Proposed legislation would raise tax rates on U.S. investment income – considerations for non-U.S. investors

The Trump administration's spending and tax bill is currently under consideration by the U.S. Senate, having passed the U.S. House of Representatives by one vote in May. The administration has a target date of July 4, 2025 for enactment.  

The bill includes proposed Section 899 of the U.S. Internal Revenue Code, entitled "Enforcement of Remedies Against Unfair Foreign Taxes", which would increase otherwise applicable tax rates on certain U.S. investment income and eliminate a statutory exemption under Section 892(a) for non-U.S. sovereign investors. The proposed rule would impact, among other types of income, U.S. source interest and dividends, as well as gains on investments in U.S. real property interests and gains on shares of U.S. real property holding companies.

Proposed Section 899 would increase federal tax and withholding rates on certain categories of income for "applicable persons," which include individuals and companies based in countries that enforce taxes that the United States deems "unfair". Unfair taxes include digital services taxes, undertaxed profits rule (a key component of the OECD Pillar II rules), diverted profits taxes, and potentially other taxes.

Background

Proposed Section 899 is widely being described as "retaliatory taxes" against countries that impose taxes that are deemed to be unfair to the United States. In particular, the proposal is in response to the implementation of the OECD Pillar II rules, which are viewed as "usurping" the United States of its tax sovereignty. Proposed Section 899 is viewed as an instrument for the United States to utilize in short term negotiations by potentially giving countries time to repeal the relevant tax rules. In the long term, it is seen as a tool to protect the United States from discriminatory taxes by foreign countries.

Proposed rules

Broadly, under proposed Section 899, increased rates of U.S. federal tax and withholding taxes would apply to interest, dividends and gains from the disposition of shares of U.S. real property holding companies, among other items of income and gain. This discussion is focused on passive investments that do not give rise to U.S. effectively connected income, which is subject to different considerations.

Under the proposal, tax rates would increase by 5 percentage points each year until the relevant jurisdiction repeals the relevant tax. However, the increased rates will not exceed the statutory rate by more than 20 percentage points. For example, the statutory withholding tax rate of 30% on dividends and interest would initially be increased to 35%, and ultimately to 50% over time. In cases where another tax rate applies in lieu of the statutory rate (for example, pursuant to a treaty), such other rate would be increased by the applicable number of percentage points. For example, if a treaty specifies a withholding tax rate of 15% on dividends, the withholding rate would initially be increased to 20%, and ultimately to 50% over time.

Proposed Section 899 is intended only to increase the "specified rates of tax" and is not intended to apply to income explicitly excluded from the application of the specified tax. Thus, the widely relied-upon exemption for "portfolio interest" on U.S. debt obligations is expected to remain available, to the extent such portfolio interest is excluded from the tax imposed on U.S. source interest. A substantial portion of non-U.S. investors, including non-originating, secondary credit funds and CLOs, should therefore be able to rely on the portfolio interest exemption. However, proposed Section 899 could be a concern for lending banks in credit facilities that typically rely on U.S. treaties to eliminate withholding tax on interest payments (and potentially other payments) under credit agreements.

Furthermore, it appears that taxation of capital gains from the disposition of securities, other than interests in U.S. real property holding companies and, in very limited circumstances, where an individual has another nexus to the United States, would not be impacted by proposed Section 899. Therefore, non-U.S. investors generally are expected to continue to benefit from an exemption from U.S. tax on such gains. However, exemptions pursuant to an applicable treaty may no longer be available.

Non-U.S. pension investors 

Currently, some non-U.S. pension funds benefit from reduced or zero rates of tax on certain U.S. income by virtue of access to a treaty or under an applicable U.S. domestic law exemption. Proposed Section 899 could change these parameters. Any reduced or zero rates of tax under a treaty may be subject to an increase under proposed Section 899. Nevertheless, certain statutory exemptions under U.S. law may remain in effect. Therefore, non-U.S. pension funds that may be impacted by this change should review their investment portfolio to assess their reliance on U.S. treaty benefits for investment returns, although they may continue to be able to rely on other statutory exemptions.

Sovereign investors 

Proposed Section 899 removes the exemption under Section 892(a) otherwise applicable to sovereign investors of countries that are deemed to impose unfair taxes. In general, Section 892 exempts from U.S. federal tax certain income of non-U.S. governments received from investments in the United States. This generally includes U.S. source interest and dividends, and gains from the disposition of shares in U.S. real property holding companies. Accordingly, Section 892 investors that may potentially be impacted should consider their investment portfolio and assess their reliance on Section 892 for investment returns. Sovereign investors, however, may still be able to rely on other statutory (non-Section 892) exemptions.

Next steps

There is currently no indication as to which countries will be designated as imposing unfair taxes. The accompanying House Budget Committee report states that the U.S. Treasury Secretary will publish a list of countries in a manner that allows for regular updates and that is accessible to the public.

Due to the uncertainty as to which countries may be affected, non-U.S. investors may want to consider minimizing investments that rely on preferential tax rates under treaties with the United States (for example, reduced rates of withholding tax on U.S. dividends). Sovereign investors may consider limiting reliance on Section 892. Instead, investors generally may wish to consider planning for U.S. investments that generate income and gains not subject to tax under U.S. domestic law (other than Section 892, in the case of sovereign investors).

As noted above, increased tax rates under the proposed rule will apply to certain entities that are tax residents of a designated country. The proposed rule will also apply to certain entities that are majority owned or controlled by persons that are tax residents of a designated country, even if the entities are not residents of a designated country. Accordingly, investors should carefully consider whether an investment includes such an entity.

It is unclear at this time whether the proposed legislation will be enacted, and if so, which countries will be designated as imposing unfair taxes. Investors holding U.S. investments, whether directly or indirectly via investment structures, should consult with their tax advisers to discuss next steps.