Brexit Analysis

The consequence of this is that key pieces of upcoming EU financial services legislation will have to be implemented before the UK formally leaves the EU.

On 29 March 2017, the UK Government invoked Article 50, and therefore began the formal two-year negotiation period with the EU, at the end of which the UK’s membership of the EU will cease. As a result, the UK will cease to be a member of the EU on 29 March 2019. The UK Parliament has also passed the European Withdrawal Act, which repeals the European Communities Act 1972 with the purposes of ending the supremacy of EU law in the UK, and converts existing EU law into UK domestic law to preserve a working Statutory Framework (which the Government is then empowered to amend by Statutory Instrument to correct any deficiencies).

Presently, a two-year transition period has been agreed to as part of withdrawal negotiations between the EU and the UK, during which EU law would continue to apply and firms can continue to rely upon existing passporting rights while the details of the future relationship between the EU and the UK are agreed. While the EU has stated that the transition period will only take effect if a full withdrawal agreement is ratified by the relevant EU and UK bodies (which has yet to occur), the FCA and PRA have stated that financial services institutions can incorporate a two-year transition period into their Brexit planning.

The UK’s post-Brexit relationship with the EU

Since the invocation of Article 50, there has been considerable uncertainty concerning the future relationship between the EU and the UK, the extent to which the EU and UK regulatory regimes will be aligned following the UK’s withdrawal from the EU and the resultant level of access the UK will have to the EU single market. While a number of details are still to be negotiated and agreed with the EU and the ultimate outcome of negotiations remains subject to change, the UK Government has now agreed to a proposed model for its post-Brexit relationship with the EU, published in a white paper on 12 July 2018, with the following key features:

• that the UK will "maintain a common rulebook for all goods" with the EU, maintained by a treaty and overseen by Parliament. The common rulebook would (amongst other things) cover agricultural products and environmental, employment and consumer protections;
• a ‘facilitated customs arrangement’ between the UK and the EU to minimise border friction and allow for a ‘combined customers territory’ in which domestic policies may be applied to goods intended for the UK, but EU equivalents would be applied to goods to be exported into the EU. The intention is stated to be that the UK controls its tariffs with respect to trade with the rest of the world, but applies EU trade policy to trade with the EU;
• a "joint institutional framework" to interpret agreements between the UK and the EU, with disputes to be resolved by joint committees and by independent arbitration with a joint reference procedure to the European Court of Justice for the interpretation of EU rules;
• "regulatory flexibility" in the services sector, with arrangements on financial services, but which do not replicate the EU’s existing passporting regime. It is proposed that these arrangements will include the mutual recognition of professional qualifications, reciprocal recognition of equivalence under existing third-country regimes, a bilateral framework of treaty-based commitments facilitating market access and reciprocal supervisory cooperation; and
• the end to free movement, but "reciprocal mobility arrangements" with the EU in a number of defined areas in the interest of economic, cultural and scientific cooperation, including: visa-free travel for short-term business reasons, students and tourism, participation in cultural exchanges such as Erasmus+ and streamlined border arrangements.

This model for future relations is without precedent; it would entail less than the full single market access engendered by the "Norway Model" (by which the UK would join the European Economic Area (EEA) and the European Free Trade Association (EFTA) and be subject to EU standards and regulations in most areas). However, in some areas (in particular, the market for goods) it would entail greater access to the single market and regulatory alignment than a "no deal" Brexit and a reversion to World Trade Organisation (WTO) rules.

The proposal has yet to be agreed with the EU and as such, may be subject to change in the course of continuing negotiations. However, the proposal to maintain "regulatory flexibility" in the services sector would, if agreed to by the EU without amendment, mean that the UK will have reduced access to the EU single market and lose the benefit of the EU passporting regime. This analysis proceeds on the basis that the UK will, accordingly, be treated as a "third country" post-Brexit.

