The Jean Monnet Program

Professor J.H.H. Weiler
European Union Jean Monnet Chair

Jean Monnet Working Paper 13/01

Cecília Hargitai

Value Added Taxation of Electronic Supply of Services
within the European Community

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No part of this paper may be reproduced in any form
without permission of the author.

The Jean Monnet Working Papers are published under the auspices of the
 Jean Monnet Program 
hosted at Harvard Law School from 1995 to 2001
and now based at New York University School of Law

ISSN 1087-2221
 Cecília Hargitai

I.	Introduction

Symantec, an American company selling its software to Europeans through its web site, encourages customers to download the software directly by saying that there is "no value-added tax, shipping or export charge." At first sight, this one-sentence scenario may not sound strikingly problematic to anyone. However, it gives a condensed summary of the problem constituting the core of this paper, following from the awkward situation of European online traders being at a handicap under the present system of European value added tax compared to their American competitors. This essay is an inquiry into the efforts made by the European Community to preserve the functionality of the European system of value added taxation within the digital trade environment.
In general, the legislative efforts examined in this essay form the part of the comprehensive amendatory legislation necessitated worldwide by the emergence of electronic commerce. E-commerce, by utilizing the Internet for commercial purposes takes advantage of all the benefits of this network of interconnected computers: it is quick, convenient and not bothered by geographical or physical barriers. Such a radical change in the traditional conditions of commercial activity requires legislators to adjust all branches of law governing trade to the new circumstances.
Tax law is one of the fields of law that are not entirely functional within this new ‘virtual’ world. This is especially true with respect to taxes on transactions, such as value added tax. Traditional value added tax concepts are mainly designed to operate based on the geographic location of the parties or the transactions. These tax points disappear when business activity is pursued through the Internet. Governments therefore are facing the task of defining new tax points capable of catching online transactions if they wish to preserve their revenues. 
The law of the European Community is the most appropriate context for examining the interaction between electronic commerce and the value added tax (hereinafter referred to as: ‘the VAT’). The VAT has a special task in the European integration process. Apart from contributing to the resources of the Community, the VAT, as a tax on transactions, has an outstanding role in ensuring the free flow of trade within the Community, which is the primary ambition of the integration process. The result of the European VAT harmonization therefore is a good example of how to tackle the inter-jurisdictional problems of this tax in order to avoid any barriers to international trade. Community efforts to adjust the VAT system to the digital environment might also serve as a model for global co-operation on this field.
Before delineating the route of further discussion a few comments seem necessary with respect to the background of European VAT harmonization.
Following from the unprecedented opportunities brought about by e-commerce for improving the efficiency and competitiveness of the economy, governments generally intend to enhance the flourishing thereof even if extending the existing regulatory framework to online trade. The European standpoint in this question is expressed in the Green Paper on Electronic Commerce that presents the general structure of policy instruments, including tax policy, necessary to encourage the development of e-commerce. Despite favoring regulation, the principle of “no regulation for regulation’s sake” is defined as one of the basic premises of an appropriate legislative framework. VAT legislation therefore should take account of this ambition.
The European Community should also consider the international context of the legislation concerning e-commerce. By cutting through national borders with ease electronic transactions might be the subjects of several jurisdictions. Unless the laws of these jurisdictions are coordinated internationally, the conflicts thereof will represent a major obstacle to the flourishing of e-commerce. The inherently global nature of online trade, therefore, makes international co-operation indispensable and assigns a significant role to international fora in policy harmonization. International agreement in the specific field of taxation is even more crucial. If governments wish to avoid double- or non-taxation, they must find a way to approximate their views. Consequently, success of the European proposals largely depends on their international acceptability.
The discussion will proceed as follows. Part II of this essay contains an overview of the European VAT system. In chapter 1 the characteristics of the internal market as a background to the operation of VAT will be examined. After the discussion of the basic features of VAT in chapter 2, chapter 3 gives a brief survey of the historical development thereof within the Community. The survey will show that the problems of the VAT system arisen due to e-commerce mainly have their roots in the inconsistencies of the present regulation. Other difficulties are owing to the special new features of online trade. Therefore, part III will start by describing the basics of e-commerce transactions. Further inquiry will be narrowed down to direct electronic commerce, the value added taxation of which seems to be the most problematic. Chapter 3 specifies the problems and establishes the serious dysfunction of the present VAT rules by closely scrutinizing the application thereof to electronic supplies. At the end of part III attempt is taken to show the possible impact of this dysfunction to the common market. Part IV, after giving a brief overview on the principles that should guide any prospective legislation on this field, describes the proposed Community legislation in detail. The main analytical work is contained in chapters 3 and 4, which intend to highlight the inconsistencies of the Commission’s Proposal and to explore possible alternatives. Analysis in these chapters will examine Community actions from the viewpoint of the different interests concerned with the results of legislation on this field: requirements of the VAT system in abstract, the special requirements of the common market, the interests of electronic commerce and that of the international trading partners. Part V contains the conclusion.
Before entering into the main analysis, part II aims to lay the historical groundwork and basic characteristics of the European VAT system.

II.	Value Added Tax in the European Community
1.	The Common Market as a Background to the European System of VAT
Exploring the legal and economic background against which the European VAT system is functioning helps to understand the role and features thereof. The scrutiny in this chapter includes a brief survey of the relevant rules of primary Community law, namely the static and the dynamics of the VAT legislation as laid down in the Treaty of Rome.
In 1957 six European countries founded the European Economic Community. Their aim was to secure peaceful co-operation through economic integration. By signing the Treaty of Rome (hereinafter referred to as: ‘the Treaty’), the Founding Members committed themselves to “promote…a harmonious, balanced and sustainable development of economic activities” and “…a high degree of competitiveness…” The Member States undertook to achieve these goals by establishing a common marketplace. According to the Treaty the common market “shall comprise an area without internal frontiers in which the free movement of goods, persons, services and capital is ensured.” 
	For the purposes of creating a common market the Treaty specifies the obligations of the Community, fulfillment of which is essential for carrying out this project. These obligations include the harmonization of Member State laws when necessary for the establishment and functioning of the common market. Harmonization of laws happens by means of secondary legislation passed by the institutions of the Community. With regard to each field where approximation of national laws is required, the Treaty accurately delineates the competencies of the Community institutions. Each competency specifies the form of legislation and the role and powers of each Community institution participating in the procedure.
In order to understand the rather complex process of legislation within the Community in general, and in the area of taxation in particular some remarks seem necessary with respect to the institutions involved. According to the ‘separation of powers’ within the Community the initiator of legislative action is mainly the Commission. The fact that it comprises of independent Commissioners, i.e. officials not directly representing the interests of each Member State, makes the Commission the most efficient spokesman of Community interests. The decisive power principally lies with the Council. This organ of the Community, consisting of the respective representatives of the Member States is horizontally segmented in correspondence to the sectors of Community policy. For the purposes of this essay, the most important sectoral Council is the so-called ECOFIN Council, comprising of the Ministers of Finance and Economic Affairs of each Member State. The Parliament is elected directly by the nationals of the Member States, therefore it is regarded as the ‘democratic’ institution of the Community. It plays a varying, but predominantly secondary role in the legislative process. Though not a participant in the legislative process, the role of the European Court of Justice (hereinafter referred to as: ‘the ECJ’) with respect to Community law should me mentioned. By issuing ‘preliminary rulings’ to highlight the correct interpretation of Community legislation for the judicial bodies of the Member States, the ECJ secures the coherence of the Community law.
One of the most important and at the same time the most sensitive field of harmonization is taxation. To understand the complexity of this issue the general role of the tax system among state affairs should be examined shortly. 
Taxation is an activity exercised by the states under the aegis of fiscal sovereignty since ancient times. It has two major roles: one is to raise the revenues of the government to cover necessary expenditures and the other is to stimulate and regulate the national economy. In fulfillment of these tasks, governments determine the types, rates and other features of taxes within the tax system. In practice the operation of national tax systems often resulted in the protection of national markets against foreign products in pursuance of the goals of national economic and fiscal policy.
In the age of trade liberalization the fiscal autonomy of national governments generally suffers some curtailment. Since the introduction of the GATT in 1947 the requirement of national treatment of foreign products in the importing market is one of the fundamental principles of international trade. The purposes of the high level economic and political integration the European Community seeks to achieve necessitates a trade policy limiting the fiscal autonomy of the Member States beyond the requirement of non-discrimination. Even without protectionist intentions the existence of significant differences between tax regimes of the Member States has the potential to hinder the creation of the internal market. This fact has been acknowledged by the Commission in its White Paper on Completing the Internal Market, where fiscal barriers, such as the differences in the VAT rates were denounced as one type of the main obstacles to achieving the common market objective. 
Recognizing the major role of taxation in the integration process, the Founding Members of the Community devoted a separate chapter to tax provisions in the Treaty. Articles 90 to 92 of Chapter 2 stipulate the general prohibition on discriminatory taxation and other types of protectionist measures. Article 93 establishes the competence of the Community to harmonize the national indirect tax regimes. The reason for emphasizing indirect taxes lies in the fact that these taxes, including VAT, are levied on products and therefore have an immediate effect on the international flow of goods and services. 
The rules providing for the competence of the Community in the field of indirect tax harmonization reveal the unease of Member States when allowing intervention with their fiscal powers. The decision-making power is vested exclusively in the Council. On proposal from the Commission, the Council should pass legislation with unanimous vote. The requirement of unanimity, by allowing a veto power for each Member State, places Member State interests in the forefront and slows down the legislative process. Legislation should proceed in compliance with the so-called consultation procedure. This procedure provides for consultation by the Council of the Parliament and the Economic and Social Committee, but without the obligation to take account of their opinion. 
Article 93 also stipulates that legislation should be passed in the form of directives. Directives bind the Member States with regard to the result set forth therein, but leave autonomy for them to choose the means of harmonization. As the result of approximating their laws, the tax regimes of the Member States are becoming compatible with each other, though they still fall under the sovereign power of each state. The determination of VAT rates and exempt supplies, for example, largely depend on the Member States. For the success of the integration process it is crucial that despite the differences in their laws national tax authorities interpret and apply the provisions of the directives homogeneously. The ECJ, as mentioned previously, has an outstanding role in the achievement of this objective.
Before discussing the most important VAT Directives in detail, the next chapter aims at introducing the abstract characteristics of the value added tax.

2.	Characteristics of the VAT
When writing about the VAT and its exceptional conquest of the globe, it is almost natural to cite the famous sentence of Alan Tait that “the VAT maybe thought of as the Mata Hari of the tax world – many are tempted, many succumb, some tremble on the brink, while others leave only to return, eventually the attraction appears irresistible.” With this characterization of the VAT in mind it is hard not to wonder what the reasons are for this success.
The VAT has three distinctive features, which designate its role within the family of taxes. It is an indirect, multi-stage consumption tax.

- As an indirect tax, the VAT is levied upon the articles of trade before they reach the customer, who eventually pays the tax-inclusive market price. The label ‘indirect’ follows from the fact that the payer of the VAT does not suffer a corresponding reduction in his incomeas opposed to direct taxes, such as personal income tax. This indirect nature assigns a special role to the VAT in the tax system. Due to its insensitivity to the individual circumstances of the taxpayer following from its ‘indirectness’ the VAT is not an effective means of redistribution. Therefore, its chief role is to raise government revenue without influencing consumption patterns. Indeed, it is the unprecedented revenue-productivity of this tax what makes it appealing to many states. In order to preserve its neutrality, the VAT system should comply with a number of principles. These are the requirements of a comprehensive tax base, a uniform rate and as few exemptions as possible. Application of multiple rates and broad range of exemption increases administrative and compliance burden and distorts consumer choices. In practice, though, both political and administrative concerns make at least some exemptions necessary.

- As a multi-stage tax the modern VAT collects revenue at all stages of production and distribution. In close connection with the multi-stage nature of this tax, the VAT provides for the right to recoup the tax paid by the business participants of the supply-chain. The right to regain the VAT is put into practice by the application of the credit-invoice administrative method. Under this system, businesses keep track of the tax paid by issuing invoices registering the price of the transaction and the amount of VAT due on it. They calculate their tax liability by offsetting the amount of VAT paid against the VAT due. The right to recoup the tax makes it possible to avoid the negative consequences of tax ‘cascading.’ 	

- As a consumption tax the VAT is applied to a base consisting of personal expenditure. As seen above, enterprises of the supply-chain have the right to regain the tax. It is the last link in the chain that bears the tax: the consumer. According to the theory, which states that taxes are fees for public services, burdening the VAT on final consumption is justified by the fact that consumers are the main beneficiaries of public services.  Being a consumption tax, the VAT not only aims at taxing final consumption but also at taxing it at the place of consumption. This ambition gains the most importance in the context of the inter-jurisdictional application of VAT.	

