The EU's Council of Economic and Finance Ministers agreed earlier this month to require companies outside the EU to collect taxes on the goods and services they deliver digitally to European consumers, such as music, videos and e-books.
The agreement, expected to be approved in February and take effect in 2003, is another step toward ending the Internet's status as a largely duty-free zone, and it complicates the already controversial debate in America about whether to tax the Internet.
Just last month, President Bush signed a bill to extend a ban on Internet taxes in the United States, relieving anti-tax advocates who had to fight off attempts to include a provision that would eventually allow states to tax Net sales. But the bill's supporters were only able to have the ban extended two years--far shorter than they originally hoped.
The concessions illustrate the increasing pressure to tax online goods both in the United States and elsewhere. Led by politicians such as Utah Governor Mike Leavitt, a group of states is working to simplify their sales taxes and make them easier to collect by online vendors.
The EU proposal, which was originally put forward last year, has already drawn questions and objections from businesses and trade organizations in the United States. The biggest question revolves around how the new rule would be enforced.
In the United States, an individual state can't force a company based outside its borders to collect sales taxes if that company has no physical presence within the state. Likewise, the EU may have trouble forcing foreign companies to collect the value-added tax (VAT) if they have no physical presence in the EU.
"The U.S. is not about to set up a VAT compliance arm of the Internal Revenue Service," said Professor Walter Hellerstein, a tax-law expert at the University of Georgia. "I think the EU is going in a direction that it needs to go in philosophically, knowing full well there (are) going to be leaks in the system.
"If nobody complies, obviously it's going to be a problem."
Jim Campbell, a vice president at Beyond.com, which builds Web stores and would be affected by the proposal, said that while his company is prepared to comply, there are still many unanswered questions.
"The biggest question we have is: How is it going to work? What are the parameters and policies?" said Campbell, vice president of marketing. "We're kind of still in limbo in a sense."
Currently, the EU requires its member countries to tax sales of digital goods and services such as e-books and digitized songs at the place at which they are sold. Thus, U.S. stores do not have to collect the value-added tax when they sell to EU customers because the point of sale is not in the EU.
Under the new proposal the point of taxation shifts to where the goods are consumed--meaning U.S. companies selling to an EU customer would have to collect the tax, and EU companies selling to a customer outside the union would not. The proposal has been backed by a number of EU-based companies which consider the current situation unfair.
"We think this is an important step in the right direction," said Katrin Gaertner, head of Germany media conglomerate Bertelsmann's liaison office in Brussels. "We're striving for a level playing field."
The proposal only applies to electronically delivered goods and services. Foreign companies don't have to collect the VAT on physical goods such as CDs or books that they ship to the EU. Instead, consumers are typically expected to pay the tax after they receive a shipment.
The proposal would exempt companies that sell less than 100,000 euros (about $90,000) worth of digital goods and services to EU consumers from collecting the VAT. In an effort to make the tax easier to remit to tax authorities, the EU would require foreign companies to register in only one EU country to pay the VAT.
EU officials say that while they hope companies will voluntarily collect the tax, the union said it will not guarantee the legal protections of companies that do not comply.
"We think that most big players will be interested in (conforming to) the law," said Jonathan Todd, a European Commission spokesman on internal markets and taxation. "If a big player didn't want to levy the VAT on sales to consumers, it couldn't expect much sympathy from us if they were trying to enforce their copyright in the EU."
U.S. businesses also have concerns about the administrative costs of complying with the new rules. Each EU country sets its own VAT rate and foreign companies would be expected to keep track of where they sell each digital good or service and collect the appropriate VAT. Additionally, some EU countries have reduced tax rates for particular products, which could extend online and further complicate tax collection.
"No one's going to appreciate being required to collect a tax," said Jeff Friedman, a tax expert with consulting firm KPMG. While larger companies may be able to shoulder the administrative burden, "smaller sellers won't know about this and won't be able to respond because of the technology required."
It could also spread beyond the European Union, others say. Poorer countries may see taxing digital goods and services originating from the United States and other wealthy nations as a way to shore up their thin tax bases. Instead of having to collect VAT taxes for 15 different EU nations, companies could soon have to collect taxes for dozens of countries around the world.
"That's the biggest fear: that developing countries will see this as the go-ahead to do things that are much more onerous," Friedman said.
There is also the question of precisely defining a "digital good." While all agree that digitally delivered books, music and videos would almost certainly be taxed, other items such as subscriptions to music download sites and Web-based services may fall into a gray area.
"There are probably going to be lots of things that aren't entirely clear," Hellerstein said.
What's unclear to some U.S. observers is why the EU is even tackling this issue now. Despite the popularity of MP3's, few consumers are purchasing digital products online. Meanwhile, the EU has not lost any revenue as a result of digital transactions, said Mark Bohannon, general counsel and vice president of government affairs for the Software and Information Industry Association.
"We think they are chasing unsubstantiated types of losses when it comes to this," Bohannon said. "We think this is driven by un-researched, undocumented concerns that e-commerce is creating."
But Hellerstein said the EU is taking on the issue at the right time.
"All of the prognostications are for this area to grow, and grow substantially," he said. "It's important to not come up with the wrong answer for how this should be taxed."