Leaving the EU. Consideration of impacts on corporate tax rules of EU member states

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1 October 2016 Tax Services Leaving the EU Consideration of impacts on corporate tax rules of EU member states Following the UK s referendum vote to leave the European Union on 23 June 2016, the UK Government has repeatedly confirmed, mostly recently at the Conservative Party conference, that the UK is committed to leaving the EU (Brexit) saying that Brexit means Brexit. At this stage, there seems to be little consensus between the UK, the other EU Member States (EU27) and the European Commission as to what any ongoing relationships might look like. A range of potential models for such settlement have been suggested, but at the time of writing no formal negotiations on the Brexit terms, or the post-brexit settlement, between the UK and the EU27 have begun. We do know however that the UK will serve notice to the European Council under Article 50 of the Treaty on European Union (TEU) of its intention to leave before the end of March The impact of Brexit on many of the issues considered in this note will be dependent on the precise terms of the post-brexit settlement, and therefore our comments should be read in light of future political developments. Brexit and the impacts on corporate tax rules of EU member states an introduction European Union law has had an important impact on the corporate tax rules of EU Member States. As well as passing new legislation such as the Merger Tax Directive, Interest & Royalties Directive and the Parent-Subsidiary Directive and, more recently, the Anti-Tax Avoidance Directive, EU law has been used a shield by taxpayers to provide an effective defence against tax assessments raised by the tax authorities of Member States and also as a sword, to assert repayment of tax (and interest) which they assert have been levied contrary to EU law. In fact, Decisions from the Court of Justice of the European Union (CJEU) has produced well over two hundred decisions over the last 30 years or so looking at the compatibility of national tax rules with the fundamental freedoms contained in the EU Treaties; for example, the freedom of establishment and the free movement of capital. In many of these cases, the CJEU has held that national tax rules have infringed the EU Treaties and effectively drawn up a jurisprudential framework within which corporate tax rules must operate. In the UK alone, it is estimated that HM Revenue & Customs (HMRC) have paid 7.87bn to taxpayers as a result of CJEU decisions and that a further 7.3bn will be paid by HMRC before 2020.

2 More recently, there has also been an increase in EU State Aid investigations into corporate tax rules as well as rulings given by tax authorities in Member States. The key issue is whether such national tax rules or tax authority rulings constitute an unlawful subsidy afforded by those Member States to taxpayers. This question has recently assumed significant prominence in the framing of international tax policy. 1. The post-referendum pre-brexit position As things currently stand, post-referendum, but pre-brexit, EU law fully applies in the same way as it did before the referendum vote, because the UK is still a member of the EU and that the legal relationships (at least, so far as germane to corporate tax issues) between it and the EU27 remain unaffected by the referendum vote. Therefore, in principle, the position of taxpayers and Member States with regard to the operation of EU tax legislation and CJEU case law is unchanged. Subject to any express agreement to the contrary, technically, this position will not change upon the UK serving the Article 50 notice on the European Council. The notice merely triggers the negotiation period for the post-brexit settlement. The notice does not itself cause any change in the legal relationships (at least, so far as germane to corporate tax issues) between the UK and the EU27. It should be noted, however, that serving the notice triggers a two year deadline for the parties to agree the post-brexit settlement. If no such agreement is reached then, unless the EU27 and the UK unanimously agree to extend it, EU law would cease to apply to the UK from that point (see below). Furthermore, during the referendum campaign, it was suggested by the Leave campaign that the UK Parliament should pass legislation removing the rights of taxpayers to reclaim tax paid to HMRC contrary to EU law. To date, there has been no such suggestion from Theresa May or other Ministers in the UK Government and, so long as the UK is a member of the EU, EU law has direct effect in, and supremacy over, UK law. Therefore, in the pre-brexit period, Parliament should not lawfully be able to take away EU law rights from taxpayers. In the course of the recent debate on the UK Finance Bill 2016, Jane Ellison, the Financial Secretary to the Treasury, confirmed that the Prime Minister has been very clear that our rights and obligations remain in place until we leave the European Union. Notwithstanding the strict technical position (i.e., no change) noted above, there may be some practical considerations that arise during this period including the following: Under Article 267 of the Treaty for the Functioning of the European Union (TFEU), the courts and tribunals of Member States, including the UK, may request a ruling from the CJEU on EU law issues. Following the referendum vote, it is conceivable that UK courts and tax tribunals may be more reluctant to refer points of EU law to the CJEU and that the CJEU may be more reluctant to hear or prioritise such cases. Anecdotal evidence to date suggests this may be an emerging trend. Leaving the EU 2