As simple as it seems, the law of VAT gets quite complicated when it comes to inter-national trade. In case of cross-border transactions more tax jurisdictions are concerned with the taxation of the sale. To designate the country of taxation there is a need for special, so-called ‘place-of-supply’ rules. These rules, by resolving potential conflicts between the jurisdictions pursue the goal of avoiding double-taxation or accidental non-taxation. The literature takes account of various principles guiding the arrangement of the place-of-supply rules. In practice, taxation of the traded goods and services may occur either in the exporting or in the importing country.
The most common way of determining the place-of-supply rules is based on the destination principle. According to this principle the exporter receives a tax rebate in the amount of the VAT levied on the goods and services that are being exported. This practice is referred to as zero-rating. Zero-rating is a special type of exemption under which the exporter charges a rate of 0% on the tax base and retains the right to claim back his input-credits. As the outcome of the destination principle the international trade in goods and services is based on net-of-tax prices therefore the effects of the differences between national tax rates is neutralized. Eventually, the destination country taxes the imported product – usually only upon resale – by applying its own rate.
The administration of the border tax adjustments under the destination principle requires close cooperation from the tax administrations of the countries involved in the transaction. To avoid double- or non-taxation it is necessary to keep track of the cross-border movement of physical goods. This is only possible through the checking of the documentation of the merchandise at the border. As a result, there is a need for border controls. 
As opposed to the destination principle, the origin principle assigns taxing jurisdiction to the exporting country. The destination country charges no tax. Under this solution importers in each country compare the tax-inclusive prices of domestic and foreign goods. There are no border tax adjustments under this scheme, consequently there is no need for border controls. Application of this principle is not common, since it directs all revenues from the VAT imposed on international trade to the country of origin. As seen above, this practice conflicts the ambition of the VAT to tax consumption at the place of consumption. 
How to choose between these principles? This question and weighing of pros and cons of both principles have been following through the history of the European VAT. As the next chapter will illustrate, the choice is more complex than simply keeping the ideal functioning of the VAT regime in mind.

3.	The European VAT System
After giving an overview of the common market and the value added tax system in abstract, this chapter is the place to examine the results of the practical interplay between the two. Without the intention of giving a comprehensive survey on the historical development and results of the European VAT system, the chapter aims at highlighting some details important from the viewpoint of further discussion. As intra-Community trade is inherently of cross-border nature the way Community legislation has been trying to solve the appropriate allocation of taxing jurisdiction is scrutinized with special emphasis. 
Harmonization in this field started in 1960, by setting up the Fiscal and Financial Committee to study how indirect tax regimes of the Member States could be approximated in the interest of the common market. The First VAT Directive has come to existence upon the recommendations of this body. The First and Second Directives, representing the first phase of VAT harmonization permitted the Member States a wide-ranging discretion in several questions. Consequently, by the end of this first phase a patchwork of different and separate national laws had come to existence instead of a single European VAT system. 
A process of further harmonization was triggered by a Council Decision in 1970. Until that year the Community budget was financed by the contributions of the Member States. In 1970 the Council passed a Decision to change this scheme by creating own resources for the Community. The ‘own resources decision’ provided that from 1975 the Community budget should comprise, inter alia, of a certain percentage of the Member States’ VAT revenue. This share was determined as 1 percent of the VAT base. To secure equality between Member States and to prevent the erosion of Community resources strict delineation of the base of assessment became crucial. 
The Sixth Directive aimed at the more precise definition of certain areas necessary for achieving closer harmonization of national VAT systems. This Directive, passed in 1977, is the most comprehensive one in the series of VAT directives and provides the grounds for further harmonization. Though it was amended on a lot of occasions the present form of the Community VAT system has been tailored after its provisions. The following summary confines itself to the rules of the consolidated Sixth Directive relevant for the purposes of this paper:

(a)	Scope
The European VAT applies to the supply of goods and services effected for consideration within the territory of the country by a taxable person. It is apparent upon this definition that the Directive pursues the goal of applying the VAT in as general a manner as possible. It intends to implement the principle of territoriality in assigning taxing jurisdiction. It is also important to note that the VAT does not apply to transactions between unregistered persons or to free supplies. 

(b)	Taxable Person
The definition of taxable person is not relevant for the discussion in this paper. Rather, further analysis will be concerned with the obligations of taxable persons themselves and of Member States with regard to them. 
Taxable persons are obliged to report the commencement of and any change in their taxable activity. They should keep sufficient accounts of their finances and issue an invoice when supplying to another taxable person. Taxable persons are required to submit their return at the end of each taxing period and pay the VAT due. 
Member States should take measures necessary to identify taxable persons by means of an individual registration number. Verification of the taxable status bears outstanding importance in cases of cross-border supplies to businesses, where the Sixth Directive assigns tax liability to the business recipient of certain services under the so-called ‘reverse charge’ method. To be able to disregard further VAT obligations, the supplier should be certain about the taxable status of its customer.
Identification of registered business with regard to intra-Community transactions are facilitated by the VAT Information Exchange System (hereinafter referred to as: ‘the VIES’). According to Article 6 of the Regulation governing the VIES, the competent authority of each Member State shall ensure upon request that persons involved in the intra-Community supply of goods or services obtain confirmation of the validity of the VAT registration number of any specified person. 

(c)	Taxable Transaction
Taxable transactions include the supply of goods and the supply of services. Supply of goods is defined as the transfer of a right to dispose of tangible property as owner. Supply of services means any other transaction not constituting a supply of goods. By means of this catchall definition the Directive intends to ensure that intangible supplies do not escape taxation. The rationale behind this distinction lies in the fact that place-of-supply rules, as seen immediately below, differ with regard to the two categories.

(d)	Place of Taxable Transaction
Detailed analysis of the relevant place-of-supply rules of the Sixth Directive will be given in part III of this essay. Here some general comments seem necessary in connection with these rules.
The task of place-of-supply rules is to assign taxing jurisdiction in cross-border trade, as briefly mentioned in the previous chapter. The Sixth Directive chose to solve this task through the implementation of a dual place-of-supply regime. The place of taxation with respect to goods is determined upon the physical location of the goods concerned regardless of where the parties reside. In case of services such physical location does not exist. In lack of tangibility location of services is only possible through the application of fictious place-of-supply rules. Therefore, in case of services the relevant information when assigning the taxing country is the location of the supplier or the recipient. For purposes of administrative feasibility place-of supply rules for services may further differ in accordance with the type of service. 
As shortly mentioned earlier, the Community faces a serious dilemma when trying to choose among the principles underlying the place-of-supply rules. Both the destination and the origin principles have their pros and cons when considered within the special context of the internal market. 
The precise and expeditious border tax adjustments of the destination principle satisfy the requirement that intra-Community competition should not be distorted and the free flow of goods and services should not be hindered through the application of indirect taxes. It also satisfies the general requirement of VAT of allocating the tax into the country of consumption. The serious drawback of this principle is its essential co-existence with border controls. These border controls, by necessitating the presence of the same infrastructure at the borders as would be in place were the Community not a customs union, are incompatible with the idea of a true European common market described in the Treaty of Rome. 
The most appealing feature of the origin principle is evidently the lack of need for border tax adjustments. The weaknesses of this principle, though, seem to be outweighing this virtue. The inability of the origin principle to concentrate the VAT revenue to the country where consumption takes place conflicts the general requirements of a consumption-based taxation scheme, as seen earlier. With respect to the interests of the Community, dislocation of VAT revenues among Member States would distort competition within the common market. These serious shortcomings could only be overcome by the parallel operation of a clearing system. Under such system the country of consumption would receive the VAT revenue collected by the country of origin.
Abolishing the tax-frontiers has been the ultimate goal of the Community from the outset of the harmonization process. Accomplishment of this goal only seems possible through the application of the origin principle. Despite this fact place-of-supply rules have been guided predominantly by the destination principle since the adoption of the First Directive. The fragmentation of the internal market following from the operation of border controls has indeed been acknowledged by the Commission in its White Paper issued in 1985. This document proposed a so-called ‘definitive system’ of VAT built on the origin principle and the parallel operation of a clearing-house. Fearing to lose fiscal sovereignty the Members have yet been unwilling to take the measures necessary for the introduction of a clearing-house. The continuous efforts taken by the Commission in its subsequent series of proposals during the last decades to reconcile the conflicting interests of the internal market and the Member States resembles a fight with windmills. 
At present place-of-supply rules are based on a transitory solution. This ‘interim system’ was introduced by a Council Decision, which, as the first step toward the implementation of the origin principle, terminated border controls from 1993. According to this regime sales to consumers have become subject to the origin principle, while the destination principle remained effective for sales to business customers. This system was supposed to be in force until 1996, but the Community is behind schedule in implementing the ‘definitive system.’ 

(e)	Taxable Amount
Following the ‘own resources decision’ of the Council, the Sixth Directive homogenized the base of VAT throughout the Community.

(f)	Rates
Determination of VAT rates is one of the most sensitive areas of Community VAT, largely contributing to the formation of a stalemate between the clashing interests of the Community, the Member States and the ideal VAT system. The broad autonomy of Member States in setting the VAT rates leads to the fragmentation of the internal market. It also results in the untenable complication of the VAT system. At the same time it is the most important reflection of retained fiscal sovereignty.
According to the Sixth Directive the standard national rate of VAT may not be less than 15% at present. Apart from the standard rate Member States may apply either one or two reduced rates in line of their social and cultural policy.

(g)	Exemptions
As mentioned earlier, the Directive draws a distinction between exemption and zero-rating. ‘Genuine’ exemption releases the exempt entity from all obligations under the VAT regime and at the same time denies granting the right of deduction. Member States may exempt certain activities on grounds of public interest or complexity of taxation. Under the scheme of zero-rating the Directive allows for the deduction of input credits despite the exemption from paying the tax. Administrative obligations are retained for the purposes of ensuring a continuous audit-trail. Zero-rating occurs in case of supplies leaving the territory of the Community and on grounds of social and cultural policy, but in a much stricter sense than exemption.

(h)	Small Business Scheme
Among the special schemes of the Directive, the regime governing small businesses should be briefly mentioned for the purposes of this paper. The rules of this special scheme enable businesses below the specified amount of annual turnover to supply goods and services exempt from VAT. The rationale behind this special treatment lies in the fact that compliance with VAT regulations means a disproportionately greater burden for small undertakings due to their low assets.

After reviewing the concepts and operation of the European VAT within the traditional trade environment the next part of this essay aims to show the deficiencies in its handling electronic transactions. 

III.	Shortcomings of the Present European VAT System with Respect 
to Electronic Supplies

This part of the paper intends to examine the operation of the Sixth Directive within the digital world. The rule-by-rule analysis of the Directive in chapter 3 will show that the European VAT system is unable to handle electronic transactions with certainty. The last chapter will inquire into the impact of this dysfunction on the operation of the internal market. For the better understanding of the shortcomings of the present VAT system, first the basic characteristics of electronic transactions should be described.  

1.	Classification of E-Commerce Transactions
This chapter provides a brief summary of the changes in the trading environment owing to the emergence of e-commerce. To identify the specific fields of online trade where the conventional VAT model proves to be dysfunctional a distinction should be made between the different types of e-commerce transactions. Based on the extent to which the Internet is utilized in the course of a transaction, the essay will talk about indirect and direct electronic commerce. This classification will help us to see that the problematic issues of VAT are concentrated to a very narrow section of e-commerce. 
Electronic transactions take place in a virtual marketplace. This virtual marketplace is formed by utilizing the Internet for commercial purposes. The Internet and other types of electronic networks altogether constitute the metaphoric concept of “Information Highway.” This chain of interconnected computers, by using common protocols for communication, ensures the unlimited flow of information regardless of the real physical location of the computers. The most user-friendly version of the Internet is the World Wide Web, which facilitates the network with the use of texts, images and sounds through multimedia systems. 
The individual transactions take place through websites. Companies wishing to offer goods and services over the Internet create a website displaying information on the company and its products. The website, after having been placed on the Internet through a computer, becomes accessible to all customers with a computer connected to the network. After inspecting the information and the offers placed on the website the customer may order goods and services from the company.
Depending on whether the whole transaction or only some phases thereof take place through the Internet, e-commerce activities are categorized as indirect and direct. 
According to the Green Paper indirect e-commerce means the ‘electronic ordering of tangible goods.’ The definition indicates that transactions belonging to this group make use of the Internet for the purposes of providing information, ordering products and perhaps payment. The phase of delivery happens through traditional channels. A common example for indirect e-commerce transactions is the ordering of computer hardware through the website of a specific company, such as ‘canon.com’ or through general distribution websites like ‘amazon.com.’ Indirect e-commerce may include the supply of services as well, such as purchasing air tickets via the Internet. In both cases the conclusion of the contract and perhaps the payment take place online, but the company sends the product by traditional courier service or performs in other conventional ways. 
Direct electronic commerce, on the other hand, utilizes the virtual market place to full extent, not only as a means of transferring information. In such cases every phase of the commercial activity happens online, including delivery. The most prevalent type of such activity is the downloading of software from the Internet. Downloading of music from the network is also becoming quite popular, suffice to mention the notorious website of Napster.
Based on its relation to traditional forms of trade a further categorization of direct e-commerce transactions may be introduced. In some instances of direct e-commerce traditional goods and services are digitized and transferred through the Internet. This happens when downloading software or music from the network, which were previously provided in the form of tangible CD-ROMs. In these cases, online commerce competes with traditional forms of trade. In other cases the goods and services supplied through the network are inherently digital, therefore online provision is the only way of supplying them. Such is the case with web-design or colocation services, which do not compete with any traditional business activities.  
The advantages brought about by e-commerce, both direct and indirect, have already induced a rapid growth of supply and demand of goods and services through the Internet. Statistics and estimates promise a further exponential increase in the next few years. It has also been recognized, though, that for e-commerce to thrive, certain critical characteristics must be in place. These include a secure financial environment. The following chapters of this essay will be concerned with identifying and solving the dysfunction of the VAT system with respect to digital trade impeding the creation of a secure financial environment. 

