Applying VAT to electronically supplied services
Although this guide has been prepared to assist a business in assessing its own needs, it cannot address every aspect of the relevant e-service tax. In addition, the latest updates may not be reflected here. It is therefore recommended that any business affected by these rules obtain additional support before taking any action.
There are some common themes that apply to value-added tax (VAT) obligations for electronically supplied services, and a number of key points need to be understood to determine how to comply with the various VAT rules that exist around the world.
Generally, the tax being addressed here relates to the transaction tax charged on the value of a supply. In most countries, this is VAT; this guide will use the term “VAT” to also refer to all similar taxes. Some countries, however, have adopted slightly different models and the tax in scope could be on goods and services, consumption and sales.
Each country that seeks to tax electronically supplied services has implemented rules specific to the objectives of that country, but there are some common themes that taxpayers can use to better understand how VAT can apply to e-services.
Certain tax authorities have introduced measures to ensure that nonresident suppliers of electronically supplied services are not at a competitive advantage over domestic suppliers, and that tax is charged, collected and remitted at the point of consumption. This also ensures that the revenue base of the particular country is not eroded by suppliers establishing businesses overseas to avoid having to remit tax on those transactions.
Assessment and collection
The way the tax is assessed and collected varies by country, but there are three basic models:
- Local registration: Requires the supplier to charge, collect and remit tax on its periodic tax return.
- Split payment: Funds are extracted at the source and held in a designated account either by the supplier or a third party.
- Withholding tax: The customer is required to extract an amount from the payment to the supplier equivalent to the tax due.
Each of the above methods has subtly different consequences for the supplier regarding compliance obligations and earned income, which in itself might require additional consideration of terms and conditions of any supply and pricing structure.
The commonly accepted definition of electronically supplied services is:
Any service that is supplied via electronic means that requires limited human intervention.
The term “electronic means” generally covers broadcasting, telecommunications and the internet, but other methods of delivery might also be covered. For the majority of companies, it is likely that the internet is the main channel for delivering electronic services.
“Limited human intervention” generally means that the service has a high degree of automation and that the consumer is able to request and receive the service with limited interaction with a person.
Examples of electronically supplied services include—but is not limited to―the following:
- Database access charges
- Electronic data storage, such as cloud storage
- Email service
- File sharing
- Internet service providers
- Online gaming
- Online membership programs, including discussion forums
- Software licenses, including renewals
- Subscription services
- Telecommunication services, both fixed line and mobile
- Television and radio broadcasting
- Trading platform access fees
- Video and music downloads
- Web hosting services
The size of a company is generally not a factor for tax authorities; small businesses are just as likely to be covered by the e-service tax rules as larger ones. Therefore, any business or organization that derives foreign-sourced income from electronically supplied services is likely to have some VAT obligations.
It should be noted that businesses that use the internet to communicate with customers are not likely to trigger a VAT obligation under the eService rules to the extent that the communication involves human input. For example, consultancy services that are provided over the internet are unlikely to be caught where the service has been provided by an individual rather than automated.
One of the most critical―and challenging―aspects of charging VAT on electronically supplied services is being able to accurately identify the customer. Customers themselves fall into different categories but, in general, they are split between business customers and nonbusiness consumers. (There are specific country differences as well, which are discussed in more detail in the country sections of the guide.)
In general, business customers are not charged VAT by nonresident suppliers, unlike their nonbusiness counterparts who are charged VAT by nonresident suppliers. The reason for this distinction is that business customers should have the ability to self-assess VAT on any services received from a foreign location and report any VAT due on their VAT return. This avoids the need for the nonresident supplier to register for VAT and also achieves a higher level of compliance because it falls to the domestically established customer to account for the VAT rather than the nonestablished foreign supplier.
Most countries assume that nonbusiness customers are not able to self-assess VAT and, as a result, the nonresident supplier is required to satisfy the country’s VAT obligations. In most cases, this would require the nonresident business to register for VAT and charge VAT in addition to the service fees. This VAT would then be collected by the nonresident supplier and remitted to the appropriate tax authority.
In most cases, customers effectively self-certify their status as a business customer or a nonbusiness customer. But it is typically the supplier’s obligation to confirm that the customer has provided the correct information. This is particularly important for business customers, as they are effectively declaring that they will self-assess VAT―thereby removing that obligation from the supplier. As such, suppliers should consider requiring evidence to support a claim of business status. For the most part, VAT registration details (or some equivalent) will suffice. But other evidence might also be needed, depending on local rules and definitions of what constitutes a business customer.
Identification of the status of a nonbusiness customer is less critical as suppliers will need to charge, collect and remit VAT on these transactions. What becomes more important is determining the customer location. VAT is charged by reference to the country of consumption, and some rules need to be followed to enable the place of consumption to be fixed. If customers are accessing services in a mobile situation, however, that place can change. If nonbusiness customers provide erroneous information regarding their whereabouts, the wrong amount of tax could be charged, and it could be remitted to a country that is not entitled to it.
Consequently, there are existing rules that require suppliers to confirm the location of nonbusiness customers. From a practical perspective, this can create commercial challenges: Not only does the business need to gather and confirm corroborating evidence, it also runs the risk that requiring evidence to be provided could deter customers from signing up for the services offered.
Of equal importance to identifying customer status is confirming the party responsible for making the supply and, therefore, the person with the obligation to comply with the local VAT rules.
