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Jurisdiction: Building Confidence in a Borderless Medium

July 26-27, 1999
Montreal, Canada

Electronic Commerce and Tax Neutrality: Current VAT Issues

Carol Dunahoo
PricewaterhouseCoopers LLP
Washington National Tax Services
1301 K Street, NW, Suite 800W
Washington, DC 20005
1-202-414-1755 Tel.
1-202-414-1301 Fax

Electronic Commerce and Tax Neutrality: Current VAT Issues 1

  1. The Principle of Neutrality

    Much of the international tax policy world has, from the very start, widely embraced neutrality as a fundamental principle that should guide the formation of international tax policy regarding electronic commerce. It has been endorsed by the Committee on Fiscal Affairs of the OECD and the European Commission, as well as by the U.S. Treasury and Internal Revenue Service, the Canadian Minister's Advisory Committee on Electronic Commerce, and other governments, organizations, and businesses participating in the wide-ranging discussions about how electronic commerce should be taxed. Notwithstanding these enthusiastic endorsements, however, it remains to be seen whether a neutral approach to electronic commerce will, in fact, be adopted in the VAT arena.

    1. U.S. Statements

      The U.S. Treasury issued the first national policy paper on the taxation of electronic commerce, Selected Tax Policy Implications of Global Electronic Commerce (the "U.S. Treasury Paper"), in November 1996. The U.S. Treasury Paper strongly endorses neutrality as a first principle that should guide the development of tax policy and administration with respect to electronic commerce:

      Neutrality rejects the imposition of new or additional taxes on electronic transactions and instead simply requires that the tax system treat similar income equally, regardless of whether it is earned through electronic means or through existing channels of commerce. 2

      In its discussion of income classification issues, the U.S. Treasury Paper elaborates and explains the neutrality principle as follows:

      Classifying transactions involving digitized information may require a more complex analysis that disregards the form of the transaction — without regard to whether tangible property is involved — in favor [of] an analysis of the rights transferred. This is necessary to ensure neutrality between the taxation of transactions in digitized information and transactions in traditional forms of information, such as hard copy books and movies, so that decisions regarding the form in which information is distributed are not affected by tax considerations. 3

      At about the same time the U.S. Treasury Paper was released, the U.S. Internal Revenue Service issued proposed regulations regarding the characterization of income from "computer program" transactions (Prop. Treas. Reg. Sec. 1.861-18, commonly referred to as the "software regulations").4 The software regulations similarly adopt a form-neutral approach, rejecting a distinction between tangible and intangible property and looking instead to the rights transferred. Although they are guided by copyright law principles, the software regulations depart from those principles where necessary "to treat functionally equivalent transactions in the same way."5

    2. OECD Statements

      The Committee on Fiscal Affairs of the OECD also has endorsed neutrality as a guiding principle for electronic commerce tax policy. For example, its discussion paper for the Government/Business Dialogue on Taxation and Electronic Commerce on October 7, 1998 (the "OECD Discussion Paper") states that "the CFA reaffirms that the widely accepted general tax principles of neutrality, efficiency, certainty, simplicity, effectiveness, fairness and flexibility should apply to electronic commerce."6 The OECD Discussion Paper describes the principle of neutrality as follows:

      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. Taxpayers in similar situations carrying out similar transactions should be subject to similar levels of taxation.7

      Consistent with this neutrality goal, the OECD has proposed an approach to the taxation of software payments similar in approach to that of the U.S. software regulations. Its recently revised Commentary on Article 12 (Royalties) of the OECD Model Tax Convention concerning software payments states:

      The method of transferring the computer program to the transferee is not relevant. For example, it does not matter whether the transferee acquires a computer disk containing a copy of the program or directly receives a copy on the hard disk of her computer via a modem connection.8

      The OECD Committee on Fiscal Affairs also specifically endorsed a neutral approach for consumption tax purposes in a paper prepared for the November 18, 1997 Informal Round Table Discussion Between Business and Government in Turku, Finland.9 In discussing the distinction between goods and services for VAT purposes, the CFA acknowledged the difficulty of the issue and the need for further evaluation but stated firmly that:

      It is clear that the classification as a good or a service should not depend on the means of distribution (e.g. sale of standard software through a retail outlet versus sale of standard software via direct download).