2.	General Problems of the Operation of the VAT System
Upon reviewing the types of online commercial activity it is not difficult to conclude that it is direct e-commerce that causes major headaches to taxing authorities. While utilizing the opportunities offered by the Internet, the indirect form of online trade retains traditional forms of distribution, and therefore does not put a pressure on conventional tax concepts built on the physical reality of trade. This cannot be said of direct e-commerce. Within the virtual world ordering and supplying of goods mean nothing else than a series of digital signs traveling through the global network without geographical and personal identity. This phenomenon represents such a fundamental change in the circumstances of commercial activity what the concepts and presumptions of the traditional VAT systems are not prepared to handle. 
The emergence of direct electronic commerce surprises the traditional VAT system on three main ‘fronts.’ 
The first problem follows from the sudden growth in the number of international business-to-consumer transactions. Within the traditional trade environment the consumer was supposed to be in the ‘neighborhood’ of the supplying business, or at least had to change his location if he wished to purchase from supplier located further away. Therefore, traditional VAT systems are designed with the assumption in mind that business-to-consumer transactions predominantly take place within national boundaries. The emergence of mail-order systems changed this scenario somewhat, but it still had not resulted in such a boost of international business-to-consumer transactions as e-commerce. Since the proliferation of Internet as a common communication tool, entering into a contract with a foreign supplier has become possible for consumers even without leaving their cozy armchair. Present systems of VAT, based on the previously mentioned assumption are unable to catch foreign transactions to consumers in many cases.
As a second problem, direct e-commerce questions the traditional classification of supplies as goods or services. Within the sphere of e-commerce, where electronic transactions compete with traditional forms of supply, the goods, originally supplied through conventional channels become digitized. Upon digitization the products lose physical appearance, therefore the regime governing the taxation of goods cannot be applied anymore. The question therefore is how to tax these supplies or whether to tax them at all. The same doubts arise with respect to new types of digital supplies. In addition, new types of transactions are difficult to fit into the existing lists of goods and services to which different rules are applicable under the present systems of VAT.
Thirdly, tax administrations are overwhelmed by the evasive nature of online commerce. Under all existing VAT systems suppliers need to tell the tax status and the location of their customers if they wish to discharge their administrative and payment obligations properly. Accordingly, enforcement in lack of voluntary compliance is based on the authority’s knowledge of the identity and geographical data of the supplier. Acquiring of these data was not problematic within the traditional trade environment where trade partners met in person and articles of commerce traveled through physical checks. It goes without saying that the picture is different in case of digital trade. Based on the anonymous series of digital signs representing the transactions it is almost impossible to identify and locate the supplier and the customer. 
After the exposition of problematic issues in a general manner, the subsequent chapter will provide for a specific analysis thereof within the context of the European VAT.

3.	Specific Problems of the European VAT System Owing to E-Commerce
Upon the foregoing it has become evident that the traditional conceptual framework of value added tax has not proven to be entirely functional within the digital environment. This chapter aims at highlighting these functional problems with regard to the European VAT system in detail. Given the intrinsically cross-border nature of electronic commerce analysis will primarily focus on the theoretical and practical weaknesses of the Sixth Directive in handling inter-jurisdictional transactions. 

A.	Theoretical Problems of the Place-of-Supply Rules of the Sixth Directive
The place-of-supply rules answer the primary question of a VAT system in connection with cross-border trade, namely which country has the jurisdiction to tax. These rules, by ensuring the proper allocation of tax revenues and tax burden play a crucial role in securing level competition throughout the internal market. However, when it comes to e-commerce the playing field cannot be limited to the territory of Member States. The international nature of electronic trade requires thinking in terms of ensuring fair competition and even allocation of revenues on a global scale. The question is whether the VAT system designed to handle European trade can live up to these expectations. 

(a)	Classification of Digital Transactions – Goods or Services?
For the proper determination of the applicable place-of-supply rules the Sixth Directive requires the knowledge of several factors from the supplier. The first of these is the classification of the supply as one of goods or services. How should the digital supplies be categorized? To find the satisfactory answer to this question, all possible alternatives under the Sixth Directive should be examined.
The first issue to be decided by the Community is whether the Sixth Directive should tax digital services at all. This question equals to asking whether these supplies are capable at all of fulfilling the criteria of the traditional definition of either goods or services. A negative answer would place these supplies outside the scope of the European VAT. Understandably, when viewing the difference between the traditional and the new way of providing supplies one cannot help to be slightly doubtful as to the taxability of digital provisions. But, in the light of the Sixth Directive’s goal to levy VAT as broadly as possible, the answer should be in the positive. That is, apart from the usage of a new medium, digital supplies have all the characteristics of a taxable transaction. They are effected for consideration, supplied by businesses registered for VAT purposes to businesses with the same status and to final consumers. And these supplies represent an added value that forms an increasing portion of the GDP. 
Subsequent to establishing the desirability of taxing digital transmissions the next question is whether the VAT system should tax them under the regime of goods or services? As stated earlier, the definition of the supply of goods requires the tangibility of the object of supply. Despite this requirement the next section of the same article lists ‘electric current’ as tangible property. If this section were interpreted in a strict, grammatical sense, digital supplies, as a series of electric current, would be considered as supplies of goods. 
But, setting aside the strict textual interpretation, the purpose of broad taxation should be reinforced again. In pursuance of this goal, the Sixth Directive sets forth two different regimes governing the supply of goods and of services based on the lack or presence of tangible character. The reason why trade in electronic current is regulated under the rules on goods is not because of its ‘tangibility.’ The explanation lies in the fact that such activity, as provision of public utility, is usually closely controlled by the authorities, therefore its trade route is transparent enough to apply the place-of-supply rules for goods. This cannot be said about electronic deliveries. Their vague nature would render taxation impossible under the regime designed for taxing the supply of goods.
In light of the foregoing VAT systems wishing to tax digital transmissions in general, and the European VAT system in particular, should classify these supplies as supplies of services. International consensus behind this interpretation has already come to existence within the OECD framework. This consensus however has not yet been reinforced within the European Community through legislative or judicial action. Namely, the Sixth Directive has not been amended with regard to this question, and the European Court of Justice has not yet given a preliminary ruling that would oblige national authorities to interpret the Sixth Directive in line with the above conclusion. Such lack of consistency in this question obviously threatens with double or non-taxation. Efforts taken by the Commission to clear this inconsistency will be discussed in part IV in detail.

(b)	Detailed Analysis of the Place-of-Supply Rules of the Sixth Directive 
Governing the Supply of Services
After establishing that taxation of digital deliveries is only realistic if governed by the rules on services, this section aims at scrutinizing the provisions determining the place of supply of services in abstract. These provisions, as mentioned previously, implement the destination principle with respect to business-to-business transactions and are governed by the origin principle when taxing supplies to final consumers. The analysis following the brief survey of the black-letter law and the theory behind it will show that the dysfunction of these rules constitutes the core of the problems following from the application of the Sixth Directive to digital trade.
Place-of-supply rules of services are provided for by Article 9 of the Sixth Directive. This Article pursues the double aim of concentrating VAT revenue to the country of consumption, while preserving administrative feasibility. This twofold objective has resulted in a rather extensive and complicated framework of place-of-supply rules. 
Section (1) of Article 9 sets forth the general rule. This rule assigns taxing jurisdiction to the country where the supplier has established its business. As a complementary rule, taxation may occur in the Member State where the supplier has its fixed establishment if the use of the previous location would lead to an irrational result or a conflict with another State. The choice of the place of business as the general rule is justified by the reasons of straightforwardness and avoiding interpretative difficulties arising in case of applying concepts such as the ‘place of utilization.’ 
The general rule, based on the origin principle is designed to catch business-to-consumer transactions or national supplies to business customers. It is based on the already mentioned belief that due to technical limitations supply of services to consumers normally takes place within one country, therefore the supplier, the customer and the consumption are all located within the same jurisdiction. Taxation of supplies that might cross the border before reaching the consumer happens through the lex specialis described below. 
Under the section at hand, the responsibility to account for and pay the tax lies with the business supplier. This rule is in line with the administrative realities of business-to-consumer transactions, since business suppliers are the ones in possession of necessary data and equipment for the discharge of this obligation.
Section (2) of Article 9 lays down special rules with respect to certain services. For the purposes of this paper subsections (c) and (e) of section (2) bear most significance. 
Subsection (c) deems the location where the service is physically carried out as the place of supply. This rule covers services, which predominantly comprise the utilization of personal qualities, such as cultural, artistic, educational or entertainment activities. This nature of the services makes the central business establishment of the supplier relatively mobile. Therefore, apart from the intention to realize taxation in the country of consumption as best as possible, this subsection also aims at preventing the suppliers from establishing their businesses in the countries with the lowest tax-rates, which they would probably do, were the general rule applicable.
Both business-to-business and business-to-consumer supplies of the listed services are meant to come under this subsection regardless whether the two parties reside within the borders of the same country. According to this subsection the business supplier should discharge its VAT responsibilities in compliance with the tax rate and other requirements of the national VAT regime in the country where it carries out its supplies. 
Subsection (e) of section (2) contains regulations with regard to intangible services, such as consultancy, advertising or data processing. Following from their nature, these services are primarily supplied to taxable entities, therefore they are presumed by the Sixth Directive to be more susceptible to cross-border delivery. Consequently, in case the central businesses of the supplier and the recipient are not established within one Member State, the section stipulates as the place of supply the location of the recipient’s business in line with the destination principle. This rule is coexistent with the application of the ‘reverse charge’ method under which the liability to account for and pay the tax is imposed on the business recipient. The supplier in turn does not have to charge VAT, i.e. the supply is zero-rated in the country of origin. 
Upon reading this rule together with subsection (b) of section (1) Article 21 it becomes clear that the reverse charge also applies to cases where a taxable person established outside of the Community renders services to a European taxable person. 
The subsection also applies to instances where the customer – regardless of its tax status – is established outside of the European Community. This solution naturally follows from the underlying theory of taxing in the country of consumption. 
When the recipient of the services listed in subsection (e) section (2) is a final consumer residing in the Community the supply is taxable according to Article 1. The general rule also applies to cases where the supplier and business recipient both have their central businesses within the borders of one Member State. 
In order to avoid the possibility of double or non-taxation of these services following from the possible manipulation of the place of business or residence, the Sixth Directive contains a provision complementing the preceding place-of-supply rules. According to section (3) of Article 9 national VAT systems may deem the place of ‘effective use or enjoyment’ of these services as the place of supply, when this place is different from the location of the supplier or the consumer, and when these different rules lead to different results as to the applicability of the Sixth Directive. 
After reviewing the relevant sections of the Sixth Directive the following chart gives an overview of the application of these rules to intra-Community and international digital transactions. 

       TABLE I
	Type of supply	Relevant Section of Article 9	Taxed/Not Taxed	comments	
1	I. Intra-Community				
2	1. national				
3	    a. B-to-B	(2 )(c) if listed, 
otherwise (1)	TAXED at performance/origin		
4	    b. B-to-C	(2 )(c) if listed, 
otherwise (1)	TAXED at performance/origin		
5	2. cross-border				
6	    a. B-to-B	(2 )(c) or (e) if listed	TAXED at performance/receipt		
7	    	otherwise (1)	TAXED at
origin	The transaction is followed by a cumbersome VAT refund procedure/VAT stays locked in resulting in tax cascading	
8	    b. B-to-C	(2) (c) if listed	TAXED at 
performance	When supplied by electronic means the time and place of performance can be different from those of ‘consumption’ or receipt	
9		otherwise (1)	TAXED at 
origin	VAT revenue does not accrue to the country of consumption.	
10	II. International				
11	1. inbound				
12	    a. B-to-B	(2 )(c) if listed	TAXED at
performance, if within the EC	see line 8	
13		(2) (e) if listed	TAXED at
receipt	EXEPTION under section (3) – not taxed if effectively used or enjoyed outside the EC
	
14		otherwise (1)	NOT TAXED	These types of transactions are outside of the scope of the Directive	
15	   b. B-to-C	(2) (c) if listed	TAXED at 
performance, if within the EC	see line 8	
16		(2) (e) if listed	NOT TAXED
	EXEPTION under section (3) – taxed if effectively used or enjoyed within the EC
	
17		otherwise (1)	NOT TAXED	These types of transactions are outside of the scope of the Directive	
18	2. outbound				
19	    B-to-B 	(2) (c) if listed	TAXED at
performance, if within the EC	see line 8	
20		(2 )(e) if listed	NOT TAXED
	EXEPTION under section (3) – taxed if effectively used or enjoyed within the EC 
	
21		otherwise (1)	TAXED at
origin	VAT revenue does not accrue to the country of consumption	
22	    B-to-C	(2) (c) if listed	TAXED at
performance, if within the EC	see line 8	
23		(2) (e) if listed	NOT TAXED	EXEPTION under section (3) – taxed if effectively used or enjoyed within the EC
	
