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Untangling the Technical: Breaking Down Brexit: On the Brink

In less than two weeks the UK is supposed to leave the EU. Join Malcolm Joy, the Lead Partner of our London office, and Mike Whitacre, one of the leading partners in our International Tax Practice as they discuss the current status and potential tax implications of Brexit.

Untangling the Technical is available on iTunes, Google Play Music and Spotify. Listen now using the player below or download it to listen later.

Breaking Down Brexit: On the Brink Transcript

This transcript was assembled by hand and may contain some errors.

It has been edited for readability.

Adelle: Welcome to Untangling the Technical, Frazier & Deeter’s podcast series in which we take a look at complex business issues and break them down for business executives navigating today’s complicated and ever-changing regulatory environment. I’m Adelle Erdman, and today I’m delighted to welcome two of the key partners in Frazier & Deeter’s international practice as we discuss a rapidly changing topic: Brexit.

The news from the UK has been dominated by Brexit since the 2016 referendum with a narrow majority in favor of the UK leaving the EU. The scheduled date for the UK to leave the EU is the 29th of March, and I should mention that we are recording this on the 19th of March, so it’s coming up quite rapidly. But there has been a lot of recent political activity in the UK and in the EU. So today, we’re going to talk about where are we right now. I’m here with Malcolm Joy, who is the lead partner of Frazier & Deeter’s UK office to talk in detail about what Brexit means. Malcolm, good morning.

Malcolm: Good morning, Adelle.

Adelle: We also have with us Mike Whitaker, who is one of the lead partners in our international tax practice, who frequently speaks at events around the world about expanding your company across borders. Welcome.

Mike: Hi.

Adelle: Well Malcolm, here we are less than a month, really, a few weeks out from the scheduled exit date. First of all, what are we talking about with Brexit, and what is the UK actually exiting from?

Malcolm: So, the EU is a political and economic union which the UK joined back in 1973. If you go back to the history of the EU, it was formed soon after the Second World War and has an objective of promoting closer and closer union within Europe. Membership of the EU confers a number of benefits. It also enforces a number of obligations on the member states. But at the heart of membership of the EU, we’ve got four key principles. Firstly, free movement of people within the EU. Secondly, free movement of capital. Thirdly, free movement of goods. And fourthly, the free movement of services and members of the EU have to commit to uphold these principles.

But on top of the four fundamental principles, there are a number of directives that are issued by the EU from time to time, and what these do is they highlight particular areas that local countries need to make law changes in order to comply with the directives. So, in the tax world, we’ve got a number of directives that are very relevant to us. We’ve got directives around there being no withholding tax on payments of interest and royalties within the EU. This one’s known as the Interest & Royalties Directive. We’ve also got a directive on the payment of dividends between group companies within the EU. This is known as the Parent Subsidiary Directive, and a variety of other directives, such as the Manager’s Directive, that could have tax implications.

The other thing I think it’s important to mention about the EU is that our system of VAT that we have run across Europe is a direct result of membership of the EU. It was brought in as a way of raising tax in the EU and sharing out the proceeds of that tax on an EU-wide basis.

Finally, another thing that we need to think about with membership of the EU is that all the member states need to agree to having the European Court of Justice as effectively the Supreme Court for deciding many of the legal matters within the EU. But from a business perspective, the key thing that Brexit is going to cause us all to focus on is, if we do leave the EU, then we are going to move out of the free trade arrangements that are a fundamental part of the EU, so we would potentially then have customs duty chargeable as we move goods and services within the EU.

Adelle: All right. Well, this is the Untangling the Technical podcast, and that sounds fairly tangled. We are hearing people talk about the hard Brexit or the soft Brexit. What are they referring to?

Malcolm: The terms hard Brexit and soft Brexit refer to the degree to which the UK will abandon the principles which underpin membership of the EU. When the UK voted in 2016 to leave the EU, we weren’t actually given any detailed choices on how we wanted to leave. It was just a very straightforward simple question as to whether or not we wanted to stay in. So, it’s really been down to the politicians since then to determine to what extent we move away from the principles that I outlined earlier on.

A hard Brexit would involve abandoning all of the principles around free movement of people, freedom and the establishment of entities, free movement of capital, free movement of goods, et cetera, whereas a soft Brexit may involve the UK staying within some of these principles to an extent. The problem here is that if we did want to stay within the customs union or we wanted to retain free movement of people for example, then the EU would almost certainly exact some kind of price on the UK for doing that. We’d probably have to still keep the European Court of Justice as effectively the Supreme Court on legal matters, and we’d probably need to keep on paying some amounts into the EU.

