For businesses providing or hoping to provide electronic services over the Internet, life will get more complicated when a revised EU directive on value-added tax (VAT) goes into effect on July 1.

The EU's move to capture VAT from foreign companies doing business over the Internet will harm efforts by jurisdictions like Bermuda to attract offshore Internet-based businesses.

The EU directive will affect all businesses that provide digitally downloaded services to individuals residing in the EU. Currently, only EU businesses in the 15 member countries have to charge VAT on purchases of "electronic services".

From July 1 all businesses, including those based outside of Europe, will have to comply with the revised directive.

The E-commerce directive applies to "online services", broadly defined and including downloaded software, music and images, online news services, publications and games as well as education, entertainment and satellite broadcasting. The revised directive attempts to ensure consumers will no longer be able to order services from non-EU countries, such as Bermuda, to avoid paying VAT on such electronic services. Suppliers outside the EU will have to charge the VAT rate in the EU country where the consumer resides. "The means of achieving this apparently simple objective are complex and involve important changes to the VAT 'place of supply' rules," Peter Jenkins, the global head of Ernst & Young's indirect tax division, warns. "These changes place new and onerous obligations on suppliers of online services who are not based in the European Union, but whose customers are. Failure to recognise and comply with these obligations - whether wilful or not - could lead to heavy penalties in each member state where non-compliance occurs."

For non-EU businesses supplying services electronically to another business based in the EU (known as B2B services) the onus on paying VAT is left to the business customer who, being registered for VAT, can self-assess for the VAT. The real problem for non-EU businesses will be in setting up their systems for EU residents.

The act of supplying an online service to final consumers will trigger an obligation for the supplier to register and account for VAT in the EU.

To ease the headache a bit, a business supplying electronic services in the EU but which does not have an "establishment" in a member country can take advantage of a special scheme.

Under EU VAT law, a business is "established" in a country where it has sufficient "human and technical resources" to undertake the activities that it carries out.

Conversely, when an online service is "consumed" outside the EU, no VAT should be charged, according to an analysis by E&Y's Jenkins. Under the scheme, the business will be able to register and account for VAT in one EU member state rather than register for VAT in each territory where it supplies services.

The business will still have to calculate VAT at the rate applicable to the country where the customer lives. This scheme will become more important when a further 10 countries join the EU on May 1, 2004. Jenkins also suggests another alternative. A non-EU supplier could choose to establish a subsidiary or branch in one member state from which to supply its online services. It would then register for VAT in that member state, and so be able to pay VAT like any other EU-based business. For EU businesses the rule is that the "origin" rate of VAT is charged to final consumers anywhere in the EU. This means that the rate of VAT charged is the rate that applies in the member state where the supplier is registered for VAT, not the member state where the customer resides, Jenkins says.

This would make low-tax EU-members, like Luxembourg, an attractive for non-EU businesses to locate an office so as to be able to keep prices attractive for their clients. Standard EU VAT rates range from 15 percent to 25 percent, although there is a special 13 percent rate in Madeira that is due to be phased out. For those interested in determining if they will be affected PricewaterhouseCoopers has launched a tax website at www.pwcebiztoolkit.com to help businesses determine whether their products fall under the category of 'electronic services' in the EU's e-business directive.

Meanwhile the US continues to tussle over allowing the various states to charge VAT on goods and services purchased via the Internet.

In a related issue a US House of Representatives subcommittee voted last week to make permanent a ban on Internet-specific taxes, and turned down the states attempts to link it with the more controversial effort to allow online sales taxes.

he Subcommittee on Commercial and Administrative Law passed a measure by voice vote that would make permanent a ban on states assessing "multiple and discriminatory" taxes on Internet access fees and online traffic.

The current three-year ban on such taxes was due to expire in November. States are currently prohibited from assessing online sales taxes under a 1992 Supreme Court decision that forbids them from taxing catalogue, telephone and other remote sales.

The subcommittee said it would hold a hearing to examine state efforts to simplify their sales-tax codes, which would make collection of such taxes for Internet sales less difficult.

Taxware, a software developer, will hold a seminar on the directive on Wednesday, June 11, at 1 p.m. Bermuda time at www.taxware.com/euwebinar.htm.