24	
	otherwise (1)	TAXED at
origin	VAT revenue does not accrue to the country of consumption	
 - the result is in line with the requirements of the VAT and the internal market 

The above chart shows serious anomalies in the functioning of the place-of-supply rules of the Sixth Directive with regard to electronic transmissions. The number of digital transactions handled properly under the present regime is clearly outnumbered by the problematic cases.
Most of the problems seem to follow from the application of section (1) to business-to-consumer transactions more often than it would be justified by the requirement of taxing at the place of consumption. Section (1) was designed to deal with national supplies, based on the already mentioned assumption on the model of transactions to consumers. Despite the fact that this underlying assumption has been set aside by the explosion in the number of private Internet users, section (1) remains applicable in a lot of cases in lack of a better rule. 
A better rule would be one of the special place-of-supply rules. But the lex specialis is applicable only in case of services specifically listed therein and under special conditions stipulated thereby. This interpretation has been acknowledged by the ECJ in the Dudda-case: “In every situation the question which arises is whether it is covered by one of the instances in Article 9 (2); if not, it falls within the scope of Article 9 (1).” It follows that new types of services or traditional services supplied in a novel constellation fall under the general rule.
The over-application of the general rule leads to two undesirable consequences. The first of these consequences appears within the Community. Namely, taxing at origin leads to the misallocation of VAT revenues among the Member States under a given pattern of consumption (see lines 7 and 9). Moreover, it has the potential of distorting consumption patterns and intra-Community competition by offering the opportunity to consumers to make their purchases from Member States with the lowest VAT rates. It is obvious that, for example, for a Swedish consumer who has the choice to order supplies from Luxembourg with a VAT of 15 percent the decision to do so will be of no minute keeping the fact in mind that the Swedish rate is 25 percent. 
The other undesirable consequence of the overwhelming application of the general place-of-supply rule occurs on the global playing field. This problem is apparent from comparing the tax consequences detailed in lines 14, 17 and lines 21, 24 of the above chart. These lines show on the one hand that in cases of inbound international supply of services not listed by the special rules the place of supply is deemed to be outside of the Community. Therefore, supplies of these services to European businesses or consumers are not taxable under the Sixth Directive. If the country of the supplier does not have a VAT regime, like in the United States, the service remains untaxed. On the other hand, outbound international supply of the same services is taxable in both cases. 
Consequently, under the general rule situations may occur where European businesses charge VAT on their supplies to European and third-country customers, while third-country suppliers provide services without tax both within the Community and internationally. This situation is disadvantageous to European businesses on both the European and the international playing field. Moreover, it potentially distorts the pattern of transactions for two reasons. Firstly, this situation induces European businesses to supply their services through websites set up in third countries to retain their competitiveness. Secondly, due to the difference in prices final consumption will shift to VAT-free international supplies. 
As seen from the chart, even the application of the lex specialis might cause some problems with regard to digital deliveries. Namely, the place of supply of services listed under subsection (c) of section (2) might be different from the place of receipt or consumption when supplied digitally. This possibility follows from the special features of digital delivery. For example, in cases of receiving music or motion pictures online in one of the Member States, performance thereof might have occurred previously outside of the EC or in another Member State. When the place of performance does not coincide with the place of receipt or consumption there is chance of non-taxation or misallocation of VAT revenues.
After reviewing the theoretical flaws of the place-of-supply rules of the Sixth Directive governing the supply of electronic deliveries, the following section will be concerned with the difficulties of the practical implementation of these rules within the digital trade environment.

B.	Problems with the Practical Application of the Place-of-Supply Rules
Theoretical soundness of the place-of-supply rules in itself is not enough for the proper functioning of the VAT system. Taxation is possible only if these rules are capable of practical implementation.   Therefore, after reviewing the VAT implications of cross-border electronic trade in abstract, this chapter turns to more practical issues. It aims at showing that even in the rare cases when the place-of-supply rules in theory assign the proper taxing jurisdiction for digital trade, fulfillment of the VAT obligations might stumble upon the practical difficulties of compliance and enforcement arisen due to e-commerce. The following is a step-by-step analysis of these problematic issues arising in the course of applying the rules of the Sixth Directive in practice.

(a)	Goods or Services? What type of service?
Without an intention of entering into a detailed discussion on the difficulties arising in the course of classifying electronic deliveries, suffice to note here that the new and ever-developing technology, by blurring the line between traditional categories of services and offering a wide-scale opportunity for the supply of composite products, poses serious practical problems in this field. Therefore, even in case of theoretical clarity of the Sixth Directive with respect to classifying different supplies, these practical difficulties might frustrate the proper functioning of the VAT system.

(b)	Identifying the Consumer: Finding out Its Location and Tax Status
Apart from understanding the nature of supply orientation within the cobweb of place-of-supply rules requires the knowledge of several other data. As seen above, choice between the general and special rules might depend on the location and tax status of the customer.
Determination of the tax status of the recipient when necessary is facilitated by the VIES. In the process of verifying the registration number the supplier and the tax authorities make use of traditional media for the exchange of information. However, in the sphere of e-commerce, the transaction between the supplier and the customer is taking place online. Clearly, the inability of the VIES system to provide online, real time verification prevents the suppliers from fully exploiting the comfort and speed offered by electronic trade and therefore potentially hampers the pursuance of such activity. 
Simultaneously with confirming the tax status of the customer his location should also be verified. With regard to business purchasers, if the verification process through the VIES system was successful, the location of the business can be inferred from the registration number. In case of final consumers there is no such supplementary system. Within traditional circumstances the consumer either paid on the spot or was required to let the supplier know of his address for purposes of delivery and payment. When ordering online, consumers use electronic mail for communicating with the seller, but e-mail addresses tell little about the real, physical residence of its user. 
The most evident means of finding out their location is to ask the customers to self-declare this information. But, unless underlining this practice with reliable verification buyers might feel tempted by the anonymity of online trade to disclose false facts. Despite the diverse efforts to solve this problem, there is still no reliable and feasible means of identifying and locating consumers in lack of voluntary compliance. For the time being suppliers might verify disclosed data by using the credit card information requested from the purchaser previous to the conclusion of the contract. They might also rely on the currency of payment in determining the taxing jurisdiction. Evidently, neither of these examples is a dyed-in-the-wool solution.

(c)	Determining the Place of Effective Use and Enjoyment
In case of services listed under section (2) subsection (e) of Article 9 establishing the fact that the location of the customer is inside or outside of the Community is not always satisfactory. The VAT systems of Member States that implemented the derogation provided by section (3) of Article 9 require the determination of the place of effective use or enjoyment of these services. If such place is different from the location of the customer it should be considered as the place of supply to realize taxation at consumption.
In the light of the difficulties with establishing the location of the customer, the conclusion that determining the place of effective use or enjoyment is almost impossible within the digital environment may be drawn without a long analysis. The evasive nature of e-commerce necessitates new tools for detecting the flow of digital services through the Internet. In the lack of reliable technological means, the supplier remains dependent upon the information revealed by the customer voluntarily. 

The above factors have a negative impact on the fulfillment of obligations under the Sixth Directive. As the other side of the coin, these practical deficiencies also undermine the effective enforcement of VAT rules in lack of voluntary compliance. The pieces of information needed by the supplier for compliance are also essential for the tax authorities for enforcement. To recognize and fight infringement of VAT rules, they need to identify the transaction and gather data on the supplier and the customer. It is obvious that without re-tailoring the rules of the Sixth Directive according to the needs of e-commerce and finding the necessary technological means for their implementation, value added taxation of electronic trade remains vague and incidental. The steps taken by the Community to find viable solutions will be detailed in part IV.

(d)	Administrative Problems
Last, but not least some problems with regard to the performance of administrative requirements under the Sixth Directive should be mentioned briefly. Disharmony between the new way of conducting business and the traditional rules stipulating fulfillment of administrative obligations results in an increased compliance burden. The complication of rules in turn serves as a disincentive for compliance. The following are the areas where the Sixth Directive is clearly behind the requirements of electronic trade. 

(i)	invoicing
The invoice is the heart of the VAT system. It records information necessary for the proper taxation of a transaction and it is a prerequisite for claiming VAT deduction. In order for businesses to be able to realize the advantages following from paperless transactions the facilitation of electronic invoicing is crucial. Such an idea, however, is absent from the Sixth Directive. Although Article 22allows Member States to accept this type of invoice, this is clearly an inadequate basis for uniformly implementing electronic invoicing in the Community. Member State legislation already in place in this matter is often solely focused on domestic electronic invoicing. In addition, such rules are generally accompanied by cumbersome administrative requirements. 

(ii)	other
Taxable persons are required to comply with other types of administrative requirements, already listed in chapter 3 of part II. The arguments for introducing the opportunity to discharge these obligations by electronic means are the same as the arguments for electronic invoicing. The time and expense of the paperwork required under the present system obviously impairs the positive implications of electronic delivery. 

After identifying the theoretical flaws and problems of implementation of the VAT rules laid down by the Sixth Directive, the following chapter intends to explore the negative consequences following from this dysfunction.

4.	Consequences of the Dysfunction of the Sixth Directive
As explained in part II of this essay, the Member States have chosen to adopt VAT as the main form of consumption tax due to its neutrality to consumption patterns. Through its neutral functioning the VAT system is expected to contribute to the building of the internal market and a level field of competition within the Community. 
The previous chapter revealed the anomalies in the application of the present VAT regime to electronic transactions. This chapter aims at examining the consequences of the VAT system’s dysfunction and establishing whether these consequences impinge on the achievement of the internal market objective. Specifically, the chapter attempts to examine whether and to what extent these anomalies might result in the decrease of the European Community’s own resources and to assess the harmful impact of the dysfunction on the competitiveness of European businesses. 

A.	Revenue Loss
As a first step in estimating the probability and extent of erosion that might occur in the Community’s budget following from the dysfunction of existing legislation, the structure of the Community’s own resources and the nature of the VAT resource should be examined. 
Article 269 of the Rome Treaty states that “the [Community] budget shall be financed wholly from own resources.” In pursuance of this objective the Council passed a Decision on the replacement of the Member States’ financial contributions with a system of own resources in 1970. Since then the Community’s budget has been comprised of three different types of resource, including the value added tax resource. 
The VAT portion of the own resources is calculated upon a harmonized basis of assessment, which includes all taxable and zero-rated transactions according to the Sixth Directive. The rate by which this base is to be multiplied has been fluctuating through the years in correlation to the changing needs of the Community budget. The insufficiency of resources finally led to the introduction of a fourth type of own resource calculated upon the gross national product of the Member States.
Unlike customs duties and agricultural levies the VAT resource cannot be considered a genuinely autonomous source of revenue. By constituting a separate item in the budgets of the Member States, the VAT resource is fluctuating in accordance with the varying amount of their revenues. In pursuance of establishing a truly European budget the percentage of VAT revenue has been continuously decreased to the present rate of 1% since the introduction of the GNP resource. The last relevant Council Decision envisaged the reduction of the VAT resource rate to 0.75% by 2002 and to 0.5% by 2004. The complete abandonment of this source is predictable in the long term.
It is apparent upon the foregoing that a possible decrease of VAT revenues following from the anomalous operation of the VAT system would potentially effect the budget of the Community. With this conclusion in mind the following part of this section tries to assess whether the loss of Member State revenues resulting from non-taxation of certain electronic transactions and misallocation of the VAT revenues are substantial enough to have a harmful impact on the 1% of the VAT base accruing to the Community. Examination of the possible impact of the above phenomena on the Community budget is based on the following presumptions:

(i)	It will be presumed that a decrease of national tax revenues owing to the irregularities in the operation of the VAT system may occur only if electronic trade results in the reduction of the number of properly taxed conventional transactions. Since new digital services have never been taxed under the conventional VAT legislation, their present non-taxable status does not result in revenue loss in the strict sense. The focus therefore should be restricted to electronic supplies, which compete with traditional forms of transactions. 

(ii)	The possible effects of the misallocation of VAT revenues within the European Community will be disregarded for the purposes of the following impact analysis. In consequence of the fact that the amount of VAT lost by one Member State accrues to the budget of another, misallocation does not result in a decrease of Community revenues. The effect of the difference between the VAT rates of Member States is negligible.

(iii)	Focus of the analysis will be restricted to business-to-consumer transactions. The rationale behind this restriction is that under the operation of the classical VAT system business-to-business transactions do not result in net revenue for the government due to the right to reclaim the tax.

