INSIGHT: The Status of EU Directives Post-Brexit

June 2016 was a historical month for the U.K.; the decision to leave the EU was one that was met with both scrutiny and uncertainty and has continued to remain center stage.

As of January 31, 2020, the U.K. has entered its transition period, whereby the government has just under a year to see whether it can formulate a trade deal with the EU. Meanwhile, the European Union Act 2018 (Withdrawal Act) ensures that the U.K. will continue to be subject to EU rules and regulations for the next 10 months.

A significant friction for companies trading across borders is withholding tax. Withholding tax costs were traditionally managed through double tax agreements (DTA) agreed bilaterally.

To reduce costs within the EU, the Parent Subsidiary Directive (PSD) and the Interest and Royalties Directive (IRD) reduce withholding taxes for EU member states to nil in most circumstances. As such, the status and application of EU directives during the transition period and after is a material issue. Where the U.K. is not able to negotiate a deal that maintains the terms of these directives, U.K. companies trading with the EU (and vice versa) are likely to incur additional tax costs.

This article discusses the withholding tax implications of the U.K.’s departure from the EU, both during the transition period and beyond. What is clear is that, in the absence of a “managed exit,” the U.K. will revert to reliance on DTAs, some of which provide less favorable terms than the existing EU directives.

Withholding Tax and Double Tax Agreements

The issue of where income should be taxed arises when companies trade in different countries.

Either it is where a company is based (Resident State) or where the income is earned (Source State). Both countries want their share of the tax revenue, but it is often difficult for the Source State to levy such a tax.

Therefore, as a matter of domestic law, the local tax authority of a resident company will seek to tax a payment made to a nonresident company. This deduction is known as a withholding tax. Each country’s domestic provisions will provide for its own rates on dividend, interest and royalty payments.

Unusually, the U.K. does not levy a withholding tax on dividends paid by a resident company to an overseas entity. However, a 20% withholding tax rate applies to royalties and interest payments in the same scenario.

Prior to the passage of the PSD and IRD, EU member states reduced their withholding tax exposure on cross-border transactions using DTAs. DTAs are arrangements between two states that allocate taxing rights between the two jurisdictions in order to limit the risk of double taxation. DTAs supersede domestic law, ensuring that withholding taxes are minimized or removed between trading partners. It is relevant that a DTA cannot impose a tax; merely reduce it. For example, through a DTA, a Source State may forgo its right to tax income paid cross-border.

The Current Landscape: EU Directives

The situation is different for EU member states. Given that only a small number of DTAs reduce withholding tax to nil, the EU introduced the PSD and IRD, to provide, in certain circumstances, for a complete exemption from withholding tax on payments made across different member states. The PSD was first implemented in 2007, and then amended in 2015; it eliminates withholding tax on dividends between companies residing in member states.

The IRD came into effect in 2004 and, again subject to conditions, eliminates withholding tax on interest and royalty payments between associated companies residing in member states where the recipient is the beneficial owner of the income. These directives override any individual DTA member states have in effect.

What Happens During the Transition Period?

During the transition period, the U.K. will be obliged to abide by (and in some circumstances, benefit from) EU law and regulation. This means that the EU tax directives, relevant for all member states, continue to apply to the U.K. The result is that there are unlikely to be material changes to how companies within the U.K. are taxed in relation to the dividends, interest and royalties during the transition period.

That said, given that there is a degree of uncertainty about the U.K.’s status throughout the transition period, many EU member states have introduced Brexit-smoothing laws to avoid any potential adverse tax consequences of the U.K. transitioning to become a third country (i.e. non-member state) for domestic tax purposes.

For example, Italy passed a decree that allows Italian businesses to prepare in advance of a hard Brexit. Similarly, Germany passed the Brexit Tax Accompanying Act, which grants the U.K. status as a member of the EU during the transition period, delaying the 5% German withholding tax on dividends that would apply under the Germany–U.K. DTA.

Post-Transition Period

If the U.K. can agree to a deal with the EU that maintains the status quo as regards the availability of the PSD and IRD, any potential costs are likely to be minimal. However, based on commentary to date, this appears unlikely. Where a trade deal cannot be negotiated, the U.K. will lose the beneficial arrangements available under the directives once the transition period ends on December 31, 2020; after this, the U.K. will revert reliance on the DTAs it has with individual countries in the EU. However, as highlighted earlier, DTAs do not always offer full exemptions from withholding taxes such that U.K. companies may incur additional tax costs on their dividend, interest and royalty payments.

U.K. domestic law, as it stands, will reduce the impact of the loss of PSD, as dividends paid by U.K. companies are exempt from withholding tax and any capital gain derived by a U.K. parent company on a disposal of its subsidiary companies ought to qualify for the Substantial Shareholding Exemption. However, dividend payments to the U.K. will now depend on the EU member state’s domestic law and the guidance set out in the applicable tax treaty.

For example, the U.K.–Germany DTA allows for a reduction of withholding tax on dividends to 5%. As dividends paid by the U.K. are exempt under domestic law, the effects will only be felt by a U.K. parent with German subsidiaries. Similarly, payments from Italy, Portugal and Austria, will also be subject to withholding tax. By contrast, France and Spain exempt dividend payments from withholding tax. Therefore, it is imperative that companies engaging in cross-border transactions consider the implications that Brexit will have on withholding tax costs.

Similarly, the implications for payments of interest and royalties are likely to be minor. While several EU jurisdictions provide a complete exemption for interest payments under domestic law, in the absence of a DTA reduction, a U.K. company would be required to deduct 20% interest withholding tax to its EU (and non-EU) counter party. Similarly, a 20% (non-treaty rate) withholding tax applies to royalty payments made by a U.K. company. While most U.K.–EU member state DTAs provide for a nil rate of withholding tax on interest and royalties, the position is not uniform across the EU and care should be exercised in determining whether a payment will be subject to withholding tax.

In addition, one further implication is that, in order to benefit from the reduced rate or exemption provided for in a DTA, a paying company is required to claim the benefit—it is not automatic. This additional compliance requirement can cause a delay in the process.

Planning Points

Following the passage of the EU Withdrawal Act in January 2020, companies trading with EU counter parties should, from 2021, be aware that the U.K. is unlikely to continue to benefit from withholding tax exemptions included in the PSD and IRD.

Thus, in the absence of a domestic law exemption or a partial or complete exemption from withholding included in a DTA, additional tax costs may apply to payments from EU companies to and from their U.K. counterparts. At a minimum, companies should assess their operating arrangements to consider where any potential withholding tax issues arise, identify treaties between the two countries and ensure applications to take advantage of any relief are filed on a timely basis.

Andy Murray is Managing Director, International Tax Advisory, Duff & Phelps.

Andy Murray would like to thank Nayena Gami and Ravi Kavia, of Duff & Phelps, for their contributions to this article.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.