So, a lot of politicians in the UK think that would not be acceptable. And the UK government has taken the view that a soft Brexit is really going against the wishes of the people who voted. So, all the proposals we’ve seen until now have been more focused around what we’d call the hard Brexit.

Adelle: Well, this sounds relatively convoluted, and the politicians seem to be having a difficult time figuring out a way forward. Why is it so difficult, and can you give us really in a nutshell where we are right now?

Malcolm: It does seem to be incredibly difficult, and there are a number of significant factors in this. First of all, the majority of politicians themselves were not in favor of Brexit, and we do still have a wide range of views within the House of Commons on what Brexit actually means. Secondly, the vote itself by the public was very, very close. Thirdly, as I mentioned earlier, the population wasn’t asked to vote on what type of Brexit we wanted. And fourthly, and perhaps most significantly in certain areas, is the whole question of Northern Ireland.

The peace deal that was agreed there with the Good Friday Agreement is still considered to be quite precarious, and neither the Irish government nor the UK government are at all in favor of creating any kind of border between the North of Ireland, which is part of the UK, and the south of Ireland, as it’s feared that that may raise tensions there. The problem is that if you keep the border open between the North of Ireland and the South, then you have to effectively draw a border somewhere else between Northern Ireland and the rest of the UK, and that would be deeply unpopular and unacceptable to the vast majority of people in the North of Ireland and also to the main political parties in the North of Ireland. The Democratic Unionist Party (DUP), which is one of the main parties in the North of Ireland, is relied upon by Theresa May’s government to keep the conservative party with a majority in parliament.

So, without the support of the DUP, the Conservative Party would not have a majority in parliament and would not be able to get things passed. So, trying to come up with some kind of resolution that keeps all sides happy is incredibly tricky.

Adelle: Well, this is very, very complicated. So, time to get out your crystal ball. Again, it’s March 19th. Do you think the UK will actually leave the EU on March 29th?

Malcolm: I’m tempted to record three answers to this question. So, the choices now seem to be either exiting the EU on the 29th of March without any deal agreed or gaining some kind of extension, because the deal that is being negotiated by Theresa May with the EU has not achieved any kind of support in the House of Commons in the UK, certainly not enough support to enable it to be passed. I think most people in the UK realize that crashing out of the on the 29th of March without any kind of deal would be disastrous for both the UK and a lot of European Union countries.

So, I do find it hard to believe that the British parliamentarians would allow that to happen. I think it’s a lot more likely that’s an extension, whether it’s a short extension or a longer extension I don’t know, but I think it’s a lot more likely that some kind of extension would be agreed upon, and we would have time to at least try to come up with a deal that does find more favor with all the various vested interests in the UK and the EU.

Adelle: We’ll be fascinated to see how it plays out. So, if we assume that there is no second referendum, which I’ve heard batted around, what are the tax changes that are likely to happen when the UK leaves the EU?

Malcolm: I think there is still a possibility that there could be a second referendum. Certainly in the last few weeks, we’ve seen parliament vote against having any kind of second referendum, and there’s a lot of people who are concerned that having a second referendum would effectively go against the wishes of the people in the in the first referendum and therefore remove public confidence from the whole political system with referendums. But I think if we carry on for a significant time with no deal being agreed, people start to realize that it’s not an acceptable long-term solution, and there might be more of a move to having a second referendum.

But if there isn’t any second referendum and the UK does leave the EU, then we do have a number of tax considerations that we need to start thinking about. So, the first major thing that people will need to start thinking about is imports and exports, and whether or not those imports and exports are subject to customs duty and VAT. At the moment, goods coming into the UK do so quite seamlessly. There are no checks or limited checks on those goods as they come in.

But, if we are outside the EU, then there will be checks and delays and customs duty payable before those goods can be moved on. Although the UK’s VAT system was brought in as a result of membership of the EU, I think it’s highly unlikely that the UK would withdraw its own system of VAT simply as a result of leaving the EU. It does raise an awful lot of revenue for the UK government, and it’s widely accepted in the UK as a fair means of raising taxes, but there would certainly need to be some changes to the way VAT is operated. There could be additional registrations or additional procedures that people need to follow. So, I think getting your head around what kind of changes might be necessary if the UK had its own standalone VAT system, which is outside of the main EU system, then that is clearly something that companies need to think about.