3 Taxpayers with EU law-based tax reclaims pending against HMRC may find that negotiations and litigation get increasingly drawn out, as HMRC look to resist or defer paying out on such reclaims on the expectation that, post-brexit, taxpayers EU law rights will either lapse or be removed by primary legislation and / or by the terms of the post-brexit arrangements between the UK and the EU27 (see further below). HMRC have already sought to raise a number of substantive and procedural points in the course of a range of cases involving EU law points following CJEU decisions perceived to be favourable to taxpayers in the expectation of avoiding paying out such reclaims; Brexit is in our view likely to accentuate this trend even if such conduct by HMRC (or indeed other tax authorities, see below) may be susceptible to legal challenge. Similarly, taxpayers located in the UK with EU law-based tax reclaims pending against the EU27 may find themselves in a similar position when dealing with tax authorities in those countries. Although the risk for taxpayers here may be less acute, taxpayers would therefore be welladvised to seek acceleration of payments (where reclaims are legally due but not yet paid) and acceleration of litigation (where the legal strength of the reclaims remains to be determined). 2. The post-brexit position In a post-brexit world, it is possible that the UK will simply be treated as a third country by the EU27 (assuming no special accommodation can be reached). In other words, the UK would have the same relationship with the EU27 as most other countries, such as the US or Japan, and would not have any special access to, or legal obligations or responsibilities under, the EU Single Market. In this case there will be potential impacts with respect to EU law both within the UK and within the EU27. Taking each in turn: Impact on taxpayers so far as the UK is concerned Post-Brexit, the UK would no longer be bound by EU law. EU direct tax legislation The UK would therefore no longer be obliged to apply EU Directives (such as the Parent-Subsidiary Directive or the Interest & Royalties Directive), and therefore conceivably the UK would for example be able to impose withholding taxes on interest and royalty payments made by UK subsidiaries to EU parents, subject to the operation of double taxation treaties. The UK would, of course, have the choice to continue to apply domestic UK tax rules that effectively implement those Directives. So for example, section 757 et seq of the Income Tax (Trading and Other Income) Act 2005 (ITTOIA) provides for a domestic exemption from UK withholding tax for interest and royalty payments in a manner reflecting the Interest & Royalties Directive. Similarly, there are a number of provisions in the UK tax code (section 140A et seq Taxation of Chargeable Gains Act 1992; section 421 et seq, section 682 et seq, and section 819 et seq of the Corporation Leaving the EU 3

