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July 1 is ‘VAT Day’

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From July 1, the Net will have to face up to a sobering new fact of life. Suppliers of digital services from outside the European Union (EU) will have to pay tax on sales to punters inside member states.

The measure is designed to level playing fields, iron out distortions and close loopholes that have effectively meant that providers of digital services from outside the EU have been able to flog them tax-free.

The new rules apply to a number of e-services such as Web hosting and downloaded games, music and software. From July 1, suppliers of e-services from outside the EU will have to pay Value Add Tax (VAT). And it goes without saying that the new rules have caused a bit of a stink.

Still, that opposition - principally from the US - hasn't stopped the new legislation being introduced. Aside for the loss of tax revenue, Internet businesses in the EU have been concerned that while they have to pay VAT - which ranges from between 15 per cent to 25 per cent depending on the country - companies from outside the EU have been exempt. Understandably, EU companies claim this is unfair.

One of the most vocal of those calling for the bulldozers to be allowed to re-landscape the footie pitch is UK ISP Freeserve, which went to extraordinary lengths to highlight the fact that rival ISP, AOL UK, does not pay VAT.

In all, Freeserve estimates that the loophole has saved AOL UK a whopping £150m since it launched an all-out attack on the unfairness of the tax loophole in summer 2001.

And there lies the root of the problem. While ISPs such as Freeserve had to pay VAT, AOL UK didn't. It's a competitive advantage that some think just went too far.

Commenting on the introduction of the new VAT legislation, David Melville, General Counsel at Freeserve said: "For us, it is way, way too late. No one likes taxes but the failure of the UK to levy VAT on digital content meant that AOL got away with it. This will level the playing field and remove a market distortion."

Of course, there's plenty who would disagree with Mr Melville. Those who've lobbied long and hard against the new VAT laws claim that trying to figure out where someone lives could prove difficult - even costly. Arguments have also broken out concerning the different VAT rates charged by different countries, which, they claim, make a nonsense of the rules. For example, in Luxembourg its 15 per cent, the UK 17.5 per cent, while in Denmark it's as high as 25 per cent.

Whatever happens, just administering and collecting the tax is likely to lead to an increase in costs - an increase that some business leaders claim would unfairly burden non-EU companies.

Indeed, some in the US argued that there should have been a moratorium on the EU's VAT plans to give the sector "time to mature". One proposal was that the EU should not take action before a global consensus on how to tax electronic commerce has been agreed.

However, the EU argued that introducing such a temporary suspension would be unworkable and would discriminate against other traders. Crucially, it echoed Freeserve's position that European businesses are already subject to tax on the provision of electronic services and this proposal is only about extending taxation to non-EU providers of electronic services to EU customers.

Of course, how companies go about dealing with the introduction of the tax remains to be seen. Some will comply with the new tax rules, others - particularly smaller ones - might simply ignore it. But there are those who fear that some niche traders outside the EU might simply decide not to bother with sales to the EU. Time will tell.

For instance, in the last month or so we've seen how two Internet giants have handled the countdown to "VAT day". In May, AOL revealed that its was to set up a new a new company - AOL Europe Services SARL - in Luxembourg to provide all of AOL's services in Europe.

As a result, it would pay VAT on its digital sales based on a single rate of VAT across all of its country operations, instead of charging different rates of VAT based on each individual country's tax laws.

Crucially, for customers in the UK, AOL said that it would absorb the tax hike and has no plans - at the moment at least - to pass on the charge to its UK customers.

eBay, on the other hand, decided to pass on the tax hike by announcing that it was also increasing fees at the giant auction operation. The outcry from users was swift and damning. It will be interesting to see if eBay's approach dents its revenue figures as some predict.

In the meantime, non-EU companies are being urged to get to grips with the new legislation. That said, one tax expert told us that taxmen were prepared for the fact that not everyone will comply and that their priority would be ensure that larger companies meet the new rules.

But he warned that companies that do breach the rules were likely to get caught - eventually. A sobering thought indeed. ®

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Boston E-Party looms, as EU set to tax online sales
Europe to levy tax on US, non-EU web sales

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