular, member states are required to "transform" the Sixth VAT Directive into domestic law by passing legislation which is consistent with the Directive and its amendments.  Under the system of "VAT harmonization", however, EU member states reserved the right to set VAT tax rates and to exempt certain supplies of goods and services.  As a result, national regular tax rates range from 15% to 25%, and while the supply of certain goods may be taxed at a reduced rate in one member state, it may be tax exempt in another.  It may not come as a surprise that these national peculiarities tend to have a distorting effect on competition among suppliers from different EU member states.  In fact, the "level playing field" for domestic and foreign businesses championed in the political discussion with the US. has not yet been fully realized within the EU itself.

2. VAT as a Consumption Tax

Under Article 2 of the VAT Directive, VAT is levied on the supply of goods and  services effected for consideration within the EU.  While the tax technically attaches to the supply of goods and services, and businesses are required to charge and remit the tax, the incidence of the VAT is on the consumer.  Consequently, "taxable persons" - i.e., suppliers of goods and services - are entitled to a deduction of VAT amounts charged to them by their suppliers ("input tax credit"). The input tax credit is not available to consumers so that the VAT on supplies to consumers becomes final.

3. VAT Jurisdiction

A member state may impose VAT if the place of supply is within its territory (Article 2 VAT Directive).  The supply of goods and the supply of services are subject to different source rules: 

·      supply of goods: as a rule, at the place where the shipping begins (Art. 8(1)),

·      supply of services: as a rule, at the place where the supplier ("taxable person") has established his business (Art. 9(1)).

As a result, most transactions are taxable in the member state where the supplier has established his business ("country of origin principle").  If supplier and customer reside in the same country, taxation at the place of consumption is assured by simply applying general source rules.

Special rules, however, are required for cross-border supplies of goods and services: Depending on the type of supply and the type of customer (taxable person or consumer), the supply may be tax exempt in the country of origin and subject to VAT at the place of consumption ("country of destination principle").  With respect to cross-border supplies, it is appropriate to set aside the "country of origin principle" in favor of the "country of destination principle" because foreign suppliers should be subject to the VAT regime that applies to resident suppliers; thus, the objective of competitive neutrality on a given market is achieved.  The application of the "country of destination principle" is not limited to suppliers from EU member states supplying goods and services within the EU.  Generally, it also applies to taxable persons who supply goods and services to customers outside the EU.  For example, a taxable person established in Germany may export goods and services to the US without having to pay VAT to the German government.  The exemption for exports allows domestic suppliers to compete with US suppliers on the US market.  Conversely, a US supplier exporting goods and services to the EU is generally subject to VAT in the destination country; "importation VAT"  is levied on the supply of goods and the supply of services is subject to the "reverse charge mechanism".[5]

There is, however, a tax loophole with respect to US businesses supplying "digital goods" and "digital services" via electronic means to consumers in the EU: As these transactions involve no physical goods, it would be impossible for EU member states to enforce the conventional importation VAT that is administered by the Customs Department and relies mainly on border inspections and airport checkpoints.  In addition, EU consumers are not subject to the "reverse charge mechanism" applicable only to EU taxable persons who buy services from other taxable persons.  As a result, non-EU suppliers, particularly suppliers from the US, enter EU consumer markets without being subject to VAT obligations whereas their EU competitors are liable for VAT.  In most cases, profit margins are too small to absorb the VAT tax burden so that European businesses are about to lose market shares to their US competitors.  European businesses are also treated unfairly with respect to the fact that there are some exceptions to the general rule that supplies to EU taxable persons should be subject to VAT.

Before discussing these inconsistencies in detail, however, it is necessary to pinpoint the issues by categorizing e-commerce transactions for VAT purposes. In a first step, one has to determine whether a transaction that involves electronic means is actually a conventional transaction leading to the supply of physical goods or physical services.  Obviously, transactions of this type can be dealt with easily under the current rules.  In a second step, if a transaction does not belong into the aforementioned category, a decision has to be made as to how to apply existing VAT rules to this other type of transaction.  Only if the existing rules do not yield a satisfactory result, is it legitimate to ask whether those rules should be changed.

III. Taxation of E-Commerce Transactions

1. E-Commerce Transactions:  Supply of Goods or Services?

In a modern world, the solicitation of a customer, the conclusion of a contract, or the payment of the consideration often involve means of electronic communication. Therefore it is obvious that use of the Internet as a communications link or as a payment tool does not require a new category of VAT transaction if physical goods are delivered to the customer or if services are physically performed.  These transactions can be dealt with under the existing source rules of Article 8 (supply of goods) and Article 9 (supply of services), under which the place of supply for an "offline" delivery of goods is generally the place where the shipping of the goods begins.  The business model of the online book seller falls into the category "offline" delivery because ultimately ships physical products to its customers.  It should be noted, however, that distance selling within the EU is subject to special rules:  If sales to consumers in a specific member state exceed a certain threshold amount, the supply is not taxed where the shipping begins but where the consumer lives.

