The Proposed US Tax Regime for Non-US Investors and Companies

Who Is Impacted?

The surtax applies broadly to investors (applicable persons) from designated countries deemed “discriminatory.” This includes:

• Foreign governments (including Section 892 sovereign investors), individuals, and corporations that are tax resident in listed jurisdictions
• Non-US corporations that are more than 50% owned by applicable persons (applying Section 958(a) rules)
• Partnerships or other entities that the US Department of the Treasury (Treasury) Secretary may designate as applicable persons by regulation
• Trusts with majority beneficial ownership held by applicable persons
• Private foundations created or organized in a listed jurisdiction.

Notably, non-US corporations that are majority-owned by US persons are excluded from “applicable person” status (Majority US Owner Exception) and thus are not subject to the surtax. Additionally, once an entity qualifies as an applicable person, it remains “tainted” until a full year passes without any connections to a listed jurisdiction.

Practical Insight: Non-US multinationals and many closely held businesses and ultra-high-net-worth families may become subject to this surtax because of measures their home countries have applied against large multinational corporations. Most US multinational groups likely will not be affected by Section 899 because of the Majority US Owner Exception. However, to the extent such multinationals own minority interests in non-US joint venture vehicles or companies, it is possible that they may be indirectly impacted.

While it appears that US funds owning majority stakes in non-US corporations may also qualify for the Majority US Owner Exception, the proposed Section 899’s reference to “partnerships and other entities designated by Treasury regulation” provides some uncertainty. It is possible that this language may be intended to police against the use of US partnerships in settings where the majority owners are residents of affected jurisdictions.

Notably, even if a non-US company is tax-resident in a nondiscriminatory jurisdiction, Section 899 can still apply if the company is majority owned by tax residents of discriminatory jurisdictions.

When Is a Country “Discriminatory”?

A country becomes “discriminatory” when it implements taxes the US considers unfair, including:

• DSTs
• DPTs
• Organization for Economic Cooperation and Development Pillar Two measures, notably UTPRs
• Any additional taxes the Treasury designates as unfair or discriminatory.

The Treasury will maintain and publish a quarterly updated list of these jurisdictions. Some examples of key jurisdictions and regions that may be affected by this rule include most of Europe, Asia-Pacific (e.g., Australia, India, South Korea, and Japan), Canada, and certain jurisdictions in the Middle East. This list is not intended to be exhaustive.

The Surtax’s Impact and Types of Income Affected

The surtax starts at 5%, increasing annually by 5% and capped at 20% after four years. It applies to certain key categories of income from US sources:

• US Sourced-Passive Income (FDAPI): Includes dividends, interest, rents, and royalties from US sources; standard withholding (30%) could reach 50%.
• US Real Estate Investments (FIRPTA): Income from selling US real estate or real estate investment trusts (REITs) and partnership distributions, with current withholding (15%) potentially rising to 35%.
• US Business Income (ECI) for non-US Corporations: Active business profits earned by non-US corporations in the US become significantly more costly.
• US Branch Profits Tax: Increased taxes on profits sent from US branches back to non-US parent companies.
• Private Foundation Investment Income: Significantly higher US tax rates on investment income earned by non-US private foundations.

Practical Insight: Investors should carefully evaluate whether their income falls within these categories. For example, they may wish to review their structures and income stream profiles (character and sourcing) to determine if it is possible to qualify such income as “foreign sourced” rather than US-sourced. The location of the business’ assets, personnel, customers, and the jurisdiction of the payors are relevant to this analysis.

Importantly, proposed Section 899 does not appear to affect a non-US person’s capital gain income from being excluded from US tax (e.g., sale of public company stock).

Implications Under the Base Erosion and Anti-Abuse Tax (Beat)

Non-US corporations (those with more than 50% ownership from affected countries) currently subject to the BEAT may face a harsher version of the BEAT regime, presenting key opportunities for planning. Generally speaking, the BEAT applies to companies (with average annual gross receipts of at least $500 million) that make base-eroding deductible payments (e.g., interest, royalties) to non-US affiliates. Under the proposed regime, the following modifications of the normal BEAT rules would apply to affected taxpayers:

• A fixed 12.5% BEAT rate (vs. 10%).
• The elimination of the 3% threshold, meaning even minor deductible payments to non-US affiliates can trigger the BEAT.
• The treatment of capitalized amounts as deductions, significantly limiting structuring flexibility.

