Luxembourg and e-services: a perfect match

Luxembourg is increasingly seen as the “place to be” for businesses offering electronic services in Europe. There are several compelling reasons for a business to consider setting-up in Luxembourg. Those revolve around Luxembourg’s situation at the heart of Europe and its reputation for its accessible and business-friendly government. Other features that explain the attractiveness of the country are its competitive corporate tax environment -which includes special rules regarding the taxation of revenue out of the exploitation of IP (Intellectual Property)- and its state of the art IT infrastructure. This article focuses on one particular factor that has made the country particularly attractive to companies active in e-services and which lies in the way VAT ¹ applies to the supply of e-services ² .

What is VAT?
The rules governing VAT were largely harmonized across the European Union ³ when the 6th European VAT Directive was adopted in 1977. Nevertheless, there are still major differences notably between VAT rates in the various Member States. Based on current rules, standard rates of VAT in the EU vary from 15% to 25%.

As far as VAT-able transactions between businesses – “taxable persons” in VAT jargon – are concerned, the rate of VAT has no direct impact on the cost of services. Generally speaking, at each stage of the manufacturing or sales process, taxable persons will be required to charge VAT to their clients and remit the tax to the relevant authority. They will however also be allowed to deduct the VAT amount they incurred on the goods and services acquired (input-VAT) from the amount of tax to be transferred to the tax authority. In case of cross-border transactions between business parties the VAT due on the turnover is often not charged but accounted for by the customer (reverse-charged). In that case, where the customer is allowed to entirely recover VAT on purchases, he/she only needs to make the relevant VAT accounting entries.

As a result of this VAT mechanism, the tax is effectively borne by the end-consumer (mostly private persons) as part of the purchase price of the good or service. VAT is therefore an important cost component in business-to-consumer (B2C) sales. In this context, the lower the VAT rate, the more competitive the sales price can be. Also, at constant sales prices, the lower the VAT rate, the higher the seller’s margin will be.

Luxembourg has the lowest standard VAT rate in Europe (15 %) along with Cyprus and Portugal’s autonomous regions ⁴ , and thus has a real competitive edge in B2C relationships.

VAT on e-services
The VAT rate that must be applied on any given transaction depends on the deemed place of supply for VAT purposes.

In principle, the place of supply of services rendered to private persons is deemed to be in the country of the service provider, who charges VAT at the rate applicable in the country where he has established his business and remits this tax to the authority in the country of establishment.

ESSs (Electronically Supplied Services) ⁵ were not contemplated in 1977 when the Sixth VAT Directive was adopted. Since these services were not governed by any specific rule, they were therefore taxed where the supplier was located. Consequently, whenever these services were provided by suppliers located outside the EU to EU consumers, they were provided free of VAT, while EU businesses providing the same services were required to charge VAT.
The manner in which general VAT principles were being applied to ESS thus created a blatant distortion of competition at the expense of EU-based e services companies.

In 2002 ⁶ , to level the playing field, the EU Council adopted a Directive which addressed issues specific to ESS. This Directive includes provisions governing the place of supply of ESS. It also introduced VAT rules for non EU businesses providing e-services to EU consumers.
Under this Directive, which came into force on 15 May 2002, non EU companies are required to charge VAT on each sale to European consumers at the rate applicable in the consumers’ country of residence. For instance, a US-based company will have to charge French, German or Italian VAT on its online music sales to EU consumers who live in France, Germany or Italy respectively.

To facilitate VAT compliance in this situation, the 2002 Directive also provides for a special scheme whereby non EU based companies can elect to register for VAT and file their VAT returns with a single VAT authority in a Member State of their choice. Every three month, those companies must declare and pay the amount of VAT charged on their sales in the various EU Member States with this VAT authority. Along with the payment, they must file an electronic form showing a breakdown of their sales in each EU Member State. Based on this information, the Member State which collected the VAT will distribute the VAT revenues among the Member States where the consumers live.

Non EU based companies did not exactly fall over themselves to adopt this system, which involves a good deal of red tape. Furthermore, since VAT rates vary depending on where consumers live, no-EU companies found themselves faced with a complicating factor when it comes to pricing the services.

The obligation to charge the VAT of every single Member State where there are customers only applies to non EU-based companies. Therefore, most non-EU based companies decided to establish an EU bridgehead. Indeed, once they are established in the EU, e services companies are governed by the normal VAT rules under which ESS are taxed in the country where the service provider is located. Consequently, those services will then always be subject to the same VAT rate, regardless of the EU country where the customers reside. Companies which opt for that solution are therefore able to cut down on the red tape and offer a single price to all European consumers.
When it comes to choosing a suitable EU country, companies looking to provide competitively priced services and/or retain their sales margin have naturally given preference to the country combining excellent business environment with the lowest VAT rates: Luxembourg.

VAT on goods ordered online
It’s important to distinguish e-services from supplies of goods ordered online where different rules apply. These rules are referred to as the “distance sales” rules. Under those rules, a business is authorised to charge VAT to private consumers at the rate applicable in the country where it is established only if its sales to residents of other EU Member States do not exceed certain thresholds which vary from one EU country to the next.
Once the threshold exceeded, the business will be required to charge VAT at the rate applicable in the country where the goods are delivered. The purpose of this rule is to preserve Member States' tax revenue and to keep mail-order companies from VAT rate shopping.

Future changes to the VAT rules for ESS
VAT is a consumption tax and it should therefore in principal accrue to the country where the goods and services are effectively used and enjoyed. Since many EU Member States have expressed their willingness to apply this principle also for ESS (now that these services are increasingly generating VAT revenues), the rules governing ESS have been reviewed at the European level. The search for a feasible solution and one which would not stunt the growth of ESS in the EU has resulted in a trial of strength between Luxembourg and the other EU Member States as their representatives met during ECOFIN ⁷ meetings.

After some intense discussions over amendments and counter-amendments to current rules, Member States agreed to change the current VAT rules effective 1 January 2015 ⁸ . From that date onwards, ESS should no longer be taxed where the supplier is located but in the customer’s country of residence. Luxembourg will at that time cease to be an attractive location from a VAT standpoint. Nevertheless, VAT is only one of the factors explaining Luxembourg’s attractiveness. Also under the compromise reached the European Commission shall, before the end of 2014, submit a report on the feasibility of applying efficiently the new rules. One may justifiably wonder whether the matter has been settled once and for all.

Conclusion
The commercial reasons for setting-up business in Luxembourg are very compelling. VAT is an important but definitely not the only driver for a business to consider setting-up a bridgehead in Luxembourg. To quote Carsten Dierksen, Managing Director of iTunes in Luxembourg: “Luxembourg offers excellent location to reach our customers and main business partners in Europe and to find motivated and mobile employees with great language skills. The Government is very supportive to business.”

¹ “VAT” is the acronym of “Value Added Tax”, the main tax on consumption in the EU.
² The ‘VAT factor’ makes the country equally attractive for broadcasting and telecom activities.
³ Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, United Kingdom.
⁴ Madeira and Azores.
⁵ Electronically supplies services, were defined in Council Regulation (EL) n° 1777/2005 of 17 October 2005 as “services which are delivered over the Internet or an electronic network and the nature of which renders their supply essentially automated and involving minimal human intervention, and in the absence of information technology is impossible to ensure.
⁶ Directive 2002/38/CE of May 7, 2002
⁷ The name given to the EU Council of Ministers when it meets in the form of EU ministers for finance and economy.
⁸ Directive 2008/008/CE of February 12, 2008 – Article 5