European Equity Strategy: Section 899 — Expert Views and Market Implications

In a new European Equity Strategy report from Citi Research, a team of analysts led by Head of European Equity Strategy Beata Manthey looks at Section 899 of the U.S. House’s One Big Beautiful Bill Act (OBBBA), which could impose taxes on foreign entities operating in the U.S. if their home country is found to have an “unfair” tax system. Their exploration includes a discussion of Section 899 with a U.S. tax expert and implications for European equities.

The OBBBA has passed the U.S. House and now awaits approval by the U.S. Senate. Section 899, “Enforcement of Remedies Against Unfair Foreign Taxes,” could facilitate taxes on foreign companies, with much of the European Union (EU) and the UK likely qualifying as having tax systems deemed as discriminatory. The rise in tax rates for such companies would be just 5% in year one, but it would rise another 5% in annual increments until reaching as much as 20% in year four.

Much remains unclear about both the details and the implementation of Section 899, which hasn’t yet become U.S. law and could be amended or removed in budget negotiations. But the provision applies to a wide range of entities, including corporations, individuals, partnerships and government-controlled entities such as sovereign wealth funds and pension funds.

Section 899 would give the U.S. Treasury Secretary discretion in identifying “discriminatory foreign countries” and providing exceptions, with the list of such countries updated quarterly. Countries with Under Taxed Profit Rules (UTPR) or a Digital Services Tax (DST) would automatically be deemed as unfair. Currently, EU countries either implement or are required to implement UTPR; countries that already implement a DST include Denmark, France, Italy, Portugal, Spain and the UK. 

If Section 899 becomes law in its current form, the law would become effective for the tax year beginning 90 days after enactment for countries with existing DSTs or UTPRs; 180 days after a discriminatory designation; or the first date that an unfair foreign tax applies.

The Joint Committee on Taxation, made up of U.S. Senate and House members, estimates Section 899 will boost U.S. government revenues by around $116 billion over 10 years, a relatively small amount compared with the approximately $2 trillion that tariffs are estimated to generate over the same period.

We spoke with U.S. tax expert Haroon Cheema about Section 899. His takeaways include the following:

• Both active and passive income will be targeted.
• Active income, or “Effectively Connected Income,” is the trading income of U.S. subsidiaries, where the annual 5% increase would be added to the current 21% federal income tax rate, regardless of any remittances, up to a rate of 41% for corporations.
• Passive income would be subject to the same annual 5% increase added to the current rate of 30% withholding tax, to a maximum of 50%. The withholding tax on disposals will also be subject to this rule.
• The Base Erosion and Anti-Abuse Tax (BEAT), which limits interest-payment deductions from tax returns, has been expanded in terms of companies that will be caught by this rule.
• Existing treaties are overridden by the act. Notably, countries that have adopted undertaxed profits rules under the Organisation for Economic Co-Operation and Development (OECD) would be classified as discriminatory. Paying a tax rate that’s in line with or above current U.S. corporate tax rates doesn’t exclude a company from being impacted.
• If the bill becomes law, the U.S. Treasury may issue temporary regulations while full guidance is awaited, a process that could take a year or more.

Implications for European equities
Section 899’s changes, if enacted as drafted, could increase the effective income tax rate for U.S. subsidiaries of corporates tax-resident in countries deemed to be discriminatory. There are some potential offsets, and arguably Section 899 could drive some behavioral changes. U.S. subsidiaries could be incentivized to restructure their ownership or be divested, but we think this would be the exception rather than the rule. The changes could also disincentivize investments into the U.S. Companies whose needs are particularly dependent on dividends from U.S. subsidiaries are the ones most likely to change behavior.

Other tax changes in the bill could lower U.S. taxable income relative to current levels before retaliatory rates are applied. On the passive-income front, companies may get a credit or deduction for the higher withholding tax in their tax filing in their home country. U.S. subsidiaries could raise debt directly from U.S. investors rather than from parent-company loans in order to minimize passive income paid to the parent, where a higher withholding tax rate may be due. 

At the index level, we’d expect the fundamental impact of Section 899 to be relatively small, at least at first. Our rough analysis finds that year one’s additional 5% tax obligation would increase the overall tax rate for European companies by 0.8%, with total net income coming down by some 0.5%. 

We’d assume that the impact of U.S. penalty taxes would be concentrated in European companies with particularly high U.S. exposure. Some 20% of Stoxx 600 revenues derive rom the U.S., with Media, Healthcare and Food & Beverages among the sectors with the highest share of sales coming from the U.S. At the company level, though, U.S. sales exposure tends to be very concentrated, with around 30 companies in the Stoxx 600 having U.S. revenue exposure above 50%. Meanwhile, 250 companies have less than 5% of revenue coming from the U.S.

Ultimately, Section 899 may help accelerate diversification away from the U.S. We suggested investors begin such diversification late last year, and this year’s events have largely reinforced this view. 

Higher tax burdens could disincentivize investment in the U.S., potentially leading to capital outflows. Section 899 serves as another avenue of policy uncertainty, which may increase the cost of holding U.S. assets for international investors via reduced cash flows as well as higher Equity Risk Premium for the U.S. market.

From a global allocation perspective, we note that dividend-yielding stocks in the U.S. may be relatively less appealing for non-U.S. investors. This could prompt some rotation from U.S. dividend strategies to ones elsewhere.