Software as a service to comply with VAT requirements
24 March 2015
Author: John McCarthy, co-founder and CEO of Taxamo. Co-authors: Sarah Flaherty and JP McCarthy, Taxamo
Value-added tax (VAT) is an indirect consumption tax that is added to a purchase price of a product or service. This form of taxation was originally introduced by Maurice Lauré in 1950s France (of course, it was taxe sur la valeur ajoutée [TVA] in France).
Lauré’s idea revolutionised exchequer finances across the globe. It was also a godsend for tax authorities as it re-engineered how tax could be collected. The introduction of VAT enshrined the idea that the consumer paid the tax that was due, rather than the retailer, or indeed collected by the tax authorities themselves.
When the European Economic Community (EEC) was formed in 1957, one of the key elements of membership was that all indirect taxes had to be replaced with VAT. This demand catapulted VAT into the stratosphere as the EEC embraced its potential.
Since this first introduction, the application of VAT has grown into a taxation behemoth and is now used for a variety of products and services. It is a simple, but sensational, revenue-raiser for governments. As a simple example, just take a look at the most recent Irish Exchequer returns that saw a €330 million VAT boost, up 16.2%, to €2.37 billion for January and February 2015. VAT receipts in February were €40 million or 11.3 per cent ahead of target. (1)
However, the traditional taxation system has struggled to cope with the changing world of online commerce. This was laid bare by a 2011 European Commission-commissioned report which found that some €192 billion in tax revenue was lost to what is termed the ‘VAT Gap’. Revenue was lost through poor accounting systems, ignorance, or downright fraud. In 2012, that figure was reduced to €177 billion (2).
This report shocked the European Commission and copper-fastened their resolve to revamp the taxation of the digital economy. Hence the introduction of new taxation rules in the EU at the start of 2015.
How 1 January 2015 affects merchants
The new EU VAT rules on the cross-border supply of digital services require merchants to identify the location of their consumer in the EU.
On 1 January 2015, new EU VAT rules on the cross-border supply of digital services came into force. This rule change requires merchants who supply digital services to identify the location of their consumer in the EU. The term ‘digital services’ covers a huge swathe of the burgeoning digital economy, but the new rules have a narrow focus. They are concentrated on broadcasting, telecommunications and electronic services. In addition, only the cross-border business-to-consumer (B2C) supplies of these digital services are affected. For example, the B2C download of images, games, and ringtones are in scope. Video streaming services – such as Netflix – are also in scope. Personal cloud computing services are also affected.
What’s not affected? Well, the Commission’s homepage on the introduction of the new rules answers this query: “The distance selling of physical goods or of other services that involve human intervention, even though the communication is done by email (i.e. legal services carried out at distance; education at distance involving assistance by the teacher) are not covered by the changes.” (3)
Pre-2015, most B2C supplies of broadcasting, telecommunications and electronic services would have been taxable at the place of supplier. This led to a plethora of companies (EU-based and multinationals) locating in low-tax EU jurisdictions, such as Luxembourg. This is one of the loopholes closed by the 2015 change in the focus of taxation. Presently, the rules dictate that VAT on digital services is to be charged based on the location of the end consumer. The challenge now for affected merchants is this requirement to identify the location of the end consumer. This requires a series of technical alterations to internal systems.
First, some clarity. In its EU VAT legislation, the European Commission has produced a list of required pieces of evidence to enable merchants identify the location of their customer. Included are:
- The customer’s IP address;
- Their mobile phone SIM card country code;
- BIN of customer’s credit card;
- Bank billing country;
- Fixed landline;
- Other commercially relevant information, such as customer loyalty cards.
The merchant is required to identify their EU customer’s location so that they can then charge the correct VAT rate on their service.
Challenges for digital service merchants
Being familiar with VAT is not the be all and end all. VAT systems, by their very nature, are fluid and can change on the whim of a government. Companies need to have systems in place that stay up-to-date with the various VAT regimes of the EU.
Finding and capturing two pieces of non-conflicting location evidence is a challenge for many merchants whose existing systems are not designed to collect the specific data points that identify the geo-location of their customers.
To this end, merchant systems need to be revamped so as to capture the necessary data points. This revamp can be successfully achieved via an API integration or using a host of applicable shopping cart plugins. Let’s take a look at the areas that digital service merchants need to focus on.
Companies that supply electronic services to a customer based in the EU will now have to charge VAT based on the location of that customer. This means that checkout pages will need to be optimised to capture – and store – the requirements of the new rules.
These requirements include:
- Identify a transaction as being B2C or B2B. Remember, only B2C transactions are affected;
- Collect two pieces of non-conflicting evidence. The evidence is required to prove the location of the end customer in the EU;
- Store transaction data for ten years. This is necessary as any one of the 28 EU member states can request an audit of a company at any time within the ten years after a transaction taking place.
