The principles of tax policy

Written evidence submitted by Retailers Against VAT Abuse Schemes (RAVAS)

Low Value Consignment Relief (LVCR) is a relief created by European Union Directive 1983/181, which exempts from VAT any import from outside the EU of a value below a certain threshold. Member states are free to set that threshold anywhere from £ 10 to £ 18, and the UK has always set it at the maximum £ 18.

The original purpose of LVCR was to expedite the transit through customs of perishable and urgent goods , and to reduce the administrative costs on fiscal authorities of collecting small amounts of VAT that are often less than the cost of collecting them . Unfortunately, since the advent of Internet-based mail order, large UK retailers have been using it to ship products to the Channel Islands – outside the EU for tax purposes but inside the UK mailing system, so shipping is cheap – and back, often within 24 hours, in order to undercut their competitors by totally avoiding VAT. This has resulted in a group of Islands, across an inconvenient stretch of water close to France, becoming the major hub for internet fulfilment in the UK a situation that makes no sense at all. Many industries are affected, including ink cartridges, computer memory cards, computer games and DVDs. Because my personal experience and knowledge is of the music industry, I will largely restrict my evidence to that particular industry.

LVCR was clearly not created for this purpose and, in fact, the Directive creating it recognises the possibility of abuse. In its recitals the Directive makes clear that any distortion of competition arising from the relief would be contrary to its intentions. The Directive contains an article giving member states the latitude to remove mail order goods from this relief. In its very first article, the Directive contains a stipulation that member states implement it to ensure that no evasion, avoidance, or abuse arises. Furthermore, the principle of fiscal neutrality enshrined in the EU’s principle VAT Directive (2006/112/EEC, formerly 1977/388/EEC) stipulates that similar goods should bear the same tax burden.

Before 2005, the existence of LVCR did not have a huge effect on the UK CD market. The only offshore operator was Play.com, which simply matched UK-based prices , offered free postage and pocketed the VAT difference.

The shape of the market changed from 2006 onwards, after HMV moved its online operations to Guernsey in 2005, in order to be able to compete with Play.com. The effect, known as the "Play E ffect" was a stampede of UK retailers to the Channel Islan ds. HMV, WHSmith , Asda , Amazon, Tesco, Dixons, Thehut and Argos all now operate their Internet mail order operations from the islands.

One effect has been to accelerate the normal shift that was underway towards online retail. On the following graph , the light blue line traces the trend line from before 2005 through to the present. It is clear that online retail’s share of the physical music market

is much higher now – and has been on a much steeper trajectory since 2006 – than it would be if the pre-2005 trends had continued.

For clarity, when I speak of Internet retail or online retail, I mean CDs ordered on a website to be delivered to the customer’s home, not downloads, a subject to which I will return later.

The graph above shows that the trend in favour of online retail seems to be steepening rather than levelling off. Indeed, while the last figure on the graph above is the 29.6% market share that Internet retailers enjoyed in 2009, the latest figures for 2010 indicate that its share has grown once again. Market research firm Kantar estimates that in the 52 weeks ending 3 rd October 2010, Internet retailers accounted for 42% of the physical music market.

In a shrinking market, Internet retailers were the only segment enjoying growth through 2009, as shown by the graph below.

As the contraction in the UK music market continues, the Internet segment is suffering the smallest losses.

One effect of this shift has been the demise of over half the UK’s independent music stores, who have gone out of business disproportionately to the overall decline in album sales from 2006 to 2009 .

The above graphs all relate to physical album sales. However, while many commentators would like to pin the blame for the demise of so many independent retailers on to music downloads, the figures show that downloads, while they are ubiquitous in the music singles market, have yet to enjoy real penetration in the albums market, which was the staple of most of the independent retailers – and certainly the independent Internet-based retailers. Downloads may now be on their way to achieving the same status in album sales as they have in single sales, but they are not there yet, and certainly were extremely minor when most of the independent Internet-only stores went out of business around the end of 2007 and the beginning of 2008.

The two graphs on the next page compare album downloads to single downloads, and album downloads to album sales on the Internet over the last three years.

The purpose of the information given thus far has been to show that Internet retail has been a disproportionately fast-growing segment of the UK music market since 2006.

It could fairly be argued that this would have happened anyway without the abuse of LVCR, although our very first graph shows that the growth since 2006 has been out of proportion to the growth before that year.

Normally, such conditions would benefit independent online retailers. Even traditional independent retailers would have been able to catch up with the shift because many of the bigger independent stores , such as Fopp and Music Zone, did indeed have websites.

