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      Tax implications of the UK leaving the EU

       

      Overview

      • The current balance of competences between the EU and the UK on tax is quite intricate, with a tension between member states’ desire to determine their own tax systems and the EU-led aim of a level playing field.
      • The EU most obviously influences member states’ indirect taxation (particularly VAT and excise duties), but there are some business-friendly EU Directives relevant to direct taxation as well as the state aid regime, and member states must exercise their tax powers consistently with EU law.
      • A Brexit may have no immediate effect on legislation incorporated into UK law and post-Brexit, the UK could amend tax law without EU constraints – however, it may not want to depart from generally business-friendly (or, in the case of VAT, revenue raising) EU Directives.
      • The scope of change would depend on the model of any new, post-Brexit relationship between the UK and the EU.
      • A Brexit would not remove other international influences on the UK tax system, e.g. the OECD’s Base Erosion and Profit Shifting (BEPS) project and information exchange regime.
      • Post-Brexit, the UK would still benefit from and would be bound by its extensive network of double tax treaties.

       

      EU and UK balance of competences on tax 

      The current balance of competences between the EU and the UK in relation to tax is quite intricate. Some EU laws are automatically part of UK law without the UK needing to make separate laws. Others require UK legislation, which the UK is obliged to implement. UK law must accord with EU law and any tax rules which do not can be disapplied and taxes wrongly paid required to be reimbursed. In addition, the UK courts may need to consider how the EU courts would interpret legislation in coming to their decisions and must in some cases refer points of EU law to the EU courts. 

      Generally speaking, the EU-led tax rules which are incorporated into law in the member states are aimed at creating a level playing field for companies operating within the internal market of the EU and at the removal of tax obstacles to cross-border activity. However, the member states still have control of their own tax systems and the ability to adapt these systems to their specific national circumstances (and the UK government has been particularly keen to retain as much control as possible). So there can be a tension when this domestic flexibility is required to be given up to EU-led policies. 

       

      EU impact on the UK taxation system

      Indirect taxes

      Probably the most obvious EU influence on UK tax policy is in relation to indirect taxation, and in particular VAT and excise duties.

      VAT was introduced to member states as a uniform tax system with the aim of promoting competition and trade, and the VAT Directives provide for a harmonised VAT framework across the member states with set minimum rates. The UK implemented the VAT Directives when it joined the EEC in 1973, having negotiated some significant derogations, notably the UK’s zero rates which are applicable to the supply of certain goods and services. 

      Although not harmonised to the same extent as VAT, excise duties are the other main indirect taxes governed by EU rules. Tobacco, alcohol and energy are all subject to excise duties and member states are also bound by agreed minimum rates for each of these. As with VAT, member states are free to set excise duties above the minimum rates at the level they consider appropriate in light of their national circumstances. 

      The EU Capital Duty Directive is also worth a mention. This essentially prohibits member states from taxing the raising of capital. Its application has been tested recently in relation to the UK law provisions which impose a 1.5% ad valorem tax charge on the issue of shares and securities to clearance services or depositories in certain circumstances. The EU courts found that the UK rules were contrary to the Capital Duty Directive and HMRC have been forced to accept that they cannot seek to impose the charge and have repaid tax wrongly paid. 

      Direct taxes

      Direct taxes tend to be a matter for the member states themselves. There is, however, some relevant EU legislation, which is primarily aimed at removing obstacles for businesses operating within the EU. This includes the Merger Directive, the Parent-Subsidiary Directive, the Interest and Royalties Directive and the state aid regime (provided for in the Treaty on the Functioning of the EU).

      The Merger Directive applies to mergers, divisions, transfers of assets and exchanges of shares which take place between companies in different member states. The Parent-Subsidiary Directive is concerned with profit distributions between associated companies in different member states and the Interest and Royalties Directive prevents withholding taxes on royalty and interest payments. The state aid regime prohibits member states from granting state aid, which can include beneficial tax regimes, that distorts competition and trade in the EU. This has come into the spotlight recently with formal state aid investigations opened by the European Commission to review the tax ruling practices of all EU member states.

      In addition to the specific Directives and the state aid regime, member states are more generally required to exercise their power to tax consistently with EU law and in particular with the fundamental freedoms. The UK can be required to amend its tax legislation where it is found not to be consistent with EU law. A good example of this is the Marks and Spencer case, as a result of which the UK was obliged to amend its group loss relief legislation to permit relief for non-UK losses in certain circumstances. Decisions of the EU courts have also had an impact on the UK’s controlled foreign company rules and many other aspects of the UK’s direct tax system are nowadays shaped to some extent by the need to adhere to the fundamental freedoms. 

      Tax evasion and information reporting

      The EU has also sought to tackle issues of cross-border tax evasion through EU legislation. This was initially achieved by the EU Savings Directive (EUSD) which required member states to provide details of certain payments to the tax authorities of other member states. However, there have been significant developments in this regard with the amendment of Directive 2011/16/EU on administrative cooperation in the field of taxation to provide for the automatic exchange of financial account information between tax authorities of member states using the OECD’s common reporting standard (CRS). The CRS has effect in the UK from 1 January 2016. As a result of these developments the European Commission has repealed the EUSD to prevent overlap with the new CRS regime. 

       

      Advantages of the current UK–EU relationship

      Largely harmonised regulations, such as in relation to VAT, give businesses a clear framework within which to operate. The UK also currently benefits from free trade within the EU:–goods are able to move freely with no border controls and no import VAT (which is a cashflow cost for businesses) and no duties (a real cost for businesses).

      Businesses in the UK also benefit from measures which reduce the cost of doing business for groups operating in more than one member state. As mentioned above, various Directives reduce the costs of reorganisations, distributions and payments of interest and royalties. The UK can also challenge other member states that introduce state aid measures that are disadvantageous to UK businesses.

