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When asked about the consequences of the French revolution, Zhou Enlai, premier of China in the late 1960s, was reported to have said that it was “too early to say.” Whether or not he said it, and what he meant by it, remains heavily debated, but it is entirely apt to describe the consequences of the U.K.’s narrow vote in a 2016 referendum to leave the EU. Three and a half years from that vote, and more than seven months since the original scheduled departure date of March 29, 2019, it is still no clearer what it means for the U.K.’s tax system (or, indeed, for the U.K.’s economy as a whole).
However, the fog may now finally be about to lift. The U.K.’s new Prime Minister, Boris Johnson, has renegotiated the terms of the withdrawal agreement with the EU. With the U.K.’s departure date having been postponed for a third time until January 31, 2020, removing the immediate prospect of a “no deal” departure, Parliament has approved an early general election on December 12. Whilst this is likely to be one of the more unpredictable elections in recent times, it is becoming clearer what the consequences of different results are likely to be.
If the election results in a Conservative-led government, we can expect it to try to ratify the newly renegotiated withdrawal agreement, with a view to it coming into force on departure date.
The Labour party is committed to renegotiating the withdrawal agreement and putting it to a referendum, with remaining in the EU being the alternative option.
The smaller parties are mostly opposed to Brexit and advocate canceling it altogether, or holding a further referendum. If the election results in a government led by the opposition parties, a further lengthy delay beyond January 31, 2020 seems likely to facilitate a renegotiation, a further referendum, or both.
This means that the possibility of the U.K. leaving the EU without a deal appears to have receded for the moment, although if the withdrawal agreement is implemented, it may re-emerge as a possibility at the next stage of negotiations.
The withdrawal agreement is, in essence, no more than a divorce agreement. It does not, and legally cannot, establish the longer-term trading and economic relationship between the U.K. and EU. Instead, it provides for a transitional period during which this future state relationship can be negotiated. This transitional period will run until December 31, 2020, unless extended by mutual agreement for a further two years.
As it seems highly unlikely that a trade agreement can be concluded before June 30, 2020 (the last day for triggering an extension to the transitional period), it seems probable that the transitional period will, ultimately, be extended—even if it suits politicians at present to claim otherwise.
During the transitional period, very little would change in practice.
The U.K. would remain largely subject to EU law, and to the jurisdiction of the European Court of Justice. The U.K. would remain part of the EU value-added tax (VAT) regime, and U.K.-parented groups could continue to avail themselves of the benefits of the Interest and Royalties and Parent-Subsidiary Directives to repatriate funds from EU subsidiaries without suffering withholding tax.
The U.K. would also remain obliged to implement outstanding EU Directives relating to tax, such as the second anti-tax avoidance directive (ATAD II), which requires member states to introduce comprehensive hybrid mismatch rules, and the sixth directive on administrative cooperation (DAC6), which imposes a reporting obligation on professional advisers with respect to certain cross-border tax structures.
This will, however, make little difference in practice, as the U.K. has already complied with the requirements of ATAD II and is committed to implementing DAC6 regardless of Brexit.
The withdrawal agreement therefore does little more than defer any substantial change until the end of the transitional period.
The extent of any such changes at that point will depend upon the terms of any trade agreement between the U.K. and the EU, and in particular the extent to which the U.K. seeks to remain in close economic alignment with the EU.
For example, there is no reason in principle why the Interest and Royalties and Parent-Subsidiary Directives could not continue to apply to payments from EU companies to their U.K. affiliates (and vice versa) following the U.K.’s departure. A similar arrangement is in place between the EU and Switzerland. However, that is only likely to happen if the parties are seeking to negotiate a relationship similar to that between the EU and Switzerland, which have sought close alignment. It is far from clear that a Conservative-led government would pursue such an agreement.
The renegotiated withdrawal deal downgraded the U.K.’s commitments to a level playing field in the area of workers’ rights and environmental standards, which were moved from the legally binding withdrawal agreement into the political declaration on the future relationship (which is merely a basis for future negotiation).