Following from the preceding premises there are two types of digital supplies which should be put under closer scrutiny: 

(A) Services listed in subsection (e) section (2) of article 9 of the Sixth Directive, when supplied electronically by third-country businesses to final consumers residing in the Community; and

(B) Services listed in the first indent of subsection (c) section (2) of article 9 of the Sixth Directive when supplied electronically by third country businesses to final consumers residing in the Community.

ad (A) The place of supply of these services, not coming under any of the special rules, is determined according to section (1) of Article 9. The general rule stipulates the location of the supplier’s business as the place-of-supply. At first sight therefore the transaction is not taxable since the place of the supply is outside of the Community. 
Theoretically, though, there are two ways of taxing these services under the present European VAT system, as already mentioned in the preceding chapter. One of the options is the application of the “effective use and enjoyment” derogation provided by section (3) of Article 9. The other option is obliging the foreign supplier to appoint a fiscal representative acting on his behalf in the consumer’s Member State. 
In practice neither of the solutions can guarantee the taxation of these services. First of all, the Sixth Directive leaves the adoption of both of these rules at the discretion of the Member States, therefore there is no uniform Community practice in this field. Secondly, as seen above, in lack of appropriate technical means, determining the place of effective use and enjoyment or the location of the consumer is not possible with certainty.
The effect of non-taxation should be examined with respect to the volume of these services and the extent to which they are apt to substitute traditional transactions. 
An exponential growth in the number of these services and their replacement of traditional forms of supply is expected under the present consumption pattern due to the conveniences following from electronic delivery. In addition, the fact that these services remain untaxed when supplied by third-country enterprises has the potential of shifting consumption to these supplies from the taxed supplies of European businesses. This practice in turn gives an incentive to Community businesses to provide such services electronically through servers established in third countries to avoid VAT. These tendencies potentially lead to the total shift of consumption from the domestic to the untaxed foreign supplies and a consequent reduction in VAT revenue.

ad (B) the place where these services are deemed to be supplied is the place of their performance. As mentioned previously, the place of performance of these entertainment services might be different from that of consumption when supplied by electronic means. Therefore, when, for example, music is supplied digitally from a third country, the performance can easily be determined as taking place in the territory of that country. Consequently, the transaction might be non-taxable under the Sixth Directive. 
The “effective use and enjoyment” derogation is not applicable to services listed under section (c) of Article 9. The previous comments on applying the requirement to appoint a fiscal representative are equally valid with respect to cultural services.
Increase in the number of online supplies of entertainment services is expected, especially with respect to the digital supply of music and books. Substitution of traditional forms of supply, like CDs, cassettes and videotapes, by digital delivery will definitely occur in certain fields of entertainment services under the present pattern of consumption. In other fields, due to the social and cultural role of traditional performance of certain entertainment services, like theater, substitution will probably not occur in the foreseeable future. 
The potentially untaxable state of these services may shift consumption from taxed domestic supplies to untaxed foreign provisions in case of entertainment services as well. The incentive of European suppliers to supply these services through servers established in third countries will probably also occur, resulting in the decrease of taxed domestic transactions and Community revenues.

The above analysis does not reveal immediate threats to the Community budget. According to statistics electronic commerce accounts for a small portion of overall European trade at the present, especially at the retail level.  Nevertheless, action should definitely be taken to prevent the potential decrease in the Community resources that might follow from the multiplication of digital transactions. 
Community action is justified even in the light of the fact that the percentage of the VAT revenue in the Community’s budget is decreasing and might even disappear in the long term. VAT represents one fifth of the tax revenues of the 15 Member States, erosion of the tax base therefore is considered to be a sensitive issue. Since the area of VAT belongs to the competencies of the Community, any action should be taken in the form of Community legislation. 

B.	Distortion of Competition
	The European Community was established with the goal of improving the competitiveness of European economy on the world market by creating a common free marketplace where a level playing field is secured for all actors. This goal has last been reinforced at the Lisbon European Council where the Commission introduced the program called “2000 Internal Market Strategy Review.” Through the implementation of this Strategy the Community hopes to become “the most competitive and dynamic knowledge-based economy in the world.”
	To preserve competitiveness on the global playing field exploitation of the advantages brought about by electronic commerce is inevitable. The new way of doing business offers such efficiency on both micro- and macro-economical level that the competitive gap between economies utilizing e-commerce to a full extent and those reluctant to do so will soon be insurmountable. 
Europe is lagging behind the USA with regard to both use of the Internet and the importance of e-commerce. One of the obstacles to the flourishing of electronic commerce recognized in the documents of the Community is the inconsistency of the existing European regulatory framework. These inconsistencies include the irregularities of the operation of the European VAT system. The application of the place-of-supply rules of the Sixth Directive with respect to the digital deliveries impedes e-commerce by distorting competition within the internal market and putting European businesses to a disadvantageous position on the global playing field. 
For the purposes of analyzing the distortive effects of the Sixth Directive’s dysfunction in handling online transactions, the effects of misallocation of VAT revenue and burden should also be considered. Except for one case, the focus will also be on the business-to-consumer transactions. The following types of transactions will be examined:

(A)	Intra-Community electronic transactions falling under section (1) of Article 9;
(B)	International versus intra-Community electronic transactions to final consumers falling under section (1) of Article 9;
(C)	International versus intra-Community electronic transactions falling under subsection (c) section (2) of Article 9.

ad (A) these supplies are of new types of services not listed under the special rules. In case of business-to-business supplies of these services, the receiver of the supply should go through a cumbersome and expensive refund procedure in order to get back as an input credit the VAT paid by him on the purchase. If he chooses not to spend his time and money by reclaiming tax, the ‘locked in’ VAT will lead to tax accumulation. Both of the results lead to an increase in consumer prices and serve as a disincentive to engage in cross-border commercial activity or to comply with the VAT regulations. This scenario clearly conflicts the objective of creating a borderless European marketplace. 
In case of business-to-consumer supplies of these services the VAT is calculated according to the rates effective in the country of origin. It follows that businesses established in Member States with high VAT rates will add a higher amount of tax to the consumer prices and vica versa. Therefore, taxing these transactions at origin obviously distorts competition within the internal market by potentially shifting consumption to supplies including the lowest VAT.
 The results following from the inability of the Sixth Directive to properly handle these supplies conflict the goal of promoting a harmonious and balanced development of economic activities within the Community set out by the Treaty of Rome. These practices, unless corrected in the short term, will harm the competitiveness of the European Community on the global market.

ad (B) services discussed in this section include the services detailed under subsection (A) of the previous section and new types of digital deliveries not fitting into the list of services under the lex specialis. As to the services discussed in the previous section, the fact that the overwhelming majority thereof stays untaxed when supplied from outside of the Community has already been established. The same holds true with respect to the new types of services as well. The only difference between the two settings is that in case of new services the derogation of section (3) of Article 9 is not applicable. The odds of correcting the mistakes of the general rule are therefore even lower.
The same services, though, are taxed when supplied by a European business to a consumer either in or outside of the Community, since under the general rule taxation should occur at the location of the supplier’s business. The only exception occurs, if the respective Member State has adopted the derogation under section (3) of Article 9 and the supplier can prove that effective use and enjoyment of the service happened outside of the Community. The chance of success, as seen previously, is very low. This derogation, as stated above, is not applicable for new types of supplies. Considering that standard VAT rates range from 15% to 25% the above practice results in a serious disadvantage of European businesses in the price competition. 

ad (C) It has been found in section (B) of the previous chapter that these services might remain untaxed when supplied by a third-country business to final consumers in the Community. At the same time supplies provided by a European enterprise are taxed under the relevant section of the Sixth Directive. This pattern of taxation also results in a disadvantage in the competitive position of European businesses.

To sum up the comments of this chapter it should be concluded that the negative effects following from the dysfunction of the European VAT system apparently impact the balance of competition in the global ‘electronic’ market more seriously than they influence the amount of Community revenue. It seems therefore that Community action is primarily justified by reasons of creating equal competition within the internal market and on the global playing field. However, because of the truly global nature of the electronic marketplace, it is evident that acting on Community level alone is not enough to preserve the competitiveness of the Community. Concerted action of all participants of e-commerce, especially of the OECD countries is needed to create a global level playing field. 

IV.	Solutions

	   Subsequent to identifying the specific fields of dysfunction of the Sixth Directive in the digital world and estimating its possible impact on the common market, this part aims at exploring potential ways of resolving these anomalies. 

1.	Principles of the Prospective Amendments to the Sixth Directive
	Any tax system should be based on a set of higher principles to function properly. Some of these principles, such as neutrality, legal certainty, convenience and efficiency are acknowledged since the 17th century, while others have developed recently with the emergence of modern tax regimes. The most important implication of electronic commerce on the guidelines of a prospective VAT system is the necessity for international consensus. Since digital trade is truly global, national actions are not viable anymore without the consent of the involved trading partners. 
	The European Community recognized this fact when adopting the Green Paper, which articulated the need for the adjustment of the present VAT regulation for the first time. Since then the Community has been working to find a feasible solution to the problems in close cooperation with the OECD. Being the pioneer of the widespread use of value added tax worldwide and an expert in applying such tax to cross-border transactions the Community’s role in finding an internationally acceptable answer to the questions at hand is outstanding. 
	The Commission, representing the European Community in the OECD, prepared a Communication in 1997 with the intention to propose a background for future international dialogue.  The document draws up the guidelines for the necessary amendment of the VAT regulations. The proposed guidelines reflect the dual aim of enhancing the growth of electronic trade as best as possible while preserving the functionality of the existing regulatory framework. This duality follows from the fact that even though Europe wishes to take advantage of the great economic opportunity brought about by e-commerce, it also has an interest in protecting the revenues and competitiveness of its Member States. 
	The proposed guidelines rest on four basic postulates set forth at the outset of the Communication. First of all, the Commission reinforces the requirement of the broad applicability of VAT. It expresses the assumption that all supplies of goods and services taxable at the moment will remain so according to the amended regulations as well.  Further, the old tax principles of legal certainty, simplicity and neutrality are reaffirmed. 
	According to the first guideline there should be no new taxes applicable to electronic commerce. This requirement follows from the principles of neutrality and simplicity. Neutrality in this context means that the method of commerce used to effect transactions should not influence the consequences of taxation. The principle of simplicity aims at keeping the compliance burden of the tax system to a minimum. For the sake of these postulates the Commission rejected attempts to design new types of taxes, such as the ‘bit tax’ or the ‘transaction tax’ with regard to e-commerce. Hence, efforts should be concentrated on adapting existing taxes to the digital environment.
	Electronic transmissions should be treated as services in line with the second guideline set forth by the Commission. The rationale behind classifying digitized goods as services, as examined in the previous chapters follows from the principle of broad applicability of VAT. Due to the lack of tangibility in case of electronic transmissions this classification is the only way to catch these transactions for VAT purposes. By clearing up the uncertainty surrounding the interpretation of digital deliveries at the moment, this guideline also serves the purposes of legal certainty, which is essential for reducing the risks of unforeseen tax liabilities. 
	The third guideline aims at implementing the idea of VAT as a tax on consumption to a full extent. It sets forth the application of the European VAT merely on goods and services supplied for consumption within the Community. This guideline reacts to the disadvantageous situation of European businesses following from the present regulations. Implementation thereof will put an end to the discrimination against European suppliers under the existing system and will ensure fair competition in the common and the global marketplaces.  
	The efficiency of any tax system largely depends on the voluntary compliance of the taxpayers. One of the core objectives of the VAT system therefore should be the minimization of the compliance burden. To put the principle of simplicity into practice the fourth and sixth guidelines express the need for a practical and flexible tax mechanism fully in line with commercial practices. Administrative rules should take account of the diversified, decentralized and evolving nature of the electronic market. For the sake of such requirements the Commission proposes to facilitate electronic invoicing and the discharge of fiscal obligations by means of electronic VAT declarations and accounting.
	When voluntary compliance fails, tax systems should be ready to enforce fiscal obligations. This requirement is set forth by the fifth guideline. As it will be seen below, enforceability is the Achilles heel of the prospective VAT system. Enforcement causes problems owing to the difficulties in identifying suppliers and customers in general within the digital world. However, the problem is more acute with respect to foreign suppliers. On what grounds and by which means can the European system oblige third country enterprises to comply with Community rules? The proposal of the Commission detailed in the next chapter tries to find the answers to these questions.
	The above guidelines served as a ground for discussion at the OECD Ottawa Conference in 1998. The meeting was one in a series of early international policy moves to determine the framework for global taxation of online trade. As a result of the conference a document entitled “Electronic Commerce: Taxation Framework Conditions” came into existence. On the field of consumption taxes the Framework Conditions are entirely based on the Commission’s proposal. With the international acceptance of the guidelines the Community has got ‘green light’ to pursue its work for the betterment of the VAT system in line with its original ideas. The OECD, through its Committee on Fiscal Affairs, has also been working ambitiously to further the effective implementation of the Framework Conditions. 

2.	Proposal for a Council Directive Amending the Sixth Directive
	After identifying the anomalies of the European VAT system and the principles set forth to guide amendatory legislation, this chapter aims at examining the ideas of the Community institutions on translating the guiding principles into legal measures capable of clear implementation. In the center of the scrutiny will stand the Proposal of the Commission put forward last June for a Council Directive amending the Sixth VAT Directive. Account will also be taken of the respective opinions of the Parliament and the Economic and Social Committee, which discussed the Proposal in line with the consultation procedure. 

A.	The Proposal in General
	The Proposal addresses a very narrow field of electronic commerce. Within the sphere earlier defined as direct electronic commerce, it focuses on the issue of cross-border supply of digitized products, with special regard to those destined to final consumers in the Community. It defines the term ‘supply by electronic means’ to delineate the types of supplies covered by the scope of the amendment. The Proposal treats digital deliveries as services implicitly, without any express reference to the underlying OECD principle.
	The Proposal contains two separate sets of provisions. The redefinition of the place-of-supply rules for electronic deliveries and the amendment of connected administrative provisions necessary for the implementation of the redefined rules form the heart of the Proposal. The other key point of the document is the set of provisions facilitating the discharge of VAT obligations by electronic means.
	