      Currently, member states have the ability to veto EU tax measures which they don’t agree with. This approach gives member states a degree of protection for national interests, together with the benefit of a uniform taxation system as far as it can be agreed. 

       

      Disadvantages of the current UK–EU relationship

      The UK legal system is subordinate to the EU legal system in areas of EU competence and the UK must, with some caveats, adopt EU legislation and ensure that its legislation is consistent with EU law and the fundamental principles. The UK does not, therefore, have complete freedom in relation to its tax system. There have been a number of instances where the UK has been required to amend its tax legislation as a result of judgments of the EU courts (including judgments which have been criticised for their lack of foundation on precedent or poor quality of reasoning).

      There is also a sense that the EU’s influence is extending further. For example, the UK has come under pressure in relation to its VAT derogations, with the EU pushing for greater harmonisation. In addition, measures being considered include a proposal for a common consolidated corporate tax base (an initiative aimed at establishing a single set of rules that companies operating in the EU would use to calculate their taxable profits) and the EU financial transactions tax (to be levied on transactions in financial instruments where one party is in a participating member state). The UK government has objected to both of these proposals, clearly feeling that they go too far in constraining the UK’s ability to shape its own tax policy and its objective of creating the most competitive corporate tax regime in the G20. 

       

      Impact of leaving the EU

      The impact of leaving the EU would clearly depend on the relationship between the UK and the EU following a Brexit. As a general point, though, a Brexit would have no immediate effect on any legislation which has been incorporated into UK law, although, of course, the UK government would have the freedom to amend the law if it wished and without the boundaries set by EU Directives and the fundamental freedoms. 

      Assuming the ongoing relationship between the UK and the EU didn’t include similar provisions, the UK  would no longer be required to give effect to the VAT Directives, the Merger Directive, the Parent-Subsidiary Directive, the Interest and Royalties Directive, the Capital Duties Directive or the state aid regime. The loss of the benefit of the Parent-Subsidiary Directive and the Interest and Royalties Directive will to some extent be set off by the UK’s extensive network of double tax treaties which will continue in force following a Brexit. Such tax treaties will continue to act to eliminate withholding taxes on dividend, interest and royalty payments in a number of cross-border EU situations, but not all (including, for example, Germany and Luxembourg). Groups may therefore need to assess whether the tax treaty network is sufficient to deal with withholding tax issues on such payments. Further, the UK could enforce the 1.5% tax charge on issue of shares and securities to clearance systems and depositories and could impose laws contrary to each of these Directives (although there is, of course, a question over whether it would want to do so: VAT makes up a large proportion of the UK’s tax revenue and the other Directives are generally seen as business-friendly). 

      There is also a question about to the extent to which existing and future EU jurisprudence, including decisions of the EU courts, could or should be relied on to assist in interpreting UK law post Brexit. Such jurisprudence may remain binding when addressing questions relating to periods before a UK exit, but not to any questions relating to periods after that. 

       

      Other influences on the UK tax system

      It is worth noting that a Brexit would not remove international influence on the UK tax system. The OECD is becoming increasingly influential in driving international tax policy (and is perhaps more influential than the EU in some respects). The OECD’s Base Erosion and Profit Shifting (BEPS) project, which aims to create an improved system of taxation for international businesses, has reached the end of phase one with final reports on the 15 action points issued in October 2015. Phase two will focus on implementation of the recommendations and it appears inescapable that the BEPS project will have a significant impact on the UK corporate tax regime. Indeed, the UK has already published draft legislation, as part of Finance Bill 2016, introducing new rules to address hybrid and other mismatches which reflect the recommendations under Action 2 of the BEPS project. 

      The EU is working closely with the OECD in respect of the BEPS project. It is expected there will be a push to align new and existing EU legislation with the OECD recommendations set out in the final BEPS reports. Consequently, if the UK remains within the EU it may have significantly less control over the implementation of the BEPS project, as has already been demonstrated by  requiring member states automatically to exchange information on their corporate tax rulings which will take effect from 1 January 2017 and which is in line with the recommendations under Action 5 of the BEPS project.

      Following a Brexit, the UK would also continue to benefit from and would be bound by its double tax treaties including anti-discrimination provisions.

       

      Other models for a future UK-EU relationship

      There are various ways the relationship between the UK and the EU member states might operate following a Brexit.

      A detailed discussion of these is beyond the scope of this note. To give an idea of the range of possible outcomes we have considered what the position would be under the ‘Norwegian model’ (ie UK membership of the EEA) and the ‘WTO model’ (ie reliance solely on rights and obligations under WTO rules) – on the basis that these are at opposite ends of the spectrum of existing models for an alternative relationship with the EU:

      Norwegian model

      If the Norwegian model were followed, with the UK becoming a member of EFTA (the European Free Trade Association) and the EEA (the European Economic Area), the UK would have full access, in principle, to the EU single market. It would also be required to comply with the EU single market rules (including the fundamental freedoms) but would have limited ability to influence these. Further, as the EFTA Court performs largely the same functions as the Court of Justice of the European Union, the role of the UK courts in interpreting and applying EU law would remain broadly the same.

      One major difference for tax purposes would be that the UK would be outside the EU customs union. However, the UK would benefit from any EFTA customs agreements, which would likely mean that any exports to the EU originating in the UK would still be tariff-free, but tariffs would be imposed on imports from other countries (country of origin conditions). 

      WTO model 

      Another option would be a WTO model. Such an approach would mean the UK would be in a similar position to the US, namely trade with the EU would be based only on the UK’s membership of the WTO. UK goods exported to the EU would be subject to the EU’s common external tariff. The UK would not be part of the internal market nor subject to single market legislation nor the political process.