David Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Worldwide Tax Daily. This week: Checking in on Brexit. In June 2016, voters in the United Kingdom chose to leave the European Union. Following a change in government, Prime Minister Theresa May invoked article 50 of the Treaty on European Union, starting the process for the U.K. to formally cut ties with the bloc. Here to discuss how this process is going and what it means for taxes is Jeremy Cape, a tax and public policy partner with Squire Patton Boggs in London and Tax Notes International columnist. Jeremy, welcome to the podcast.
Jeremy Cape: Thank, you David. It's great to be here.
David Stewart: So why don't we start with an overview of what is the process of Brexit?
Jeremy Cape: The process of Brexit. Well, it's — the process is a long, and complex, and uncertain, and challenging one. And I must say I was getting a little bit depressed hearing your introduction, being reminded of this referendum that was held in June 2016. It went the way of leave. And some people, 52 percent, were very happy. They'd worked to have that way. Forty-eight percent were not so happy. We thought we'd get eventually some months after the referendum a little bit of clarity about direction, and I've been talking about Brexit, Brexit and tax, pretty much since the referendum. And yet we find ourselves still today knowing that the U.K. will, as a matter of law, unless it revokes article 50 or extends the article 50 period. And there are some doubts as to whether it can even do that. That the U.K. will leave the EU on the 29th of March, 2019. And that comes about as a result of Prime Minister May exercising the article 50 notification on the 29th of March, 2017. So that much we know. Right now, at the time of speaking — and the issue with talking about Brexit, is it does tend to go out of date almost immediately as you’ve said it — is that the U.K. and the EU are trying to move towards agreeing a withdrawal agreement. That doesn't set out the future trading relationship between the U.K. and the EU, but it agrees enough including in relation to Northern Ireland, which we'll talk about, because that's very significant in relation to tax.
But if they can do that, they'll move towards an agreement and getting it ratified in the U.K. and the European parliaments. The U.K. will enter into a transition period with the EU on the 29th of March, 2019. At that stage, the U.K. is effectively still a member, synthetically a member of the EU, but it no longer has any MEPs. It doesn't have a judge, European Court of Justice. It becomes a vassal state. It's subject to EU laws, including those laws on taxation, but the U.K. no longer has any say. What happens after the transition period would still have to be agreed.
David Stewart: Now I should mention for listeners we're recording this on October 22nd, and just over the weekend there was large scale protests about many of the “remain” camp were asking for another vote. Is there any possibility that they might get that, or is there any, is there any going back from invoking article 50?
Jeremy Cape: Sure. I was very pleased. I was flying out to DC on Saturday, which I was rather glad about because I think my Twitter feed would have been slightly intolerable from various people. I think 700,000 were rumored to have been on the march, although one can never be too sure. I don't know when it got to the position that people were so worried about the number of people who turned out at the marches or inaugurations, but there we are.
So, they're campaigning for a so-called second referendum. The argument behind having a second referendum is that we now know that leaving the EU is a rather different proposition from how it was set out before the 2016 referendum. Remember, that referendum asked a binary question: Should the U.K. remain a member of the EU, or should it leave the EU? If it remained, then it was pretty clear what that meant. David Cameron had got some additional concessions and those would continue in force. But as we now see, it's not very clear what “leave” means. Does leave mean leaving and entering into a customs union? Does it mean leaving and still remaining a member of the single market, like Norway does? Does it mean having a relationship like Canada does with the EU?
So, some of the arguments that a second referendum should allow British people to make a more informed choice about what Brexit should look like. The problem, it seems to me, is that the second referendum is largely a cipher for trying to reverse Brexit. It's not really a question of how the U.K. should leave the EU. It's a question of whether the U.K. should leave the EU at all. So though one campaigning for a second referendum is arguing that the choices should be between not having any deal at all or having a deal that Theresa May manages to negotiate, there's a practical issue. Referendums takes time, we're probably out of time, even if one were announced today, which it isn't going to be announced, not going to be announced. The circumstances in which there is a change in view of the prime minister or the prime minister is replaced, or there is a general election, someone else comes in, it's too far away.
So, to have that second referendum, you would probably need an extension by the EU of article 50 of the two-year period. And that would likely need to be for a number of months in order to allow that referendum to take place. The problem is that there is going to be an election of the European Parliament in May 2018. And it would be slightly odd if the U.K. was electing MEPs in May 2018 where there might be another referendum — sorry, May 2019 — where there might be another referendum in June 2019.
David Stewart: Let's turn to the issues that need to be addressed as the U.K. is negotiating its way out, assuming this all goes forward exactly as planned. What are the tax and customs implications of leaving the EU?