There could also be implications on corporate income tax and withholding tax. I mentioned right at the start, one of the things about being a member of the EU is we have these directives like the Parent Subsidiary Directive and the Interest in Royalties Directive, which effectively eliminate withholding taxes on interest royalties and dividends being paid within the EU. If the UK were to leave the EU, then these directives would stop applying to UK companies, who would then need to go back and look at the bilateral treaties to see if they would still provide any protection from withholding taxes. In many cases they do, but in certain circumstances they don’t.

So, for example, if you are a UK company that has a German subsidiary and the German subsidiary is paying dividends to the UK, then under the bilateral treaty, there is still a residual withholding tax, whereas under the Parent Subsidiary Directive, there is no withholding tax, and there’s some things that we need to think about from a direct tax point of view as well.

Mike: To me, from a US business perspective, most US companies look at Europe as one business area. So, at a high level, what Brexit means to most US companies is, it impacts the movement of goods throughout Europe, the movement of people and the movement of money. And I think the way they’ve been operating in the EU for a while is, if you set up a holding company somewhere, you have companies in different countries, probably, because you’re selling goods. You have people like the US, who look at Europe as one market since the EU’s been in place and been able to move money people and goods around freely.

What’s going to happen is, presumably, when the UK comes out of the EU, things moving between the UK and the rest of the EU may not be able to move freely with regards to those three items anymore. So, I think a big issue for these companies is how to separate the rest of the EU from the UK going forward and all the complexities around that.

Malcolm: I think that’s a good summary, Mike. I think  post-Brexit, it should still be possible to move people, it should still be possible to move money and to move goods as well. But I think it is just likely to be a slower process, as you need to think about things each time you do it. In the past, we’ve been able to quite happily move people, goods, money, et cetera without really having to think too much about it from a regulatory point of view. Going forward, we will just need to stop and think about it before we carry out any of those activities, and that is going to slow things down.

Mike: Yeah, I think what complicates that further is the UK, to Americans, is not just another one of the EU countries. It’s usually a favored location for a variety of reasons. So, it’s not like, “Oh, it’s just one country equivalent to the rest that may be breaking out,” it’s a big favorite place of US companies to headquarter or locate, which I think just adds more to the potential complexity. But we have to see how it all turns out.

Malcolm: Indeed. One of the positive things that people are talking about if Brexit does happen is that it will enable the UK to renegotiate trade deals with other countries, and the one that they are most keen to renegotiate is with the US. We’ve already heard favorable noises from the Trump regime as well as from the UK government about the renegotiation of the trade deal, and that may open up opportunities in certain sectors such as agriculture, farming, et cetera, where there have, to date, been some restrictions on imports and exports between the two countries. But the whole Brexit scenario may open these areas up to two more international trade.

Adelle: Excellent. So, if your US business has operations in the UK, today, when you think about tax issues, what should those companies be doing to prepare?

Malcolm: I think the main thing to do is to just look at how Brexit could affect the business operations you currently have in the UK and the rest of the EU, and think about scenario planning. Is there anything that you can do now to eliminate some of the problems that might occur post Brexit? Are there any changes you need to make, are there any easier ways of doing things? Are there  parts of your business that are going to be significantly affected that you need to start thinking about restructuring? And just sitting down and proactively thinking about these areas in conjunction with your tax advisers and your business advisers I think would be the sensible thing that businesses should be doing.

Adelle: Okay, well we’ve covered a lot of territory. Are there any other changes that will have a significant impact on businesses operating in the UK that we should touch on?

Malcolm: I think perhaps one of the other areas that might be worthy of a little bit more focus is the whole free movement of people. If you look at a lot of businesses, particularly in the south east of England around London at the moment, they are very reliant on some workers coming in from the EU. Particular industries that require seasonal workers or casual workers, perhaps in the hospitality sector, are very, very heavily reliant on workers coming in from the EU. Just trying to think about any things you can do now to make that less of a problem for you as you go forward. That is probably worth doing as well.

Adelle: Well, I want to thank both of you for being on the podcast and sharing your insights, and it’ll be interesting to monitor the situation as it continues to evolve. For our audience, thank you for listening to Frazier and Deeter’s Untangling the Technical podcast. Please join us for our next episode as we continue to discuss complex topics in terms that help you find your way forward.

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