Brexit – Impacts for Tax Law

( The Possible Impact on Tax Law):

European Union (EU) Member States have the right to withdraw from the Union under the Treaty on European Union (TEU), Article 50, which states that: “Any Member State may decide to withdraw from the Union in accordance with its own constitutional requirements.” No Member State has to date withdrawn, however, the United Kingdom (UK) is the only full member state that voted in a referendum on June 2016 to leave the EU. On the 29th of March 2017, Theresa May’s government served formal notice under Article 50 of the termination of the UK’s membership in the EU. This notice has started the clock for the two-year negotiation period, and the Prime Minister has indicated that she plans on achieving a new trade agreement by 2019. The treaties of the EU would cease to be applicable to the UK from the date an agreement is reached. If an agreement is not reached within two years, the UK will no longer be part of the EU unless the Member States unanimously agree to extend this period.

The exact impact of a Brexit on UK tax law is difficult to assess and certainly not possible to determine until the precise manner and timings of the exit negotiations are agreed. It is imperative that any agreement reached, will not have an adverse impact on the current trading relationship between the UK and the EU. And so, there is an incentive to keep cross-border trade moving. Ireland certainly needs trade to keep on moving, particularly as we are only surfacing from one of the biggest economic downturns of recent times, and the fact that we are the UK’s largest export market.

Most of us are now familiar with the various trade models that could be adopted between the UK and the EU following a Brexit, which we outline below:

Norwegian Model: The UK joining the European Free Trade Association (EFTA) and the European Economic Area (EEA) and so maintaining its access to the Single Market. The UK would have to comply with EU regulations (including the free movement of people) as well as making a financial contribution.

Swiss Model: Switzerland is a member of the EFTA, but it is not a member of the EEA. Switzerland has numerous bi-lateral agreements with the Member States of the EU, many of which incorporate EU law. Switzerland has partial access to the EU Single Market via regularly updated bi-lateral agreements. The UK and the EU could enter into a bilateral agreement.

Turkish Model: Establishment of a Customs Union between the UK and the EU, where external tariffs apply to cross-border trade with non-EU countries.

World Trade Organisation (WTO) Model: This model would be the default model if the UK fails to successfully agree on another model. Other nations, including Canada, have chosen to have trade agreements with the EU via the WTO agreements. Under this model, the UK would charge WTO tariffs on imports and exports to other EU countries, and vice versa. The UK is currently a member of the WTO and would continue to be a member after Brexit.

No Deal: The UK severing all trade and Customs Union relationships with the EU.

There are serious concerns as to the implications for businesses not being part of the Single Market or the Customs Union, and possibly being totally segregated from the EU if a deal cannot be reached. It could be said that Brussels has recently thrown a lifeline by putting forward an interim solution suggesting the UK could temporarily become a member of EFTA, which governs free trade between Norway, Iceland, Liechtenstein and Switzerland. This would allow the UK to become a member of the EEA, and thus gain access to the Single Market. However, following this type of transitional model would not sit well with hard-line Brexiteers, as it would require the UK accepting the four EU freedoms, rendering the UK unsuccessful in achieving their goals, one of which is clearly taking back control of immigration policy.

We now set out some of the possible tax implications of a Brexit:

VAT: The immediate turbulence of a Brexit will be felt in the arena of indirect taxes. UK VAT law derives from European law under which VAT is largely harmonised across the Member States. The UK will no longer be required to adhere to EU VAT rules and could opt not to operate VAT at all. VAT generates substantial revenues for the UK government; it is impossible to believe that the UK would abolish VAT without introducing their own sales tax. The UK will be free to make changes to the VAT rates; they might extend the application of the zero rates or introduce VAT reliefs to give the UK a competitive edge. While these changes might confer a trading advantage, the UK will now be a third country from an EU VAT perspective meaning VAT may arise on cross-border supplies. The zero rates of VAT will no longer apply to purchases and sales between Ireland and the UK. VAT costs can result in cash flow difficulties for businesses and in some cases, undermine their continuance. The UK will likely update the current VAT reclaims procedure which enables UK businesses to reclaim from the relevant EU Tax Authority, any technical changes must result in an efficient process absent of time delays and compliance costs.

The UK could lose access to the EU’s simplification measures such as; Triangulation, which reduces the administrative and compliance burden for traders and the relevant Tax Authorities in a situation where there are two supplies of goods between three EU-based VAT registered traders. The EU ‘one-stop-shop’ removes the need for a business to be VAT registered in up to 28 jurisdictions. The loss of these measures could lead to additional administrative costs for UK businesses engaging in cross-border trade.

Although none of us knows the outcome of a Brexit, it is generally thought that the UK is unlikely to substantially deviate from the current EU VAT system.

Customs Duty: The EU is a Customs Union and a Single Market; Customs Duties do not exist within the Single Market. On the importation of goods from outside of the EU, Member States apply common tariffs. The EU has also negotiated numerous free trade deals. Post a Brexit the UK may not have access to the Union nor these trade deals. Imports from the UK could be subject to Customs Duties and the administrative burdens of customs procedures. The possible imposition of Customs Duty together with the uncertainty as to what type of agreement the UK will eventually negotiate are of foremost concern for UK and Irish businesses alike. We would be hopeful that free trade between Ireland and the UK would continue despite a Brexit.

Withholding Taxes: A Brexit could terminate the UK’s rights under EU laws, resulting in certain EU Directives which minimise the tax burden for companies operating within the EU not being available to UK companies. The Interest and Royalties Directive relieves withholding taxes (WHT) on interest and royalty payments between the UK and associated companies based in the EU, and the Parent-Subsidiary Directive (PSD) eliminates WHTs on dividends paid between associated companies based in different EU countries. With access to these Directives denied, the UK’s current Tax Treaty network (which will remain in force post a Brexit) will have to be relied upon in the event of double tax arising on dividends or WHT being imposed on interest and royalty payments. Although in some cases, full relief from WHT may not be available, for example; under the UK / German DTA, WHT could range from 5% to 15%. Under an agreement between the EU and Switzerland, provisions equivalent to the PSD are extended to companies in Switzerland, perhaps the UK could enter a similar agreement post a Brexit.