Regulatory flexibility would also mean that the UK regulatory regime is not required to be aligned with the EU regulatory regime after the UK withdraws from the EU and any transition period expires, and that their respective regulatory regimes may diverge over time. Nevertheless, three factors suggest that the UK is likely to retain a robust regulatory regime following Brexit:

• UK thought-leadership - the UK has been at the forefront of the development of modern financial services regulation;
• the international nature of regulatory developments - the UK has adhered to a number of international commitments beyond its membership of the EU, including (by way of example) the commitments on financial services regulation made at the G20 meeting in Pittsburgh in 2009; and
• equivalency decision - should the UK wish to be deemed “equivalent” under European financial services legislation (to allow some level of access to the EU financial services markets post-Brexit), it will be necessary to maintain robust regulatory standards.

Fund / Investment Managers

The impact of Brexit on fund / investment managers will ultimately depend upon the nature of the Brexit model adopted. The following analysis assumes (in line with the UK Government’s proposal of "regulatory flexibility") that after leaving the EU the UK will not be a member of the European single market for services and will be considered to be a "third country".

On 13 July 2017, ESMA issued three sector-specific opinions relating to:

• investment management;
• investment firms; and
• secondary markets.

These built on the general, cross-sectoral opinion published by ESMA in May 2017.

The opinions were "aimed at fostering consistency in authorisation, supervision and enforcement related to the relocation of entities, activities and functions from the United Kingdom" and emphasized that:

• EU27 regulators are not to fast-track applicants (so there is no ‘race to the bottom’ in authorisation standards for relocating UK firms); and
• UK firms setting up in the EU27 should have a substantive EU presence; and
• delegation structures outsourcing services to the UK should be objectively justified (for example, by optimising the functioning of the business or saving costs).

The sectoral opinions make clear that the EU will not accept "empty shell" EU entities whose only purpose is to act as a vehicle allowing a UK-based financial services entity to benefit from the EU passporting regime when the UK becomes a third-country firm post-exit. Consequently, some fund / investment managers may need to restructure their corporate groups more substantively to be able to continue providing their services in the EU.

(1) Private Equity

• The current cost of compliance with the Alternative Investment Fund Managers Directive (AIFMD) has been a key criticism of the current EU approach to financial services legislation. However, the AIFMD provides the ability for EU Alternative Investment Fund Managers (AIFMs) to market Alternative Investment Funds (AIFs) throughout the EU.
• Post-Brexit UK AIFMs are likely to be treated as non-EU AIFMs, therefore they will only be able to market AIFs to EU investors via national private placement regimes (where available).
• It is anticipated that the AIFMD passport will be extended to cover non-EU AIFMs in those jurisdictions where ESMA has made an equivalence assessment.
• If the AIFMD marketing passport is extended, non-EU AIFMs not domiciled in equivalent jurisdictions may no longer be able to market into the EU on the basis of national private placement regimes. As EU investors are significant investors in UK private equity, equivalency is likely to be desirable.

(2) Hedge Funds and Managers

• Opinions of individuals within the industry are to some extent dependent on the breakdown of EU clients and the focus of some funds on different geographical locations (such as the US or Asian markets).
• On completing Brexit and prior to the introduction of any passport for non-EU AIFMs, UK-based hedge funds would only be able to passport into the EU by using national private placement regimes.
• The hedge fund industry has been subject to the European Markets Infrastructure Regulation (EMIR) with respect to derivatives trading. However, as EMIR implemented the G20’s 2009 commitment to reform the derivatives market, the UK will still be subject to those commitments. The UK is likely to remain subject to EMIR or broadly equivalent domestic legislation.

(3) UCITS Funds and Managers

• Brexit may have a material impact on UK-domiciled UCITS. UCITS funds must either be EU-domiciled and self-managed or managed by an EU management company. Consequently, there is a material risk that many of the benefits of the UCITS regime could be lost to UK funds and managers post-Brexit whichever model is chosen.
• UK UCITS may need to consider relocating to another EU state or cease to be a UCITS. UK UCITS managers may have to adopt a similar structure to US UCITS managers (i.e. delegated managers of EU domiciled funds often established in Luxembourg or Ireland).
• These issues may result in significant additional cost and an administrative burden.

