Brexit: Financial Services Tax outlook

Written by Gregory Jurion 4 July 2016


On Thursday 23 June 2016, a historic referendum on the UK’s membership of the EU was held, with the ‘Leave’ result announced the following day. The aftermath now requires careful consideration of the potential short and medium term scenarios the UK government could take in the following months and years and the potential effects each may have on the FS Tax sector specifically. This document is the first in a series introducing and discussing these key issues going forward.

Likely scenarios

On Thursday 23 June 2016, the British people voted to leave the European Union (EU). The following day, British Prime Minster Cameron announced his resignation following the ‘Leave’ campaign victory.

While the referendum was non-binding, the results evidenced the strong split within the United Kingdom and its constituent countries. For example, the results have led to renewed calls in Scotland for a second referendum on independence from the UK to “protect Scotland’s place in the EU.”

Leaving the EU will be a process, not simply an act. To initiate the process of the leaving the EU, the UK Government would need to serve notice under Article 50 of the Treaty on European Union (EU Treaty), and it is likely that the negotiations on the UK’s future relations with the EU will continue for more than two years and could last from 5-10 years until all matters are finally settled.

The referendum outcome ushers in a potentially extended period of political and economic uncertainty, with major implications for the FS sector in the UK and Continental Europe, including in relation to taxation.

While multiple scenarios could unfold depending on how the UK parliament and the EU react to the result of the referendum and subsequent negotiations, we focus on two principal scenarios going forward.

  • The first would be for the UK to negotiate either a customs union or bilateral free trade agreement with the EU, as Turkey and Switzerland have, respectively.
  • The second would be for the UK to remain a member of the EEA under the Agreement on the European Economic Area (EEA Agreement), but as a non-EU Member. The EEA includes all the EU countries as well as Iceland, Liechtenstein, and Norway.

In the following sections, we discuss both possibilities from an FS Tax specific perspective in order to introduce some of the key topics going forward.

When might it change? What might change? How to deal with it?

Firstly, it is worth noting that until the effective exit date, nothing should change. Until such time, the UK remains an EU Member State subject to its legal and treaty obligations. Thus, there is still time for organisations to prepare.

Under the EEA Agreement, the fundamental EU Treaty freedoms would continue to apply, however, most EU Directives would not.

Negotiating either a customs union or bilateral agreement with the EU would likely precipitate more far-reaching change, in particular because it is likely that all or some of the fundamental Treaty freedoms would cease to apply.

Passporting Rules

A key question affecting FS organisations that will have to be resolved as part of the Brexit negotiating process will be future access to the EU Single Market via EU ‘passporting’ rules.

Passporting allows EEA Member States to provide financial and related services covered by any one of the EU Single Market directives throughout the EEA without separate authorisations. A significant number of financial services groups (both London based and non-EU based) currently use London as their EU hub, and they benefit and depend on passporting rules to access the EU.

While this wouldn’t change under an EEA Agreement scenario, financial services outside the scope of the passport’s terms may require domestic authorisation in EEA jurisdictions where authorisation is sought.

In a non-EEA Agreement scenario, banks or other financial services organisations using the UK as their access point for the EU would lose their passporting rights unless the UK is able to negotiate an alternative agreement for equivalent access rights. In this case, the UK would be treated similarly to other non-EEA jurisdictions.

Direct Taxes

Under an EEA Agreement, most Directives relating to direct taxation, such as the Parent Subsidiary Directive, the Interest and Royalties Directive and the Merger Directive would not apply.

Profit distributions to a UK corporation could lead to permanent taxation under the applicable Double Tax Treaty (DTT). Withholding taxes on dividends could be charged if the respective DTT does not provide for a tax exemption. If the UK remains in the EEA, the impact would be reduced to those treaties that exclude EEA members from eligibility, namely: Ireland, Luxembourg, and pending treaties with Hungary and Poland.