4 Tax Act 2009) that effectively implement the Mergers Tax Directive. If the UK wished to remove such exemptions, it would need to repeal the legislation in question; Brexit per se would have no effect on the continued operation of such rules. EU law as shield to tax assessments raised by HMRC or as a sword to reclaim UK taxes Furthermore, taxpayers would, from the date of exit, no longer be able to rely prospectively on EU law as a shield to any tax assessments raised by HMRC or as a sword to reclaim taxes, irrespective of whether those taxpayers were located in the UK, in the EU27 or in third countries. A more complex question is whether taxpayers could lose, in effect retrospectively, any EU law rights that had already crystallised in the period when the UK was an EU Member State. As a starting point, we consider that such rights would not automatically fall away as a consequence of Brexit. Those rights would already have crystallised, and therefore those rights could only be lost if they were taken away. Such rights may conceivably be taken away (or at least attempted to be taken away) through legislation passed by the UK Parliament and / or through the terms of the settlement agreement between the UK and the EU27. An important and difficult question is whether such acts would be legally effective? The UK would, from the point of leaving the EU, no longer be bound by EU law, and so the question of whether the UK could take away EU law rights (from the point of Brexit) would be solely a matter of UK domestic law. Under UK domestic law, the UK Parliament is sovereign and therefore in principle Parliament should be able to legislate as it pleases. The analysis is however rather more complicated. Parliament has enacted the Human Rights Act 1998 (HRA). Section 4 of the HRA provides that the superior UK courts may, if satisfied that a law passed by Parliament is incompatible with a right afforded by the European Convention on Human Rights (ECHR), those courts may make a declaration of incompatibility. ECHR rights include a right to a fair trial (Article 6, ECHR) and an entitlement to the protection of property (Article 1 of First Protocol, ECHR). The unilateral, and effectively retrospective, removal of EU law based reclaims (as well as the denial of any assertion that taxpayers could not rely on EU law as a defence to tax assessments for periods when the UK was an EU Member State) may constitute a breach of those ECHR provisions, and therefore potentially susceptible to a declaration of incompatibility. The above point may however be complicated by the point that Parliament has already enacted legislation (e.g., section 320 Finance Act 2004; section 107 Finance Act 2007) which has already purported (in certain circumstances) to limit the timeframe within which taxpayers must make a claim for repayment of taxes. That legislation was held by the UK Supreme Court to be contrary to EU law and consequently unenforceable, but might it be argued that such legislation becomes effective, as from the date of the enactment of such legislation, as and when the UK leaves the EU? One scenario that could conceivably arise is where the UK and the EU27 agree, as part of the Brexit settlement, that EU law-based reclaims of tax by UK taxpayers against the EU27 and by the EU27 Leaving the EU 4

5 against the UK would lapse on Brexit. It may be that such agreement would be unacceptable to the EU27 and therefore not a realistic scenario. Even if it was, the legality of such agreement would need to be tested by reference to EU law, and any such agreement may be contrary to EU law on the basis of offending EU law principles of legal certainty and legitimate expectations. It is also worth noting that, post-brexit, any determination of EU law questions would be in principle solely for the UK courts and tribunals. The ability for the UK courts and tribunals to refer such questions to the CJEU would, absent any agreement to the contrary, fall away. In a tax context, it is conceivable that the prospects of taxpayer success in such cases would recede. EU State Aid Post-Brexit, the UK would no longer be bound by EU State Aid rules (subject to entering into any agreement with the EU27 providing for similar rules), and therefore would in principle be able to offer tax subsidies to taxpayers in a manner prohibited by the current operation of such rules. As a practical matter, however, the UK has signed up to all of the BEPS Action Plans, including Action 5 on Harmful tax practices, and therefore may feel relatively constrained in its ability to offer tax subsidies to taxpayers. That said, the UK may wish to amend rules governing research and development tax credits and tonnage tax to make them more attractive in a post-brexit environment. Moreover, the UK may have more flexibility to manage (i.e., reduce) its overall UK corporation tax rate (notwithstanding certain statements from European politicians suggesting such a reduction may be damaging for Brexit negotiations with the EU27) as well as the Northern Irish corporation tax rate (anticipated to fall to 12.5%). We are not aware of any formal European Commission State Aid decision or investigation into tax rulings that have been given by HMRC, and therefore we do not believe that Brexit will have any significant impact in this regard. The UK does, however, have arrangements that are subject to EU State Aid challenge (e.g., aggregates levy) or approval (e.g., tonnage tax), and it will be interesting to see whether these will come under less pressure from the European Commission going forward. EU Arbitration Convention The EU Arbitration Convention establishes a procedure to resolve disputes where double taxation occurs between enterprises of different Member States as a result of an upward adjustment of profits of an enterprise of one Member State. The Convention provides for the elimination of double taxation by agreement between the contracting states including, if necessary, by reference to the opinion of an independent advisory body. The Convention is an international treaty rather than EU legislation, and being a party to the Convention does not formally require EU membership. Consequently, the UK (unless it separately withdrew from it) would remain party to the Convention, and bound by its terms; Brexit per se would not result in the UK ceasing to be party to the Convention. However, Article 16 of the Convention defines the territorial scope of this Convention by Leaving the EU 5

