Under the agreed system, companies based outside the European Union will have to pay the VAT rate in the country where their customers are through one portal country of their choosing. That country would then pass on the VAT of the consumer's country.
The regime covers only business-to-consumer (B2C) transactions. Around 90% of e-commerce sales are business-to-business transactions and these are covered by separate rules. At present, most US firms do not add VAT on B2C transactions with EU consumers.
The new laws "are not discriminating against non-EU companies," said Rodrigo Rato, Spain's finance minister and chairman of the finance ministers meeting held earlier this week.
Firms within the EU that sell digital products or services over the internet will continue to pay VAT at the local rates in their country, although some countries, including the UK, have until now not charged VAT.
Under the new laws EU companies selling to end consumers outside the EU will not have to charge VAT. This will "remove a major competitive handicap" on European firms competing on the world market, said Frits Bolkestein, commissioner in charge of the internal market at the European Commission.
Under the new regime, a US-based software company will have to add 25% onto the sales price of its software if the consumer is in Sweden. A rival company based in Luxembourg will have to add only 15% to the price for the same customer.
This is because the EU company would pay the local Luxembourg VAT rate, the lowest in the EU, while the US competitor must pay the rate charged by the Swedish government.
The US government said the new laws, which will come into effect by July 2003, discriminate against small US firms that do not have a presence in the EU.
Deputy US Treasury Secretary Kenneth Dam said the Bush administration will try to convince the EU during talks at the Organisation for Economic Cooperation and Development (OECD) that the rules are unworkable. The OECD is trying to find a global consensus on taxing e-commerce. If that fails, the US government may lodge a complaint at the World Trade Organisation.
The US made similar threats in 1997, when VAT was imposed on non-EU telecoms providers competing on the European market, said one EU diplomat. "The US government would be naïve to think it can launch a complaint at the WTO," she said.
The laws call for a review of the e-commerce VAT regime three years after the laws come into force. The UK government received backing to develop an online VAT payments system for the whole of Europe, though details remain sketchy. The ministers agreed that such a system could take over from the current regime at the end of the three-year period.
"I am delighted that the Council of ministers has at last been able to agree the important directive on applying VAT to digital products," said Bolkestein. "This measure will remove the obligation for EU firms to apply VAT when exporting to world markets."
The law brings business-to-consumer rules in line with existing laws governing business-to-business e-commerce, which accounts for 90% of all internet transactions, the European Commission said.