Exemption for foreign permanent establishments be made mandatory

The UK government has announced it intends to make profits and losses attributable to a foreign permanent establishment (PE) of a UK resident company mandatorily exempt from UK tax.

        
            Key Insights
        
From 1 January 2027, the exemption for foreign PEs will become mandatory for all UK companies. For oil and gas companies, the change will take place four months earlier, on 1 September 2026.
Pre-exemption PE losses will likely be 'hard-stopped', and anti-forestalling rules will target abusive attempts to accelerate their use. 
Justified as funding the 'Great British Summer Savings' package of measures to support families with the cost of living, the proposal is aimed at 'super' profits generated by oil and gas companies amid geopolitical tension in the Middle East.
Piecemeal, reactionary, sector-specific, taxes risk undermining business confidence and investment.

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What has happened?

On 21 May 2026, the Chancellor of the Exchequer announced plans to make "changes to the taxation of foreign branch profits; changing how companies are taxed in relation to their overseas activities". For accounting periods beginning on or after 1 January 2027, it will be mandatory for profits and losses attributable to a foreign PE to be exempt from UK tax. For companies operating in the oil and gas extraction and exploration industry, the change will take effect from 1 September 2026.

The Policy Paper, published by HM Revenue and Customs, can be read here: Foreign Permanent Establishment Exemption — policy paper.

What is the exemption for profits or losses of foreign PEs?

A UK-resident company operating abroad can choose to do so either through a foreign corporate subsidiary or through a foreign PE. A PE is essentially a taxable presence in the foreign country through which the UK-resident company itself trades directly, but which lacks a separate legal personality.

The default position is that the UK will tax the profits of a foreign PE as part of the UK company (though the UK resident company would be able to seek double tax relief in respect of profits of a foreign PE also taxed abroad). However, under current rules, the UK company can make an irrevocable election to exempt the profits of the foreign PE from UK corporation tax.

The exemption for profits or losses of foreign PEs was introduced in 2011 as part of a suite of measures designed to place the UK taxation of companies on a more territorial basis, improve the international competitiveness of the UK tax system, and ensure greater alignment between the taxation of foreign PEs and foreign subsidiaries.

Why change?

The government is concerned that the foreign PE exemption is being abused.

Where no election is made, losses of foreign PEs can still be used to offset UK profits, reducing UK tax revenues. This is how the rules are intended to work but the concern is that at (or just before) the point at which the foreign PE becomes profitable, it is incorporated in an attempt to remove future profits from the scope of UK corporation tax.

In the view of HM Treasury, the consequence is that, "the UK Exchequer is … compensating multinational groups for costs/losses incurred overseas through reduced [corporation tax] on UK profits, without corresponding tax being collected on their foreign profits".

The issue is likely to be most obvious where international groups generate very large upfront losses, or claim very large capital allowances for construction projects, through foreign PEs. The Chancellor was clear that oil and gas companies were the main target, stating, "some oil and gas groups that operate overseas through foreign branches have structured their tax affairs in a way which ensures they pay little or no Corporation Tax on their UK energy trading profits".

However, it is worth emphasising that the proposed changes will affect all companies in all sectors.

What will change?

It is rare to have a tax policy announcement of this magnitude made without consultation and outside of the normal Budget cycle (where tax measures are more normally introduced). However, putting that to one side, the government proposal is to make the foreign PE exemption mandatory.

Details are currently scant – for example, it is not clear whether the election will be deemed to have been made or the UK company will be obliged to make it – but draft legislation is expected to be published (and will, presumably, be subject to technical consultation) over the summer. We assume that the mandatory exemption will also apply to a UK resident company that is a partner in a UK partnership, in respect of its share in profits of a foreign PE of the partnership.

The mandatory exemption will apply for accounting periods beginning on or after 1 January 2027 for all UK-resident companies with foreign PEs. However, the change will take effect from 1 September 2026 for companies with foreign PEs that carry on exploration or exploitation of oil and gas activities. For the earlier date, affected companies' accounting periods will be deemed to end on 31 August 2026, with the new regime applying from the following day.

The existing legislation taxing profits of an exempted foreign PE where there is a ‘total opening negative amount’ (TONA) is to be repealed. The TONA mechanism effectively claws back the benefit of foreign PE loss relief which has been used by UK companies, by compelling electors to bring in an equivalent amount of foreign PE profits back into the charge before the full exemption applies. This is logical because, without it, UK companies would otherwise be hit by a double-edged sword - an inability to use foreign PE losses against UK profits but incurring a UK tax liability on future profits which arise to the PE.

However, at the same time, the new rules will ensure that losses arising before the exemption takes effect are not available to relieve UK profits arising after that date. So, whilst future PE profits will not be clawed back into charge, the new rules operate as a 'hard-stop' on the use of PE losses going forwards.

Anti-forestalling provisions will also be included targeting arrangements designed to artificially accelerate the use of losses or otherwise minimise the impact of the new rules. These rules will limit structuring options available to companies who have accrued losses which would otherwise have provided value against future UK profits.

Wider issues?