Timing and Implementation

The surtax applies starting from the tax year following the latest of:

• 90 days after Section 899 is enacted into law
• 180 days after a foreign country adopts a triggering tax
• The first day the foreign tax becomes effective.

Given these short timelines, rapid evaluation of exposure and immediate planning is essential.

Treaty Implications

Though the law doesn’t explicitly override US income tax treaties, official legislative explanations suggest US treaty-reduced withholding rates would also be subject to the 5% incremental surtax increases annually. This would substantially affect withholding tax planning for investors relying on treaty benefits.

With respect to the portfolio interest exemption (PIE), the House Report explicitly states that the surtax “does not apply to portfolio interest, to the extent that portfolio interest is excluded from the tax imposed on FDAP income.” Nonetheless, in light of a possible interpretation that the PIE effectively establishes a zero rate of tax to which Section 899 could apply, we anticipate that Congress and the Treasury will hear calls for statutory or regulatory clarification to align explicitly with the House Report.

Traps for the Unwary and Open Questions

Proposed Section 899 appears largely self-executing and would be consequential for affected taxpayers. Many unanswered questions remain, and investors will likely face substantial practical challenges navigating the new rules.

Notably, the proposed surtax impacts private investors, individual taxpayers, and family offices who could find themselves impacted by Section 899 because of measures their home countries implemented to target large multinational corporations. Specific traps and challenges for non-US taxpayers include:

• Avoiding missteps around entity residency and beneficial ownership documentation (simply forming in neutral countries like Cayman or Luxembourg may not suffice)
• Assessing ultimate beneficial ownership of companies, particularly where the company itself is not a resident in a discriminating jurisdiction
• Meting compliance burdens with withholding agents – systems, documentation, and procedures may require rapid and extensive updating.

Given these challenges, clients should closely monitor tax legislation developments, including observing which countries adopt or decide to terminate a deemed discriminatory tax from applying to US taxpayers.

Immediate Planning Recommendations

To mitigate potential exposure:

• Monitor US Legislation: Closely track the progress of the bill and future Treasury announcements.
• Monitor Non-US Legislation: Closely track whether the affected foreign country approves, revokes, or modifies the discriminatory taxes.
• Clarify Effective Dates: Precisely map timing triggers based on jurisdiction-specific developments.
• Review Current Structures: Immediately analyze entity residency, ownership residency composition, and potential US tax leakage points.
• Character and Source Analysis: Evaluate the potential to reclassify certain income streams as non-US-source based on intellectual property, tangible assets, personnel, or payment sources.
• Restructuring Opportunities: Assess shifting entity residency or increasing US ownership above 50% (statutory carve-outs), utilize treaty-protected intermediaries, or implement domestically controlled REIT structures.
• Review Current and Proposed Transactions: Oftentimes, current and future payments to non-US sellers and non-US lenders can attract US withholding tax. Parties should review the transaction structure and corporate documents to access such exposure.
• Model Economic Impact: Prepare cash-flow analyses, internal rate of return scenarios, and revised after-tax return calculations to assess investment impacts.
• Withholding Preparedness: Engage withholding agents now, updating documentation, gross-up clauses, and compliance procedures.

The Bottom Line

If enacted, Section 899 would operate like an automatic sanctions regime embedded directly into US tax law. It is intended primarily as a diplomatic measure designed to discourage and eliminate extraterritorial and discriminatory foreign taxes imposed by other countries. Diplomatic negotiations may result in the withdrawal of such taxes, such that proposed Section 899 is never implemented or has a negligible practical impact. However, investors and companies must actively plan for the possibility that diplomatic objectives may not be met, making proactive evaluation and strategic planning essential to mitigate potential tax exposure.

Please reach out to your regular McDermott lawyer or the authors of this article for tailored guidance addressing your specific exposure and planning solutions.