B.	Place-of-Supply Rules
	The Proposal sets forth two distinct places of supply for digital deliveries in accordance with the varying tax status and location of the recipient. The proposed place-of-supply rules represent an amendment to Article 9 of the Sixth Directive. Without interfering with the basic structure of this Article as described in part III, the Proposal introduces an additional lex specialis. The scope of the new subsection (f) in section (2) of Article 9 would cover services specifically listed therein. The list contains traditional and novel types of services:

“(f)  …services mentioned in point (c) first indent [i.e. first indent of subsection (c) section (2) of Article 9 of the Sixth Directive] as well as of software, of data processing, of computer services including web-hosting, web-design and similar services and of information…”

(a)	Place-of-Supply Rule I.
The first rule determines the place of supplies destined to European businesses or recipients located outside of the Community. This rule reiterates the already familiar structure of subsection (e) section (2) of Article 9 by deeming the location of the customer as the place of supply. It extends the scope of the reverse charge to European business customers receiving digital supplies from abroad or from a business located in a different Member State. Consequently, in these instances the duty to account for and pay the tax lies with the business customers. As to digital transmissions to customers residing outside of the Community, the scope of the Sixth Directive would not cover these transactions. 

(i)	‘good faith’ clause
	For the implementation of the extended reverse charge the Proposal provides for an amendment to article 21 of the Sixth Directive defining the persons liable for paying the tax. The Proposal introduces a so-called ‘good faith’ clause allowing the supplier release from liability for the fulfillment of VAT obligations upon the verification of his customer’s taxable status. The ‘good faith’ clause requires the supplier to act with “all possible diligence” in the course of verification. Normally, reference to the VAT registration number of the customer satisfies this standard of conduct, but the section seems to be ready to accept verifications by other means, namely by “a consistent set of data from an independent source.”

(ii)	joint and several liability
	Despite compliance with the ‘good faith’ clause suppliers might be held jointly and severally liable for payment of tax if the VAT legislation of a Member State requires so. This opportunity of the Member States follows from article 21 of the Sixth Directive originally applicable for services covered by subsection (e) section 2 of Article 9. By extending the use of the reverse charge method to digital deliveries the corresponding extension of joint and several liability is justified by the reason of avoiding accidental non-taxation.

(b)	Place-of-Supply Rule II.
The second place-of-supply rule determines the place of transactions to final consumers within the Community. It deems the location of the supplier’s business or fixed establishment as the place-of-supply. Though this rule belongs to the lex specialis, it results in the practical extension of the general place-of-supply rule of the Sixth Directive to business-to-consumer digital transmissions.
(i)	registration
It has already been demonstrated in the previous part of this essay that the sole determination of the place of supply does not ensure taxation with certainty in cases of supplies provided by businesses established in third countries. To correct the mistakes of the lex generalis it is necessary to introduce supplementary rules firmly establishing the taxing jurisdiction of the Community with respect to foreign businesses. 
At present there are two possible ways of collecting tax from foreign enterprises lacking physical presence in the country of taxation. One is to require such enterprises to appoint a fiscal representative in the destination country to duly discharge VAT obligations on their behalf. The other is to oblige foreign businesses to register for VAT purposes in the destination country.
The institution of fiscal representative, as mentioned previously, already exists under the Sixth Directive. However, this system of representation has proven to be too complicated and costly, therefore the Council abolished it with respect to European businesses as of 1 January 2002. Though, with regard to non-established businesses Member States may continue to require the appointment of a tax representative in certain cases, the idea of applying this scheme in case of electronic transmissions was abandoned by the draftsmen in the light of the preceding drawbacks. 
 Consequently the Commission adopted the second solution. The Proposal obliges taxable persons established outside of the Community to ‘identify’ for tax purposes in the Member State, to where they first supplied digital services within the internal market. Upon registration with the relevant tax authority, the foreign suppliers should be considered as having a fixed establishment in the destination country. By introducing this legal fiction the Proposal creates a clear tax point.

(ii)	consequences of registration
	The obligation to register means a burden to foreign suppliers. The Commission aims at reducing this burden to the minimum for the sake of inducing compliance. That is why the Proposal envisages a single place of registration for foreign enterprises within the Community. According to this scheme, foreign suppliers would apply the VAT rate of the Member State of registration to all of their transactions within the Community and would pay the collected tax thereto regardless of the actual place of consumption. 
It is easy to recognize that the system of single registration results in a scheme identical to a place-of-supply regime based on the origin principle. Consequently it possesses all the flaws of this approach discussed previously. No wonder that all the institutions participating in the debate of the Proposal spotted the rule on single registration as the most disturbing part of the Proposal. In the light of Member State autonomy in fixing VAT rates and the consequent variety of VAT rates throughout the Community, allowing single registration for foreign enterprises would magnify the problem already existing with respect to intra-Community business-to-consumer supplies. Namely, taxing at origin gives an unfair advantage in the price competition to businesses registered in Member States with low VAT rates, and, by shifting consumption to those Member States, it results in the misallocation of VAT revenues within the Community. 
The Parliament, in pursuance of foreclosing the possible negative effects of the single registration scheme proposed a system of refund implemented through bilateral agreements between the Member States of registration and consumption. Another solution came up at the debate of the Proposal in the ECOFIN Council according to which third-country operators would be required to register in each of the Member States where they conduct business. The Belgian delegation in the Council was in favor of a third type of solution under which registration would be centralized in a single Member State and the revenue would be shared out on a macro-economic basis between the Member States in which consumption took place. All of these suggestions will be evaluated in the next chapter.

(iii)	threshold
	Still connected to the idea of registration and the purpose of minimizing administrative burden on suppliers, the Proposal sets forth a threshold under which registration is not compulsory for the foreign businesses. The provision on the threshold supplements the rules of the Sixth Directive regulating the special scheme of VAT for small undertakings. In accordance with the proposed amendments, foreign businesses below an annual return of EUR 100.000, if supply of electronic services is their only activity within the Community, would be allowed to supply without charging VAT. The amount of turnover is to be calculated in line with the regulations of the small business scheme.
The Parliament suggested the changing of the threshold to EUR 40.000. It justifies the proposed change by the fact that the small-business thresholds adopted by the Member States are without exception lower than EUR 100,000. By retaining the high threshold for third-country suppliers the unfortunate situation may occur in which a foreign business enjoys exemption while a domestic enterprise with the same turnover already falls outside the scope of the special provisions. This solution would result in discrimination against the most vulnerable type of European business with a turnover just above the domestic threshold.

(iv)	‘no establishment’ clause
The last important detail to be mentioned in connection to the registration is stipulated in the Preamble of the Proposal. This provision intends to make it clear and firm that the registration of foreign enterprises should only serve the purposes of the proposed VAT Directive and by no means constitutes an establishment within the meaning of the Rome Treaty. Consequently, by merely registering for tax purposes a third-country business will not become the beneficiary of the internal market freedoms. 

(c)	Rate
A specific provision on the VAT rate applicable to digital deliveries has been inserted into the Proposal. According to this rule the standard rate should be applicable to all electronic supplies. According to the Commission the rationale behind this provision is to ensure legal certainty by excluding the possibility of interpretative difficulties that might arise when trying to classify electronic services in connection with the list of supplies attracting a reduced rate. 

(d)	Discharge of VAT Obligations by Electronic Means
As a separate set of rules applicable to all suppliers under the scope of the Sixth Directive, the Proposal brings changes in the field of fulfilling administrative obligations. According to the proposed rules the Member States should allow
- the submission of statements of taxable persons as to any change in their taxable activity;
- the filing of tax returns; and
- the submission of annual reports on the taxable activity
by electronic means. 

3.	Critique
After the objective review of the rules proposed by the Commission in the subject matter, this chapter approaches the Proposal with an appraising intention. Its aim is to establish whether or not the Proposal offers adequate solution to the problems delineated in part III of this essay. The aspects of evaluation will be as follows:

-	The Proposal will be examined in the light of the general requirements of the VAT system. Namely, whether the proposed rules are capable of improving the application of the VAT to electronic transactions as a broad-based consumption tax, keeping in mind the requirements of administrative feasibility and enforceability. 

-	The scrutiny intends to explore whether the proposed rules are capable of enhancing the internal market objective, namely, whether the Proposal is in line with the requirements of European legislation in general and that of the European VAT system in particular. For this reason, the proposed rules will be examined in light of the objectives of the SLIM project and the requirements of the definitive VAT system.

-	The third aspect of evaluation focuses on the interests of electronic commerce, specifically whether the proposed rules are capable of enhancing the flourishing of electronic trade within the internal market.

-	Last, but not least the Proposal will be examined in the international context, namely whether it is in line with the OECD Framework Conditions and whether it is acceptable to the trading partners concerned. 

The analysis will follow the structure of chapter 3 part III. The Proposal will first be examined from a theoretical point of view, then analysis will proceed with evaluating the practical implementation thereof.

A.	Theoretical Questions
(a)	Goods/Services?
As seen earlier, this is one of the most important questions arising in the course of applying the Sixth Directive. Difficulty in answering it within the electronic environment has led to the adoption of relating policy within the framework of OECD at the initiative of the Commission. According to the Taxation Framework Conditions, digital goods are to be treated as services for the purposes of levying value added tax.
The Proposal, consequently, has been drafted according to this approach. The Commission, though, has not mentioned expressively the desirability of treating electronic supplies as services. According to the Explanatory Memorandum to the Proposal this approach unambiguously follows from the present wording of the Sixth Directive. The author of this essay disagrees. If this issue were so clear, neither the Commission nor the OECD countries would have had to bother with defining it on the policy-level.  
For the implementation of the internationally accepted policy within the European Community and for the sake of legal certainty and the coherence of the VAT system, the express and legally binding definition of electronic supplies as services should be adopted by Community legislation. Therefore, the Commission should complement its Proposal with a rule explicitly requiring the treatment of digital deliveries as services under the Sixth Directive.

(b)	Place-of-Supply Rules
(i)	structure of article 9
This subsection scrutinizes the structure of the proposed Article 9 and the way it fits into the existing system of place-of-supply rules. 
As we saw previously, Article 9 consists of a general rule stipulated by section (1) and special rules laid down in section (2). This structure is built on three varying factors, namely the type of service, the location of the parties and the tax status of the customer. 
 The Proposal intends to introduce an additional lex specialis as subsection (f) of section (2). This special place-of-supply rule is based on a new factor, namely the mode of delivery. Subsection (f) retains the relevance of the other three factors. It would only apply to the types of services specifically listed thereby, and it contains two separate place-of-supply rules corresponding to the location of the parties and the tax status of the customer. 
The following analysis intends to show that the proposed place-of-supply rule suffers from several structural flaws.
The first striking inconsistency concerns the list of the types of service electronic supply of which falls under the scope of the proposed rule. As to already known types of service, the proposed subsection (f) covers the supply of all the services listed under subsection (c) section (2) of the Sixth Directive that are susceptible to electronic delivery, but contains only two of them listed under subsection (e). These two types of service are not the only ones that are capable of being supplied by electronic means. Electronic delivery of the rest of the services to final consumers, though, would fall under the general rule, resulting in the same negative consequences the Proposal intends to fight.
The list seems to be unsatisfactory in respect of the novel types of service as well. Due to dynamic evolution of the Internet and electronic commerce there are already some services which would fall outside the scope of subsection (f). The taxation of these services, therefore, would also happen according to the general place-of-supply rule. 
Thus, amending the Sixth Directive according to the proposed list would obviously mean a half-solution of the problematic issues. The negative consequences following from the application of the present rules to digital deliveries would continue to apply, violating all the interests delineated at the beginning of this section. 
The next issue of concern is the over-complication of the place-of-supply rules that would follow from the adoption of the proposed amendments to Article 9 of the Sixth Directive. The proposed lex specialis reiterates two already existing places of supply. Namely, the place of business-to-business and outbound supplies of digital goods and services would be identical to the one stipulated by subsection (e) section (2) of Article 9, while the place of the same services delivered to consumers would be the exact copy of the general place of supply rule. Is such over-complication of the already complex rules justified? 
The author of this essay is of the opinion that taxation of electronic goods and services could be resolved under the present place-of-supply rules. To prove the correctness of this standpoint it should be examined whether the legal consequences intended by the Proposal to apply solely to electronic supplies could be incorporated into the Sixth Directive without introducing additional place-of-supply rules. 
The differences between the legal consequences following from the proposed subsection (f) and what is applicable under section (1) and subsection (e) section (2) of Article 9 are as follows:

(I)	the obligation of foreign businesses to register in case of digital transactions to final consumers; 
(II)	the ‘good faith’ clause applicable to business-to-business electronic deliveries;
(III)	the exclusion of the application of reduced rates to digital deliveries;
(IV)	the ‘effective use and enjoyment’ derogation under section (3) of Article 9 is not applicable to digital deliveries.

