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Rolf J. Langhammer

The evasion of VAT for the import of digital services from China is a growing problem for the EU. Rather than waiting for the completion of a European single digital market, loopholes for non-EU suppliers should be closed now. 

A customer uses his smartphone to scan a QR code in Shanghai, China.

In December 2016, the president of the German Federal Audit Office Kay Scheller called the internet a tax haven. According to him, many exports of digital services to Germany such as streaming and downloads of music, software, movies and video games or online payment and communication services went unrecorded. Local importers and consumers did not report their overseas purchases to tax authorities, evading the import value added tax (VAT) for services. What Scheller called a “billion euro market” only generated EUR 28 million in VAT revenues for the German government in 2013.

While tax evasion in cross-border trade of digital services is already an issue in intra-EU trade, Oliver Prothmann, president of the “Bundesverband Onlinehandel,” the German association for online trading, called it “an exploding issue” in trade with third countries. In the past, European authorities have focused on investigating VAT (and tariff) evasion in the trade of physical goods. When it comes to digital services, investigations have typically focused on internet traders based in the United States.

However, digital services represent the bulk of unreported trade today, and the bulk of tax evasion related to this trade originates in China. One reason is that Chinese internet traders such as Alibaba or Tencent have gained market share in the EU at the expense of Ebay and Amazon. The second reason is that many sellers who advertise “VAT-free” transactions reportedly operate from addresses in China while selling via Amazon and other sites to EU customers.

The difficulties of VAT accounting in China

According to the German Federal Audit Office, customs authorities lack the digital equipment to identify tax fraud in the internet and the motivation to sue traders who do not pay the import VAT. This is especially tricky in the case of China: Chinese VAT rules exempt services that are entirely consumed outside of China. Foreign customs authorities fail to record the VAT exemption for Chinese exports of such services, which normally serves as the basis for levying the import VAT. Furthermore, VAT registration in China usually requires a company’s physical presence and involves a lot of paperwork. Businesses in the digital economy therefore fall through the cracks in the regulatory systems. The OECD has estimated that approximately 55 percent of all VAT revenue is not properly accounted for in China.

It fits into this picture that German trade statistics fail to record an exact figure for expenditures for service imports from China and label them as “uncertain.” But evidence suggests that the true share of traded services sold by China to Germany and the EU is substantial. Second, the problem may become more serious in the near future due to the rise of companies like Alibaba, the Chinese giant in cross-border online trade. Alibaba’s payments system Alipay is offered by a growing number of retailers and other service providers in Germany and other EU countries as a mode of payment, since it offers access to China’s consumer market via Chinese tourists for whom digital payment is the rule rather than the exception.

The most clean-cut solution would be abandoning the destination country principle and to charge the VAT at the source of production. This means that products would be charged at the point of export from China. The similar level of VAT in China and Germany (17 percent in China versus 19 percent in Germany) would make this sound reasonable.

But for this solution to work, China would have to change its current system. There would also be obstacles on the German side, as the large number of exceptions from the standard VAT in China would likely raise fears of unfair tax competition. Abandoning the destination country principle is not even feasible within the EU, whose member states have widely differing tax rates and systems of taxation.

Slow progress on the EU’s digital single market

The European Commission is therefore working to create clear rules for a digital single market within the EU, as well as for digital trade with non-member countries such as China. But the development of such a new system takes too long to keep up with the rapid technological advancement and popularity of the digital services trade.

The Commission’s calendar envisages the introduction of this so-called One-Stop-Shop (OSS) for digital service imports not earlier than 2021. The hope is that this mechanism will help to report digital service imports and that it creates incentives for traders to register by offering them a fast-track customs mechanism. Yet, without an overhaul of the Chinese VAT rules on digital service exports, the incentives to sell cross-border digital services without reporting the VAT will continue to exist.

EU tax authorities risk loosing massive amounts of VAT if they don’t find a way to force non-EU suppliers to report their trade and pay the tax as soon as possible. Waiting for a grand solution would be an invitation to traders and consumers to elevate tax evasion to the status of a rule. It should remain an exception.