Digital blur: goods becoming services
As a result of digitization, items that were previously supplied as goods are rapidly becoming supplied as services; examples include printed books and CDs (goods) that are being sold as electronic books and music downloads (services).
In addition, even where there is a supply of goods, it may be accompanied by a supply of services; for example, when a game player buys a computer game on disc (goods) and then downloads additional features online (services). These changes are having a significant impact on the value chain and on the application of indirect taxes.
Key indirect tax issues
Various indirect tax issues arise from the shift from trading in goods to trading in services, including:
- Cloud manufacturing
Cloud manufacturing is a new, networked manufacturing model. Basically, in cloud manufacturing, manufacturing resources and capabilities are connected through the internet and are managed and controlled using technologies which can then be accessed, invoked and deployed through cloud computing technologies. As cloud manufacturing is basically a service or collection of services aimed at producing physical goods, the activity gives rise to the question of whether the supply should be qualified for VAT/GST as a supply of services or as a supply of goods or even as different supplies. This question is most significant for cross-border supplies or for the manufacture of goods subject to VAT/GST at a reduced rate (such as pharmaceuticals). In the EU, while the Court of Justice of the European Union (CJEU) has in the past provided some criteria for identifying the nature of this type of supply, it is worth noting that those CJEU decisions referred to different scenarios and therefore their application do not always offer the legal certainty needed for concerned businesses to act with digital tax confidence.
- 3D printing
Customs duties apply to imports of goods not to imports of services (although some service elements may be dutiable as part of the customs value). The widespread use of 3D printing at the customer’s premises is likely to increase the trend towards shifting the value chain to services. In traditional manufacturing, a manufacturer makes a product and ships it as an item of goods to the customer. VAT/ GST and customs duty (if applicable) are calculated on the full value of the goods. However, 3D printing changes the relationship. The manufacturer typically sells the design and knowhow (which is a service) and the end-customer purchases the raw materials to print out the item (goods), often purchased from a separate party. The value assigned to the goods is likely to be low compared to the service element. In this new environment, questions may also arise on the customs duty implications of intellectual property or design investments.
Read more in our article How could 3-D printing upend tax strategies?.
- Loss of indirect tax revenues
The shift away from physical importations and the reduced value attributed to goods in mixed supplies may have a significant impact on customs revenues for some countries. Potentially, customs authorities may seek to increase the dutiable value of imported goods (see below) or governments may seek to make up this shortfall in higher VAT/GST rates or through additional internet taxes. Governments also risk suffering a loss of tax revenues if e-services are not subject to consumption tax, if cross-border services are not subject to VAT/GST, or if there is no effective way to collect the VAT/ GST due (e.g., from final consumers).
- Royalties and license fees
Current WTO Valuation Agreement Article 8.1 (C) states that royalty and license fees related to imported goods must be paid as a condition of sale are dutiable. Historically, in most jurisdictions, a transaction can be structured so that payment of the royalty is not a condition of the product sale. WCO Technical Committee on Customs Valuation (TCCV) — Advisory Opinion 4.15 confirms concept that “control” over the purchasing environment can create a practical condition of sale. WCO states that “each case must be considered individually.” There is no comprehensive list on elements of control which are often part of normal commercial arrangements. The latest draft of the EU’s Union Customs Code stipulates three rules with the condition of sale, which may result in more cases of royalties and license fees being included in the custo ms value of goods imported into the EU.
- VAT/GST registration and compliance obligations
Vendors of digital services may encounter additional indirect tax compliance obligations that did not apply to sales of goods (because they were taxed at the border by customs). Complying with their obligations is likely to have an impact not only on their accounting systems but also on their customer contracts, pricing and customer interface. This issue is discussed in more detail later in this document.
- Different VAT/GST rules for goods and services
Although supplies of goods and services generally fall within the scope of VAT/GST, different rules apply which may include the time of supply, and the place of supply for cross-border sales and even whether a supply is recognized at all (e.g., if there is no payment). Digital goods may be subject to VAT/GST at different tax rates than physical goods, even if the supplier considers them to serve equivalent purposes (for example, printed books may attract a reduced VAT rate in the EU but digital books do not). These differences may have an impact on profitability and create distortions of competition between businesses. Complying with these rules requires the supplier (and potentially the customer) to be aware of the different rules and apply them correctly for each transaction.
- Mixed supplies
Many supplies now involve both goods and services (e.g. a boxed game sold with a voucher to download characters). The VAT rules for mixed supplies and for the redemption of vouchers are highly complex, which may increase the risk of errors. The VAT rules on vouchers are complex, and can vary between EU Member States, due to the absence of harmonized VAT rules across the EU. This could lead to potential double or non-taxation. The European Commission is currently in discussions with all Member States to generate harmonized VAT rules on this issue. There may be potential VAT saving opportunities for businesses that sell subscription-based products to restructure these products into vouchers.