What will replace EU membership?

Amanda Hulme, partner and head of financial regulation at Addleshaw Goddard LLP, said: “All firms, especially financial services firms, are rightly concerned by the Leave vote, not least because of the uncertainty that this will create. There is no clear exit plan as yet and we just do not know how much legislative change there will be as a result of a decision to leave.”

Under EU law, the UK will have a two-year period (potentially extendable) for full membership to continue after the decision to leave pending possible agreement on alternative arrangements.

The strongest form of association agreement would be membership of the European Economic Area (EEA),giving full access to free trade with EU countries in commercial services through the European Single Market (ESM), as well as in industrial goods.

The leading example of a non-EU member of the EEA is Norway, along with two smaller countries, Iceland (currently seeking full EU membership) and Liechtenstein. These countries must comply with all ESM rules, except for very limited (and so far largely untested) opt-out rights. They have no votes the relevant EU decisions, though they are consulted on those particularly expected to affect them.

Compliance with ESM rules by non-EU members of the EEA is overseen by executive and judicial arms of the European Free Trade Area (EFTA), to which the few non-EU West European states all belong, rather than by the European Commission and European Court of Justice.

Switzerland, although an EFTA member, is not within the EEA. Its own association arrangements provide for free trade in goods with the EU. It also has a series of bilateral agreements covering particular commercial service sectors, which together amount to participation in some but not all aspects of the ESM. These agreements are “static” in that they did not commit Switzerland to full alignment with subsequent ESM decisions by the EU, though in general the Swiss authorities do adopt reciprocal rules.

In the absence of any post-Brexit association agreement to replace full EU membership, the UK's trade with the remaining EU would revert to World Trade Organization (WTO) terms. There would be no UK participation in the ESM, and no general free trade in goods. UK “visible trade” exports to EU countries would face tariffs, ranging up to rates of around 10% for motor vehicles though significantly lower (amounting to a weighted average of 2.7% according to one estimate) for other industrial goods. The UK would be free (if it chose) to adopt similar tariffs on imports from all other countries including the remaining EU.

It is certainly not clear what post-Brexit arrangements the UK will end up with, nor even which ones it would aim for given the pattern of views on this and related matters within the pro-Brexit camp and the possibility of ministerial changes following a leave vote. The German finance minister Wolfgang Schäuble has recently suggested that the UK may not participate in the ESM unless it agreed to retain free movement of labour with the EU. This is a challenging condition given that UK immigration from the relatively new EU member states in Eastern Europe appears to be the largest single factor behind the level of support for Brexit.

Financial sector regulation

If UK participation in the ESM were to end, there could clearly be consequences for the regulation of UK financial services. However, Hulme said: “It is not at all clear to what extent - and in what timescale - the UK government following a leave vote would embark upon a radical review of all EU based legislative requirements. My instinct would be that they would not rush to do that (other than in highly controversial areas) since they would not want to make it harder for businesses to operate cross-border.”

Harmonized EU rules relating to regulation of credit agreements are at present very much confined to contracts with “true consumer” customers. Features of the UK Consumer Credit Act, and of the Financial Conduct Authority's extensive rulebook, that apply to contracts with some unincorporated business customers, do not reflect any EU requirements. Consequently asset finance is not an area where Brexit would have direct implications for business conduct rules.

For bank-owned finance companies in the EU, solvency regulation is subject to a three-tier structure. The “Basel rules” provide global minimum standards which national regulators agree to accept, though not on a legally binding basis. EU law adds to these some additional minimum requirements, all fully binding with compliance overseen by the European Banking Authority (EBA). The national regulators (or for large banks in Euro zone states, the European Central Bank) are then free to add further rules.

In many areas the UK Prudential Regulation Authority (PRA) goes substantially beyond the EU's minimum requirements – notably in the minimum capital requirements for the largest UK banks. Brexit would therefore be unlikely to affect the broad thrust of prudential regulation in the UK.

There is nevertheless one area - though more relevant to investment banking operations than to asset finance ones – where Brexit would almost certainly produce an easing of EU rules adopted for supposedly prudential purposes. This relates to the “bonus cap” limiting the variable proportion of remuneration for all bank employees, which was introduced following the adoption of the EU’s Fourth Capital Requirements Directive (CRD IV) in 2013 and has been widely criticised in the UK by both the authorities and the banks.

Another regulatory aspect that would change with the UK outside the ESM would be that of “passporting” for cross-border asset finance operations. Currently bank-owned credit companies based in one EU (or EEA) member state can write credit business in another while being subject to the rules of its home state for licensing and prudential regulation, though the host state's business conduct rules are generally applicable.

However, currently passporting is mainly confined to large ticket deals. For taxation and other reasons, cross-border operations are normally done through national subsidiary companies that will be subject to the host state's licensing and solvency rules.

Hulme said: “In the absence of some agreement along the lines of the UK becoming an EEA state, Brexit may mean that any firms who were passporting services into the UK from another EU state, or in the opposite direction, would no longer be able to do so.”

“My sense would be that the numbers of companies affected by a passporting issue are likely to be relatively limited. For non-bank-owned credit companies, passporting is in any case not possible. Brexit could raise bigger issues in pure consumer credit, where there is more EU harmonization of conduct rules, than in business-to-business asset finance.”