In case of negotiating bilateral agreements, the UK will be treated as a third party and thus, beneficial domestic legislation regarding exit taxation for EU and EEA corporations will no longer apply. The same treatment could apply to a cross border merger that involves a permanent establishment in the UK and to beneficial domestic CFC rules for EU and EEA corporations.

Furthermore, if the UK leaves the EEA, EU/EEA countries that rely on UK owners for access to benefits under other EU/EEA treaties may lose access to US treaty benefits unless the relevant treaty is modified to address this concern.

This lost access to US treaty benefits may have a significant impact on group financing arrangements as many UK organizations rely on income tax treaties between the US and certain European countries, and this could result in an increase to US withholding taxes on intragroup payments.

Exactly what trade deals are negotiated, as well as in which European jurisdictions UK organizations have substantive trades or businesses could be relevant to whether US treaty benefits continue to apply.

For periods after exit from the EU, the UK could also decide to introduce tax charges that may be considered a breach of fundamental EU Treaty freedoms. In practice, this may be unlikely as the UK seeks to maintain international competiveness.

Indirect Taxes

For the FS sector, considerations and uncertainty surrounding VAT laws and regulations following Brexit may have the most significant impact going forward.

After the exit of the UK out of the EU, the UK VAT Act will no longer need to comply with the VAT Directive (2006/112/EC), and EU regulations will no longer be applicable. After exit, the UK will no longer be bound to follow the decisions of the European Court of Justice, although detailed transitional rules may be required to deal with legal rights which have accrued up to the date of exit.

It is not likely that the UK government will immediately compose divergent UK VAT laws and regulations, but the exit will give greater flexibility to make amendments in the current UK VAT legislation. There are a number of areas where the UK takes a different view and changes may arise for insurance outsourcing arrangements, cross border supplies between head office and branches, and the status of qualifying funds for VAT purposes.

The amendments will depend on the terms of the exit that will be negotiated between the UK and the EU as well as the need and desire the UK government will have to make certain amendments.

Furthermore, UK VAT legislation that was previously challenged at the European Court of Justice and had to be amended, might be reinstated.

In general, the UK might change VAT rates and reliefs. One of the specific areas that might be amended and could have a significant impact for the financial services industry in the UK is the scope and application of VAT exemptions on insurance and financial services.

To maintain or expand the financial services industry, the UK government may wish to broaden the application of these VAT exemptions. This might be beneficial for UK financial service providers, but could also lead to double taxation or non-taxation for companies doing (or outsourcing) part of their business cross border from or to the UK.

Organisations in the EU that provide certain financial services to recipients in the UK will be entitled to recover the input VAT referred to these services and may see their VAT recovery rates increase after the UK exits the EU. Furthermore, services from and to the UK may also be subject to certain measures to avoid double taxation or double non-taxation, as EU Member States are allowed to implement such measures for transactions from and to non-EU states based on the VAT Directive. Also the UK needs to decide whether to allow input VAT recovery rates with respect to specified supplies where the counterparty is in another EU Member State (where recovery is not allowed today), although this is not likely at this stage.

State Aid

Under an EEA Agreement, the current state aid rules would continue to apply. Although the EEA state aid rules are not identical to EU rules, the EFTA Surveillance Authority (responsible for enforcement) is vested with similar powers to the European Commission under the EU Treaties.

It is unclear to what extent the European Commission will remain competent after Brexit to require recovery of unlawful state aid granted by the UK while it was still a Member State. This may depend on the agreement reached between the EU and the UK upon exit.

If the UK were to exit the EEA, the state aid position would likewise depend on what will be agreed upon in bilateral negotiations. For example, if the UK joins the European Free Trade Association (EFTA), the EFTA Convention provides much less extensive EU state aid rules than the EU does. Depending on the model the UK will follow, the UK’s tax policy would cease to be constrained by state aid regulations.

What happens next?

For financial institutions with a business footprint in the UK, it is essential to closely monitor the Brexit negotiation process as it unfolds. There will be a variety of impacts, and ensuring operational flexibility and readiness for the changes ahead to manage the potential tax impact will be crucial.