Any system or software used on the checkout page will need to calculate and apply the correct VAT rate, in addition to carrying out foreign exchange conversions – there are 28 EU member states, but ten countries are not members of the Eurozone. This means that merchants have to consider 70+ different rates of tax across the Eurozone.
Sales to countries outside the Eurozone will need the sale price in the local currency, the VAT calculation in the local currency and the foreign exchange rate calculated from euro to the local currency.
As stated above affected companies must remember that not all EU member states (ten of the 28) are members of the Eurozone. Therefore, VAT foreign exchange calculation as well as pricing foreign exchange calculations will have to enabled as a result of the rule change. The bottom line for companies supplying electronic services in the EU is that their pricing structures will have to be reviewed.
As an example, take an Irish customer downloading an e-book costing €10.00 from a company based in Luxembourg. In 2014 that e-book was subject to Luxembourg’s 3% VAT and therefore cost the customer €10.03, but from 2015 and beyond this Irish customer will have to be charged Irish VAT (where the standard rate is currently 23%) and so the same e-book will cost €10.23.
The decision facing companies in this retail space is whether their pricing model (post-2015) will be the same or fall of their EU customers (‘universal pricing’), or a price that varies depending on the VAT rate (‘dynamic pricing’) in a specific EU country.
A decision on price point will have a knock-on effect on profit margins. Will the VAT differential be absorbed or passed on to the customer? Taking the above example, will the e-book merchant absorb the 20% VAT differential, or will they pass on the price difference to their end consumer in the Ireland?
Pricing, though, will not be the only concern as companies look at their costs ahead of the introduction of these new EU VAT rules. The fact that there is no minimum threshold for VAT registration means that a host of SMEs across the EU will now be caught in the VAT net. For these companies, this is going to have a major impact on their business models.
MOSS registration and global taxation of digital economy
Prior to 1 January 2015, a decision will have to be made regarding VAT registration. There are two choices for all companies, regardless of size.
- Affected companies can register for, and declare, VAT in all of the EU countries in which they have sales, or
- They can register with the new mini One-Stop Shop (MOSS) system. (4)
Registration with MOSS is optional. Its main benefit is that it will enable a company to file one VAT return per quarter for all of their EU sales. The company must select one EU tax authority to register with. This tax authority will then allocate the relevant VAT to the EU countries in which the company’s sales took place.
Some companies may decide against using MOSS and go for the first option of registering with each EU country in which they have sales. If choosing this option, then language barriers, and familiarity with all EU VAT systems, will have to be taken into account.
In recent months, Japan, Australia, Canada, Korea, Russia, and New Zealand have all flagged intentions to introduce similar rules to those introduced in the EU in January. The Japanese plan is for the introduction of a 10% consumption tax for all digital services provided by foreign companies to consumers in Japan. This tax is to due to come into effect on 1 October 2015. (5)
The nature of the digital space means that businesses will have to account for supplies in multiple jurisdictions. For example, in January 2015 the first month of the new EU VAT rules Taxamo’s small EU merchants (those with turnover less than £5,000 per month) recorded sales to customers in 108 different countries.
The benefits of the digital economy have not been harnessed by governments across the globe. This is why they are aim to use Monsieur Lauré’s VAT creation as the means through which they will finally recoup the billions that have fallen through the loopholes in existing legislation.
John McCarthy is CEO of global tax compliance specialists Taxamo (6). Based in Killorglin, Co Kerry, Taxamo develops global digital tax solutions. Working at the forefront of new taxation legislation affecting the supply of digital services, Taxamo’s SaaS-based tax products enable digital sellers to transcend virtual taxation barriers and embrace the global digital economy. Taxamo’s flagship EU VAT product enables full compliance as it relates to European VAT calculation, evidence collection, invoicing, EU MOSS returns and audit services.
(1) Tax revenues surge – The Irish Times, March 3, 2015 – http://www.irishtimes.com/business/economy/tax-revenues-surge-by-over-900m-1.2124577
(2) Taxation: Study confirms billions lost in VAT Gap – http://europa.eu/rapid/press-release_IP-14-1187_en.htm
(3) Explanatory notes on the EU VAT changes to the place of supply of telecommunications, broadcasting and electronic services that enter into force in 2015 http://ec.europa.eu/taxation_customs/resources/documents/taxation/vat/how_vat_works/telecom/explanatory_notes_2015_en.pdf
(4) The European Commission’s guide to the Mini One-Stop Shop (MOSS) http://ec.europa.eu/taxation_customs/resources/documents/taxation/vat/how_vat_works/telecom/one-stop-shop-guidelines_en.pdf
(5) Japan: Significant changes in consumption tax http://www.bna.com/japan-significant-changes-n17179923339/
(6) Taxamo: how it works http://www.taxamo.com/how-it-works/