Although the UK voted to leave the EU on June 23 2016, the actual tax consequences that flow from that decision will not be known for some time. The formal process for triggering the UK’s exit from the EU will only commence once the UK government issues notice under Article 50 of the Treaty on the Functioning of the European Union, following which formal negotiations will take place to agree the terms of that exit.
This process (which, at the time of writing has not yet commenced) is expected to take around two years to conclude, and until such time as those terms are agreed, and the UK’s exit actually takes place (Brexit), the status quo will be maintained and uncertainty will largely prevail.
This uncertainty will be particularly problematic for businesses planning to engage in merger and acquisition (M&A) activity over the next couple of years. Changes to the tax cost and profile of target businesses operating in the UK and interacting with the rest of Europe will be one concern, with any increased tax costs that arise due to Brexit potentially impacting the value of the target business. Another concern will be potential tax costs associated with either the post-acquisition integration of UK target businesses into a wider European group, or pre-sale reorganisation activity intended to prepare a business for sale. Brexit could potentially impact all these different features of M&A activity.
Potential tax risks arising from Brexit
Set out below are some key areas where there is potential for adverse tax consequences to arise as a result of Brexit.
EU Merger Directive
The EU Merger Directive provides tax reliefs for mergers, divisions, transfers of assets and exchanges of shares which take place between companies in different EU member states.
Although implementation of the Directive has been achieved in the UK through its domestic legislation, which would not be affected by Brexit, changes would need to be made to the UK’s legislation (which works, for example, by specific reference to EU member states) to ensure that it remained effective. As the UK would no longer be required to give effect to the Directive following Brexit, it may therefore decide to make no changes to its legislation or to make changes which are no longer consistent with the Directive. The same considerations would also apply in other EU member states.
The loss of the tax benefits provided by the EU Merger Directive could increase the tax costs of European cross-border M&A (or pre/post-sale reorganisations) involving UK entities.
Parent-Subsidiary and Interest and Royalties Directives
In a similar vein, the EU Parent-Subsidiary Directive and the Interest and Royalties Directive could cease to apply in the UK.
The effect of these Directives is broadly to eliminate withholding taxes on dividend, interest and royalty payments between parent-subsidiary companies in the EU and to exempt dividends and other profit distributions paid by a subsidiary in one member state to its parent in another.
Although the UK’s domestic tax code (which does not impose withholding taxes on dividends and generally exempts dividend receipts) and its wide network of double taxation treaties (which includes treaties with each of the other 27 member states) will help to mitigate the removal of the benefit of these Directives, there will still be the potential for tax leakage in cross-border transactions and payments. For example, dividends paid by subsidiaries in countries such as Austria, Germany, Italy and Portugal to their parent in the UK will be subject to withholding taxes as will interest and royalty payments made to a UK company by its subsidiaries in Italy and Portugal.
Any such additional costs on intra-group payments of this kind might either increase the tax costs of a target group, or impose costs on profit repatriations and other payments between target businesses and parent groups.
UK corporate tax system
Although member states retain their sovereign rights in relation to direct tax (the Directives above being notable exceptions to that position), they are still obliged to exercise those rights in a way that is compatible with treaty freedoms and other relevant EU laws. As a result, there are areas of UK domestic tax law that have been amended following EU law challenges. Examples of these include the changes made to the UK group relief regime following the Marks & Spencer and Philips Electronics cases to allow foreign tax losses to be utilised in the UK in certain, limited circumstances.
In a post-Brexit era, when EU freedoms and laws may no longer be relevant, changes could be made to the UK corporate tax code to reverse previous EU law compliant changes or introduce further changes that are not EU law compliant. Moving outside of the EU will therefore remove some of the comfort and certainty that a purchaser of a UK business currently has regarding the UK tax code.
VAT and Customs Duties
As an EU member, the UK is part of a customs union with all other EU member states, meaning that goods can move to and from other EU member states without either customs duties or import VAT, and without the compliance obligations associated with importing and exporting goods.
Without negotiating an alternative arrangement, Brexit would mean that the UK would be outside this customs union. Consequently, exports of goods to the EU would be subject to EU customs duties and import VAT, and imports into the UK would be subject to applicable UK duties and import VAT. The UK would also lose access to any favourable terms of export that have been negotiated between the EU and third countries. Again, this could increase the tax costs of a target group.