If a Conservative government is returned, multinationals should probably therefore assume that the directives will no longer apply from the end of the transitional period.
In many cases, the U.K.’s tax treaty network will provide equivalent benefits, but there are two notable exceptions.
Dividends paid by German subsidiaries of U.K. parents will attract a 5% withholding tax in the absence of the Parent-Subsidiary Directive, and payments of dividends, interest or royalties from Italy to the U.K. will attract withholding tax of 5%, 10% or 8% respectively if relief under the directives does not apply.
Similarly, a Conservative government would be unlikely to seek to remain aligned to the EU’s VAT system—and provisions inserted into EU withdrawal legislation in 2018 by Eurosceptic Conservative MPs in 2018 make this outcome more difficult by preventing HM Revenue & Customs (HMRC) from accounting for VAT or excise duties to foreign tax authorities unless they reciprocate. This could make it difficult for the U.K. to remain in the “mini-one-stop-shop” mechanism for collecting VAT on electronic supplies.
Domestic U.K. legislation has been enacted to detach the U.K. VAT system from that of the EU. When activated, presumably at the end of the transitional period, this would treat movements of goods between the U.K. and the remaining EU member states in the same way as goods moving to and from third countries—thus triggering a VAT charge in the importing country. The U.K. has indicated that it will allow the importer to account for this import VAT through its VAT return rather than at the border, which will mitigate any cash flow disadvantage relative to the current position.
Any divergence from the EU VAT system in relation to goods will, however, introduce additional complications for businesses moving goods to or from Northern Ireland.
Under arrangements designed to avoid the need for border checks on goods moving between Northern Ireland and the Republic of Ireland, Northern Ireland will remain aligned with EU VAT and customs duty rules in relation to the movement of goods.
There are scant details at present on how this will work in practice, but it would suggest that goods moving between Great Britain and Northern Ireland will need to be reported for customs and VAT purposes, and may attract import VAT. This would represent a significant additional compliance burden for those businesses.
The Labour Party has pledged to negotiate a revised deal with the EU, which would involve remaining in a customs union and closely aligned to the single market. This may mean that the U.K. remains within the directives relating to withholding tax and the EU VAT system—although the only certainty in such a situation is a fairly lengthy delay to Brexit to allow for the renegotiation and a likely referendum on the outcome.
Brexit also has the potential to affect the tax treatment of transactions to which no U.K. entity is party. Take, for example, a loan from a company resident in an EU member state to its U.S. subsidiary. In order to get relief from US withholding tax, the lender will need to rely on the relevant tax treaty, which will contain a limitation on benefits clause.
These clauses, in turn, generally include an “equivalent beneficiaries” provision, which would allow the lender to claim relief, subject to certain additional conditions, if it is at least 95% owned by equivalent beneficiaries—being entities which would be entitled to equivalent relief under the applicable tax treaty with the U.S. if they received the income directly.
Many U.S. treaties with EU member states restrict the definition of equivalent beneficiaries to residents of member states of either the European Economic Area (EEA) or NAFTA. Logically, once the U.K. leaves the EU (and therefore also the EEA), U.K.-resident companies can no longer be equivalent beneficiaries—although there is no published guidance as yet to confirm this conclusion.
This, however, is perhaps something of a niche concern. More generally, while Brexit receives a considerable amount of airtime, the most radical changes to the corporate tax system over the next few years are far more likely to derive either from the Organisation for Economic Co-operation and Development (OECD) or from domestic politics.
The ongoing OECD Programme of Work relating to the digitalization of the economy could result in the most substantial changes to the international tax system in nearly a century, with the main foundation stones of the system—the arm’s length standard and the permanent establishment concept—up for redefinition.
At home, the main parties are proposing sharply divergent tax policies—more so than in any election for at least a generation. Whilst Brexit is capable of reshaping the U.K.’s economy, it will probably not fundamentally reshape its tax system. However, that fundamental reshaping may well happen anyway.
James Ross is a Partner at McDermott Will & Emery UK LLP
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Read the full archive of the Bloomberg Tax International Forum articles here.