It has been three years since the biggest and most ambitious expansion in the EU's history. On May 1 2004, 10 countries (the Czech Republic, Poland, Hungary, Slovakia, Slovenia, the Baltic States, Malta and Cyprus) joined the EU, increasing its population by 75 million people to 453 million. On January 1 2007, when Romania and Bulgaria joined, this figure grew further, adding nearly 30 million more citizens.

Business advisers looked forward to the new challenges and opportunities which the enlargement of the EU would bring; the increased scope for using shared service centres on the grounds that so many more countries would be operating from a standardised basis of VAT legislation was just one example. Teething problems were anticipated and ensuring that all member states were working from the same standard was set to be a significant challenge.

With the dust from EU enlargement now settling, this seems like a good time to review some of the indirect tax consequences of expansion. First, in looking for evidence of how well (or not, as the case may be) the new member states have fared, there is some unsettling evidence of the extent to which the older member states continue to defy the European VAT directive.

Second, the enlargement of the EU to include such a large number of countries wishing to emulate the economic turn around of certain other EU members (notably Ireland and Spain) has created a real sense of tax competition. Has this improved the indirect tax environment for corporate taxpayers?

Who is the most compliant?

According to recent statistics published by the European Commission (see table 3), Lithuania is the most compliant in terms of notifying its implementation of EU directives. Directives are European legislation that each member state is required to implement into its domestic law, so the level of implementation is a key measure of compliance. Perhaps less surprisingly, Romania is in bottom place and Bulgaria is 23rd. However, three of the top four positions are held by countries that joined the EU in May 2004 and eight of these 10 joiners are in the top half of the table.

Looking at the statistics in terms of broad groups comprising (1) the original 15, (2) the 10 who joined in 2004 and (3) Bulgaria and Romania, the percentage of directives with which the member states have notified compliance are respectively: 98.91%, 99.33% and 97.445%. In short, all of the new joiners with the exception of Romania, Bulgaria and (marginally) Poland have a better record of implementing directives than the average older member.

So it would appear that, in terms of implementing directives, the EU's newest members have taken their obligations seriously and have for the most part a much better record of compliance than older members of the EU.

But is this general trend also reflected in specific areas of indirect taxation? During 2005, the Commission carried out a process of screening the legislation of the new member states to check it was EU compliant. According to its annual report Monitoring the Application of Community Law, EU enlargement was one of the reasons for the increasing number of infringement cases that year. However, the indirect tax proceedings which the report singles out as most worthy for note are those taken against the UK (the requirement to have a VAT invoice to support claims for VAT on employee fuel costs), Spain and France (rules limiting the right to deduct input tax).

A review of the Commission's press releases relating to infringement procedures in recent years also confirms that the new member states have not featured heavily in high profile cases: since January 2005 the Commission has issued 11 press releases relating to VAT infringements, which cite a total of 29 counts of non-compliance. Of these citations only four involve new member states (the Czech Republic, Hungary, Malta and Poland). These were all in the same case concerning the unauthorised application of a reduced rate to children's nappies.

The new member states fared less well in the Commission's campaign against car taxation policies that impede effective cross border trade. Recent press releases identify 11 counts of non-compliance, of which six have been against new members.

Three years on and there have also been very few tax referrals to the European Court of Justice (ECJ) from local courts in the new member states. To date, only the Hungarian courts have referred a number of cases seeking clarification of whether local business tax is an illegal turnover tax (the European VAT rules prohibit other turnover taxes that are similar to VAT) and a Polish court has referred to cases seeking clarification of whether their 30% mis-declaration penalty and security deposits link with VAT repayments are permitted under EU VAT law.

So there is little evidence in the form of hard statistics to point to serious non-compliance on the part of the new joiners. On the contrary, formal infringement proceedings have been notable by their absence.

Train the trainer

While illustrating general trends, statistics do not tell the whole story (the Rt. Hon. Benjamin Disraeli's phrase, "lies, damn lies and statistics", springs to mind).

For instance, it should not be forgotten that the formal infringement process is only brought into play after informal discussion and prompting by the Commission has failed. Also, the Commission doesn't have full sight of the many challenges being faced by companies in the new member states.

It is worth pointing therefore to some of our experiences of where the new member states have struggled to harmonise their VAT laws but where formal infringement proceedings have been averted – sometimes, it must be said, by using the Commission and the threat of formal proceedings as a stick.

There are a number of cases where businesses have faced significant challenges in the new member states that joined in May 2004. However, some countries have now amended their legislation or practice.