6 reference to what is now Article 52 TEU. Following Brexit, the UK would not be one of the countries listed in Article 52, and so would fall outside the territorial scope of the Convention. This likely means that: Disputes involving the UK arising pre-brexit would fall to be dealt with pursuant to the terms of the Convention. Disputes involving the UK arising post-brexit would not. Consequently, there may be merit in looking to accelerate disputes in order to fall within the terms of the Convention. Impact on UK taxpayers so far as the EU27 are concerned EU direct tax legislation EU direct tax legislation applies only to companies located in EU Member States. Consequently, the relevant EU Directives would not apply, post-brexit, with respect to situations involving transactions involving UK companies. Therefore, the EU27 would for example be able to impose withholding taxes on dividend, interest and royalty payments made by EU subsidiaries to UK parents, subject to the operation of double taxation treaties. EU law as shield to tax assessments raised by EU27 or as a sword to reclaim taxes imposed by EU27 The first point to consider is the degree to which UK taxpayers would, from the date of exit, be able to rely prospectively on EU law as a shield to any tax assessments raised by tax authorities in the EU27 or as a sword to reclaim taxes paid in those countries. Assuming that, post-brexit, the UK was a third country, UK taxpayers would no longer be able to rely on any of the fundamental freedoms contained in the TFEU, except for the free movement of capital, which also applies as between EU Member States and third countries, albeit with a number of important limits in favour of EU Member States. The key limitations with respect to the free movement of capital in third country situations include the following: First, the CJEU has held that the free movement of capital is not applicable to, and hence does not protect, third country investments, when the contested tax rule is confined exclusively to situations involving an investment that confers on the investor definite influence over corporate decisions. This implies that corporate tax measures solely designed for groups of companies fall outside the scope of the free movement of capital. Examples would typically include tax grouping / consolidation rules, thin capitalisation rules and CFC rules, although each case must be assessed on its own merits. However, where a national tax rule is not confined to situations involving such definite investor influence, then the legality of that rule may generally be tested under the free movement of capital, irrespective of whether as a factual matter an investor Leaving the EU 6

7 happens to have a definite influence over the investment. Examples of such rule would typically include withholding taxes on portfolio dividends and double tax relief measures. Second, restrictive tax measures that already existed on 31 December 1993 and that involve direct investment including investment in real estate establishment, the provision of financial services or the admission of securities to capital markets are excluded. The application of this grandfathering rule should be considered on a case-by-case basis. Third, the CJEU has accepted that an EU Member State may be able to demonstrate that a restriction on capital movements to or from third states may be justified for a particular reason in circumstances in which that same reason would not constitute a valid justification for a restriction on capital movements between Member States. In particular, the CJEU appears to have accepted that in such circumstances EU Member States may have more latitude for accepting justifications based on the need to combat tax abuse the need for effective fiscal supervision and the objective of combatting tax havens. Notably, the CJEU has decided that a discriminatory tax measure (e.g., withholding taxes) may be justified where the third state in question has no obligation to exchange information with the EU Member State that is equivalent to the obligations that apply within the EU. Lastly, the TFEU provisions on the free movement of capital vis-a-vis third countries contain a number of emergency brakes. For example, pursuant to Article 64(4) TFEU, the Commission or, in the absence of a Commission decision within three months from the request of the Member State concerned, the Council, may adopt a decision stating that restrictive tax measures adopted by a Member State concerning one or more third countries are to be considered compatible with the EU Treaties in so far as they are justified by one of the objectives of the EU and compatible with the proper functioning of the internal market. Hence, the question of whether, post-brexit (if the UK was a third country), UK taxpayers would be protected under the free movement of capital provisions of the TFEU would need to be examined on a case-by-case basis. Similar to the position noted above vis-à-vis the UK, the question arises whether taxpayers could lose, in effect retrospectively, any EU law rights that had already crystallised vis-à-vis the EU27 in the period when the UK was an EU Member State. One key difference however between the UK s position post-brexit and that of the EU27 is that the EU27 will (as noted above) continue to be bound by EU law, including judgments of the CJEU, and will therefore constrained by EU law principles of legal certainty and legitimate expectations. This may make it more difficult for the EU27 to retrospectively remove such rights through legislation, especially in circumstances where the taxpayer has a case before the CJEU in the first place (by reference from a national EU27 court). Leaving the EU 7

