Making the foreign branch exemption compulsory

The government has published draft legislation for implementing reforms to the UK foreign branch exemption to effectively make it compulsory with effect for accounting periods beginning on or after 1 January 2027. The draft legislation also includes targeted anti-avoidance and anti-forestalling rules.

Background

In May, the government announced that UK resident companies with a foreign permanent establishment (PE) would be required to exempt the profits and losses from those PEs. The change is designed to prevent losses attributable to such foreign PEs being utilised in the UK whilst foreign profits are not similarly taxed.

Under the current rules, introduced in 2011, a UK resident company operating abroad through a PE may make an election to exempt the profits of its foreign PEs (the foreign branch exemption). In the absence of such an election, the PE profits are subject to UK tax (subject to the provisions of any applicable double tax treaty). Where an election has not been made, the foreign losses of a UK company attributable to its foreign PE are available to be used to relieve UK profits of the main company or the wider group. Elections are irrevocable and require the company to determine whether losses were made in the years prior to the election, in which case an equivalent amount of profits must be brought into charge in the years following the election (the loss clawback rules).

The government is concerned that this relief is not being appropriately balanced by equivalent foreign profits being brought into the charge of UK tax as intended by the original rules. In some cases this is because the UK profits are largely or fully sheltered by the availability of double taxation relief and in other cases a multinational group may incorporate a foreign PE at the point that it becomes profitable, which removes those profits from the charge to UK tax without the transfer of the PE business generally giving rise to a taxable gain.

According to the announcement, the result is that “the UK Exchequer is in some cases compensating multinational groups for costs/losses incurred overseas through reduced UK tax on UK profits, without corresponding tax being collected on their foreign profits. This effect is particularly significant for groups which generate very large foreign losses or are able to claim very large amounts of capital allowances in relation to their foreign PEs, for example in the oil and gas sector.”

Proposed changes

The government has now published draft legislation which will make the foreign PE exemption mandatory, generally with effect for accounting periods beginning on or after 1 January 2027. The measure repeals the current loss clawback rules and replaces them with a new transitional regime that prevents companies carrying losses and other amounts allocable to a foreign PE forward into a post transition period.

The rules include targeted anti-avoidance rules to counteract arrangements designed to undermine the reform. In particular, the rules include:

• a purpose-based rule which will apply to arrangements made on or after 13 July 2026 and where it is reasonable to regard those arrangements as circumventing the intended commencement or operation of these changes
• specific rules to prevent the impact of the reform being delayed by changing the length of accounting periods by applying the rules in general from the first anniversary of the start of the shortened accounting period.

Permanent establishment meaning

The draft legislation modifies the definition of ‘permanent establishment’ that will be used for these purposes, applying the international rather than domestic definition. This means that in the case of a PE located in a treaty jurisdiction, the definition in the double tax treaty will apply. In other cases, the definition in Article 5 of the OECD Model Tax Convention will apply.

Oil and gas companies

The May 2026 announcement indicated that for UK-resident companies with foreign PEs that carry on activities in connection with the exploration or exploitation of oil and gas, the measure would commence from 1 September 2026 by deeming the accounting periods of such companies to end on 31 August 2026, with the new regime applying from the following day. However, the draft legislation makes no such provision and no mention of this earlier application of the rules is mentioned in the accompanying materials. As such, it appears that the changes will have effect for accounting periods beginning on or after 1 January 2027 for all companies.

Comment

The draft legislation is open for comments until 13 September 2026. The legislation will be included in Finance Bill 2026/2027.