The policy is presented as paying for the short-term support package to soften the impact of inflation and the rising cost of living caused by the energy price shock arising from the US-Iran war and the closure of the Strait of Hormuz. Some of the support measures relate to the cost of energy itself (fuel duty 5p cut retention; electricity price calculator); some do not (the cut in VAT rate on certain leisure activities), but all are notable for their short duration.

However, making the foreign PE exemption mandatory is another in a growing list of recent policy changes (including the extended and increased Energy Profits Levy, and the new Electricity Generator Levy), that increase the tax burden on the oil and gas sector. The sector has reported that it is generating 'exceptional' profits, arising as a direct result of geopolitical friction and rising oil prices. However, while profits have recently soared, total UK oil and gas revenues have been steadily falling, year-on-year, as the energy transition towards renewable sources takes shape. As business revenues decrease, so do government tax revenues.

While the government wants to support families with the cost of living, it also needs to invest in the infrastructure that is needed to build energy security and supply chain resilience for the long term. In an increasingly volatile and unstable geopolitical environment, it needs to fund the energy transition to achieve its net zero ambition by 2050.

The government will inevitably need to find new sources for tax revenue to replace those based on fossil-fuels. Increasing the effective rate of tax on fossil-fuel companies is not, therefore, a sustainable long-term strategy, and could prove to be counter-productive in the short to medium term. Reshaping the UK's tax base, while leading the country's energy transition, will require more considered, holistic, and fundamental tax reform, over the medium to long term.

It is also important to note that the impact of the changes is not in any way limited to the oil and gas industry or limited in time and so, whilst it has been presented as such, whilst it has been presented as such, in practice, the true impact of the measure is much wider than the government's presentation might suggest.

So what?

The exemption for foreign PE profits and losses provides a simple system which avoids the need to claim double tax relief for tax incurred on profits and income of a foreign PE. The system enables UK-based businesses to invest overseas.

Making the exemption mandatory further simplifies the position by drawing a clear dividing line between UK-generated profits and losses and those generated offshore, but removes some of the flexibility, potentially jeopardising investment. As intended by the government, it will no longer be possible to utilise early-stage losses of an overseas branch to shelter UK profits before choosing to make an election for the exemption to apply.

Impacted businesses should consider the following actions:

Assess income loss relief assumptions and planning

Business with loss-making foreign PEs, that have not yet made an election for the exemption to apply, should model the impact of the election becoming mandatory on 1 September 2026 (or, if not in the oil and gas sector, for accounting periods beginning on or after 1 January 2027). It may be necessary revisit business structures and economic modelling. Appropriate allocation and documentation for pre-change losses and other attributes will be crucial for the accurate application of the transitional rules (and as protection from the anti-forestalling provisions).

Reassess monitoring of PE creation

The definition of what constitutes a PE becomes more important. Recent changes in domestic and international law have meant that the threshold for creating a taxable presence has been lowered. In an increasingly digitalised economy, where jurisdictional boundaries are crossed more easily, it is probable that pressure to reduce the threshold further will continue. Making the exemption for profits or losses of a foreign PE mandatory means that, from a UK perspective, creating a PE overseas immediately traps any losses (and tax) offshore.

Analyse profit attribution calculations

In general, a PE is liable to tax on profits (and relieved from tax for losses) attributable to it. Broadly speaking, to calculate the profits and losses attributable to a PE, international rules normally seek to identify the profits and losses that would have been made by the PE as if it were 'separate enterprise'. This normally requires an assessment of transactions by applying the 'arm's length principle'. Operating robust arm's length pricing arrangements, appropriately allocating risks and cost margins, between UK head-offices and foreign PEs, will become increasingly important. It will also be necessary to keep an eye on whether such calculations relating to the allocation and attribution of profits and losses to foreign PEs currently prescribed under legislation will be amended.

Revisit tax assumptions about operating overseas

The proposed change, from the perspective of profits chargeable to UK corporation tax, eliminates the distinction between operating overseas through a corporate subsidiary or through a PE. In both cases, profits and losses will fall outside the scope of the UK tax net. Any decision about whether to operate via a PE or incorporate a subsidiary will become more nuanced, depend on the materiality of differences in treatment for other taxes and, more importantly, wider commercial considerations.

Engage with the technical consultation

As always, the 'devil will be in the detail'. Many elements of the proposed change remain unclear. These include:

o The precise nature and operation of the transitional rules

o The scope and impact of the anti-avoidance rules

o The Policy Paper refers to "losses and other attributes", but does not expand on what 'other attributes' means

o How making the PE exemption mandatory will (if at all) impact other UK international tax regimes, such as its transfer pricing rules, the operation of, and availability of relief under, its double tax treaties, and its multinational top-up tax and domestic top-up tax rules.

The government asserts that the proposal will preserve "the UK’s competitive exemption regime for the taxation of foreign PE profit which is simple and supports companies seeking to expand into foreign markets". They will be keen to ensure that the practical impact of the legislation reflects that assertion.

How we can help

We advise UK and international businesses on their tax position across the full range of corporate and infrastructure transactions. We can help structure businesses operations, assess loss availability, and advise on contractual arrangements.

Our policy practice can assist in tracking consultations and help represent the interests of businesses as the government develops its policy approach on all aspects of taxation, both directly and through our membership of influential representative and professional bodies.

For more information on this topic or how we can help, please contact a member of our tax team.

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