What happens to the UK tax system if we leave Europe?

25 May 2016

George Bull

Relax – this isn’t another doom-laden set of predictions on what might happen if the UK votes to leave the EU in the forthcoming referendum. But we thought it might be helpful to think about the big tax picture before revisiting some of the detail.

First, the big picture. Whether we stay or whether we go, the UK needs to collect taxes to keep the country running, to deliver necessary services and to pay interest on the nation’s debt. After years of cutbacks (some would call them prudence; others austerity) there are no easy candidates for reducing public expenditure. So the level of tax-funded expenditure is likely to continue at roughly the same level for some time yet. To put it another way, if GDP continues to run at the same level, then we can expect taxes to continue at around 39 per cent of GDP. So far, so understandable.

However, if the economy grows significantly, or shrinks markedly, then the government of the day might have scope to reduce tax as a percentage of GDP, or might have no choice but to increase it. In other words, while the whole issue is hedged around with countless imponderables, if the economy changes then so will the tax burden faced by individuals and companies.

Now for the detail.

For so long as the UK remains a member of the EU, two key principles guide the imposition of taxes within the UK.

First, direct taxes. These are imposed by UK law but must be operated in accordance with EU law.

Second, VAT. This is both imposed and operated in accordance with EU law.

In the past, the UK has had a number of disagreements with the EU over the scope and operation of UK taxes. These include:

  • patent box;
  • changes to the taxation of controlled foreign companies;
  • differential rates of insurance premium tax;
  • capital duty.

If the UK left the EU, the way in which the UK tax system subsequently operated would depend on the terms of the UK settlement with Europe.

On the direct tax front, in the event of Brexit a number of changes are likely to the UK tax system:

  • Transfer pricing. For many groups of companies, the number-one direct tax annoyance is UK-to-UK transfer pricing, caused by having to be EU-compliant. If the UK government wished to do so, it could abolish these rules. 
  • EU State aid rules would – subject to the terms of the Brexit settlement - no longer prevent the UK government from giving selective advantage to companies via advance tax rulings;
  • future incompatibilities between UK tax law and EU would cease to be a problem on exit: quite what would happen to the disputes, potentially involving billions of pounds, currently before the courts is an open question; and
  • while the UK is a member of the EU, UK tax reliefs and benefits are extended to both EU citizens and corporations: following Brexit these could once again be restricted to UK citizens/residents and corporations.

Now for VAT. Following a Brexit, the interpretation of VAT law would not be bound by the European Court of Justice. Even if UK VAT law does not change, there could well be changes in the way HMRC applies VAT in the UK.

Specifically, the taxation of cross-border transactions may change. Although the EU is developing plans to extend the One Stop Shop mechanism to non-EU suppliers of online sales of goods, it is likely that many UK traders will, nevertheless, have to register for VAT in each EU country in which they trade.

Businesses should look at their contracts with EU suppliers now. If VAT in a contract is defined solely by reference to EU law, it might be worth changing the definition so that it will continue to work as intended following a Brexit.

We are likely to see an increase in import duties following a Brexit.

In addition, there may be no relief for import VAT unless UK law is changed to accommodate this. There may also be issues with output VAT which could harm UK exporters unless a mechanism is developed to allow EU importers to reclaim import tax in much the same way that they do now.

If the UK leaves the EU, some EU tax developments will proceed without UK influence. This includes the EU Financial Transactions Tax (FTT) as well as the Common Consolidated Corporate Tax Base. The UK has hitherto opposed both of these. Any loss of influence might harm the interests of UK businesses active in Europe.

If you would like to discuss any of these points further, get in touch with George Bull or your usual RSM contact.