Nick Skerrett considers the tax disputes and areas of controversy we are likely to see in the aftermath of Brexit
Given the tensions and uncertainty of Brexit, tax will inevitably be a key area of disputes for UK businesses trading internationally and for foreign firms trading with the UK.
There are obvious issues as to the ongoing effect of EU law and extant proceedings as the UK moves through and out of the transition period; there is much academic commentary speculating on those points which will play out in the courts in time.
Many clients have made substantial changes to their organisational and operational structures in response to the changed regulatory and trading environment they envisaged post-Brexit. Assets, staff, IP, functions, supply-chains and contracts have all been impacted. This will have significant tax consequences and managing the tax risks from operating such structures will not be straightforward.
Brexit was an unusual event in a tax context in that the need to adopt a structure that allowed business continuity in compliance with regulatory laws was paramount, with tax considerations secondary. Tax efficiency is usually more to the forefront in shaping the structure of a business transaction. We now move into a phase where the immediate tax consequences of some of those reorganisational steps will come to light. Moreover, our client conversations are increasingly turning to consider their new operational footprints and assess the increased likelihood of tax disputes and controversy inherent therein.
Brexit has undoubtedly altered the international footprint of UK-centric businesses, particularly those in financial services, who are reliant on EU passporting to carry out regulated activities in the EU. While temporary permissions and alternative regimes provide interim relief, businesses have been compelled to find longer-term solutions. This has necessarily resulted in the bolstering of existing operations and/or the setting up of new ones (in the form of subsidiaries or branches) within the EU and the transfer of (part of) UK business to the relevant member states.
Such fundamental changes in business models inevitably give rise to tax risks and opportunity for authorities to speculate aggressively in raising tax revenues. What will be HMRC’s approach – punishment or pragmatism? What HMRC has made clear is that, while the UK’s exit from the EU is exceptional, it by no means lessens HMRC’s obligation to collect its fair share of tax. On the flip side, EU authorities have set the bar low on substance and regulatory compliance to entice companies to see them as a jurisdiction of choice for their EU relocations, with tax policies following suit. Once established, companies will inevitably find host authorities push for greater substance and consequent tax yield, regardless of the level of substance that has been added.
The current international tax climate, the OECD’s Base Erosion and Profit Shifting project and the focus on anti-avoidance measures both at home and abroad, such as Diverted Profits Tax, all provide good cover and rationale for tax authorities to push to levy further tax or increase their share of tax on cross-border activities as they become increasingly sophisticated and tough in their approach.
What will draw tax authority attention?
In terms of the restructuring transaction itself, much will depend on whether there has been any significant transfer of assets from the UK. In most cases, this will be a question of intangible assets; customer contracts and lists, IP rights and goodwill may all have been transferred to a new EU-based entity or transferred offshore into a new EU branch. We expect to see disputes over whether a business or part of a business has been transferred, and there has therefore been a transfer of goodwill, a collection of assets has been transferred with no associated goodwill or simply a new business set up. This will not always be obvious from the facts.
If goodwill has transferred, its valuation will frequently be contentious giving rise to forensic valuation disputes. Arm’s length valuation of intangible assets is rarely straightforward. Businesses may need to consider a variety of different approaches to valuation, based on the precise facts and circumstances of the assets under consideration and the restructuring undertaken. The complex and subjective issues to consider in the valuation of intangible assets is an area ripe for speculative tax authorities looking to levy further tax.
It may not even be clear whether there has been a transfer or not. For example, where an existing contract is cancelled and renegotiated between the client and the group’s newly authorised EU entity, the business will need to determine whether there has been a transfer of the underlying assets. Whether or not there is a transfer of the rights granted under a contract will depend on what, if anything, has changed. In any event, the termination of an existing contract may still be the realisation of an asset for tax purposes requiring the application of arm’s length pricing to determine the proceeds of realisation. A novation of a contract may or may not be treated as a transfer depending on the facts.
‘We also expect to see more transfer pricing disputes… given the heightened desire to protect UK tax revenue in light of Brexit.’
Nick Skerrett, Simmons & Simmons
These ‘taxable transfer’ risks may not even materialise immediately. The movement of functions and people to a new EU entity or PE may take place gradually, over a number of years. What will be the tipping point to determine if and when goodwill, for example, may have been transferred out of the UK? The arm’s length allocation of profits between the UK and the new EU jurisdiction under the new structure will need to be continually monitored, with both the UK and the relevant EU jurisdiction having a vested interest in ensuring that profits are allocated to the correct jurisdiction based on the activities taking place there.