However, the general growth of Internet retail stands in stark contrast to the fact that every significant independent Internet -only CD & DVD retailer based on the UK mainland has gone out of business since 200 6.

In comparison books which do not attract VAT have also seen an increase in sales on the internet however book retailers are not located on the Channel Islands in any significant numbers (due to the fact that there is no VAT to be avoided and logistically the islands are inconvenient) and since there is a level playing field of no VAT in the book trade, retailers compete on price and service and therefore can still be found spread across the UK mainland and even in the high street .

I repeat, for clarity. Despite the strong growth of Internet retail demonstrated over the last few pages, there is no independent Internet-only CD & DVD retail remaining on the UK mainland of any significance . Additionally a number of specialist genre music retailers who should have easily been able to benefit and transfer to the internet have disappeared.

Indeed, my business, Delerium Mail Order, was an Internet-only specialist genre business and, through 2006, I was enjoying strong growth, until the effects of the stampede to the Channel Islands took hold. It is now impossible to run a mail order operation selling CD s and DVDs on the UK mainland since the Internet mail order market for these products is almost entirely VAT free and based in The Channel Islands, as is common knowledge within the music industry.

Although figures do not exist in the public domain that split out the Internet retail part of the CD market into onshore and offshore, the last quoted estimate from a knowledgeable source was that Channel Islands retailers account for 96% of the online CD & DVD market. This was the estimate of Matt Moulding, CEO of thehut.com , which provides logistical fulfilment services to UK companies using the loophole. He told the Guardian in March 2009: ""Everybody does it. If you look at the main players you've got Amazon, HMV and Play who have got 80% of the entertainment marketplace and they're offshore. And we make up pretty much the balance; we have about 15%, 16% now." The Entertainment Retailers Association has described this as a ‘concentration’ of internet retail in The Channel Islands.

Unlike other forms of tax avoidance which are not always visible, VAT abuse is immediately apparent, as it has an immediate effect on retailers who are obligated to pay VAT. I know from my own experience running a successful mail order and online business from 1991 to 2007 that customers soon become aware of the fact that your prices are higher than those of VAT-free competitors, but they do not understand why this is so. They immediately assume that you are overcharging, causing misunderstanding with customers and seriously damaging reputation and profitability . If a UK retailer buys an item at £10 and sells it for £12 then he has made no profit and has to pay £2 in VAT to HMRC. However an offshore retailer selling the item at the same £12 price can pocket the £2 profit margin or undercut the UK retailer forcing them to sell their item at a loss if they wish to compete. Such a huge trading advantage means that offshore retailers now regularly price products within the 20% VAT advantage knowing that it is impossible for any UK mainland retailer to match the price , other than the likes of Amazon who have been price matching offshore products and losing money when they have been unable to supply them though their offshore partner Indigo Starfish in Jersey . This unjust and damaging practice has been allowed to develop unchallenged by HMRC to levels of abuse that can only be described as industrial creating a complex market distortion that has been highly damaging to UK music retail.

It is for this reason that Matt Moulding, CEO of thehut.com, t old the Guardian newspaper in March 2009: " If you aren't offshore you couldn't possibly compete. Your cost price would be above what people would be retailing at."

In response to HMRC ’ s failure to deal with LVCR abuse I have set up Retailers Against VAT Avoidance Schemes (RAVAS), which includes 20 members from various mail order sectors. It is supported by a number of major Music Industry Trade bodies including IMPALA (Independent Music Companies Association) AIM (Association of Independent Music) The Musicians Union (MU) The Music Managers Forum (MMF) and Music Publishers Association (MPA) who represent 90% of UK copyrights. I also have contacts through UK music retail both traditional and online.

This issue is highly relevant to the terms of reference of the Committee’s inquiry , because it relates to one of the fundamental principles of taxation on which free and competitive markets are based: namely, fiscal neutrality. Similar goods should bear similar tax burdens. If an onshore retailer has to pay VAT and an offshore retailer does not, the offshore retailer will win the customer even if the product is not as good, causing a market distortion. The OECD has said that a tax system should distort economic incentives as little as possible.

I feel that I would be able to provide a great deal of information to The Treasury Select Committee regarding the abuse of LVCR and its impact on UK internet retail. HMRC has, until recently, actually not been aware of how this abuse operates, and officials within HMRC have not always provided the full information to ministers. Indeed, I can provide several examples of demonstrably factually incorrect statements made by ministers playing down the extent of the abuse of LVCR.

January 2011