Jeremy Cape: They're not widely discussed, David. The tax issues have been largely anonymous from the debate. There are some journalists who write extensively on VAT and the challenges that VAT brings to the U.K. leaving the EU. Now, VAT is a European tax. It is a requirement of being a member of the EU that you have a VAT, and that is in accordance with the principal directive.
And the U.K. before it joined the EU, didn't have a VAT. It had purchase tax and it introduced VAT, but countries joining now need to introduce VAT. And the challenge with VAT is that it arises on the border when goods are imported from outside the VAT area. So, it is true to say that there is a VAT border between Ireland and Northern Ireland. And that there's a VAT border between Germany and France. But the reality is because of information sharing, because of a consistent legal framework, is that there is no need to make a VAT declaration at that border. So, goods can travel over that border without any friction. The big challenge then, if you look at the border between Ireland and Northern Ireland, and the U.K. has agreed that that border should be as it is today; i.e., there should be no checks at that border, because of the historic troubles, because of the Good Friday Agreement. It's acknowledged that there should be no physical border. And the challenge then is well, how do you have an invisible VAT border between the U.K. and Ireland, and you have that issue as well. There's another VAT border, a land border, and that's on the Channel Tunnel, under the sea. And I've heard Eurotunnel say this, how do you deal with that? Well, it is slightly different, it is slightly less porous, one would at least hope. If you look at the VAT borders across the world, even the one between Norway, which is a member of the EEA and the EU, it is significant. There are checks that are made, there is documentation.
So, it's not clear how one can impose a border which is effective for VAT purposes, but which you cannot see. And the U.K. government has set out a way in which it would like to make a border as invisible as possible. And one of the ways it's going to do that is by effectively abolishing import VAT, which is the VAT that you pay, as the name suggests, on import, where that is accounted for and where the tax point arises on import, and for that to be paid instead later, as is the case, with imports from the EU. So that is the intention, but it's not clear to me how, in practice, that is going to work without giving rise to huge amounts of VAT fraud. And there are huge amounts of VAT fraud, and the EU gets annoyed at the U.K., because it doesn't think that we're tough enough on VAT fraud. So how you deal with that, and also how you deal with the jurisdictional issues, and how the U.K. can apply its own VAT rules, which may end up being different from the EU rules and still keep porous borders seems satisfactory in the way in which it's been answered, if it has been answered at all.
David Stewart: Since they did not have a VAT before joining the EU, is there an appetite for going to a different system of consumption tax later on or making massive changes to the VAT as it's applied in the U.K.?
Jeremy Cape: There is a certain nolstagia that one sees. I can't remember which MP it was, he would say, well, maybe you should go back to the purchase tax. Purchase tax didn't even really work in the 60s and 70s. It was a really strange tax that is certainly not going to come back. You do sometimes see the case being made for the reform or the abolition of VAT. And I think sometimes it's a cipher for a desire to have lower taxes more generally. And this is an issue that we're seeing a little bit in the debate to the extent there's a discussion about what the UK should do after Brexit. There is sometimes this discussion about whether it should become more like a tax haven, more like a low-tax jurisdiction like Singapore or Hong Kong. So, there is some of those who are arguing that the U.K. should go for a lower tax model, see an opportunity with the abolition of VAT. VAT raises a huge amount of money for the government. It's not popular in the U.S., particularly amongst Republicans, because it's regarded as an easy way for the government to make money.
One of the huge irritations you have as a Brit in America is you go and you see a price at a shop, and you think it's $20, and then it ends up being a bit more, and always ending in an odd number of cents. This is less of a problem now that everything gets paid with a credit card, but if you've got the cash, it's a little bit of an irritation. And where this can be appealing to those who want to see lower taxes, and there are those who think the U.K. should move to a sales tax model, because then it's clearer. If I go to a shop and I buy a £20 t-shirt, then I don't think there is a receipt that will show the VAT on it, but no one ever looks at that receipt. If you go and buy a £20 t-shirt, and then there's a sales tax, then that takes the price up. The idea is you look at that and you think, this is outrageous! Look at this tax I'm paying. I'm going to rebel against this, I'm going to vote for low taxes, I don't like taxes.
That's the argument that gets raised, but also sales taxes generally raise less revenue than VAT does, partly because it tends to be on goods rather than on services. So, some of the desire to get rid of VAT and replace it with sales tax isn't a technical thing. There can be technical arguments that VAT and cascading through a supply chain is a bit of an irritation, is a bit of a complexity because so many businesses within that supply chain will pay VAT out, and then they'll just recover it through their VAT return, and you could respond to that and say, well, what's the point in just having the massive reclaim? Why not just apply it to the final stage of sale where it gets sold to a consumer? So the answer is, I don't think the U.K. can afford to get rid of VAT. I think there's only a small constituency who thinks that it would be a good idea to get rid of VAT.