A good example of this kind of success is in the Czech Republic where legislation to correctly extend the VAT exemption for education to international schools was introduced. This was achieved after much lobbying of the local tax authorities, the Ministry of Finance and politicians involved in the review of new education legislation. This is just one example. Others include Hungary and Poland's amendments to their invoicing requirements shortly after accession and Poland's correction of the VAT treatment of software services.

In summary, if there is a message to be taken from the statistics and examples of compliance with EU law it is that there is a genuine desire in the new member states to get it right and to avoid being brought before the ECJ for getting it wrong. There is still a long way to go in many of the new member states – as illustrated by the case studies in Bulgaria and Poland where local legislation and practice is still at variance with the EU standard. However, progress is being made.

Case study 1 – VAT infringements in Bulgaria

Bulgaria and Romania are the newest entrants to the EU and have a relatively poor record of compliance to date. The only case of the European Commission starting infringement proceedings is against Romania in relation to car taxation (above). However, the following are all areas where the Bulgarian VAT legislation continues to follow pre-accession practices that are in clear conflict with the European VAT directive:

Fiscal representatives - All foreign taxpayers are required to have a Bulgarian fiscal representative before they can register for VAT. Under the European VAT directive this requirement is only permitted for non-European taxpayers; European taxpayers are entitled to register for VAT without any local representative.

Invoicing rules - Invoices still need to be prepared in Bulgarian and physically signed by an authorised person on behalf of the taxpayer. The European VAT directive does not permit any language requirements for invoices (although tax authorities can require them to be translated to assist with an audit) and specifically prohibits requiring any kind of physical signature.

Branches – Supplies between a foreign company and its Bulgarian branch are subject to VAT. The FCE Bank case (C-210/04) confirmed that the European VAT directive does not, generally, tax supplies that take place between the branch and head office of a single legal entity.

Each of the above infringements causes considerable issues and increases costs for companies doing business in or with Bulgaria.

Case study 2 – Clinical trials in Poland

One of the prompts for this article is an issue in Poland relating to clinical trials for pharmaceutical companies, where the trials are carried out for businesses in other EU states.

The EU VAT directive provides specific rules for determining the correct VAT treatment of services between entities in different countries and under EU law it would generally be accepted that the customer would not be required to pay Polish VAT on these services, as they are deemed to be supplied where received. Unfortunately, the Polish are insisting that Polish VAT should be paid because their VAT law continues to refer to their domestic statistical classifications to determine the VAT treatment of services.

The result – a business venture designed to take advantage of the widening borders of the EU and the lower cost of services in the new member states comes with a hidden VAT cost. There are ongoing discussions with the Polish tax authorities and the EU Commission to try and resolve this issue.

The use of domestic statistical classifications is not unusual in the ex-communist countries. For example, the Czech Republic, Slovakia and Hungary also refer to domestic statistical classifications in their tax rules. In Hungary, for example, they are used to determine which services are VAT exempt and the VAT treatment of real estate transactions. Crucially though, these countries appear to accept the supremacy of EU law over their domestic statistical codes.

Older member states

But can the same be said of some of the older member states? France and Italy have particularly poor compliance records when it comes to implementing EU directives in general – and indirect tax rules in particular – and this trend shows no signs of reversing. France is currently facing action due to the new anti-avoidance rules introduced in September 2006, which discriminate against non-resident entities (although this has yet to result in formal infringement proceedings) and its application of a reduced rate for lawyers providing services under legal aid. Italy is currently being challenged for its violation of some fairly fundamental principles such as the obligation to pay VAT (its VAT amnesty allows payment of a flat fee or a small percentage (2%) of the VAT which would have been due and exonerates businesses from the usual requirement to account for VAT per transaction and from future scrutiny of the true liability) and the right to recover VAT (the set percentage of input tax recovery on vehicles).

The UK also has issues when it comes to current infringement actions in relation to indirect taxes, although issues around invoicing (for example the requirement for a VAT invoice to support claims for VAT on employee fuel costs) and the currently proposed invoicing rule changes required by the Commission (which are likely to include a new requirement to use sequential numbers for invoices and to issue VAT invoices to overseas customers for exempt (without credit) supplies) illustrate that the European rules don't necessarily make life easier for business.

Competition

The desire of many of the new members to create an attractive tax environment has been clearly demonstrated in relation to corporate income tax rates. This is understandable given their need to attract foreign direct investment to help them catch-up economically with the older, more affluent members of the EU. The gap between old and new is slowly diminishing but we should not lose sight of it: for example, in 2004 the combined GDP of the 10 joining countries was broadly the equivalent to the GDP of the Netherlands.

