By Andy Walton

(CNN.com, June 15) -- In the days of "one market" in Europe and a global Internet with few constraints on information, talk of taxing commerce "at the border" seems almost quaint. But for European countries that have taxed imports via border inspections -- some of them for decades -- how to tax something you can't stop at the frontier is a critical question.

In most European nations and all members of the European Union, the Value Added Tax (VAT) is a key component of national finances. The VAT, as its name implies, is incurred at every step in manufacturing, processing and distribution where value is added.

While the EU sets upper and lower limits for its members' VATs, there is a wide range -- from 15 percent in Luxembourg to 25 percent in Denmark and Sweden.

Traditionally, retailers add the VAT into the sales price, or customs inspectors spot imports at the border and assess the VAT. But how can nations tax goods delivered electronically -- downloaded software, pay-per-view television, bought-and-paid-for music files, the downloadable movies promised for the future -- that cross the border in milliseconds?

Currently, if a user in the EU downloads software from a supplier in an EU country, the VAT is built into the price. If a user from outside the EU buys software from an EU country, the VAT is charged. If a customer in the EU buys and downloads software from a country without a VAT, like the United States, the transaction is not taxed.

EU officials say that arrangement is unfair to European companies competing in the world market, and also to "main street" retailers in Europe.

"We treat purchases that are made on Main Street or are made on the Internet in the same way," says Gerard de Graaf, trade counselor to the EU's mission in Washington. "There is no distinction. The Internet is not a tax-free zone, in the Europeans' view."

The European Commission, the executive branch of the European Union, formally proposed a policy in early June that had been rumored for months. The EC plan would require companies doing business in Europe to collect the VAT on behalf of the customer's country, or to register in any one EU country. It would also drop the VAT from purchases exported out of the EU.

The Commission's proposal must be approved by the European Parliament and unanimously by the 15 EU member states before it could take effect. It applies only to goods delivered electronically, which are taxed as services; physical goods shipped from outside the EU are already subject to VAT and tariffs.

The EU proposal reflects one approach to a worldwide controversy. In the U.S., where sales taxes are assessed by state and local governments and vary from one jurisdiction to another, Congress responded with a moratorium on any new taxes on e-commerce until 2001. As the deadline approaches, the debate over Internet taxes in the U.S. has only gotten fiercer

The Advisory Commission on Electronic Commerce, appointed by the U.S. government to examine online taxes, failed to reach the two-thirds majority required for a formal recommendation.

Many local and state governments, fearing a loss in sales tax revenue as more purchases are made online, favor charging sales taxes on e-commerce. But American companies have argued, and Congress thus far has agreed, that new taxes would sap the momentum of the fast-growing Internet sector. But that fast growth may actually work against regulators who wait, de Graaf says.

"We believe that the problem is big enough to see and small enough to solve," de Graaf says. "We feel that if we would put this off and if we would wait too long, that it would be much more difficult to solve this problem of Internet taxation."

Who is the tax collector for the EU?

Critics of the EU plan complain that the measure effectively forces overseas companies to become tax collectors for EU countries. Addressing the U.S. commission in December, Fred Smith of the Competitive Enterprise issue attacked the idea of requiring U.S. companies to collect the VAT.

"In a world where everything is physical and lumpy ... thousands of suppliers in the United States and around the world registering with the OECD (Organization for Economic Cooperation and Development) or with EU it makes a lot of sense," Smith said. But on the Internet, "where literally our wives, our children, our friends can all be suppliers, the idea that they're going to be able to create tax agents in Europe boggles the mind."

The U.S. government also has criticized the plan. When the plan was announced, Deputy Treasury Secretary Stuart E. Eizenstat said the Clinton Administration has "serious concerns with both the substance and process" of the EC's proposal. In a statement, Eizenstat said the EC's proposal appears to apply the VAT so that the tax applied on electronically delivered books and newspapers could be higher than those applied to sales of the same physical books and newspapers.

Eizenstat said unilateral proposals like the EC's could have unintended consequences.

"Furthermore, technology in this area is changing rapidly. Finally, the policy issues are extraordinarily complex and, in some cases, could have effects outside the taxation area," he said. "Given the relatively small amounts involved, the unintended implications of the EC proposal are not worth the short-term tax revenues that may result."

EU officials argue that the proposal does not excessively burden small businesses.

"We have, we believe, taken all necessary steps to keep the bureaucratic burden to an absolute minimum," de Graaf says. He points out that the new provisions apply only to companies with at least 100,000 Euros (about $96,000) in annual sales, and that companies can register online or in any single EU member state.

"This is a condition of doing business in the European Union," de Graaf said, "just as if an American manufacturer wants to sell cars in the European Union, they'd better comply with European emissions standards.

"This is just the way business has to be done."