    3. European Commission Statements

      The European Commission has also endorsed tax neutrality for electronic commerce. Although it noted in its initial April 1997 communication on the topic that present VAT legislation, for example, might need to be adapted, it stressed the importance of maintaining neutrality "so there is no extra burden on these new activities as compared to more traditional commerce":

      [T]horough analysis is needed to evaluate the possible impact of electronic commerce on present VAT legislation ... and to judge if, and to what extent, present legislation needs to be adapted, while ensuring tax neutrality.10

      In its July 1998 Communication by the Commission to the Council of Ministers, the European Parliament and the Economic and Social Committee, the European Commission again stressed the importance of tax neutrality. Expanding upon its earlier statement, the Commission explained that:

      Neutrality means that:
      • the consequences of taxation should be the same for transactions in goods and services, regardless of the mode of commerce used or whether delivery is effected on-line or off-line.
      • the consequences of taxation should be the same for services and goods whether they are purchased from within or from outside the EU[.]

      Certainty, simplicity and neutrality are all essential to ensure a level competitive playing field for all traders in the developing global market place, and to avoid market distortions.11

    4. The Canadian Report

      The 1998 Report to Canada's Minister of National Revenue from the Minister's Advisory Committee on Electronic Commerce (the "Canadian Report") provides perhaps the fullest exposition to date of the concept of neutrality as it bears on the taxation of electronic commerce:

      A tax is neutral ... when it does not induce taxpayers to change their behaviour in response to the tax....

      The principles of tax neutrality and equity dictate that taxpayers should not be subject to different taxes simply because they provide services either on or off the Internet. Subjecting online providers but not offline providers (or the general business taxpayer) to tax is inequitable. It may also distort economic decision making by increasing the cost of doing business on the Internet and by inducing businesses and customers to redirect their efforts to offline activities.12

      The Canadian Report is especially helpful in stating the tax policy rationales for the neutrality principle more explicitly than other government-sponsored studies have done. As it makes clear, the tax policy goal of neutrality is motivated not only by a concern regarding equitable treatment among taxpayers but also by the recognition that a non-neutral approach may distort economic behavior in an undesirable manner.

    5. Summary

      There has been general agreement in principle, then, that neutrality requires similar tax treatment for similar transactions, regardless of whether delivery (or order) is made physically or electronically. The concern is that taxation could otherwise create an economic disincentive that would discourage the conduct of business electronically and yield inequitable tax results.

      Application of the neutrality principle in practice clearly will require careful analysis. It may not always be easy to agree whether the requisite similarity exists. For example, the Australian Taxation Office has suggested that a distinction may be appropriate for income classification purposes between physical and digitized products:

      It may also be argued that minor differences in the nature or mode of delivery of a product could lead to significantly different tax results, although such differences could be argued to involve considerable differences in substance (e.g., physical book vs. digital book).13

      Some have made similar arguments in the consumption tax context. For example, writing in their personal capacities, Frances M. Horner and Michael Hardy of the Fiscal Affairs Division of the OECD Secretariat have argued that "[n]eutrality only demands that the same transactions receive the same treatment."14 They maintain that, in many cases, consumers do not receive "the same thing" when a product is delivered online, suggesting, for example, that a "real" newspaper that can be taken to a café is "very different" from the online version viewed on a computer screen.15.

      Despite such questions, the major participants in the international tax policy debate regarding electronic commerce have continued to endorse the neutrality principle. Unfortunately, however, this broad consensus on neutrality in principle now appears to be breaking down in discussions regarding the application of VAT.

  2. Proposed Consumption Tax Treatment of "Digitised Products"16

    1. The EU Approach

      The European Commission has taken the position that "[a]ll types of electronic transmissions and all intangible products delivered by such means are deemed, for the purposes of EU VAT, to be services."17 The ECOFIN Council took a similar position in the following "conclusion" adopted on July 6, 1998:

      A supply that results in a product being placed at the disposal of the recipient in digital form via an electronic network is to be treated, for VAT purposes, as a supply of services. These supplies of services include so-called virtual goods.