Like the physical delivery of goods, the physical performance of services is easily dealt with even though use of the Internet may somehow have contributed to that supply.  The supply will be categorized as an "offline transaction" and sourced under the rules of Article 9 of the VAT Directive.

Things become difficult, however, if a taxable person delivers "digital goods" or performs "online services" via the Internet.  Typical "online transactions" such as

·      purchase of software or electronic books via download,

·      fee-based subscription to online databases and periodicals,

·      online banking and brokerage,

·      point-to-point streaming audio and video,

·      online advertising (e.g., "banner ads"), and

·      Internet based distance learning

do not fit readily into the traditional categories of goods and services.  One could argue that these transactions should be characterized in accordance with their physical equivalents so that the purchase of an electronic book would be sourced under Article 8 VAT Directive (place where the shipping begins), whereas the place of supply of banking services would be the place where the supplier has been established under Article 9(1) VAT Directive.

While this approach might have provided some competitive neutrality for offline and online transactions involving comparable products, neither the OECD nor the EU adopted it.  Instead, both organizations agreed that all transactions involving supplies via the Internet should be characterized as "supplies of services" for consumption tax purposes.[6]  Consequently, the online transactions mentioned above are sourced under Article 9 VAT Directive without exception and regardless of the fact that the supply of an electronic book or sound file, for instance, may be taxed differently from the supply of a comparable physical product.  Furthermore, Article 9 applies to B2B transactions as well as to B2C transactions.

2. VAT Jurisdiction for B2B Transactions under Article 9 VAT Directive

Article 9(1) sets forth the general source rule for supplies of services by taxable persons to other taxable persons:  The supply is taxable at the place where the supplier has established his business ("country of origin principle").  As a result, exports of services are subject to EU VAT, imports are not.  Within the EU, this rule could achieve competitive neutrality if tax rates were uniform (which they are not).  With respect to US imports, Article 9(1) results in a distortion of competition because US suppliers are neither subject to EU VAT nor to US VAT. As the US does not impose a general consumption tax at the federal level, and state sales taxes are easily avoided by setting up a subsidiary in a state that does not impose a sales tax, US suppliers can offer their online products at prices lower than those of their European competitors.  In the past, US suppliers utilized Article 9(1) VAT Directive to provide low cost telephone services to German customers.  That loophole was closed by legislation in 1997, and many European businesses argue that the rule should also be amended with respect to B2B online transactions.

But the matter is not so simple because some online transactions are already covered by Article 9(2)(e) VAT Directive, under which the supply of certain B2B services is taxed at the place where the customer has established his business ("country of destination principle").  The exception to the general rule of Article 9(1) applies to

·      transfers of intangible property,

·      advertising services,

·      legal services and the supplying of information, and

·      certain financial services.

Under this rule, exports of services are exempt from EU VAT, whereas imports are taxed (the recipient of the services owes VAT under the "reverse charge mechanism"). Within its scope, Article 9(2)(e) VAT Directive achieves competitive neutrality for EU suppliers as well as US suppliers.  Furthermore, it is consistent with the demand to tax supplies at the place of consumption.  While the principle set forth in Article 9(2)(e) VAT Directive could serve as a model for the taxation of online transactions, the current language of Article 9(2)(e) is not of much help with respect to the taxation of online transactions.  By limiting the application of the "country of destination principle" to a few types of services, Article 9(2)(e) subjects some online business models to taxation while exempting others. This is not consistent with the EU's objective to provide uniform rules for the sourcing of all types of online transactions.  What is more, the current catalog of services covered by Article 9(2)(e) is too vague to produce clearcut answers as to the categorization of B2B transactions.  For instance, does the download of software qualify as a "supply of information"?  If so, a taxable person established in the EU would have to apply the reverse charge procedure on his payment to the US supplier (Note: The German finance administration takes the position that Article 9(2)(e) applies to software downloads from the US, but the language in the German VAT Act is as vague as the wording of Article 9(2)(e) so that the ultimate decision rests with the European Court of Justice).

3. VAT Jurisdiction for B2C Transactions under Article 9 VAT Directive

B2C online transactions are also subject to the source rules of Article 9 VAT Directive.  Again, the general rule is that the supply of services by EU suppliers to EU consumers is taxed where the supplier has established his business (Article 9(1) VAT Directive).  Therefore, supplies by EU suppliers to EU consumers are taxed in accordance with the "country of origin principle".

The supply of services by EU suppliers to non-EU consumers is also taxed where the supplier has established his business, unless the services fall into one of the categories listed in Article 9(2)(e) VAT Directive:

·      transfers of intangible property,

·      advertising services,

·      legal services and the supplying of information, and

·      certain financial services.

In this case, the place of supply is outside the EU, and EU VAT is not chargeable ("country of origin principle" is replaced by "country of destination principle").  By contrast, the supply of services by non-EU suppliers to EU consumers is not subject to EU VAT because the place of supply is outside the EU under Article 9(1) VAT Directive.

