Taxation In Europe After Brexit

The UK's decision to leave the EU will have significant economic implications for the country and for the EU. Although the full impact of Brexit will not be seen for at least another two years and yet to be determined by the secession negotiations, some conclusion can be made.

First, the decisions of the European Court of Justice will no longer apply in the UK. Second, the UK will, most likely, leave the Customs Union and, therefore, will have to introduce its own customs system. Third, the EU's attempts to harmonise corporate taxation in Europe will end at the UK's border. Fourth, the UK is likely to continue the policy of tax preferences to foreign investments and to keep taxes low.

Customs Union

The EU, among other things, is a customs union. This means that there are no customs duties within the EU and that Member States share common external tariffs with non-EU countries.

The implications of leaving the EU, therefore, will concern duties on trade between the UK and the EU and duties on trade between the UK and the rest of the world. This will depend on the relationship between the UK and the EU after Brexit.

The possible models are:

Membership of the EEA (the "Norway model"). Norway, Iceland, and Liechtenstein are members of the European Economic Area (EEA) while they are not members of the EU. The EEA model implies membership in the customs union and gives access to the Single Market. EEA members must follow most of the rules of the Single Market, though they without a vote or vetoes on how those rules are made. They also must make financial contributions.

For the UK, this model seems problematic since EEA members have to accept the free movement of people.

Negotiated bilateral agreement (the "Switzerland model"). Bilateral agreements with the EU offer some access to the Single Market. They rarely go as far as to establish a Customs Union. Switzerland's arrangements with the EU go furthest in replicating the benefits of EU membership but they also imply financial contributions and accepting the free movement of people.

Membership in the customs union (the "Turkish model"). Some non member countries, like Andorra, San Marino and Turkey, are members of the European Union Customs Union (EUCU). This model implies free movement of goods without any customs restrictions. However, it does not cover certain economic areas such as agriculture and public procurement. More importantly, this model does not cover services, which is a key part of the UK economy. There is no obligation to accept free movement on people.

Advanced Free Trade Agreement (the "Canada model"). This means very limited access to the Single Market. The EU-Canada agreement does not give tariff-free access to the Single Market for all Canadian manufactured goods, it does not cover a number of key sectors. It does not cover services.

WTO membership (the "Hard Brexit model"). The World Trade Organisation sets out rules governing trade between WTO members (including, of course, the UK). WTO rules do not include any preferential access to the Single Market, or to any of the 53 markets with which the EU has negotiated Free Trade Agreements.

The most likely scenario is that the UK will have to leave the customs union and, therefore, reintroduce customs and tariffs on trade with the EU.

Although there are voices to 'punish' the UK, it is unlikely that very significant customs duties will be imposed. While only around 10% of exports from the EU are to the UK, most EU countries benefit from significant trade in goods surpluses with the UK; in particular, Germany, Belgium, the Netherlands, Spain, France and Italy.

Imports from the UK into the EU would follow the EU’s WTO “most-favoured nations” regime. This would put UK business to some disadvantage when compared with competitors within the EU.

In terms of trade with third countries, the UK would need to adopt three sets of tariff rates for its imports: general rates for non-WTO members, most-favoured nation rates (for WTO members, including the EU member states) and GSP rates (generalised system of preferences for the least developed countries).

It is still not clear what will happen to the free trade agreements to which the UK is a party as a member of the EU. Whether the UK will continue to be a party to them after leaving the EU has been the subject of debate. If they cease to apply to the UK, then imports which had previously been tariff-free would become subject to WTO's 'most-favoured nation' rates.

Countries with which the EU currently has free trade agreements include South Korea, Mexico and South Africa. Agreements with the US, Canada and Japan are still to be negotiated.

Indirect Taxes

The EU has been harmonising indirect taxation, first of all VAT, across member states since late 1970s. Following Brexit, the UK will move outside of the EU's laws and, therefore, will be able to change how VAT is charged in the UK or even to replace it with an entirely different tax.

After secession, the UK will have to replace the EU legislation with its own. Also, the jurisdiction of the Court of Justice of the European Union will cease any such VAT related question will be dealt with entirely by the UK courts.

However, significant changes seem unlikely. The cost to UK business would be big and superfluous. Although over time we could see some divergence, the country will, most probably, keep its VAT system materially aligned with the EU’s.

