Increased Taxes, Including Withholding Obligations by Funds, on Certain U.S. Sourced Income Allocated to Foreign Taxpayers from Certain Countries
Current law: Foreign taxpayers with income that is effectively connected to a U.S. trade or business (ECI) generally are subject to regular U.S. tax rates on such income (currently 21% in the case of corporations and a maximum of 37% in the case of individuals). Foreign taxpayers with certain passive income that is not effectively connected to a U.S. trade or business (fixed, determinable, annual, or periodical income” or FDAP) are subject to tax at a flat rate of 30%, which rate is often reduced by a treaty between the U.S. and the relevant foreign country. FDAP income tax is collected by withholding. Interest income that qualifies as “portfolio interest” (generally, non-contingent interest received by certain unrelated investors not engaged in a lending business) is not subject to such withholding. Non-trade or business capital gains of foreign taxpayers are generally not subject to U.S. income tax. A foreign taxpayer’s gain or loss from the disposition of a U.S. real property interest is treated as effectively connected to a U.S. trade or business, and the payor of such income is generally required to withhold tax from the payment.
Foreign corporations that engage in a U.S. trade or business through a branch rather than a subsidiary are subject to an additional branch profits tax on their ECI.
Under Section 892, foreign governments are exempt from U.S. tax on certain of their investment income.
Tax Bill. New Section 899 would impose a retaliatory tax on persons that are residents of, or otherwise have sufficient nexus with, foreign countries that, in the view of the House of Representatives, unfairly target and impose discriminatory taxes on U.S. taxpayers doing business abroad. Increased tax rates would apply to certain types of income of persons that are residents of or otherwise have sufficient nexus with “discriminatory foreign countries” that impose “unfair foreign taxes.” Unfair foreign taxes would include (i) taxes that may be imposed under the undertaxed profits rules (UTPRs) of Pillar Two, (ii) digital services taxes (DSTs), (iii) diverted profits taxes (DPTs), and (iv) any tax, to the extent provided by the Secretary, that is an extraterritorial tax, discriminatory tax, or any other taxes enacted with public or stated purpose that it will be economically borne disproportionately by U.S. persons.[1]
An increased rate of 5% would apply for each year of the unfair tax, up to a 20% maximum increase. The increased taxes would be incremental additional taxes that would apply on top of tax rates that would otherwise apply. For example, if dividends would otherwise be subject to a 30% withholding tax, then Section 899, as proposed, could increase the rate to as high as 50%. If a tax treaty reduces the rate on dividends to 10%, then Section 899, as proposed, could increase the rate to as high as 30%.
The increased rates would apply to: (1) taxes on dividends, interest, royalties, rent, or other FDAP income (currently subject to 30% withholding, unless reduced by treaty), (2) income that is effectively connected with a U.S. trade or business (ECI) (but for individuals, ECI is limited to gains on the disposition of U.S. real property interests) and (3) FIRPTA withholding (currently 15%) on U.S. real property dispositions, (4) the branch profits tax, and (5) investment income of non-U.S. private foundations.
The Tax Bill would also modify the application of the base erosion and anti-abuse tax, or BEAT to corporations that are primarily owned by tax residents of discriminatory foreign countries.
In addition, the Tax Bill provides that the exemption from tax under Section 892 that applies to certain income of foreign governments (including their sovereign wealth funds) would no longer apply to foreign governments of discriminatory foreign countries.
Troutman Take:
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Based on a footnote in the Committee Report, it is expected that portfolio interest would continue to be exempt from withholding, as would liquidating distributions by corporations, and non-liquidating distributions by corporations with no current or accumulated E&P. As a result, U.S. investment funds may place an even greater focus on the use of leveraged foreign blockers in tax planning, as well as planning to qualify for other exemptions from withholding.
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Increased focus may develop on creating offshore investment structures that seek to avoid foreign investors from being considered to have nexus with discriminatory foreign country.
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Given that Section 899 increases the tax on ECI of foreign corporations (but only the ECI from the sale of U.S. real property interests by individuals) and the fact that the Section 899 tax increase would apply to the branch profits tax, there may be decreased use of foreign blockers that are engaged in a U.S. trade or business.
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U.S. investment funds that allocate ECI to foreign investors should start to consider the potential for increased taxes on their foreign investors, and tax planning strategies to minimize such increased taxes.
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Foreign governments that currently do not have to file income tax returns with respect to dividends received from, or gain on the sale of a U.S. real property holding company because it is not a “controlled commercial entity” should start to consider they may have return filing obligations.
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Dividend distributions and capital gain dividends on the sale of U.S. real property by REITs to foreign residents of discriminatory foreign countries would become subject to increased withholding, thus increasing the compliance and withholding burden on REITs.
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It is possible that one or more countries that have an existing “unfair foreign tax” may terminate such unfair foreign tax and stop being a “discriminatory foreign country,” thereby preventing the increased tax rate from apply to the U.S. income of their residents. U.S. investment funds with investors from discriminatory foreign countries should closely monitor how such countries deal with their unfair foreign taxes.
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There are many unanswered questions that funds may have to face relating to the practical application of Section 899, including the means to identify the persons with respect to which a fund must withhold.
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For the implications of Section 899 to lending in the U.S. by foreign lenders, please see our advisory: The Big Beautiful Bill and the Effects on Bank Lending Into the US.