The demise of the floppy disk and what it means for international tax compliance
Remember the floppy disk? And when getting new software involved sliding a disk into a slot then perusing the instruction booklet while waiting for it to load? Most Gen Zers don’t. Like so much else, software has gone digital.
The digital transformation has definite perks for businesses, especially software and SaaS sellers. It’s more agile, for one, and it’s made shipping delays obsolete. The only things customers need to complete a transaction today are computers or devices and internet service — and that’s on them.
Global sales of digital goods and services are strong, fueled by consumer preference for downloadable goods and businesses’ growing reliance on applications, infrastructure software, and cloud-based technologies. Forrester expects the commercial application and infrastructure software markets alone to exceed $400 billion by 2023, representing a compound annual growth rate of 12%.
But if the digitalization of the economy is a boon for many businesses’ bottom line, it’s a bugbear for their finance departments. The more businesses grow internationally, the more complicated tax compliance becomes.
The tax implications of selling digital goods, software, and SaaS internationally
Cross-border taxes on electronically supplied services first surfaced in the European Union in 2003, when the EU began requiring nonresident firms, including U.S. businesses, to pay value-added tax (VAT) on goods and services sold to consumers in the EU. Since then, more than 100 jurisdictions worldwide have introduced similar requirements.
Companies that sell digital goods and services internationally may need to understand and comply with sales and use tax requirements in the United States, goods and services tax (GST) obligations in Canada and Australia, etc., and VAT requirements in the EU and elsewhere. And where they don’t already have a tax obligation, they likely soon will.
“Taxing foreign supplies of B2C digital services is the clear direction of travel,” says Alex Baulf, senior director of Global Indirect Tax at Avalara. “The number of jurisdictions will continue to increase. It’s a case of when, not if.”
Countries seeking to tax digital services get a leg up
The Organisation for Economic Co-operation and Development (OECD) is in favor of taxing digital services, noting that “VAT is not collected effectively under existing rules” on online sales of services and digital products.
To “help governments secure important VAT revenues and to safeguard an even playing field between brick-and-mortar stores and foreign online sellers,” the OECD is developing a series of VAT digital toolkits in partnership with the World Bank:
- The VAT Digital Toolkit for Latin America and the Caribbean published in June 2021
- The VAT Digital Toolkit for Asia-Pacific published in March 2022
- The VAT Digital Toolkit for Africa is under development
The toolkits provide “detailed guidance for the successful implementation of a comprehensive VAT strategy directed at all types of ecommerce.”
It’s hard to fault countries for taxing digital goods and services sold by foreign providers. Doing so both increases tax collections and removes a competitive advantage for nonresident companies. It levels the playing field the way taxing remote online sales did in the U.S.
But asking businesses to manage 100+ different ways of taxing digital goods and services is a lot. And who has their backs?
Why international tax compliance is tough for software and SaaS businesses (and others selling digital goods and services)
You need to figure out if you have a tax obligation
One of the first hurdles businesses must overcome is determining which jurisdictions currently tax their sales of electronically delivered goods and services, and which plan to tax them in the future.
More than 20 countries require all nonresident sellers of taxable digital services to register, no matter how great or meager their sales. Other countries base a GST or VAT registration requirement on a certain volume of sales in the country, the way states (that have a general sales tax) in the U.S. all have an economic nexus threshold for remote sales tax. Businesses therefore need to monitor their annual sales volume in those markets so they’ll know when they trigger a tax obligation.
For example, Canada’s threshold is CA$30,000, and the threshold in the Bahamas is B$100,000. Countries like Canada that allow local taxes on top of federal taxes create another layer of complexity. Provincial tax obligations kick in for businesses whose sales exceed CA$10,000 in British Columbia and CA$30,000 in Quebec, but in Manitoba and Saskatchewan, remote sellers may be liable for provincial taxes from the first transaction.
Bear in mind that in some countries, like Switzerland, the threshold is based on global revenue. And while most countries only include B2C sales in the threshold, some may include both B2C and B2B transactions.
Avalara tracks VAT and GST on digital services and can help you monitor new and changing obligations in key international markets.
You need to know where your customers are
If you have to deliver something like a plant or a table to a customer, you can bet your customer will provide their delivery address. But if you’re sending digital goods or software to the cloud, securing a customer location at the point of sale isn’t strictly necessary. As a result, the location of the customer may not be captured.
And what is the correct location, anyway? The nature of digital products and services makes it difficult to pinpoint. How should a business source a sale for tax purposes if the services sold are used in six different offices and by an unknown number of employees at various locations? Or if a customer who resides in France purchases and downloads an ebook or streams a movie while on holiday in Spain or Sweden?