Addressing these risks in an M&A transaction
Businesses engaged in M&A activity during the current transitional phase will therefore need to carefully assess the potential tax changes resulting from Brexit. Where possible and relevant, restructuring steps should be taken to mitigate the potential impact of such changes. This could include accelerating timetables to secure access to EU-related tax reliefs where these are fundamental to a particular transaction or implementing a pre-transaction group reorganisation to minimise withholding taxes or dividend tax charges.
It is of course possible that restructuring transactions or groups is not possible, or that changes cannot be made to timetables, such as where transactions are conditional on circumstances outside the parties’ control, e.g. competition approvals.
In addition, it is possible that post-Brexit events may be relevant to pre-Brexit transactions. For example, the value placed on a business by a purchaser may be affected by the UK’s departure from the EU customs union if exports of goods from the UK to the EU become subject to EU customs duties and import VAT and imports into the UK become subject to applicable UK duties and import VAT.
In those circumstances (which will be increasingly likely the closer we get to Brexit), the parties may seek to address such risks via the contractual documentation for the transaction. The attitude of the parties to such an approach is, however, likely to vary depending on the nature of the risk which is sought to be addressed. For example, while it is common for a purchaser to benefit from a variety of contractual protections in the context of a corporate transaction, such protections are almost exclusively confined to historic matters. Future risks, in particular risks relating to future changes in law, are generally considered to be for a purchaser’s account.
As such, while a purchaser could seek contractual protection for adverse tax consequences that may flow from Brexit, this is likely to be met with strong resistance from a selling party. General, wide ranging contractual protections would almost certainly be resisted, although where specific, quantifiable risks can be identified, it might be possible to allocate such risks to a seller. However, in most cases, it is more likely that the potential tax consequences of Brexit on a transaction will be an issue for purchaser due diligence and possibly mitigation post-acquisition through restructuring the acquired business.
Conversely, there may also be circumstances where a seller might want to seek protection for post-transaction changes caused by Brexit. One example of this could be where a seller is due to receive further consideration payable under an earn-out or deferred consideration arrangement and the quantification of such consideration could be affected by changes to the underlying tax position. Another example might be where the transaction involves post-completion supply contracts with the seller, where the value of such a contract represents part of the overall value of the transaction for the seller and that value could be reduced through new, post-Brexit taxation.
Finally, where there may be a split between entering into a contract and its subsequent completion, and it is possible that Brexit will occur in that split or Brexit-initiated changes may occur in that period, the parties could consider the inclusion of a Brexit specific ‘material adverse change’ clause. Such clauses, which are a common feature of private M&A documents, are traditionally used by purchasers as an exit mechanism, allowing them to withdraw from a transaction if there is a material adverse change in the business, assets or profits of the company they have agreed to acquire between entering into a conditional contract to acquire the company and the contract becoming unconditional. With appropriate modifications such a clause could also potentially be utilised by a seller, such as where the benefits of the Merger Directive are withdrawn, materially changing the tax consequences of the transaction for the seller.
While the precise scope and impact of any tax consequences resulting from the UK’s exit from the EU will not be known for some time, it remains possible for businesses engaged in M&A activities to identify the key areas relevant to their transactions where there is the potential for change.
Armed with this knowledge, steps can be taken to restructure transactions and relevant group relationships or, failing that, appropriately allocate risk between the parties through contractual documentation. Ultimately the approach taken in such documentation, and accordingly the party which bears the risk of any changes, will be dictated by commercial considerations such as the respective party’s bargaining position and their general attitude and approach to risk. As such a consistent or universal approach to dealing with the uncertainty brought about Brexit is unlikely to emerge. However, what businesses engaging in M&A activity involving the UK over the next couple of years should do is give proper consideration to the potential impacts of Brexit.
This article was contributed by David Smith and Ben Jones principal associate and partner, respectively, of the tax group at Eversheds in London.
David Smith,Principal Associate – Tax Group, Eversheds
T: +44 113 200 4349; email@example.com
Ben Jones, Partner – Tax Group, Eversheds
T: +44 207 919 4686; firstname.lastname@example.org
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