In light of these differences the following part of this section will examine the possibility of the ‘merger’ of the existing and proposed rules, by including business-to-business electronic supplies under subsection (e) section (2) of Article 9 and treating business-to-consumer electronic transactions under the general rule.

ad (I) In case of treating business-to-consumer digital deliveries under the general rule the obligation of foreign suppliers to register would have to be extended to all cases falling under section (1) Article 9 of the Sixth Directive. This solution would bring about virtually no changes in the present obligations under this section. Based on the previous analysis of the nature of traditional and electronic supplies, it can be concluded that supplies arriving from abroad to consumers will overwhelmingly be electronic supplies, where registration is intended by the Proposal. Other deliveries falling under this section would be of off-line intangible services. For the case of these services arriving from abroad to final consumers the majority of the national VAT systems already stipulate the obligation of foreign suppliers to appoint a fiscal representative, therefore to obligate these businesses to register would not make a great difference. For the provision of supplies to consumers other than electronic or intangible services the third-country suppliers have to set up a business establishment in one of the Member States due to the difficulty of supplying such services from a remote location. In these cases taxation would naturally follow from the treatment of these foreign businesses like European businesses.

ad (II) In case of treating electronic business-to-business supplies under subsection (e) section (2) of Article 9, the ‘good faith’ clause envisaged by the Proposal would have to be extended to all supplies listed under this subsection. In fact, this clause would have to be extended to all subsection (e) supplies even if electronic supplies stay under the proposed subsection (f). Namely, such extension would be the only way to avoid discrimination between electronic versus off-line supply of the same services. This is especially true with respect to services under subsection (e) that are closely connected to e-commerce, such as provision of Internet access. Extension of the ‘good faith’ preference to other types of intangible services would not be inconsistent with the spirit of the Sixth Directive either. 

ad (III) The unacceptability of excluding the application of reduced rates to digital deliveries will be examined in the next subsection. Suffice to say here that this provision of the Proposal does not justify the introduction of separate place-of-supply rules for electronic supplies.

ad (IV) The last comment concerns the application of the ‘effective use and enjoyment’ derogation. In case of extending the list of subsection (e) section (2) of Article 9 to digital deliveries the derogation of section (3) would become applicable thereto. The rationale behind the derogation lies in the evasive nature of intangible services. Electronic deliveries are of the same nature for the purposes of this derogation. Nevertheless, we already saw in the preceding part of this essay that defining the place of effective use or enjoyment is almost impossible in case of electronic supplies. Therefore, applying the derogation to these services would discredit the operation of this rule. To foreclose this negative consequence, an amendment would have to be introduced to the derogation, which would ensure the exclusion of digital deliveries from its scope.

Upon close scrutiny of the differences above, neither of them seems capable of adequately justifying the introduction of an additional subsection to section (2) Article 9. The unnecessary over-complication of the place-of-supply rules would harm the interests of the VAT system and the operation of the internal market. The SLIM Program has recognized the negative impact of over-complex legislation on the operation of the internal market. The Proposal clearly conflicts the objectives of this program.
In light of the above negative consequences the Commission should rethink the proposed article at hand.

(ii)	scope of proposal
In part III of this essay the full range of problems arising from the application of the Sixth Directive to electronic deliveries was explored. This subsection aims at examining the extent to which the Proposal intends to give a solution to these problems.
The admitted aim of the Proposal is to fight the competitive disadvantage of European businesses vis-à-vis third-country suppliers following from the lack of taxing the latter. For this reason the Commission proposes an amendment to the present place-of-supply rules to resolve taxation of foreign enterprises. The Proposal is almost totally short of reactions to the problems of the European VAT system in handling intra-Community electronic commerce. What is more, the proposed system of single registration, by implementing taxation at origin, would even magnify the problems of intra-Community misallocation of tax burden and tax revenue already existing with regard to business-to-consumer transactions.
The question is whether amendatory legislation with such a narrow focus could be justified. The argument for the Proposal is the necessity to eliminate unevenness of the global level playing field with respect to European suppliers of digital goods for the sake of enhancing the growth of European electronic commerce and preserving the competitiveness of European economy. Arguments against the Proposal include its lack of responsiveness to all existing problems and its potential to increase the already existing intra-Community misallocation of VAT revenues. Counter-arguments also include the unacceptability of the prospective series of fragmented legislative actions tackling separately with each aspect of the VAT system’s dysfunction from the viewpoint of the SLIM project and the credibility of the VAT legislation.
In the light of the fact that the volume of business-to-consumer electronic transactions is quite modest at present, the arguments for the acceptability of this narrowly focused Proposal seem quite weak. Without disregarding the importance of the Proposal’s objective, the conclusion should be drawn that fighting the problems at hand is more desirable by legislation with a broader scope.

(iii)	clearinghouse
Two comments seem necessary in connection with the idea of a clearing system put forward by the Parliament. The first comment concerns the justification of the clearing system and the second deals with the questions of its practical implementation.
The Parliament proposes the introduction of a clearinghouse to tackle the problems arising from the scheme of single registration put forward by the Commission. Namely, it intends to foreclose the intra-Community misallocation of VAT burden and revenues potentially following from supplies to European consumers from third-country suppliers. The writer of this essay thinks that introduction of a clearing house solely with regard to supplies by foreign enterprises to consumers is unjustified.
It has been recognized in part III of this paper that misallocation of VAT burden and revenues already exists within the Community owing to taxing business-to-consumer transactions at origin. It follows that the idea of a clearing system is not at all to be rejected. Nevertheless, its introduction would be justifiable only if its scope covered intra-Community transactions as well. 
This conclusion is especially true when viewing the ultimate goal of the European VAT system. Since the definitive system of VAT will be implemented through a clearing system covering all supplies under the Sixth Directive, designing a clearinghouse solely to handle the transactions of third-country suppliers would be an unnecessary expenditure of time and resources. Consequently, the system of clearing should be redesigned to include all business-to-consumer transactions conducted within the Community. 
The second comment with regard to the clearinghouse concerns the practical implementation of the idea. The essay has intended to highlight the conflicts between the fiscal sovereignty of Member States and the interests of the internal market on several occasions. It has become evident that the Member States are not willing to accept curtailment of their fiscal power necessary for the introduction of the clearing system without weighty reasons. The Proposal at hand, full with inconsistencies and unanswered questions – partly highlighted in the following sections - is hardly the appropriate means of convincing Member States to restrain their fiscal autonomy. Therefore, proposals of the Parliament and the Belgian delegation to introduce a clearing system should not expect positive reactions in the Council. 

(iv)	registration in all member states
Besides the scheme of single registration with a clearing system the ECOFIN Council heard another solution to the problem of revenue-misallocation potentially following from the Commission’s Proposal. The French Presidency suggested that foreign suppliers should be required to register in all Member States. 
The positive side of this solution is that it would make the introduction of a clearing system avoidable. However, under this scheme compliance would become significantly heavier for foreign businesses as opposed to European businesses, which may conduct transactions throughout the Community by registering in a single Member State. Such practice would probably be in conflict with the Community’ obligations under the WTO Agreement on Subsidies and Countervailing Duties and therefore is internationally unacceptable.

(v)	threshold
The Commission when proposing the scheme of single registration determined a threshold below which foreign businesses are not required to register. Two points are worth mentioning in connection with the registration threshold.
The first remark concerns the amount of turnover below which the third-country business qualifies for exemption. When determining this amount, the draftsman should keep the rationale behind the concept of threshold in mind. Registration thresholds in the world of VAT serve a dual objective. They remove the burden of compliance in cases where such burden would reduce or eliminate the incentive to carry on business activity. In international context they have a role in securing equal competition between domestic and foreign businesses. 
The Commission, on the one hand, when setting the registration threshold at EUR 100,000 focused on inducing compliance of foreign enterprises by reducing the compliance burden to minimum. The Parliament, on the other hand, drew the attention to the importance of securing competitive equality within the internal market and proposed to determine the registration threshold at EUR 40,000.
It follows that the Commission should rethink the Proposal by balancing on the edge of the above twofold objective. It should converge the proposed threshold to domestic thresholds by weighing the increase in the burden of foreign businesses and its potential effect on compliance against the consequences of a possible distortion of competition following from the gap between the two rates.
The second comment in connection with the threshold concerns the imprecise wording of the proposed rule. The Proposal is clear on the point that foreign businesses with an annual turnover above the threshold should register. The rule is silent on the question whether registration is an option for businesses below the threshold. Though the main idea of registration thresholds is to relieve small businesses from administrative obligations, in certain instances registration might be the more convenient solution. This is the case of businesses expecting to exceed the threshold only after a certain period. Leaving the option of registration open for small businesses therefore is desirable.

(c) Right to Tax Deduction
The Proposal describes registration as an obligation to be fulfilled by foreign businesses when their annual turnover exceeds the stipulated threshold. The document does not contain any provisions regarding the ‘other side’ of such obligation, namely the rights deriving therefrom vested with foreign businesses. 
The right to deduct input credits from the VAT due on supplies is the focal point of the rights of taxable entities under the Sixth Directive. The Proposal does not provide for the right of deduction with respect to third-country businesses. It is true that foreign enterprises are only required to register for VAT purposes with regard to their supplies to final consumers. However, it would be a crude oversimplification of business reality to disregard the possibility that these businesses, once registered, will conduct business-to-business transactions within the Community. As soon as these businesses enter the European supply-chain they need to have the right to deduct the VAT incurred on business investments for purposes of avoiding tax accumulation and securing equal competition within the internal market. 
The Commission presumably intends to grant such right to foreign businesses without explicitly mentioning it. Therefore, when refining the Proposal, to right of foreign businesses to deduct input credits should expressly be stipulated for the sake of legal certainty.

(d)	Exclusion of Reduced Rates
The Proposal for the reasons stated in the previous chapter excludes the application of reduced VAT rates to digital deliveries. This provision would clearly result in the discriminatory treatment of certain goods and services based on the mode of their delivery. Namely, digital goods and services should be considered as identical to their physical counterparts for the purposes of applying reduced rates. This statement holds true despite the fact that for the purposes of implementing the principle of broad taxation, digital deliveries are treated under different categories of supply than the offline deliveries of the same goods and services. 
Such discriminatory treatment would constitute an obstacle to the development of e-commerce in general by imposing more favorable tax consequences on offline deliveries. Within the specific context of the internal market impeding electronic commerce would lead to the frustration of the objective of improving the competitiveness of the European economy on the global market. Within the international context, the discrimination would definitely conflict the principle of neutrality incorporated into the OECD Taxation Framework Conditions. This is especially true viewing the fact that the discrimination would be more strongly present with regard to certain third-country suppliers, who conduct solely digital transmissions to the Community.
All in all, the Commission should rethink the provision at hand. In theory, equal treatment of physical and digital deliveries could be achieved by allowing application of reduced rates to the respective electronic transmissions or by disallowing the application thereof to traditional forms of supply. In practice, general elimination of reduced rates is unthinkable in the light of the emphasis Member States put on the preservation of their fiscal autonomy. Consequently, the Commission should extend the application of reduced rates to digital deliveries.
	
B.	Implementation
	This section aims at highlighting the practical difficulties arising in the course of implementing the double scheme of place-of-supply rules applicable to electronic deliveries according to the Proposal. It should be noted that these problems will rise regardless of whether the ‘double-scheme’ is implemented separately under subsection (f), as proposed by the Commission or as an integrate part of the existing rules, as suggested by the author of this essay. 
	The following chart illustrates the steps in the process of complying with the respective rules of the Sixth Directive:
											            TABLE II

STEP I

LOCATION OF CUSTOMER
 - inside or outside of  the EC? -

STEP II

TAX STATUS OF CUSTOMER

STEP IV

REGISTRATION

STEP III/a

ANNUAL TURNOVER
- above or below the threshold? -

STEP III/b

VERIFICATION OF REGISTRATION NUMBER

in the EC

registered

unregistered

above the threshold

STEP I
For suppliers established in third countries to find out whether the transaction falls under the scope of the European VAT system and for European enterprises to know whether to charge VAT on the supply the first question to be answered is where the customer is located. 
As discussed earlier suppliers of digital services encounter serious difficulties when trying to determine the location of their customers. The Proposal, apart from drafting a system that requires the localization of the customer does not provide any guidance as to the technical means necessary for the fulfillment of such duty. The Technology TAG of the OECD has been taking major efforts to find feasible technology for the verification of customer location. Unfortunately, it is evident upon the latest Report of this body that presently there exists no technical means, which could offer the verification of location with certainty.
The Proposal therefore is obviously built upon the faith vested in the genuineness of self-declaration. In case of business recipients self-declaration is likely to go smoothly since the right to deduct the tax paid motivates their compliance. They will only be able to deduct the VAT on their purchases if the invoice registers their valid business address. Self-disclosure by private individuals raises more questions. In their case anonymity of the Internet offers an opportunity to specify a false location for the purposes of paying less or no tax on the supply. As stated previously, information available to the supplier at present is not reliable. Moreover, as a response to increasing consumer sensitivity about personal privacy and data protection businesses are reluctant to seek the collection of more information from consumers than they need for commercial purposes. 
All things considered, it seems that the Proposal fails to offer a certain way of establishing the whereabouts of the consumer.