There are different ways to solve this problem, such as sourcing the sale to the customer’s billing address or the Internet Protocol (IP) address of the device used. Geolocation software can also be used to pinpoint the location. It falls to businesses to learn each country’s requirements and, if they don’t already have them, develop the tools to comply with those requirements. In the event of an audit, businesses will need to be able to substantiate how they’ve sourced such sales.
You need to apply the right rate to each transaction
The location of the transaction is key to determining taxability rules and tax rates, since GST and VAT rates vary by country (and sales tax rates vary by state). In the EU alone, VAT rates on e-services range from 17% to 27%, depending on the country. The rate in Andorra is 4.5%; the rate in Iceland, 24%.
Canada GST applies to most taxable sales of digital goods and services, as does the harmonized sales tax, or HST (a combination of federal and provincial goods and services taxes in five provinces), and rates vary depending on the location of the sale. Transactions that are subject to GST/HST may be exempt from local sales tax in the provinces that don’t participate in the HST but do levy a provincial sales tax (PST): British Columbia, Manitoba, Quebec, and Saskatchewan. There’s a lot of detailed information in this Bloomberg Tax article.
Tax can also vary depending on the product or service sold, how it’s sold, and even the type of customer. In Canada, for example, the person required to charge and collect the tax due can be affected by whether sales are made directly or through a distribution platform, how the business is registered, and whether the recipient’s residence is usually in Canada or elsewhere.
Tax compliance challenges for all global sellers
The challenges for digital services providers don’t end there. Like other companies with an international clientele, they must register with the tax authorities, comply with various reporting requirements, and file returns as necessary.
You need to register with tax authorities in multiple countries
Registering for GST or VAT in different countries can make registering for sales tax seem simple. Though it may be a fairly straightforward process in countries that have introduced self-service portals in English, it can also be quite complex.
Many EU member states require non-EU businesses that provide taxable services in the country to appoint a fiscal representative. Fortunately, businesses can register through the Non-Union One-Stop Shop (OSS) return, a single streamlined Pan-European registration that allows a business to charge, collect, and remit VAT on all B2C digital sales across the 27 EU member states.
Read about the difference between Union and Non-Union OSS.
You may need to comply with different invoicing and reporting requirements
A growing number of governments worldwide are implementing electronic invoicing and reporting requirements. Thus, instead of seeing only a sample of paper invoices, tax officials can examine transactional data in real time.
Real-time compliance mandates are helping reduce the VAT gap — the difference between the tax due and the tax actually collected — which is considerable. The European Commission estimates EU member states lost about €134 billion in 2019 due to tax fraud and inadequate tax collection systems.
The challenge for businesses, of course, is building the capability to both issue and receive e-invoices and comply with e-reporting requirements as they emerge.
You probably don’t need to worry about HS codes … yet
One thing providers of digital goods and services generally don’t need to worry about today is Harmonized System (HS) codes, the codes assigned to tangible products shipped across international borders. HS codes are linked to international tariffs: If you assign the wrong code to a product, you may end up with the wrong tariff.
Customs officials frown on that, of course, so assigning the wrong code to products can cause shipping delays while everything gets sorted out. It can also lead to fees or fines or cause your shipments to be seized. Businesses that are repeat offenders may be flagged for more thorough inspections, which will cause delays.
HS codes can be a weak spot for many businesses, but they shouldn’t be a problem for businesses that sell digital goods because the World Trade Organization (WTO) banned countries from applying customs duties on electronic transmissions.
That could change.
A 2019 report by the United Nations Conference on Trade and Development (UNCTAD) said developing countries lost about $10 billion in tariff revenue in 2017 because of the WTO’s moratorium. UNCTAD also found that there were $116 billion in physical imports of 49 digitizable products (e.g., audiovisual works, books, and computer software) in 2017 instead of the estimated value of $255 billion. This suggests there were about $139 billion in online global imports, or global imports via electronic transmissions, that weren't subject to customs duties.
Given the revenue losses and the growing global market for digital goods and products, there’s a good chance there will be tariffs on intangible goods at some point in the future.
How you can simplify international tax compliance
According to a 2021 Avalara/Potentiate survey, small and midsize businesses generally spend a combined 163 hours and $17,672 on sales tax compliance every month. Software companies spend an average of 121 hours per month on tax management activities.
And that’s just for U.S. sales taxes. Tracking down and complying with VAT or GST requirements takes more time and more resources.
Minimize missteps and risk with tax automation
Automating tax compliance helps reduce errors. It’s a cost-effective, efficient way to manage international tax compliance. See our solutions for digital services and software for more details.
Stay up to date
Sign up for our free newsletter and stay up to date with the latest tax news.