Passporting

• Passporting is the exercise of the right by a firm, authorised within one EU member state (its home member state), to carry on activities in another EU member state (a host member state) on the basis of its authorisation in its home member state without the need to obtain additional authorisation from the host member state.
• The key impact of Brexit in respect of passporting is that UK fund / investment managers will be treated as third country firms and would, therefore, potentially be able to rely on third country passports. Broadly speaking the passporting option hinges on the concept of equivalence of regulation, therefore, the UK would need to be deemed equivalent in each area a passport covers.
• There is currently no single unified concept of equivalence and it applies differently in different contexts. The adjudication of equivalence is made by different EU bodies in each case. Establishing equivalence can be a time-consuming process and equivalence decisions are made at a point in time and have no permanence. Adjudicating bodies can (in certain circumstances) reverse decisions on equivalence.

(1) MiFID II passport

• The MiFID II passport is used by fund / investment managers providing investment services other than AIFMs and UCITS managers. MiFID II – comprising the Markets in Financial Instruments II Directive (MiFID II Directive) and the Markets in Financial Instruments Regulation (MiFIR) - entered into force on 3 January 2018. MiFID II introduced two new passports for “third country firms” which could potentially mitigate the position for UK firms post-Brexit. The position under MiFID was that third-country passporting was not permitted and instead each member state’s national regime must be complied with, for example, requiring firms to establish an authorised entity in that member state.
• Under Article 39 MiFID II Directive, the “branch passport” may permit firms to establish a branch in an EU member state to provide services to all clients (including retail and elective professional clients) in that member state, provided that certain conditions are met. Individual member states have to “opt-in” for this passport to be available to firms. Not all EU member states have opted into the branch passport, so UK-authorised firms could not use this option in all member states to provide services to EU clients.
• Alternatively, the Article 46 MiFIR “cross-border passport” does not require a branch to be established but does require an assessment of equivalency by the European Commission with respect to the third country. Firms would also need to register with ESMA and comply with certain conditions. This passport can only be used by firms to provide cross-border services to per-se professional clients and eligible counterparties. Firms would not be able to use this passport to service retail clients.
• In addition to the two new passports, MiFID II provides for the possibility of EU clients accessing services from third country firms at the exclusive initiation of the client (the so-called “reverse-solicitation” exemption). However, this is not seen as a practical solution for providing services into the EU as there will be significant regulatory focus when operating under such provisions.

(2) AIFMD passport

• UK AIFs and UK AIFMs will be reclassified as third country AIFs / AIFMs.
• Pending the introduction of third country passports, UK AIFMs will only be able to market their AIFs to EU investors under the national private placement regimes of individual member states. Additionally they will not be able to manage EU AIFs.
• Assuming that third country passports are introduced and made available to the UK by the European Commission, UK AIFMs should be able to market UK AIFs to professional investors in the EU and to manage EU AIFs.
• Irrespective of whether third country passports are made available to the UK, UK firms should still be able to conduct portfolio management with respect to EU AIFs on a delegated basis (subject to the conditions in the AIFMD regarding delegation of portfolio management being satisfied).

(3) UCITS passport

• Subject to any special arrangements, post-Brexit UK funds will no longer be capable of being classified as UCITS and as a result will lose their access to the UCITS fund passport and not be able to freely market to retail investors in the EU.
• UK management companies will not be permitted to act as management companies of EU UCITS and will lose the ability to use the UCITS management company passport. Despite the loss of the two passports (fund and management company) UK fund / investment managers could continue to provide portfolio management services to EU UCITS from outside the EU on a delegated basis, subject to complying with the UCITS delegation regime.

Remuneration

(1) AIFMD remuneration

• The FCA implemented the AIFMD remuneration requirements through SYSC 19B of the FCA Rules which will remain in place after the UK leaves the EU.

(2) UCITS remuneration code

• The current UCITS Directive introduced the UCITS remuneration rules and the European Banking Authority produced guidelines addressed to national supervisors regarding the application of those rules. SYSC 19E of the FCA Rules contains the FCA’s implementation of the UCITS remuneration requirements. EU UCITS management companies can delegate the management of a UCITS to UK entities which are compliant with SYSC 19E. As SYSC 19E is a UK rule, it will continue to exist once the UK’s membership of the EU expires; therefore, current delegation arrangements to firms that apply SYSC 19E are unlikely to be affected.