In the majority of cases, the identification of the responsible party will be relatively straightforward. It will be the person, company or organization identified on any supply contract or within terms and conditions embedded in a website.
However, there are circumstances where such arrangements are not obvious:
- Trade names: Businesses that use trade names need to identify the principal entity that is contractually responsible for making the supply.
- Multiple entities: If there are multiple entities involved in supplying and supporting the services, this could add to the confusion regarding which one is the principal. Some organizations have separate sales and marketing businesses responsible for generating the sales, support service centers responsible for after-sales care and customer support, service centers that take care of administration such as billing and collection, and organizations that are established to hold intellectual property and conduct research and development. The service itself might actually be provided by another entity, and working through the contractual relationships will be an important part of identifying the supplier for VAT purposes.
- Agents: Working with agents can also change the contractual nature of the supply and therefore, the party responsible for complying with the VAT rules. Some larger organizations provide a range of support services and marketing platforms to help smaller businesses access a wider global market. These agents can provide services to collect and manage customer information, raise bills and collect funds, offer automated payment arrangements, and serve as a gateway for customers to obtain the service. They function like a principal in the supply chain and; consequently, many (but not all) tax authorities allow the agent to comply with the VAT rules on behalf of the true supplier. This avoids the need for the supplier to register for VAT and comply with the relevant rules.
The model for VAT varies between countries. Primarily, the nonresident supplier will be required to register for VAT in order to charge, collect and remit VAT payments. Registration for VAT does not generally imply that the business has created a taxable establishment for other purposes (such as income tax, for example), but it is a point that should be verified with each country.
In addition to collecting and remitting VAT, an organization may have other compliance requirements to meet. These could include:
- Producing invoices with specific content
- Maintaining VAT accounts in a prescribed way
- Retaining evidence and data to support the VAT functions
- Introducing compliance processes that enable VAT to be reported accurately and on time
Some countries do not have a provision to allow nonresident companies to register for VAT remotely without having some form of local presence. This local presence could be a third-party fiscal agent that assumes joint and several liability for any VAT requirements, or the country could require the creation of a local company to act as a reseller of the services. Both of these routes have additional challenges and implications over and above direct nonresident VAT registration.
The process for collecting and remitting VAT also varies. When the business is directly and remotely registered for VAT, the process generally requires that business to complete a periodic VAT return and remit the VAT collected through that process. For tax authorities, there is an element of risk associated with this approach, so some have adopted other methods to create a more secure compliance environment.
The split payment method, for example, requires a designated account or process to be established. At the time a customer makes a payment, the VAT component is deposited into the designated account, which can only be used to remit funds to a tax authority. Unlike the direct method, the VAT funds cannot be received by the business and held in general funds. In some locations, this payment method can be managed by the payment processing company that handles collections on behalf of the supplier.
In other circumstances, the tax authorities may require a physical presence. This can be provided by a third-party fiscal agent that effectively meets the compliance burden and is jointly and severally liable for the accuracy and timely filing of VAT returns. Alternatively, the supplier may need to create a local establishment by forming a company or branch that enables the services supplied to be treated as domestic transactions.
Suppliers have often traded and generated revenue through the provision of electronic services for a significant period of time, yet have not identified the requirement to account for VAT. In these cases, when the initial approach is made to a tax authority to establish a VAT compliance process, the supplier may need to recognize historic transactions and retrospectively account for VAT that has effectively been under-declared.
There are a couple of key challenges associated with historic transactions. The first is that the business did not budget for VAT in its original pricing structure, so any retrospective payments will need to be funded from reserves, unless there is an opportunity to charge customers an additional amount. This places a financial burden on the business and will affect profit margins and cash reserves. Tax authorities are generally unsympathetic to the commercial implications of any historic VAT liabilities.
The other key issue that arises is the risk of penalties. As a general rule, most tax authorities penalize businesses for failing to meet their VAT obligations at the right time―this includes failing to register for VAT. Although there is less negotiating room on the amount of historic VAT owed, many authorities will mitigate penalties based on a number of factors. These include actions such as voluntarily registering for VAT, cooperating with any inquiries, and establishing processes and procedures to ensure compliance going forward.
There is generally a statute of limitations on look back periods, which means that a business that has been operating for many years may need to account for only the more recent periods. The statutory period varies by country, but generally they fall between three and five years in length. Nevertheless, failing to meet VAT obligations carries the risk of significant financial exposure. It should be noted that the statutory period might only apply to VAT registered businesses. In other cases the look back period could extend to the inception date of the relevant rule, which could extend beyond the statutory period.
Businesses that choose to disregard the requirement to register and account for VAT in accordance with local rules run a number of risks. Within certain trading blocs, such as the European Union, there are mutual assistance arrangements that enable one tax authority to request the assistance of another tax authority to apply enforcement measures and bring noncompliant businesses to account.
But there are generally limited enforcement steps that a foreign tax authority can take directly against the business in its home country.
If a business fails to comply, however, it runs the risk of reputational damage and devaluation of the business. Reputational damage may be significant if the business is a public brand and relies on a wide consumer base for revenues. With the increasing influence of social media, negative brand messages can circulate very quickly.
Commercially, a business may find it more difficult to obtain third-party financing if the lending institution discovers the noncompliance activity and determines the historic exposure puts the business at risk. In a similar vein, if the business owners seek to dispose of their interest, either in a private sale or public listing, any noncompliance discovered through financial due diligence could have a detrimental effect on the value that the owners might otherwise have expected to achieve.