    2. The OECD Approach
    3. The OECD Discussion Paper advocates a similar approach. It argues that the supply of "digitised products" should not be treated as a supply of goods for purposes of consumption taxation across international borders. The clear implication is that the supply of digitized products should be treated as a supply of services for consumption tax purposes, at least within the EU.18 Although classification as a service need not result in taxation as a service even under the EU VAT Directives,19 the OECD Discussion Paper clearly signals an intent to tax all electronic deliveries in the same manner as the supply of services for consumption tax purposes.

  3. Non-Neutrality of Proposed VAT Treatment

    The VAT approach proposed by the EU and the OECD is fundamentally inconsistent with the principle of neutrality espoused by those organizations and others. In a number of important instances, it would yield very different VAT treatment for very similar transactions, based solely on the method of delivery. As explained below, in many cases, products delivered electronically would be subject to a much heavier VAT burden than would similar physical products.20 The resulting price differential could seriously impede the adoption of electronic commerce by consumers in important sectors of the economy.

    1. Books, Newspapers, and Journals

      The treatment of books, newspapers, and journals is a prime example of non-neutral treatment. Many EU Member States apply a zero or reduced rate of VAT on books, newspapers and journals, reflecting a fundamental policy judgment that VAT should not be levied on information and knowledge. Under the proposed approach, VAT would be charged at full rates (presently 15 to 25 percent) on the same product simply because it is delivered electronically.21 Although delivered differently, the electronic version typically is identical in content to the physical version. Indeed, the electronic version can be printed off and read, and the physical version can be scanned and digitized.

    2. Software

      As another example, "standard" or "off-the-shelf" software imported into an EU Member State on a physical carrier medium (i.e., a diskette or CD-ROM) often is subject to VAT only on the minimal value of the carrier medium itself. This treatment results from the fact that the import and cross-border VAT rules for goods generally follow the customs duty treatment of the same item. However, the approach embraced by the OECD Discussion Paper would subject the same software to full VAT if delivered electronically.22

    3. Music and Video Recordings

      A similar issue arises in connection with the treatment of music and video recordings on import. These items are conceptually similar to software in that they represent content on a carrier medium. Therefore, there is an argument for imposing VAT only on the carrier medium value. In any event, these recordings often are VAT-free under de minimis exceptions for low-value items when imported in physical form by EU consumers.23 This is another instance where it would be inappropriate to draw a distinction at this juncture by taxing all electronic deliveries as services for consumption tax purposes.

      Good EU VAT Treatment of Physical Delivery24 Proposed Treatment of Electronic Delivery of Digitized Good
      Books, newspapers, journals Subject to VAT at zero or reduced rate Subject to VAT at full rate
      "Standard" software In the case of imports, often subject to input VAT only on value of carrier medium Subject to VAT at full rate
      Music and video recordings Imports often receive de minimis relief for low-value packages Subject to VAT at full rate

    4. "Performance Services"

      Another potential instance of non-neutrality vis-à-vis electronic commerce may arise in connection with the supply of what may be referred to as "performance services." In this instance, there would not appear to be any question that the supply should be classified as a service regardless of the method of delivery. The issue, rather, is a potential difference in the level of taxation.

      Medical and educational services, for example, are largely exempt from VAT when delivered traditionally. It is not entirely clear whether the electronic supply of medical services ("telemedicine") or educational services ("distance learning") will fall within the specific definitions of such services, either in the EU 6th Directive on VAT or in the more detailed rules adopted by Member States. Thus, they may not qualify for the preferential VAT rates extended to the traditional, in-person delivery of these services. Similar non-neutral treatment may occur in the case of cultural, sporting, and entertainment services.

    5. Other Legal and Administrative Differences

      In addition to these differences in applicable VAT rates, there are substantial legal and administrative differences between the VAT treatment of goods and that of services that may further disadvantage digitized products treated as supplies of services:

      • The place of supply rules are markedly different. For example, a simple test of physical movement generally applies to goods, whereas the place of supply of services depends on several factors, such as the status of the customer.
      • The tax point rules and consequent timing of cash payments may be different.
      • The "reverse charge" rules and VAT collection responsibilities are different. For example, in most countries, there is no reverse charge procedure on import of goods: the VAT must be paid to the authorities on import.