Derivatives trading – European Markets Infrastructure Regulation (EMIR)

• Fund / investment managers trading derivatives within the scope of EMIR are subject to extensive requirements regarding trade reporting, clearing and risk mitigation requirements. EMIR is an EU regulation and, therefore, is directly applicable in each member state without the need for national implementing legislation.
• Post-Brexit, EMIR will cease to apply. However, as EMIR stems from the UK’s commitments as a G20 member, it is likely that the UK will implement national regulations that are similar to EMIR. UK fund / investment managers facing EU counterparties will still, to some extent, have to comply with the requirements of EMIR to enable their EU counterparties to themselves comply.

Benchmarks

• The new Benchmarks Regulation (BMR) has applied since 1 January 2018. Non-EU third countries will not be caught by the scope of the BMR directly. However, where third country managers wish to market collective investment schemes in the EU, they will need to avoid using, as benchmarks, indices which are not registered with ESMA.
• Regulated firms within the EU will need to ensure that they only use ESMA registered benchmarks. The BMR includes an equivalence provision to enable third country benchmarks to be registered with ESMA, as well as third country recognition and endorsement provisions. Post-Brexit, it will be important to ensure that UK benchmarks benefit from the third country provision in the BMR.

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Market Abuse Regulations (MAR)

• MAR came into effect on 3 July 2016 and repeals and replaces the previous civil market abuse regime in the UK. The FCA is unlikely to relax regulation in this area when the UK leaves the EU, and it is likely that the UK will be required to maintain compliance with MAR for equivalence purposes under other regimes.
• Regardless of whether the UK maintains compliance with MAR, the regulations themselves have extra-territorial effect as they apply to all actions and omissions relating to financial instruments admitted to trading on an EU trading venue (and other financial instruments whose price or value depends on or impacts a financial instrument traded on an EU trading venue). However, financial instruments admitted to trading on a UK trading venue will no longer fall within the scope of MAR once the UK leaves the EU.

Fourth Money Laundering Directive (MLD4)

• MLD4 replaced MLD3 and was implemented on 26 June 2017. Even when the UK leaves the EU it is unlikely to make major changes to the MLD4 legislation as it is committed to compliance with the Financial Action Task Force Recommendations.
• On leaving the EU, the UK will become a third country under MLD4 and will no longer be in scope. However, it may still impact UK firms to the extent that they deal with entities based in the EU, particularly in relation to due diligence requirements. In addition, given the UK’s commitments as a member of the Financial Action Task Force, it would be required to implement a broadly equivalent domestic anti-money laundering regime in any event.

Tax

• Post-Brexit, the UK may be in a position to simplify its current VAT regime and reduce the VAT applicable to certain products. However, whether it would do this given the revenue VAT generates is a different matter. The UK’s double tax treaty will be largely unaffected by Brexit, however, provisions which assume the UK’s membership of the EU may require amendment.
• Without the benefits of EU directives, tax leakages in cross-border transactions and payments may occur. Consideration should be given to implementing any cross-border mergers before the UK leaves the EU. Additionally, without a requirement to comply with EU case law, the UK Government could reverse legislative changes made to accommodate EU treaty principles. 

Consequences for high-net-worth individuals

• In 2015, it was announced that any individual who had lived in the UK for more than 15 out of the last 20 years would, from April 2017 be treated as domiciled in the UK for all tax purposes. Any individual born in the UK with a UK domicile of origin would also be treated as UK-domiciled at any time that person is resident in the UK.
• Certain anti-avoidance provisions have exemptions designed to make them compliant with EU law, these may no longer be necessary when the UK leaves the EU.
• There is potential for the economic slow-down caused by Brexit to require UK tax rates to be increased.
• Whilst VAT is harmonised across the EU, we are unlikely to see significant changes given that VAT is the second highest revenue raiser for the UK government after income tax.