Adapting to European Digital Goods VAT Changes

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As of January 1, 2015, there are significant changes to the European (VAT) Value-Added Tax rules.  The new rules, which were approved in 2008, will apply the tax rate on digital services such as cloud storage and movie streaming services based on consumer location.  This tax change will impact the large U.S. digital medium service providers including Netflix, Amazon, Google, Apple, and Microsoft.  

Previously, the tax rate was based on where the company selling the product had its central headquarters.  Under that system, large digital service providers benefitted from conducting central operations in tax favorable countries such as Luxembourg.  There, the tax rate was as low as 3 percent for certain purchases.  Other countries, like Britain, charge up to 20 percent for similar purchases.  Such differences in tax rates provided a tax advantage to consumers and larger enterprises that could benefit from location planning.  All that will change however with the new regulations.  

In order to comply with the rule, businesses selling digital goods will be required to:

  • Charge the VAT rate based on the consumer's location
  • Validate the consumer's location; and
  • Report VAT to each corresponding consumer EU country

Proponents for the new system argue that it will add up to $1 billion in annual tax revenue for the European Union.  The rule change aims to spread revenue from digital goods more evenly throughout member countries.  Nonetheless, not all countries will be affected equally.  

Some smaller countries with lower populations consume disproportionate amounts of digital services. Take France, for example, although the country has a population of 64 million which accounts for only 12 % of the larger European Union, the country generates nearly 50% of all European Union Netflix sales.  Of course, Luxembourg will be affected the most.  In order to make up for the lost revenue they will increase the value added tax on non-digital goods from 15 to 17 percent.  

Before the rule change, many large digital service providers, like Amazon and Netflix, utilized bundled pricing (including transaction taxes) in order to keep things simple for the customer.  These companies have indicated that for now this practice will continue.  The initial reaction of large service providers is to maintain bundled pricing and absorb the higher tax levels.  This however is troublesome for large service providers because the net profit margin in high VAT countries is going to be substantially reduced.  It remains to be seen how they will respond long-term.  Once these digital service providers achieve desired market penetration, some possible options could be unbundled VAT changes or raising the overall bundled price.

The new European VAT charge comes at a time when all of the major U.S. digital content providers are expanding in Europe and the rest of the world.  A billion in new revenue is attractive to government tax authorities and we expect other countries to closely follow the European experience.  

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Charles R Goulding Attorney/CPA, is the President of R&D Tax Savers.

Michael Wilshere is a Tax Analyst with R&D Tax Savers.