Section 899: The Quiet Tax Proposal That Could Upend Cross-Border Fund Flows

Introduced as part of the Trump administration’s “Big Beautiful Tax Bill,” Internal Revenue Code (IRC) Section 899 is now drawing sharp focus across the asset management industry, not for its branding, but for its quiet potential to unravel long-standing structuring norms that underpin how foreign capital accesses U.S. markets.

The provision passed the U.S. House on May 22nd and could change how investment managers set up their funds and work with foreign investors. It also presents a clear deterrent to foreign investors, who may face punitive U.S. withholding taxes despite existing treaty protections or reliance on long-standing offshore structures. Section 899, as proposed, would authorize the U.S. Treasury to impose an additional withholding tax of up to 20% on U.S.-source income paid to individuals and entities from “discriminatory foreign countries” (DFCs) or those that have enacted digital services taxes (DSTs), undertaxed profits rules (UTPRs), diverted profits taxes (DPTs), or other perceived “unfair foreign taxes” on U.S. businesses or investors. In simple terms, Section 899 would let the U.S. government add extra taxes (up to 20%) on money that flows from U.S. investments to foreign investors from certain countries. These are countries the U.S. considers to have ‘unfair’ tax policies.

If implemented, the rule would override existing tax treaties and increase U.S. tax rates on U.S. source income received by certain foreign investors deemed “applicable persons.” That category includes non-US individuals, foreign governments, and entities that are tax residents of a “discriminatory foreign country” deemed to have imposed “unfair foreign taxes” on U.S. businesses. The Treasury may also designate other taxes as unfair if they are viewed as discriminatory or extraterritorial in nature. Based on this definition, it is expected to include many EU countries, the UK, Canada, Japan, and others.

This would mainly affect income from U.S. investments, such as dividends, interest, and rent. The extra tax could raise total tax rates as high as 50%. The proposed legislation does not eliminate statutory exemptions, such as for portfolio interest, bank deposit interest, and certain capital gain distributions, although Treasury would retain discretion to recharacterize income under anti-avoidance rules. This means that even categories currently excluded from FDAP withholding, including interest that qualifies under the portfolio interest exemption, could become exposed to additional tax if the Treasury adopts a look-through as part of its anti-avoidance authority. This uncertainty has prompted many managers and allocators to carefully revisit the investor composition and income sourcing of their structures, particularly when using Cayman feeders or hybrid cross-border entities.

Why This Matters Now

Foreign institutional investors rely heavily on U.S. tax treaties and statutory exemptions to access U.S. markets efficiently. Section 899 directly targets that foundation. While these rules wouldn’t directly impact all strategies, they raise serious questions for funds that rely on offshore structures to pool international capital and shield LPs from withholding.

Look–Through Risk and the Cayman Question

Section 899 does not explicitly require a look-through to underlying investors in offshore entities, but it gives the Treasury full discretion to implement one. If exercised, even indirect investors from DFCs participating through Cayman structures could be subject to an additional 5–20% U.S. withholding tax, bringing total rates on U.S. dividends to as high as 50%. This would be a significant departure from existing U.S. tax principles, which generally treat foreign corporations as the taxpayer of record.

While the proposal appears to preserve the portfolio interest exemption, Treasury could invoke its anti-avoidance authority to look through and recharacterize income received by DFC investors through offshore structures, effectively subjecting U.S.-source interest to the Section 899 surcharge. The unclear rules around how this affects sovereign wealth funds and central banks could hurt demand for U.S. government debt and affect dollar funding markets.

Initial Market Reaction

The implications could be significant, and the uncertainty may influence allocator behavior in the near term. While the provision has not yet passed the Senate, it is reasonable to expect some foreign institutional investors to pause on new commitments or demand greater transparency around fund structure, investor composition, and income classification. Depending on the final bill, foreign investors may reassess how they allocate to U.S.-focused strategies, particularly those that rely heavily on treaty relief or long-standing statutory exemptions.

According to a Goldman Sachs research paper, which aggregates data from the Federal Reserve, Treasury, Department of Commerce, Tax Foundation, and Goldman Sachs Global Investment Research, countries with DST, UTPRs, or DPTs, those most likely to be designated as discriminatory, account for a substantial share of foreign capital invested in U.S. markets. According to their analysis, these countries represent over 70% of foreign direct investment and more than 60% of U.S. equity holdings by non-U.S. investors. If Section 899 is enacted without carve-outs or clear limitations, allocators could face a material repricing of after-tax return expectations across their portfolios. In this environment, managers must be prepared to quantify potential exposure and proactively engage investors around tax risk and structural resilience.

What Strategies Are Most Exposed?

Section 899 will not affect all strategies equally. Funds most reliant on U.S.-source income and treaty-based withholding relief are likely to feel the greatest impact:

• Equity and long-only strategies that generate U.S. dividends face the most direct exposure. The proposed surcharge targets precisely these income streams, and treaty overrides would leave many foreign investors facing effective withholding rates of up to 50%.
• Credit strategies may be partially shielded, provided the portfolio interest exemption remains intact, and the Treasury does not exercise anti-avoidance authority to look through. However, where credit vehicles include investors from DFCs or hold complex or non-qualifying interest instruments, there is still a meaningful risk. For example, sovereign wealth funds or tax-exempt LPs relying on Section 892 or treaty exemptions could see those benefits curtailed if they fall into the “applicable person” definition.
• By contrast, futures-based and systematic strategies are likely to be the least impacted. Trading gains from regulated U.S. futures are generally excluded from U.S.-source income under Section 864(b)(2). Still, if the Treasury chooses to apply the anti-avoidance authority via look-through, the portfolio interest earned on cash and cash equivalents posted as margin could come into scope.

Structuring & Capital Formation Implications

Industry groups are already engaging with the Treasury to advocate for clarity. If the Treasury issues aggressive guidance, even master-feeder structures with Cayman blockers may need revision. Managers may add nuanced disclosures, explore segmented share classes or investor carve-outs, and other strategies that may be able to mitigate exposure.

Regardless of the final outcome, Section 899 is forcing a conversation. Funds that previously relied on treaty relief or statutory exemptions without much scrutiny may need to quantify exposure, segment investor bases, and plan for potential changes to withholding assumptions.

What to Watch

The rule has cleared the House and awaits Senate consideration. Section 899 could take effect as early as January 1, 2026, if passed. However, the Senate may soften provisions, delay implementation to 2027, or remove passive income elements entirely. Key areas to monitor include:

• Whether the Treasury opts to implement a look-through test for offshore entities
• Whether the anti-avoidance authority will be used to recharacterize portfolio interest
• Whether sovereigns, central banks, or SWFs will be explicitly exempted
• How broad the country designation list becomes (likely including UK, Austria, Canada, France, Italy, Spain, Turkey, Australia, South Korea, Japan, and other EU states)
• What enforcement mechanisms apply to diversified funds with passive foreign ownership

The Bottom Line

Section 899 has the potential to materially disrupt capital formation and cross-border investment strategy for the hedge fund industry. At a time when allocators are already demanding more alignment, transparency, and downside protection, a new layer of tax friction, especially one that is dynamic and jurisdiction-based, adds further complexity.

For managers, this is not just a legal or compliance issue, but a forward-looking business risk with the potential to affect fundraising, fund design, and after-tax alpha delivery. For investors, it may accelerate the trend toward tax-efficient strategies, favoring systematic, global, and non-income-centric approaches that are inherently less exposed. Section 899 is another reminder that structural awareness is now a core investment competency in a market increasingly shaped by policy and regulation.

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