Not-so-beautiful US taxes

The Republicans’ signature “One Big, Beautiful Bill Act - the bill)” is currently going through US Congress. Within the bill are tax cuts for individuals from President Donald Trump’s first term that are to be made permanent, elimination of taxes on tips/overtime and an increase in the state and local tax deduction. 

The non-partisan Committee for a Responsible Federal Budget (CRFB) estimates that the bill would add another $3 trillion to outstanding US public debt of $36 trillion - 133% of gross domestic product (GDP) - over the next decade. If temporary provisions are extended without any offsets, then this could increase by $5 trillion¹. With higher interest rates, this puts the US public debt burden on an unsustainable path. 
However, beyond the fiscal cost, the bill includes a controversial provision known as Section 899, which could affect capital flows in and out of the US by changing the tax treatment of foreign investors. Broadly put, Section 899 of the tax code would appear to effectively override treaties and allow the US government to levy taxes on non-residents operating within its borders if their home country is considered to have an unfair tax system.

The proposed legislation would use long-standing US tax treaty obligations as a base line from which to layer on new taxes on non-US residents by 5% points a year up to a maximum of 20% points. This would start next year and marks a significant policy shift that affects the tax liability of foreign taxpayers.

Importantly, if the bill goes through Congress in its current form, it will give the Trump administration discretion on imposing so-called “retaliatory taxes” on non-US residents. No doubt, this would be welcomed by the president, since it would give him a new tool in negotiations with countries to strike deals with. This would likely lead to greater uncertainty for investors.

The bill is still working its way through Congress, so there is time for amendments to refine the scope of the legislation. Nevertheless, from what is known at the time writing, Section 899 is wide in scope.

First, it covers many countries and establishes countermeasures against nations that levy Digital Services Taxes (DSTs), Undertaxed Profits Rules (UPRs), or Diverted Profits Taxes (DPTs) on American enterprises. As an example, the EU, the UK, and various other US trading partners would be classified under the “unfair tax system” designation due to their implementation of the UPR. This rule permits a country to raise taxes on a business if its parent company pays less than the OECD’s proposed global minimum tax of 15% in another jurisdiction.

China is currently not affected by Section 899, as it does not apply these tax rules. However, the US Treasury would list “discriminatory foreign countries (DFC)” quarterly, meaning China could be added if it adopts policies targeting US businesses.

Second, it could cover a wide range of financial actors, from corporations, individuals, partnerships and government-controlled entities, including sovereign wealth funds and pension funds. 

Third, although specific details remain uncertain, Section 899 would apply to both passive income (interest and dividends) and business income (profits) of non-residents.

Within passive income, the House Budget Committee report confirms that Section 899 excludes income already tax-exempt under the Internal Revenue Code, such as portfolio interest (including US Treasuries). Though central banks and other foreign government entities may still face higher taxes on US interest payments, as the provision lacks clarity on their classification. This ambiguity makes it uncertain whether the portfolio interest exception would apply to them at all. However, it is apparent that the tax would apply to dividends. 

In terms of business income, Section 899 would also increase taxes on US profits earned by certain foreign companies associated with DFC entities. This would mean that the US corporate tax rate on income earned by these foreign companies could rise from 21% to a maximum 41%, in equal increments of 5% points over four years¹.

Most capital gains would likely be exempt, as they are not classified as US income. Though the key exception would be gains on US real estate, which could be subject to higher withholding taxes.

Even if Section 899 remains unused, its existence signals the U.S. government’s willingness to use economic measures against competitors, which could unsettle investors. This could significantly affect their behaviour and have a marked impact on markets.

Historical examples show that taxes on capital flows can reshape markets. Malaysia’s 1997 capital controls stabilised its economy, but temporarily reduced foreign investment. Elsewhere, Brazil’s 2009 financial transaction tax curbed speculative inflows though discouraged long-term investments.

In a worst-case scenario, the trade war could morph into a capital war and increase market volatility. Foreign investors, who currently own 18% of all outstanding US equities, could reduce their holdings (or at least be reticent in buying more), potentially putting pressure on valuations¹.

In a best-case scenario for investors, Section 899 could encourage foreign governments to lower taxes on American multinationals, benefiting US equities, especially tech companies vulnerable to DSTs. New taxes on dividends for U.S. stocks held by foreign investors might incentivise companies to return capital to shareholders via buybacks instead.

The cynics could argue that Section 899 is just a way to give the president more negotiating power to strike deals with other governments. Potentially, this could lead to more market volatility, as was seen in early April after “Liberation Day” on trade tariffs.

Section 899 also introduces a groundbreaking strategy, effectively turning the US tax system into a diplomatic tool in the ongoing international battle over the global tax base.

Over the longer term, the threat of higher taxes could make the US a less favourable investment destination. Nevertheless, if Section 899 is successful in getting other countries to lower taxes on US multinationals, then US stocks are likely to gain. 

Arguably, the biggest loser under this new legislation could be the US dollar, as potential lower demand for US financial assets, as well as a wider budget deficit, could weigh on its performance.

However, the ultimate impact of Section 899 will depend on its final wording and how the US Treasury implements it. There also remains the possibility that it could get dropped entirely by the Senate, so we are watching developments closely. For all its bold rhetoric, the bill’s long-term impact may prove that beauty is in the eye of the beholder—and it is unclear on whether markets will be impressed.

1. Evelyn Partners/LSEG