Corporation Tax: While UK domestic law determines the rules for UK Corporation Tax, it must be consistent with EU law. The design of the UK Corporate Tax system has been heavily influenced by EU law in the areas of transfer-pricing, group relief, and controlled foreign companies. The outcome in the prominent ECJ Marks & Spencer case afforded cross-border group loss relief so that the freedom of establishment was not compromised. A Brexit will confer freedom on the UK to amend its tax law, perhaps by introducing pro-business tax benefits for domestic companies. However, the UK is a popular destination for international companies to operate and holding companies to locate, the UK government will want to maintain this business and encourage others to invest in their country. Although armed with fiscal sovereignty little may change.

The EU Commission is increasingly active in its proposals to consolidate Corporates Taxes with the Anti-Tax Avoidance Directive (ATAD), the introduction of a Common Consolidated Corporate Tax Base (CCCTB), and via the OECD’s Base Erosion and Profit Shifting (BEPS) Action Plan implementation. It is evident from the recent signing of a Multilateral Instrument by the Member States that there is a consensus among them to harmonise international tax practice. A Brexit means the UK will no longer be a party to EU policy negotiations, this might hasten the introduction of the CCCTB for the remaining Member States. Although a Brexit will remove EU policy constraints, the fact that Britain is heavily engaged in cross-border trade means EU measures do and will matter.

Currency Exposure: The volatility in the sterling exchange rate has made EU exports to the UK less profitable. On the flip side imports are cheaper. The latter is a positive for Ireland as we take in significant levels of goods from the UK. Businesses will need to identify their currency risk and determine if they have any tax exposure on realised foreign exchange gains. Sterling fluctuations are inevitable for the foreseeable future.  

Social Security Contributions: Under the EU Social Security system an individual working in the UK can work in any other Member State of the EU and will pay contributions in that State only. Following a Brexit this system will not apply to UK workers, thus resulting in Social Security Contributions applying in the UK and the temporary State of work. The UK may sign up to the EU system to avoid the double collection of contributions.

Funding: Certain institutions and businesses, including farmers and charities, receive funding from the EU. UK based recipients will probably not be entitled to these EU subsidies and/or grants after a Brexit. Doubtless, they will call on the UK government to continue these subsidies and grants.

For illustrative purposes, we set out a brief example of some of the possible tax implications for a corporate group post a Brexit:

UK Entrepreneur Co receives royalty income from UK and EU Distribution Cos, and licensing and dividend income from EU Manufacturing Co: Royalty and licensing income will continue to be liable to UK CT at the prevailing rate (currently 19%, with the intention to reduce it to 17% by the 1st of April 2020). The dividend from EU Manufacturing Co should still be exempt from CT under UK domestic law. WHT should not apply on the payment of royalties, licensing fees and dividends, as WHT from non-UK based companies should be relieved under the relevant DTA. No WHT should arise on the royalty payments from UK Distribution Co to UK Parent Co as they are in a 100% group relationship.

In this example VAT on royalties and licensing fees is currently tax-neutral. If the UK were to leave the EU, then presumably the UK will still have a sales tax. This sales tax could be charged on cross-border royalty and licensing fees levied on the EU group companies, therefore, resulting in an added cost, which would no longer be recoverable by means of the EU Directive.

UK Distribution Co purchases finished goods from EU Manufacturing Co for distribution in the UK: As mentioned above, if the UK were to leave the EU, then EU Manufacturing Co may have to levy local VAT on the sale of goods to the UK; these would no longer be zero-rated for VAT using the reverse-charge mechanism. UK Co could be liable to import, customs and excise duties on the importation of the goods. This would result in time delays due to the re-establishment of border crossings and, in turn, potentially harm business relationships with customers. Costs would further rise due to additional tariffs, in that there would no longer be any cross-border exemptions. This could lead to a loss of cost competitiveness and the erosion of profits.

The Unthinkable: The European Union (Withdrawal) Bill sets out the UK government’s proposals for ensuring a functioning statute book once it has left the European Union. It provides detail about:

  • The repeal of the European Communities Act 1972;
  • How EU law will be converted into UK law;
  • How corrections will be made to the statute book to ensure that the law continues to function once the UK has left the EU;
  • Ministerial powers to amend legislation.

These powers will allow legislation to be amended using statutory instruments that do not require much parliamentary scrutiny. Going forward, these recently reported powers will be of great concern to the government’s opposition, anti-Brexit campaigners and the overall democratic process.

However, the current and long-awaited Brexit negotiations may result in the UK crashing out of the Customs Union & the Single Market in two years’ time and an ensuing period of instability that may weaken the value of sterling significantly. Furthermore, if the question of the status of EU citizens currently living in the UK and vice versa is not resolved, there could be further instability and uncertainty, as characterised by the recent beginnings of an exodus of EU workers from the UK that is already facing a skills gap that could take a generation to fill.

If a scenario of this nature were to materialise or the agreements reached severely restrict UK companies’ ability to do business, companies may have to invest heavily in capital, for example, to re-locate the business, to train new staff and so on, rather than investing in growth. For example, the recent announcement by EasyJet to set up operations in Austria in order to protect its routes within the EU from any adverse effects of a Brexit. All these aspects are of concern and continue to underpin the general uncertainty as regards this issue.

We are in uncharted waters with a Brexit; long, slow, hard, soft, call it what you May!

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Rachel Barry

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