What I think we will see, and we're already seeing a hint at it — in fact, my latest column talks about this — is removing VAT from certain supplies. So that could be a supply of domestic fuel, currently subject to VAT at the rate of 5 percent, or school uniforms for older children, currently subject to a rate of VAT at 20 percent. And we're going to start to see a narrowing of the base and a making of exceptions for certain supplies, and on the face of it, it sounds quite compelling, right? Domestic fuel, now the poorer pay a larger proportion of their income on fuel as a general rule. So if you reduce VAT on, or you eliminate VAT on the supply of domestic fuel, that's a tax cut that benefits the poor more than it benefits the rich. But the problem with that, let's say that the benefit of such a tax cut to taxpayers would be $100 million, let's just say that's the VAT that currently arises from domestic fuel, or whatever it is. And let's also say that the poorest 20 percent in the country account for, say 10 percent of that VAT, because they'll generally have small houses, have the temperature on, they’ll waste less domestic fuel. Sure, that as a proportion of their income is more, but what have we done? We've given a tax cut of $100 million across the board, but the poorest 20 percent are only getting $10 million of that. The richest 80 percent are getting $90 million of that. You're asking too much of VAT for it to redistribute by narrowing that base by having some targeted exceptions.
If you really want to benefit the poor, then raise as much as you can through that broad base, the domestic fuel, all being subject to actually a higher rate of VAT. This is the paradox. You go, and I was on Twitter and people were attacking me for saying it, for saying actually, the best way to help the poor is to increase the rate from 5 percent to 20 percent. And then with that amount, which won't be $100 million anymore, but it will be $350 million, then give that all to those poor people who are suffering because they have lower incomes. If that's what you want to do, that's the way to do it, but sometimes tax policy is counterintuitive.
David Stewart: So, beyond the redistributive goals of some of these exemptions, I assume that you'll also be creating all kinds of disputes over definitions about what fits into that new exemption if they're adding these?
Jeremy Cape: Right, yeah, I mean, the more exemptions you get — I get so bored, but saying this is the example, but we always talk about the Jaffa Cakes. Do you have Jaffa Cakes here?
David Stewart: We don't, but we have Pringles, which those also created a dispute that I thoroughly enjoyed watching.
Jeremy Cape: Our Pringles are Pringles crisps. One of the things when you read these cases, when you see how processed food is created, you never really want to consume it ever again. But yeah, the more differences you create within tax legislation, the more scope you give for disputes to determine whether something nature to the supply is one thing or another. And where there's a principal supply which is zero-rated, and an ancillary supply that comes in under that zero rate. Great for lawyers, but there are better things for people to be worrying about.
David Stewart: Well, one of the things I do like to point out is that in the U.K., in the Pringles dispute, they argued that Pringles are not crisps. However, in the U.S., on the canister they're called crisps.
Jeremy Cape: But what's your view, David?
David Stewart: They're close enough.
Jeremy Cape: Close enough is good enough.
David Stewart: Alright, so we discussed some of the issues that come up in Brexit. How about, you mentioned the Norway model, the Canada model — what are the differences between these models that may be used?
Jeremy Cape: So the Norway model means the U.K., being a member of EFTA, European Free Trade Association, through that the EEA, the European Economic Area, and what does that mean for the U.K.? Well, it's not part of the customs union. It's not part of the VAT area. It is part of the single market, not subject to the jurisdiction of the European Court of Justice, but subject to the jurisdiction of the EFTA Court, which is close to the European Court of Justice but not absolutely identical to it. Criticisms that could be made of the EEA model is that it does keep the U.K. too close to Europe, that it stops the U.K. making its own laws. Although, there are some more restrictions on the freedom of movement of people, and it is important. I haven't mentioned it yet, but it is important to bear in mind that one of the reasons that the referendum went for leave was a desire amongst those number of those voting to leave to control immigration. And you do have some mortals as a member of the EEA rather than a member of the EU to limit free movement but not many. Now, my own view is I think that that would deliver on the referendum result. You do leave the EU if you join the EEA. It takes the U.K. out of the political and legal protection I think the EU has. You are able to have trade deals, and it is possible that the government, if it is faced with a cliff edge getting towards the 29th of March, would want to put the U.K. into the EEA at least as a temporary measure.
