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Tech's Euro tax test
Cash-strapped states eye new European Net tax eagerly; techs rush to comply.
June 25, 2003: 10:32 AM EDT
By Eric Hellweg, CNN/Money Contributing Columnist

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SAN FRANCISCO (CNN/Money) - Starting July 1, it will become more costly for some U.S.-based technology companies to do business in the European Union. On that date, the E.U. value-added tax (VAT) directive, passed in May 2002, will go into effect.

American companies have been enjoying a competitive advantage in Europe: Their customers on the Continent haven't had to pay taxes on certain purchases. No longer. Some U.S. companies and their lobbyists are arguing that they will be at a disadvantage.

Investors should keep an eye on how this directive plays out, since it could cost U.S. tech companies in the short term and serve as a blueprint for a stateside Internet tax rollout in the long term.

Here's a simplified version of what's happening: European Internet companies complained that they were getting shafted, having to collect taxes from their customers while their U.S. competitors in the "electronic services" market (which includes everything from Internet access to auctions and digital services) were offered VAT-free transactions.

Now the U.S. companies will be forced to pay taxes as well. But there's a catch: European companies must collect taxes only if the customer resides in the country in which the company has a nexus office; non-E.U. companies must collect taxes from all 15 member states, which have varying tax rates. Non-E.U. companies also have the option of opening a physical office in a European country and charging only that country's tax rate to its European customers.

Adhering to the E.U. directive will "be an added cost for companies," says Mike McGuire, an analyst with Gartner G2. The expense will likely hit companies in three different ways:

First, there are the operational costs involved with opening additional offices in Europe, training employees, and purchasing software to track customer location.

Second, according to University of Michigan economics professor James Hines, there are the costs involved with a "demand drop" as European customers stop flocking to eBay (EBAY: Research, Estimates), for example, because the site is no longer tax-free. Some companies will likely lower prices to try to retain customers who now must pay more for their goods. This will hurt the bottom line.

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Third, many observers predict marketing costs will increase in countries affected by the change, as firms combat customer drain through advertising.

Obviously, the European market is a big concern -- and hugely lucrative -- for Internet firms. Those I spoke with said they will work to comply with Europe's new law.

"[The directive] will impact all companies who do business in the E.U.," says Patty Smith, an (AMZN: Research, Estimates) spokeswoman. recorded $368 million in international revenue from France, Germany, Japan, and the United Kingdom last quarter, up 68 percent from a year ago.

But the U.S. market is an even bigger concern, and many observers think cash-strapped U.S. states will follow the European example. "It's definitely a harbinger," says McGuire. Since the tax plan has yet to go into effect, however, "it's too early to tell" what kind of role model it will be, he adds.

Tech lobbyists are already sharpening their arguments. "I'm sure some states are eagerly watching what happens in Europe and may try to use the implementation as an excuse to say, Why can't we do the same thing in U.S.?" says Harris Miller, president of the Information Technology Association of America, a Washington, D.C., lobbying group that represents major tech companies such as IBM (IBM: Research, Estimates), Microsoft (MSFT: Research, Estimates), and Oracle (ORCL: Research, Estimates). "But we think [the European VAT tax] should be a substantial concern to anyone interested in free trade and open markets."

Of course, lobbyists are paid to make such dire proclamations, and the truth usually resides somewhere in the middle. I've argued in this space before that stateside Net taxes are inevitable and will likely come sooner rather than later in today's economic climate.

Investors anxious to see how the tech companies in their portfolio handle such a change would be wise to pay attention to comments about their firms' European sales for the next two quarters.

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