We also expect to see more transfer pricing disputes. Given the heightened desire to protect UK tax revenue in light of Brexit, it can be expected that HMRC will want to see appropriate profit allocations to and/or arm’s length charges by any retained UK entity and businesses will find themselves required to justify and evidence positions taken. This may mean renewed interest in transfer pricing policies and other documentation updated to reflect revised business models. Advance pricing agreements (APAs) may assist to provide tax certainty in the first instance, particularly where businesses are able to engage HMRC early on before practices are formed; but they are not a panacea and may prove to be challenging to sustain over time, when facts change as businesses adjust to the post-Brexit reality of operating cross-border.
Conversely, Brexit restructuring also presents an opportunity for HMRC’s EU counterparts to establish taxing rights and increase their take of tax revenue. Enquiries are likely to focus on questions of substance and income recognition; what and how much businesses have in the locations in which they operate post-Brexit? Clients will need to consider how to manage the competing claims of different jurisdictions. We will likely see an increase in mutual agreement procedures, but given there can be no guarantee that affected tax authorities will readily agree, international arbitration using new dispute resolution methods may need to be deployed.
The consequences of moving personnel in response to Brexit is potentially an area of vulnerability. Businesses are likely to have determined their resourcing requirements to ensure ‘business as usual’ post-Brexit, seconding, relocating or employing individuals within the EU as necessary. However, the implementation of such measures is likely to draw attention from an employment tax perspective as a result of the practical challenges of individuals carrying out dual roles, working for both retained UK and new EU parts of the business. The UK and host countries may examine such working patterns more closely to ensure income taxes and social security contributions are being collected and accounted for in accordance with altered tax regimes post-Brexit; depending on the outcome of exit negotiations (and whether reciprocal arrangements with the EU or bilateral arrangements with individual member states result), for example, short-term visitor safe harbours may no longer be available.
We anticipate challenges as to the existence of a permanent establishment where branch structures are used and as to the appropriate profit allocation to the permanent establishment. Tax authorities will look at the activities of personnel, including secondees, to argue that permanent establishments have been created and profits should be allocated and taxed.
There are obvious commercial drivers to minimise the substance transferred to a new structure. However, if HMRC considers that the arrangements lack economic substance it may look to use the diverted profits tax (DPT) provisions to challenge it where the new EU jurisdiction is a low-tax jurisdiction. HMRC has recently launched a disclosure facility in relation to profit diversion cases intended to encourage multinational enterprises (MNEs) to review their arrangements and their transfer pricing policies, change them if appropriate and use the facility to put forward a report with proposals to pay any additional tax, interest and, where applicable, penalties due. While the facility was not focused on Brexit restructurings, it will clearly be a useful weapon in HMRC’s armoury.
UK parents with new non-UK subsidiaries might also fall foul of the UK’s Controlled Foreign Companies (CFC) rules, when funding the subsidiary and repatriating profits to the UK. In particular, the payment from EU subsidiaries to a UK parent of dividends and interest free of withholding taxes may no longer be possible without the benefit of the EU Parent Subsidiary Directive (Council Directive 2011/96) and the Interest and Royalties Directive (Council Directive 2003/49), except where the UK’s bilateral double taxation treaties provide for 0% withholding tax.
No discussion on Brexit would be complete without mentioning borders and customs matters. Plainly the customs compliance burden is likely to increase substantially with additional customs declarations and registration requirements. Post-Brexit, businesses may need to register and account for VAT in other member states. For example, UK businesses supplying digital services to EU customers will no longer be able to utilise the EU VAT MOSS scheme and will need to register for the VAT MOSS non-Union scheme in a member state. Much of this will be a matter of interpretation, or misinterpretation, with plenty of opportunity for tax grabbing by authorities. We expect a slew of indirect tax compliance disputes.
Cross-border transfers of assets to new EU entities may give rise to disputes on whether the transfer qualifies as a transfer of a going concern or whether VAT might be due in the member state into which the business is being transferred.
We expect VAT grouping to be a key area of dispute. HMRC in the UK is already challenging international branch structures that allow the supply of services into UK VAT groups without VAT being chargeable. Supplies to EU branches may be problematic depending on quirks of local law on VAT grouping, following the decision in Skandia America Corporation USA v Skatteverket (Case C-7/13). Where new entities or branches have been VAT grouped there will be a focus on substance and in the UK HMRC are pushing the position this requires a ‘real trading presence’. Such requirements have a significant degree of subjectivity and are policy areas where HMRC is taking an aggressive position. We expect other jurisdictions to look carefully where they see services being imported VAT free.
Changes to the business model will also need to be considered from the perspective of any VAT partial exemption special method (PESM). Partial exemption negotiations are, in the UK at least, rarely free of dispute.
And what about trade outside the UK/EU? With the myriad of new trading relationships that will arise, a whole new world of tax disputes awaits.