  4. Discussion of Proposed Consumption Tax Treatment

    A recent UK tribunal decision expresses serious concern regarding the non-neutrality of proposed consumption tax treatment of electronic commerce, which was advocated by the U.K. Commissioners of Customs and Excise in the case. In Forexia, the U.K. VAT and Duties Tribunal in the case of Forexia (UK) Ltd and the Commissioners of Customs and Excise, Paul W de Voil, Chairman (released Apr. 22, 1999), the Tribunal considers whether a news digest regularly sent to clients electonically, via fax, website posting, and e-mail is a "leaflet or periodical" entitled to a zero rate of VAT under current U.K. law. The Tribunal concludes that only "goods" and "tangible property" are zero-rated under current law. Forexia is instead supplying "information, presumably in the form of electrical impulses," concludes the Tribunal, which is a supply of services subject to the standard 17.5 percent U.K. VAT rate. In an openly critical opinion, the Tribunal notes that it reaches this conclusion "with the greatest reluctance," and argues that this result is not neutral, distorts competition, and is contrary to the U.K. Government's own recent statements advocating a neutral approach to the taxation of electronic commerce.

    Neither the OECD nor the EU, however, has acknowledged that the proposed consumption tax treatment of electronic commerce is inconsistent with the neutrality principle they have otherwise endorsed. Although the OECD Discussion Paper strongly endorses the principle of neutrality generally, it does not discuss the concept of neutrality in connection with consumption taxation.25 Nor does it acknowledge that the proposed approach is inconsistent with the position taken by the Committee on Fiscal Affairs in its 1997 paper for the Turku conference.

    In remarks delivered at the October 7, 1998 Government/Business Dialogue, Jan de Waard, Co-Chairman of the OECD's Special Sessions on Consumption Taxes, did acknowledge that "[t]he distinction between goods and digitised products indicates that different sets of rules are applicable to both categories." However, he added, "[t]his is without prejudice to the actual level of taxation which remains an item for national policies; exemptions and different rates are not influenced by these rules." Perhaps this statement was intended to remind tax policymakers of the negative impact of the proposed approach on electronic commerce. In the absence of any call for neutrality in this connection, however, the remark might be taken instead as carte blanche to impose heavier consumption taxes on electronic commerce transactions.

    Several reasons have been suggested for the proposed consumption tax treatment of "digitised products." The primary rationale stated by the OECD Discussion Paper is that the "treatment of digitised products as something other than goods provides certainty for consumption tax purposes."26 It is true that the proposed treatment would provide a measure of certainty. Certainty is particularly important in the consumption tax context and, all things being equal, generally is desirable from a tax policy perspective. However, the price of providing certainty in the proposed manner is too high. The "rough justice" approach it entails would result in substantially less favorable consumption tax treatment for many products delivered electronically than for physical deliveries of similar products.

    The OECD Discussion Paper adds that the proposed consumption tax rules on electronic deliveries are meant "to prevent the tax base erosion that could occur under some systems if these types of products were to be considered goods for the purpose of application of tax on importation and for the purpose of applying place of supply rules."27 However, merely classifying electronic deliveries as services would not resolve collection difficulties for online deliveries to individual consumers, the transactions of greatest potential concern to tax authorities. Protection of the tax base, therefore, does not seem to be a persuasive justification for imposing additional consumption tax on electronic forms of commerce in cases such as those noted above.

    The OECD Discussion Paper unfortunately leaves room for argument that the proposed rules can be justified because they are not intended to discriminate against electronic commerce. It argues, namely, that "existing taxation rules can implement these principles [neutrality, efficiency, certainty, simplicity, effectiveness, fairness and flexibility], although new or modified measures are not precluded provided that they ... are not intended to impose a discriminatory tax treatment of electronic commerce transactions."28 This intent standard, which the Committee on Fiscal Affairs applies to electronic commerce for the first time in the OECD Discussion Paper, substantially lowers the bar on the neutrality principle. It suggests a more limited, traditional standard of non-discrimination, rather than the broader neutrality protection otherwise advocated for electronic commerce. Application of such an intent standard would create an unacceptable degree of latitude for non-neutral treatment.