Lease accounting

The largest single regulatory issue affecting asset finance in the coming years will be the global adoption of requirements for lessees to capitalize operating lease commitments that are currently off-balance-sheet. In the UK this is affected by EU rules. Yet it does not seem very likely that Brexit would make a difference to them.

The lessee capitalization rule will take effect from 2019 in international financial reporting standards (IFRS) through the new IFRS 16 standard, and also in partially convergent new rules in US generally applicable accounting standards (GAAP). EU law requires the use of IFRS by listed public companies.

The UK authorities post-Brexit would be more than ever concerned to maintain the country's global attraction as a base for international companies. It therefore seems extremely unlikely that there would be any weakening of the requirement for full IFRS compliance for UK listed companies.

However, one area where Brexit could conceivably have effects on lease accounting is for existing and potential voluntary adopters of IFRS among unlisted company lessees, who make use of the. simplified IFRS SMEs accounting standard.

The current version of IFRS SMEs incorporates the pre-2019 lease accounting standard IAS 17, with operating leases off-balance-sheet, and no change is expected in this before 2022. However, EU rules do not permit the use of IFRS SMEs (in place of the main standards which will include IFRS 16) by any IFRS users in member states. This is an area where the UK could relax the rules after Brexit, though this is perhaps not especially likely.

Taxation

EU rules currently affect a number of features of national tax systems, especially in VAT where tax rates to some extent – and other parameters to a much greater degree – are harmonized. Yet it does not seem clear that Brexit would affect many tax areas specifically relevant to asset finance.

For example, arrangements for effectively taxing the private use value of leased business cars for VAT purposes have not been harmonized and vary widely from one EU country to another. In the UK this takes the form of a 50% disallowance of input tax recovery for the lessee, while some other member states instead disallow the car acquisition cost for the lessor. While Brexit would in principle permit a number of departures from existing harmonized VAT rules in other areas, none seems especially likely.

The EU has recently started to exercise more limited jurisdiction over national corporate tax systems, principally by questioning apparently favourable treatment for some multinationals which may contravene EU “state aid” competition rules.

The current UK approach to corporation tax is to move to low “headline” rates, but with other features that can add significantly to the tax burden – ranging from less than adequate write-off rates for plant and machinery to a higher tax rate for banks and restrictions on the use of carried-forward tax losses. This kind of approach does not seem to be challenged currently by the Commission, and so would not obviously be affected by Brexit.

The EU Budget

The UK's substantial net contribution to the EU budget has been a significant issue in the referendum campaign. Its gross contribution, currently running at some £13 billion per year, far exceeds the expenditure of EU institutions in the UK, giving a net annual contribution of some £8.5 billion.

Most West European member states have started to make substantial net EU budget contributions in recent years because of the extension of membership to poorer countries in Eastern Europe which benefit more from the expenditure programmes. For the UK this effect has compounded with the continuing impact of other factors, notably the UK's smaller agricultural sector compared with other member states.

A special UK rebate first agreed in 1984 has resulted in a saving now running at £5 billion a year on its gross contribution, but still leaves the current major net contribution. The ending of any UK contribution to the EU budget would therefore bring an annual benefit of £8.5 billion to the UK government's net budget balance, registering also as an equivalent improvement in the UK current account balance of payments. It would also give the UK authorities greater discretion over current UK based spending by the EU.

However, continued UK contributions to the EU budget will almost certainly be required as a price of continued UK participation in the ESM. Norway and Switzerland both make substantial net contributions. These resulted from negotiating processes about the various EU spending programmes to which these countries would contribute, and not from any automatic legal connection between the ESM and the budget. The French economy minister Emmanuel Macron has recently suggested that remaining EU members would insist on continuing net UK budget contributions as an ESM condition.

This does not mean that it would be impossible for the UK post-Brexit to make any EU budget saving, even given ESM participation. Norway's current net contribution is proportionately around half that of the UK allowing for the relative sizes of the two national economies. The Norwegian government estimates that its own net contribution could be four times higher than at present if it were a full EU member.

The wider issues

Any savings on the EU budget contribution are likely to be dwarfed by the impact of uncertainties on the future of the UK's trading relationship, in both goods and services, with the remaining EU members. The post-Brexit negotiations on this could be a protracted process.

There is a strong consensus among economic analysts that shocks to general business confidence from Brexit would leave UK gross domestic product by 2020 lower than it otherwise would be by a margin of 3% or more.

The longer term impact would of course depend on how the UK might take advantage of discretionary options that might open up as a result of Brexit – and of course on how the EU will itself evolve in the future.

Whatever the outcome on the ESM, Brexit may open choices for the UK in the two particular sectors of agriculture and fisheries, where common EU policies are particularly interventionist.

Brexit may also bring the UK more freedom of action on employment regulation affecting all economic sectors, though this might depend on the outcome of ESM negotiations. Initially the UK negotiated an opt-out from the EU Working Time Directive that was adopted in 1991 under ESM procedures, but a subsequent UK government in 1997 rescinded this. Whether the UK would take advantage of this potentially doubtful, though, given recent decisions in areas like the minimum wage that are not constrained by EU law.

Probably the greatest challenge currently facing the EU as a whole, ultimately with fiscal and economic implications for many member states, is the pressure of migration from outside Europe. As a non-member of the Schengen free travel area, the UK is currently more insulated from this factor than other major EU countries. Exactly what difference if any Brexit would make on this front is far from clear.