In addition, the relatively small distances between many of the new member states' urban populations mean consumers can and do cross borders to shop: it is not so difficult to make the short drive from Budapest to Bratislava to buy a new television if Slovak taxes make the same product cheaper than in Hungary.

It is not surprising that EU enlargement has had an impact on VAT rates. Under the EU VAT directive there is no single EU unified VAT rate, but standard rates must be between 15% and 25%. A number of the new members with rates towards the top of this band reduced them around the time of their accession: Hungary reduced from 25 % to 20%, the Czech Republic reduced from 22% to 19% and Slovakia introduced its famous flat tax with a single rate of 19% for VAT, corporate and personal income tax (see table 1).

The opportunity to create a more attractive indirect tax environment was also not lost on many of the new member states. The EU VAT directive gives member states discretion in a number of areas to introduce business friendly simplification measures and a number of the new member states have taken advantage of these opportunities (see table 2).

The adoption of these measures demonstrates that many of the new member states have been willing to listen to companies and their representatives who have pushed for the adoption of these simplifications.

There is also evidence of some of the older member states improving their own indirect tax environment in direct response to the accession of new members. A good example of this was the introduction by Austria of import VAT deferral arrangements with effect from October 1 2003. This measure was adopted by Austria to avoid losing trade (and customs duty revenue) to its neighbours who have the simplification, that is Hungary or the Czech Republic.

Table 1

Table 2
Simplification	VAT grouping	Call off stock	Consignment stock	Supply & Install	Extended reverse charge	Import VAT deferral
Country
Bulgaria						Available to taxpayers implementing special investment projects
Cyprus				Previous notification from tax authorities required.
Czech Rep
Estonia						From 1 January 2008
Hungary	Financial services companies					Available to taxpayers holding special Customs Authority permits
Latvia	Date not known					Date not known
Lithuania		Since January 1 2007				Available to taxpayers holding special Customs Authority permits
Malta						Available to taxpayers holding special Customs Authority permits
Poland		Date not known				Date not known and limited scope is expected.
Romania						Available to taxpayers whose imports exceeded the amount of EURO 45 million in the previous year
Slovakia
Slovenia
Simplification not available     Simplification to be introduced      Simplification available

Table 3

It's never that simple ... competing demands

Despite its underpinnings in the European VAT directive, VAT remains a political pawn and the development of the VAT rules and practices adopted in each EU country is still affected by the political aspirations and requirements of the ruling government.

All of the new member states are required to replace their existing local currencies with the Euro within the mid term, which means that they must meet the strict borrowing rules set down by the European Central Bank (including the limit on borrowing of 3% of GDP). This is increasing the pressure on governments and tax authorities in the new member states to protect tax revenues at a time when corporate income tax rates have been reduced and continue to fall.

With this in mind, VAT can be an effective and relatively reliable mechanism for securing additional tax revenues and making up the gap, as demonstrated by Germany, who raised its VAT rate from 16% to 19% with effect from January 1 2007. We can expect to see similar pressures on VAT in the new member states. For example, Hungary has recently abolished its interim reduced rate of 15% and the Czech Republic is currently considering a proposal to raise its reduced rate by over 55% from 5% to 9% and has still to introduce the long promised earnings cap on social security contributions.

Pressure to balance the books is likely to come through in the approach that tax authorities in the new member states take to dealing with VAT controls and disputes with taxpayers.

The importance that domestic politics can play in facilitating indirect tax policy can also be seen in Slovakia where the change to a more 'socialist' government has resulted in the reintroduction, with effect from January 1 2007, of a reduced rate (10%) albeit that it only applies to a limited range of drugs and medical equipment.

Drive to harmonise

The European landscape has changed radically in the last three years with the introduction of 12 new members. These members have made great strides to harmonise their domestic legislation with EU directives and their record of compliance is generally good. Nonetheless, there remain gaps and the opportunity to influence the process to bridge these gaps. In this sense, we are all still working towards the same standard, even though in truth the complexity of the European VAT system conspires against us (witness the continuing infringements in countries who have been working with the tax for years).

Patrick Walker is the UK head of indirect tax and Toby O'Reilly a tax senior manager at PricewaterhouseCoopers in the UK

patrick.d.walker@uk.pwc.com 
toby.oreilly@uk.pwc.com