    In contrast, the OECD Discussion Paper urges the application of a simple de facto standard for determining whether electronic commerce is favored over "traditional" commerce because of lower taxation in practice. This de facto standard is much lower than the intent threshold applied to determine whether a measure discriminates against electronic commerce. Application of these disparate standards can only operate to disadvantage electronic commerce, compared to non-electronic commerce. This is clearly not neutral.

    There appears to be a third concern motivating the proposed consumption tax treatment for electronic commerce. As noted above, the most recent Communication from the European Commission redefines neutrality to mean not only the same tax treatment for online and offline transactions, but also the same taxation for services and goods purchased from within and from outside the EU.29 The Communication explains this concern as follows:

    The absence of [VAT on online deliveries by suppliers outside the EU to EU private consumers] would lead to unfair competition for EU operators who already have to tax their supplies of services for private consumption within the EU. Similarly, because many on-line services are currently subject to tax under EU rules at the place of origin, VAT is payable by EU suppliers on all the services they supply to non-EU countries. Conversely, supplies from non-EU countries to the EU would not be taxed - clearly a double competitive disadvantage for EU businesses. Such discrepancies in the application of tax clearly offend against the principle of neutrality.30
  5. Conclusion

    Equity requires an approach that does not disadvantage resident suppliers vis-à-vis similarly situated non-resident suppliers, or vice versa. It also calls for a system that facilitates the collection of consumption tax where properly due, in fairness to both resident and non-resident suppliers that comply. However, the approach proposed by the European Commission and the OECD does not address these issues in an appropriately targeted manner. The blanket characterization of all online deliveries as supplies of services, even where a similar product can be delivered physically at a zero or reduced rate, does not level the playing field. Unless rates and other differences in treatment are equalized, it simply results in the heavier consumption taxation of many electronic commerce transactions. This result is not neutral for either resident or non-resident suppliers of electronic commerce, from within or outside the EU. Tax authorities and business should work together to identify more targeted methods of addressing legitimate concerns, rather than rushing to adopt the proposed broad-brush approach.

    The consumption tax issues surrounding electronic commerce are, admittedly, complex and difficult. As in the case of income taxation, there inevitably will be cases in which the proper application of the neutrality principle will not be clear. Application of the neutrality principle will require a careful analysis of which types of electronically transmitted information have close physical analogues and, thus, should be treated for consumption tax purposes in the same manner as their physical analogues. This task will require difficult line-drawing in some situations. It may also require other changes to existing consumption tax systems. However, neutrality requires a more nuanced approach to the consumption taxation of electronic commerce than is currently proposed.

    Current consumption tax rules were largely developed at a time when the ability to digitize and deliver many types of goods or services at a distance was limited. Recent advances in telecommunications, computing, and other technologies, and the changes they have wrought in our business and personal lives, could hardly have been anticipated. It may be that a comprehensive review of consumption taxation is needed to address the changes brought about in the marketplace by these new technologies and other relevant developments in a consistent and neutral manner. Given the small amounts of tax revenue currently at stake, this approach is far preferable to a position that would be fundamentally inconsistent with the neutrality principle and hamper the further development of electronic commerce.


  1. This paper is based in part on a submission prepared on behalf of the Electronic Commerce Tax Study Group by the author and her colleagues, Peter R. Merrill and Christine Sanderson, for the October 1998 OECD-sponsored Government/Business Dialogue on Taxation and Electronic Commerce in Ottawa. The then-members of the Electronic Commerce Tax Study Group were America Online, Inc., Cisco Systems, Inc., Eastman Kodak Company, Electronic Data Systems Corporation, Hewlett-Packard Company, International Business Machines Corporation, Intel Corporation, J.D. Edwards & Company, Microsoft Corporation, NCR Corporation, Netscape Communications Corporation, Sun Microsystems, Inc., and 3Com Corporation. The Thomson Corporation, Time Warner Inc., and the Walt Disney Company have since joined the Electronic Commerce Tax Study Group. Although PricewaterhouseCoopers serves as advisor to the ECTSG, the views expressed in this paper should be regarded as those of the author. This paper is an updated version of a paper presented by the author at the 27th Annual Meeting of the USA Branch of the International Fiscal Association in February 1999.