Apparently, the rules for the taxation of B2C online transactions are as inconsistent with EU policy objectives as those for B2B transactions:  While full competitive neutrality is achieved with respect to the supply of services by EU suppliers to non-EU customers, non-EU suppliers are not required to charge VAT when they supply services to EU customers.  As a result, US businesses have a considerable advantage over their European competitors when they sell digital products or online services to consumers within the EU.

IV. Proposal of the EU Commission of Feb. 12, 2002

The uniform characterization of all types of online transactions as supply of services has brought some progress in that only the source rules of Article 9 VAT Directive apply.  As we have seen, however, Article 9 yields different results depending on the characteristics of supplier and customer as well as on the type of service.  In particular, US suppliers are not required to charge VAT on supplies to EU consumers; the supply of services to EU taxable persons is also not subject to VAT, unless the services are expressly mentioned in the catalog of Article 9(2)(e) VAT Directive.

Under the current VAT rules, the goals of fairness and competitive neutrality cannot be achieved.  In response to this, the EU Commission proposed amendments to the VAT Directive which were confirmed by the Council of Ministers on February 12, 2002.[7]  The amended rules would apply to the online delivery of digital products, the online supply of services, and online broadcasting as well as pay-per-view systems (point-to-point audio and video transmission); their goal is to provide uniform VAT rules for e-commerce transactions.[8]  The legislation has yet to be formally adopted by the European Parliament and transformed into national law, which may take up to 12 months.[9]

Under the new rules, EU suppliers would not be required to charge VAT on online transactions involving non-EU customers so that competitive neutrality with respect to EU exports to the US is achieved.  The rules for supplies by EU suppliers to EU customers remain unchanged, i.e.

·      supplies to taxable persons remain subject to the reverse charge procedure, and

·      supplies to consumers are taxed where the supplier has established his business.

The VAT treatment of non-EU suppliers, however, would change completely:  B2B-transactions with EU taxable persons will be taxed at the location of the EU customer; the tax would levied via the reverse charge mechanism which requires EU taxable persons to withhold, remit and account for VAT.

Non-EU suppliers who sell their products to EU consumers would have to register with the VAT authorities of a member state of their choice.  They would be required to levy VAT on their transactions with EU consumers if their revenues exceed a certain threshold amount.[10]  VAT would have to be levied at the rate that is applicable in the member state where the consumer lives.[11]  In addition, the EU would implement a "clearing procedure", under which the member state of registration is required to allocate VAT collected from non-EU suppliers to those member states where the customers were located.  In order to facilitate the introduction of the new system, non-EU suppliers would be offered a simplified online registration and compliance mechanism that would allow them to fulfill their VAT duties without establishing a physical presence or "fiscal representative" within the EU.[12]

Whether the EU can deliver on its promise of simplicity and fairness remains to be seen.  US businesses already criticize the fact that they are required to identify and locate their EU customers in order to apply the proper tax rate, whereas EU suppliers are not required to do so.[13]  The proposed legislation calls for an "evaluation period" of three years.  By then, hopefully, we will know whether we have a system that works for all.

[1] Sixth Council Directive 77/388/EEC of 17 May 1977 on the harmonization of the laws of the Member States relating to turnover taxes – Common system of value added tax, OL L 145, 13.6.1977, p. 1.

[2] Informal round table "Electronic Commerce: the Challenges to Tax Authorities and Taxpayer" held in Turku, Finland in November 1997.


[4] Consumption Tax Aspects of Electronic Commerce - A Report from Working Party No. 9 on Consumption Taxes to the Committee on Fiscal Affairs, February 2001, (

[5] Under the reverse charge mechanism, the taxable person the services are performed for is required to deduct VAT from the consideration he pays to the supplier.  If the supply is for the business of the taxable person, the taxable person is entitled to an input tax credit.

[6] Consumption Tax Aspects of Electronic Commerce.


[8] Art. 9(2)(e) VAT Directive would be amended to include radio and television broadcasting services as well as electronically supplied services such as (illustrative list in Annex L)

1.        web site supply, web-hosting, distance maintenance of programmes and equipment;

2.        supply of software and updating thereof;

3.        supply of images, text and information and making databases available;

4.        supply of music, films and games, including games of chance and gambling games; and of political, cultural, artistic, sporting, scientific and entertainment broadcasts and events;

5.        supply of distance teaching.

[9] The deadline for implementation is July 1, 2003.

[10] The initial proposal contained a "minimum turnover threshold" of Euro 100,000.  At present, it is not clear whether this threshold will be dropped entirely so that a non-EU supplier would have to register with a EU member state even though there are only occasional sales to EU consumers.

[11] Art. 9(2)(f) as amended reads as follows: "the place where services referred to in the last indent of subparagraph (e) [electronically supplied services] are supplied; when performed for non-taxable persons who are established, have their permanent address or usually reside in a Member State, by a taxable person who has established his business or has a fixed establishment from which the service is supplied outside the Community or, in the absence of such a place of business or fixed establishment, has his permanent address or usually resides outside the Community, shall be the place where the non-taxable person is established, has his permanent address or usually resides."

[12] Art. 26c VAT Directive as amended.

[13] D. Hardesty, European VAT on Digital Sales,