STEP II
Simultaneously with finding out the location of the customer, the supplier should also inquire into the tax status thereof. Upon the customer’s assertion of its taxable status, the supplier is obliged to check the validity of the disclosed registration number. Under the ‘good faith’ preference the supplier should make every reasonable effort to verify the taxable status of the recipient in order to become released from tax liability.  
Part II of this paper has already expanded upon the deficiencies of the VIES system, the primary means of verifying registration numbers. Concurrently with introducing the Proposal at hand, the Commission put forward a draft Regulation initiating the reform of the VIES. Unless the VIES system is capable of providing third-country suppliers with assistance in the verification process, the ‘good faith’ clause remains paper-law.

STEP III/a – IV 
When the recipient of the service claims non-taxable status the articles of the Proposal providing for business-to-consumer transactions become applicable. The obligation to register forms the core of these provisions. To calculate the amount of annual turnover and to appropriately comply with the obligation to register knowledge of exact customer-location is indispensable. As seen earlier, there are no means at present for establishing the location of the customer with certainty.

Enforcement
So far it has been presumed that foreign enterprises will act in compliance with the obligation to register, provided that necessary technological means are available.  However, the legislator, to remain on the grounds of reality, should count with the possibility of non-compliance. Therefore, the VAT system should be able to address non-cooperation of third-country suppliers by appropriate means of enforcement. 
The Proposal does not expand upon the issue of enforcement. From the Explanatory Memorandum to the Proposal it is clear that the Commission drafted the amendments with the firm belief that the overwhelming majority of enterprises will comply with their VAT obligations. The driving motivation for such compliance would be the intention of businesses to maintain their goodwill in the “world’s largest market-place.” This pattern of conduct, however, may only be legitimately expected from large, well-known businesses. What will happen to smaller enterprises, which do not have such motivation? 
The importance of answering the previous question is even greater in view of the necessary reduction of the registration threshold. As to the means of enforcement the Explanatory Memorandum vaguely mentions the sanctions of “additional penalty and interest charges” and “civil and criminal sanctions against the managers.” The Commission’s ‘trump’ among the envisaged sanctions seems to be the idea of depriving third country suppliers of the protection of their intellectual property rights in case of their non-compliance with VAT rules. This approach is seriously flawed. First of all, it ignores the fact that intellectual property rights do not only protect the businesses selling copies within the internal market, but also the original authors, who has nothing to do with the VAT obligations of these companies. Secondly, the Commission seems to be disregarding the fact that intellectual property rights are protected under international treaties, interference with which is not in the authority of taxing bodies. 
Unfortunately, even if the Commission offered acceptable sanctions, practical implementation thereof would still be impossible. Namely, taxing authorities, in order to enforce VAT regulations need to identify the infringing enterprises. When trying to fulfill this duty, tax authorities encounter the very same difficulties described above with respect to consumer-identification. Again, the Proposal is short on indications with regard to the technical means necessary for the practical implementation of the proposed rules. Until finding the necessary technology for implementing sanctions on non-compliance the obligation to register would function as a ‘de facto’ lex imperfecta.

	Based on the foregoing the conclusion should be drawn that the Proposal put forward by the Commission is unsuitable for acceptance by the Community. Reasons for this conclusion lie in the theoretical and practical flaws of the envisaged amendments.
On the theoretical level, the imprecise wording, the incoherent structure and the one-sidedness of the Proposal in many questions make it incapable to comfort the interests delineated at the beginning of the chapter. It does not comply with the basic postulates of the VAT system, such as simplicity, neutrality and certainty. Since these principles have been reinforced within the OECD framework, infringement thereof makes the Proposal internationally unacceptable as well. Due to its lacking the response to the whole range of problematic issues and its potential to magnify the consequences of the present dysfunction of the VAT system the draft Directive is unsuitable for the purposes of enhancing the internal market objective. The deficiencies of the theory, by threatening with unexpected tax consequences, have the potential to hamper the growth of e-commerce.
On the practical level the most striking flaw of the Proposal is the lack of technological means necessary for its implementation. The Commission intends to resolve a legitimate policy question independently from understanding the technology required thereby. Nevertheless, policy and practice are symbiotic and need to be developed concurrently, given the ultimate goals of compliance and enforceability. 
The lack of means for compliance and enforcement, apart from discrediting the VAT system and frustrating the goal of creating a level playing field within the Community, has a serious impact on the international acceptability of the Proposal. First, the dysfunction of the VIES prevents foreign businesses to be released from liability by taking advantage of the ‘good faith’ clause. Second, the impossibility of enforcing VAT rules results in discrimination against compliant businesses, the group of which will include a lot of international companies. This scenario is obviously inconsistent with the Taxation Framework Conditions and would lead to serious conflicts with the trading partners of the European Community. 
The foregoing is concordant to the conclusion reached at the meeting of the ECOFIN Council on November 27, 2000. After discussing the Proposal of the Commission together with the opinions of the European Parliament and the Economic and Social Committee, the ECOFIN requested the Commission to rework its Proposal until June 30, 2000.

4.	Alternatives
After establishing the unacceptability of the Proposal put forward by the Commission for the taxation of electronic transactions, this chapter aims at highlighting the possible alternatives of the Community for resolving the problems at hand. Analysis will extend to short-term and long-term solutions.
The ultimate goal of the Community and the OECD is clearly the taxation of electronic transactions. That is, any contrary solution would contradict the fundamental principle of neutrality by positively discriminating in favor of digital deliveries as compared to conventional trade. It should be recognized, though, that coming up with a viable solution for taxing e-commerce and accepting it might take a longer process. Therefore, the Commission should think of alternative approaches for the short term.
One of the alternatives may be the preservation of status quo during the following 1-2 years, until the volume of e-commerce increases significantly. Although, the operation of the European VAT system with regard to electronic commerce is not satisfactory, the negative consequences of not taxing foreign supplies are not acute at present due to the small number of digital transactions, as seen in part III of this essay.
Nevertheless, failing the introduction of the ultimate scheme of taxing e-commerce during the following years, the Community needs to work out an acceptable temporary scheme to handle the expectedly increasing negative consequences of the dysfunction of the VAT system, especially the widening competitive gap between European and third-country suppliers.
Refraining from the application of VAT to European electronic supplies could serve as a temporary solution. In light of the fact that the flaws of the Sixth Directive are the most emphatic with respect to business-to-consumer transactions, relieving these types of supplies from VAT could create equal competition between European and foreign enterprises. Specifically, the author of this paper suggests that supplies of European businesses to European consumers and foreign customers enjoy tax relief.
Following from the policy stating that electronic transactions fall under the scope of value added tax, relieving the above supplies from tax may only be achieved by the application of the respective rules of the Sixth Directive. Title X of the Directive contains the rules providing for the exemption of certain supplies from the VAT. The articles of this Title draw up two separate schemes of exemption, as mentioned earlier. One type of tax relief is generally considered as ‘true’ exemption by the world of VAT, while the other form of exemption is referred to as zero-rating. 
In the following the pros and cons of the two types of exemption will be considered from the viewpoints of e-commerce, the VAT system, the internal market and the international principles of taxation.

A.	Exemption
The scope of exemption under the Sixth Directive covers certain services supply of which is in the interest of the public and some other supplies, where due to the complexity of calculating the added value setting aside taxation is more convenient. Exempting electronic deliveries could be justified under both categories by reasons of lacking appropriate means of taxation and desirability of enhancing the growth of e-commerce.
There are some drawbacks of exemption following from the inability of enterprises to recoup tax. Firstly, as a result of denying tax deduction, the VAT would appear in the books of the business as an absolute cost, which is in contrast with the idea of levying VAT only on final consumption. Secondly, though exemption relieves the business from the administrative obligations under the VAT, the necessity to properly attribute its input tax credits available on taxable sales among the exempt and taxable activities means an increase in the administrative burden. Increased burden could induce non-compliance or decrease in the number of electronic transactions.
Exemption has a drawback from the viewpoint of outbound deliveries of European businesses as well. As stated previously, the European VAT system traditionally handles foreign supplies under the scheme of zero-rating. Therefore, introducing exemption with respect to outbound electronic deliveries would again lead to increased administrative burden on European suppliers with the consequences delineated above.
From the viewpoint of the internal market exemption could create equal competition between European and foreign suppliers in theory. In practice, however, the positive effects of this approach are partly offset by the increased administrative burden following therefrom with respect to European enterprises.

B.	Zero-Rating
The scope of zero-rating under the Sixth Directive covers deliveries concerned with public interest and supplies for export. Zero-rating of electronic deliveries within the Community therefore could be justified by reason of enhancing the growth of e-commerce to increase the welfare of the public. Electronic supplies to foreign consumers could be zero-rated under the general practice applicable to exports.
Zero-rating has some drawbacks following from the right to deduct input tax. Firstly, as there is no outgoing tax liability on the transaction neutralizing input credits, zero-rating might lead to positive payment obligation and increased administrative burden on the side of tax authorities. Secondly, the advantage following from zero-rating may encourage enterprises to test the limits thereof, which practice leads to an increase in the number of litigation.
Nevertheless, the above undesirable consequences of the right to tax deduction are offset by its overall positive effects. Treating the suppliers of zero-rated items equally to other taxable businesses as to the right of tax deduction is closer to the spirit of the ideal VAT system, than exemption. By not resulting in increased compliance and financial burden on the side of businesses, zero-rating is more favorable also from the viewpoint of the common market. 

After drawing the conclusion that zero-rating of electronic supplies is the more desirable alternative, some further comments seem necessary. 
First, when introducing special treatment of electronic deliveries the general premise of the VAT should be kept in mind according to which the only way to ensure efficiency and simplicity of the VAT system is the application of the tax as broadly as possible. Any exemption or special treatment obviously results in increased administrative burden both on the side of the enterprises and of tax administrations. Therefore, whichever of the solutions is chosen, it should strictly be treated as a temporary answer to the problems.
The second comment concerns the justification underlying the discriminatory treatment of electronic vis-a-vis traditional trade. At present, differential tax treatment of the two types of trade may be justified by the lack of feasible technology implementing taxation and the desirability of enhancing the spread of digital trade. With the growth of e-commerce, such justification will not hold anymore. Failing to find appropriate technical means for taxation during the following years, the Community, for the sake of neutrality, would have to consider exempting from VAT the part of physical trade that suffers a competitive disadvantage from electronic transactions until feasible technology becomes available for the taxation of the latter. 
The third comment concerns the amount of revenue loss following from the zero-rating of electronic transactions. Despite the fact that equal competition is more endangered by the dysfunction of the VAT system than the budget of the Community, the impact of special treatment of electronic supplies on Community revenues should be considered. With the growing number of electronic transactions and the rising degree of its substituting traditional commercial activity, an increasing loss in revenue should be expected. Serious revenue loss will probably not occur during the following 1-2 years. The issue at hand, however, would become acute in case of relieving traditional transactions from tax in accordance with the suggestion of the preceding paragraph. In the medium term, therefore, the cut in the VAT revenues will probably necessitate the compensation of the Community budget from other sources. Increase of VAT or other tax rates and similar actions to balance the budget will have to be considered very cautiously and thoroughly in the light of the overall tax policy of the Community and of the Member States. Suffice to mention here that it is a quite complex and sensitive issue.
All in all it seems that non-taxation of electronic commerce should be considered as a short-term, transitory measure. To avoid the negative consequence and difficult questions delineated above, the Community should attempt to achieve results in the field of technological development as soon as possible.

V.	Conclusion

This essay aimed at analyzing the background and wording of the Proposal put forward by the Commission of the European Community to tackle the problems in connection with the value added taxation of electronic trade.  It suggested that the challenges posed to tax systems by the Internet and e-commerce are real. However, the paper showed that the Commission has not chosen the appropriate means to take up these challenges. Focused narrowly on the interests of the common marketplace, the Proposal disregards the real, broader context of the issues and the necessity of technological means to resolve them.
The finding of the paper was that efficient handling of the problem at hand presupposes the recognition of the complexity of interests it touches upon. The bedrock limitation of any approach to this question is the prerequisite to conform to the fundamental principles of value added tax to preserve the functionality of the system. Furthermore, the spirit of collective, international co-operation should characterize the search for appropriate solutions. Such spirit assumes acknowledging the interests of the international trading partners and ambition to enhance the flourishing of electronic commerce. The essay found that the fate of any proposal in this field depends on its ability of striking the right balance between the above interests.
With regard to the practical side of the problematic VAT issues the essay concluded that theoretical soundness of the prospective proposals would not in itself suffice for the implementation thereof. Given that electronic commercial activity has been evolving with the development of technology, its regulation should also be technology-based. What is more, for the sake of effective control, tax authorities must always be a step ahead technology-wise of the parties to the taxable transactions.  This goal has already been recognized in the first Working Paper put forward by the Commission in this field:

“A stronger insight into the technicalities and organisational aspects of the Internet will be needed to equip tax authorities with the knowledge which will enable them to influence the shape of e-commerce structures so that a clear and simple tax framework can be constructed and operated.”

The Commission should find its way back to this objective in the course of rethinking its Proposal. Until identifying the essential technology for the implementation of VAT within the digital world, the negative consequences following from the preferential treatment of Symantec and other foreign companies vis-à-vis European businesses should be addressed by a deliberate temporary solution taking account of all interests delineated above.

***

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