  2. U.S. Treasury Paper, Executive Summary at 1 (1996).

  3. Id. at 28.

  4. The software regulations have since been finalized with no material change in this regard. See Treas. Reg. Sec. 1.861-18, T.D. 8785 (Oct. 2, 1998).

  5. Preamble, Prop. Treas. Reg. Sec. 1.861-18 (Nov. 13, 1996).

  6. OECD Discussion Paper, supra note 2, at 4 (emphasis added).

  7. Id., paragraph 6(a) at 7.

  8. Revision of the Commentary on Article 12 Concerning Software Payments, Working Party No. 1 of the OECD Committee on Fiscal Affairs (1998).

  9. Electronic Commerce: The Challenges to Tax Authorities and Taxpayers, OECD Committee on Fiscal Affairs (1997) at paragraph 69.

  10. A European Initiative in Electronic Commerce, COM(97)157 (1997) at paragraphs 56 and 57.

  11. E-Commerce and Indirect Taxation, Communication by the Commission to the Council of Ministers, the European Parliament, and the Economic and Social Committee, COM(98)374 (1998), at 3 (emphasis in original).

  12. Electronic Commerce and Canada's Tax Administration: A Report to the Minister of National Revenue from the Minister's Advisory Committee on Electronic Commerce (1998), paragraph at 50-51.

  13. Australian Taxation Office, Commonwealth of Australia, Tax and the Internet: Discussion Report of the ATO Electronic Commerce Project (1997) at 47.

  14. Frances M. Horner and Michael Hardy, The OECD Work on Taxation and E-Commerce, Tax Planning International e-commerce (Oct. 1998) at 27. This standard appears to be a higher one that that suggested by the OECD Discussion Paper, which requires only that products for which similar tax treatment is sought be "similar," not "the same." See discussion at A.2., supra. This author disagrees both with the distinction drawn and with the standard applied.

  15. Id.

  16. This discussion is limited to the issue of the characterization of supplies for purposes of national consumption taxation. Both the EU and the OECD also have endorsed other important changes to existing consumption tax regimes, including a destination-based system under which electronic commerce transactions would be taxed at the place of consumption rather than at the place of origin.

  17. E-Commerce and Indirect Taxation, supra note 10, at 5.

  18. Unlike the recent statements from the European Commission and ECOFIN, the OECD Discussion Paper does not state explicitly that the supply of digitized products should be treated as a supply of services. Absent any indication to the contrary, however, this is the clear implication under existing EU VAT regimes, which treat everything that is not a supply of goods as a supply of services.

  19. For example, the supply of electricity is taxed as a good for VAT purposes (see 6th VAT Directive, Art. 5.2).

  20. This discussion focuses on the category of transactions identified by tax authorities as the primary collection concern: deliveries made through electronic means to individual consumers. These consumers, along with so-called "exempt" taxpayers such as financial institutions, bear the economic burden of the typical VAT and are, therefore, most sensitive to differing taxation of functionally equivalent transactions.

  21. In this connection, see also discussion of the Forexia case under D., infra.

  22. The same result generally would obtain if software on a physical carrier medium were imported by an EU distributor and resold locally to the end consumer. For purposes of the neutrality analysis, however, it is submitted that the appropriate comparison is to the treatment that would be accorded to such software when imported directly into the EU by the end consumer.

  23. This discussion is not intended to suggest any change to these de minimis rules, as some have proposed. The administrative concerns that prompted the adoption of such de minimis exceptions are as relevant for electronic commerce as for other commerce.

  24. The EU VAT rules are referenced for purposes of illustration.

  25. The OECD Discussion Paper does acknowledge that the consumption taxation of electronic commerce should " not hinder the development of electronic trade." OECD Discussion Paper at paragraph 41(e). This "non-hindrance" criterion would appear to require similar consumption tax treatment for similar electronic and non-electronic transactions in any event, because less favorable tax treatment for electronic commerce presumably would discourage its development in certain circumstances.

  26. OECD Discussion Paper, supra note 2, at paragraph 43 (emphasis added).

  27. Id.

  28. Id., Executive Summary at 4 (emphasis added).

  29. See E-Commerce and Indirect Taxation, supra note 11.

  30. Id. at 6.


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