The real consequence of Brexit would likely be the imposition of “import” VAT when goods enter the EU from the UK and when EU goods enter the UK. The VAT would be recoverable but there would be cash flow cost because of the delay between the moment of import and the moment of recovery.

Material changes to the excise duty in the UK are unlikely, though not impossible, since the tax is not fully harmonised in the EU. As with customs duty, the movements of excise goods between the UK and member states will be treated as import or export. Therefore, such movements are likely to be subject to different procedures than those applied to the trading within the EU.

Direct Taxes

The EU has implemented several directives intended to support the establishment and functioning of the internal market. All of them require unanimity and member states implemented some these directives.

The most important are the Parent Subsidiary Directive and the Interest and Royalties Directive which prohibit withholding taxes on intra-group interest, dividend and royalty payments made within the EU.

The UK is the key foreign direct investment gateway into the EU. Half of all EU headquarters of third country multinationals are based in the UK. The main EU beneficiaries are the Netherlands, Luxembourg, France, Ireland, Germany, Sweden, Spain, Belgium and Italy.

EU subsidiaries would not be able to rely on these Directives to pay dividends or interest to their UK holding companies free from withholding taxes. Relief under double tax treaties would be an alternative.

Not all treaties, however, set a 0% withholding tax. Payment of dividends by German or Italian subsidiaries may become problematic.

A significant amount of foreign direct investment into the UK also comes from the EU (mostly from France, Germany, Luxembourg, the Netherlands and Spain). The UK does not impose dividend withholding taxes. It does, however, impose withholding taxes on interest and royalty, yet treaties with EU member states normally reduce the withholding rates to 0%. There, of course, exceptions. The treaty rate for withholding taxes on royalties paid to Luxembourg is 5%.

Mergers Directive concerns deferral of tax on gains that become due at company or shareholder level for certain cross-border mergers, divisions, transfers of assets and exchanges of shares taking place within the EU.

Mutual Assistance Directive concerns administrative co-operation between tax authorities including the exchange of rulings within the EU. This, however, is also covered by Action 5 of the G20/OECD Base Erosion & Profit Shifting project.

Recovery Assistance Directive is about assistance in connection with recovery of tax.

Currently, the Court of Justice of the European Union has the jurisdiction over tax matters, specifically whether national law infringes any of the treaty freedoms: freedom to provide services, free movement of people, free movement of capital and freedom of establishment. This will no longer be the case.

Tax Harmonisation v Tax Competition

The EU has been pushing hard to 'harmonise' taxation within the union for over a decade. Although the word has not been used, 'tax harmonisation' is seen as tax equalisation leading, eventually, to a fiscal union.

This policy has three main forms: the Court of Justice of the European Union's case, the European Commission's State Aid proceedings and the tax base unification initiative, known as CCCB - Common Consolidated Corporate Tax Base.

Over the last decade the Court of Justice has taken progressively more activist position in challenging the member states laws on the basis that they are discriminatory, contravene the treaty freedoms or constitute state aid.

The European Commission have become increasingly proactive in restricting member states’ freedom within the tax area through proceedings for state aid. This is a controversial concept that prohibits EU member states from providing impermissible tax benefits to companies, expanding the jurisdiction of the EU's institutions into the realm of domestic taxation.

According to the CCCB initiative, a predefined share of a company’s total income will be allocated to each member state and then taxed at a local rate. The attribution of income is in stark contrast with conventional taxation principles: it would depend on sales, assets and workforce based in each country.

The proposal implies that a company headquartered in Ireland, with Europe's lowest rate of 12.5% but operating also in France will now have a large part of its income taxed in France at much less attractive rate of 33.3%. Although it may seem fair, the end result would be the loss of incentive for Ireland to keep its tax rate low. What is likely happen, therefore, is the gradual equalisation of rates across the EU somewhere closer to the higher end.

The UK has been the vocal opponent of tax harmonisation: the idea that the UK would ever agree to surrender its tax sovereignty seems somewhat naive.

In the absence of the UK, the tax harmonisation would receive new boost - even though it is likely to increase the division within the EU by making strong economies stronger and weak weaker. The CCCB clearly favours affluent countries of the North and thwarts relatively poor countries of the South.

The UK, outside the EU, would have new incentives to continues its policy of tax preferences.