Now, there's a question about whether Norway, which is currently the big cheese in EFTA and the EEA will actually want the U.K. in there and whether the U.K. as a kind of renegade will try and change it and make it an anti-EU body. There's also the issue, as I've mentioned, that whether politically, the government, and particularly Theresa May, would be prepared to sign up for the EEA in the knowledge that it still means free movement is questionable.
So that's the EEA model. Being in the customs union, so not in the EEA, being a member of a customs union looking to replicate the customs union that the U.K. is already in is seeing as providing a possible solution to the Irish border problem. It is an incomplete solution, though, because it's not just about the tariffs and the rules of origin, it's also about the regulatory checks. So being in a customs union, as Turkey is, not a complete customs union. So the U.K. could seek to enter into a customs union effectively replicating the customs union. Can't be in the customs union if you're not a member of the EU. So the U.K. would look to replicate. One problem with that is being in a customs union, even if it is a complete one, unlike the one that the EU has with Turkey, is that it doesn't eliminate all checks that are necessary at the border. And the regulatory checks still remain extremely important, and would be necessary, and the VAT checks. So a customs union does not get you into a VAT area, so those would remain. The problem is it does solve some issues, it helps in some way the supply chain issues where having to demonstrate that certain materials originate in the U.K. rather than the EU is going to be an issue for a number of manufacturers, and others. But the problem then, is that the U.K. can't do its own trade deals. Now, you might think that, you might take the view that the U.K. isn't going to enter into great, ambitious, the most beautiful trade deals in the world with countries like the U.S., also with Canada, Australia, New Zealand, China, etc., etc. There are those who take the view that the U.K. won't be significant enough or big enough to be able to do those bold new trade deals. But the logic of Brexit — and having had a referendum, and it was won by those who wanted to leave — the problem is that trade deals won't be capable of being negotiated and entered into by the U.K. if it is in a customs union.
And given that Dr. Liam Fox had a department created for him in, I guess it was July, August, 2016, to go out and negotiate trade deals that would be something of a slap in the face for government policy if the U.K. was not able to negotiate those deals.
Furthermore, the EU negotiates trade deals on the U.K.'s behalf, and it would be strange if the EU took the U.K.'s concerns into account more than its own concerns. So, on the face of it a customs union does solve some short-term problems, but there's a pressure in terms of having a customs union as a long-term solution for the U.K.
The Canada deal is a free trade agreement, zero tariffs, looking to make some inroads into trade and services, which trade agreements generally don't cover. So that's the aspiration for a number, I think, in the Conservative Party there's a real desire for a Canadian Free Trade Agreement, but the real problem with Canada is it doesn't solve the Irish border issue. And the U.K. government, which has an agreement with the DUP, a Northern Irish unionist party that keeps it in power, is not to have a border with Ireland. And to do that, you need really to have a border in the Irish Sea, and that is just unacceptable to the DUP and indeed a majority in the Conservative Party.
I suspect if you didn't have a border in Ireland, then that is where the U.K. would be. And the EU has made it clear that they are happy to offer the U.K. an FTA along the lines of Canada. But, you can't ignore the fact that that effectively means a border in the Irish Sea, and that is just simply unacceptable to those who want to see Northern Ireland remain an integral part of the U.K.
David Stewart: So where are negotiations now? This has been going on for a while now. Have they gotten any closer to coming to a resolution of these issues?
Jeremy Cape: It appears that the E.U. and the UK are inching towards an agreement. They need to enter into a withdrawal agreement that doesn't set out the ongoing trading relationship, whether that's a customs union, whether that is EFTA, EEA, whether that is Canada+ or Canada+++, or some variation on that theme, but that doesn't get it agreed, which is something of a concern for some in the U.K., that if the U.K. isn't in a particularly strong position now, it won't be in a strong position when it's outside the EU when it's paid a so-called divorce bill of €39 billion.
So when it's outside, it's in an even weaker position, but it has been agreed that that will be just a political declaration, so it doesn't then become a legally binding agreement. I suspect, because politicians fudge things, that the EU and the U.K. will get to a position where they agree, a withdrawal agreement. I suspect the European Parliament, which has been kept in the loop on things, will approve that. The big question then is whether the U.K. Parliament will agree with the deal that Theresa May does, and the indications at the moment are that there doesn't seem to be a majority for any deal that she can strike. Because, and it is bizarre that the U.K. government, two and a half years on from the referendum, is still in this position where it thinks it can get outcomes that are contradictory. So, this idea that there doesn't need to be a special status for Northern Ireland, and yet the U.K is not part of the single market, and it's not part of a customs union, and that’s before you even get onto that question of VAT. Because ultimately you could get to a position where Northern Ireland stays in the VAT area. I think that must be the logic of the backstop under which Northern Ireland doesn't have a border with Ireland unless you include the U.K. in all of that.