8 EU State Aid rules The EU State Aid rules would continue to apply to the EU27. Therefore, UK taxpayers would in principle remain equally impacted post-brexit by the potential application of State Aid rules to any rulings they (or their EU subsidiaries or branches) have obtained (or obtain in the future) from EU27 tax authorities. UK as signatory to the EEA Agreement It is thought unlikely that the post-brexit settlement would result in the UK becoming a signatory to the EEA Agreement. This is for a number of reasons. First, because such a settlement would result in the UK needing to make a contribution to the EU budget; second, because the UK would be bound by many rules similar to those imposed on EU Membe States, but without having any say over the formulation of those rules; and thirdly, because the UK would have only very limited ability to impose restrictions on the free movement of persons. Nonetheless, EEA membership has been suggested as a possible stop-gap measure while the UK and the EU27 negotiate permanent settlement arrangements. Against that backdrop, we turn to consider what consequences this would have. As a preliminary point, if the UK were to leave the EU, it would need to become a signatory to the EEA Agreement. The UK is currently a signatory to the EEA Agreement but we believe this is only because it is currently an EU Member State. Post-Brexit, the UK would neither be an EU Member State nor an EFTA country, and therefore EEA membership is something that the UK would need to negotiate and agree with the EU27 as well as the other EEA countries (Norway, Iceland and Liechtenstein). EU direct tax legislation As noted above, EU direct tax legislation applies only to companies located in EU Member States; it does not apply to companies located in the other EEA countries. Consequently, the relevant EU Directives would not apply, post-brexit, with respect to situations involving transactions involving UK companies, and the EU27 would for example be able to impose withholding taxes on dividend, interest and royalty payments made by EU subsidiaries to UK parents, subject to the operation of double taxation treaties. In other words, for these purposes, there would be no material difference between a post-brexit scenario where the UK was a third country (as noted above) or a signatory to the EEA Agreement. Leaving the EU 8

9 EEA Agreement as shield to tax assessments raised by UK / EU27 or as a sword to reclaim taxes imposed by UK / EU27 The EEA Agreement, like the EU Treaties, contains provisions which provide for the freedom of establishment, free movement of services and free movement of capital.in broad terms, therefore, many of the considerations that arise in relation to the intersection of national tax rules and the fundamential freedom provisions in EU Treaties will also apply to the intersection of national tax rules and the equivalent provisions in the EEA Ageement. Recent CJEU case law indicates that both the CJEU and the EFTA Court (the judicial body responsible for interpreting the EEA Agreement) have recognised the need to ensure that the rules of the EEA Agreement which are identical in substance to those of the Treaty are interpreted uniformly, and both the CJEU and the EFTA Court have applied this principle (either expressly or implicitly) in a number of cases concerning the compatibility of national tax rules with the EU Treaties and the EEA Agreement. That said, there are some examples where the EFTA Court has adopted an approach that is more favourable to the taxpayer than the approach taken by the CJEU. For example, in Amurta, the CJEU ruled that the availability of a tax credit in the state of residence should be taken into account when considering whether withholding tax levied by the source state was unlawful; in contrast, in Fokus Bank, the EFTA Court ruled that a tax credit in the state of residence state was not a relevant consideration for determining whether withholding tax levied by the source state was unlawful. The EEA arrangements provide that EEA countries may refer points of interpretation of the EEA Agreement to the EFTA Court. There a number of differences between the reference procedure under the EEA arrangements and those under the EU Treaties. First, there is no obligation to seek an advisory opinion from the EFTA Court. Secondly, an opinion may be sought only on the interpretation of the EEA Agreement, not on the validity of acts of the bodies established under the Agreement. Third, the response by the EFTA Court is not binding on the requesting court. In addition, EFTA States may permit their courts to request that the CJEU decide on a question of interpretation of provisions of the EEA Agreement which are identical in substance to provisions of the EU Treaties. EFTA States thus have discretion as to which court would be entitled to seek a decision. State Aid rules The EEA Agreement, like the EU Treaties, contains State Aid rules, which would bind the UK. EU Arbitration Convention See comments above. Leaving the EU 9

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