That starts to look very uncomfortable constitutionally, if Northern Ireland is part of a VAT area, and generally in the VAT area, if you're not a member of the EU, you generally have to have some sort of sponsor to make sure that you're complying with the rules. Well, who's going to be the sponsor if it's Ireland? That starts to feel slightly odd in terms of tax jurisdiction.
David Stewart: Now do you have any predictions on how you think this is going to come down ultimately, which approach is going to wind up being taken, and also will the current government survive this process, as messy as it has been?
Jeremy Cape: It's going to be really dangerous to make a prediction. Unless I can get you to promise to take this podcast down when my predictions turn out to be wrong. I mean I can only really do it in percentage terms. I think at the moment, the chances of there being a second no-deal Brexit with the U.K. leaving on the 29th of March and not going into transition, having to trade on WTO terms, having to negotiate new agreements on aviation, etc., etc. I think those odds are about 30, 35 percent, which is astonishing really when you look at the consequences, when you look at what the U.K. government says that means. That's a lot of disruption in the U.K. We won't have seen a situation like that, certainly in my lifetime. One of the things about the British is we think that history only happens to other people. Well, history would be coming to us right at that time. So for that reason, I kind of think that there'll be some way where all the constituent parts and all the stakeholders in the U.K. and EU will come up with something. But it is really, really hard to see where that is, and that all comes down to Ireland. It all comes down to being able to get to an agreement with the DUP, which is holding the government up, that enables the House of Commons to vote on something that so many of its MPs have said they will not vote for. So I don't know where that ends up.
All I think I can predict with absolute certainty, there are a lot of people who think, okay, well the two-year period ends March 2019. We'll get where we are, we'll leave, and then Brexit will be over and we'll never have to listen to another damn word about Brexit. Well, the reality is we are going to be talking about Brexit for the rest of our years. This is, I'm 43 now. I expect Brexit issues to take me through to my mid-50s, and possibly beyond. This is not going to get resolved. It's going to be very interesting. And I do think that the U.K. had to confront the issues that hadn't been addressed in relation to its involvement in the EU. There should possibly have been referendums on other treaties that led to have a closer union. Because at least if the U.K. hadn't voted to ratify those treaties, the consequences wouldn't be anything other than that treaty. I mean, there might have to be some renegotiations but essentially your referendum there means that referendum doesn't apply. It gets renegotiated, you have a second referendum. You don't get to that scenario where you vote to leave without really having a clear path about what the outcome should be. So that the sad truth of this is that people who are bored of reading about my thoughts on Brexit are going to have a decade of hearing some more of them.
David Stewart: Well, I can tell you that I'm never going to get bored of reading your thoughts on Brexit. I always find them interesting. Well, we'll have to follow up again when we get some answers on this when you're well into your new career of talking about Brexit into your 50s. Jeremy, where can listeners find you online?
Jeremy Cape: They can follow me on Twitter @jeremydcape.
David Stewart: Excellent. Thank you for being here. And if listeners are interested in finding out what we were talking about with Jaffa Cakes and Pringles, you can see some links in the show notes.
And now, Coming Attractions. Each week, we preview commentary that will be appearing in the next issue of the Tax Notes magazines. We're joined by executive editor for commentary, Jasper Smith. Jasper, what will you have for us?
Jasper Smith: In Tax Notes, Gary McBride and Philip Storrer argue that the IRS exceeded its authority by removing customary business meals from the definition of entertainment under section 274. And David Gordon analyzes how the Supreme Court approached the challenging issue of statutory interpretation in a recent case involving railroad workers and stock-related compensation.
In State Tax Notes, Rachael Chamberlain address several changes to Kentucky's economic development incentives, and Rick Handel discusses a recent South Carolina Supreme Court decision addressing the propriety of the Department of Revenue auditing government.
And in Tax Notes International, Jeremy Cape discusses the global development and prospects of the VAT, while practitioners from DLA Piper discuss several issues stemming from Notice 2018-78.
David Stewart: You can read all that and a lot more in the October 29th editions of Tax Notes, State Tax Notes, and Tax Notes International. That's it for this week. You can follow me on Twitter @TaxStew, that's S-T-E-W. If you have any comments, questions, or suggestions for a future episode, you can email us at podcast@taxanalysts.org. Be sure to subscribe to us on iTunes or Google Play to make sure you get the next episode of Tax Notes Talk.
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