MARKET NEWS

BY Melissa Shin and Rachel Graf

(Bloomberg) -- A measure in President Donald Trump’s tax and spending bill that’s meant to penalize foreign investors may also raise interest costs for some US borrowers.

The so-called Section 899 provision takes aim at nations such as Canada, the UK and France that have digital services taxes or other corporate tax rules the US deems unfair. Investors and companies from those countries may see gradually higher tax rates on income they earn from US assets — which some analysts have called a “revenge tax.”

But Section 899 would affect loan interest payments in a way that would hurt some US companies, according to legal experts. Many lending agreements require borrowers to cover such tax hikes if they’re enacted after the deal is signed.

These requirements are known as withholding tax gross-up obligations. Borrowers remit the withholding tax to the US government, but they must “gross up” their payment to ensure the lender still receives the full amount of interest owed.

For example, a 5% withholding tax would require a borrower owing $1,000 in interest to remit $50 to the US government, and then gross up its payment so the lender still receives $1,000. The borrower’s combined tax and interest payment would actually be about $1,053 — because the gross-up payment itself is also subject to withholding tax.

“It’s a significant problem,” said Matthew Brown, a partner in the Washington office of law firm A&O Shearman, as the measure would likely touch loans made by foreign banks that lend to US borrowers from outside of a US branch. That scenario is very common for syndicated loans, he said.

The tax bill still faces plenty of hurdles, including opposition from a number of Republican Senators over Medicaid cuts and the size of the deficit. The legislation was attacked by Elon Musk, who called it a “massive, outrageous, pork-filled Congressional spending bill” and “a disgusting abomination.”

Some borrowers may be able to sidestep the increased interest costs of the proposed Section 899 by booting non-US lenders from their credit facilities. But whether they do so depends on “how strong a position the borrower is in and their ability to have lots of options for lending,” Brown said.

Some lenders may also choose to absorb the tax costs, since those demanding a gross-up from borrowers might be denied future deals. “Memories are long,” said Carolyn Alford, partner with King & Spalding LLP in New York.

If the measure takes effect, lenders — not borrowers — from affected countries would be expected to bear the increased cost of credit deals signed after that. That could make them less willing to lend to US entities.

A French or British bank, for example, “will have to assess whether or not it wants to continue to make loans if it’s running the risk of incurring this uncompensated withholding tax,” said Michael Mollerus, partner with Davis Polk & Wardwell in New York.

House Ways and Means Committee Chair Jason Smith said last week he hopes Section 899 will be a deterrent that is never deployed, and Senate Majority Leader John Thune told reporters his chamber is examining the provision.

Nonetheless, the proposal has alarmed Wall Street, where analysts fear it would drive away foreign investors. As written, the tax rate increase is designed to rise over time — it starts at five percentage points and increases another five points each year until it’s 20 points above the statutory rate.

Brown said he expects the provision is meant to “bring countries to the table” to discuss their corporate tax rules. “I do not believe the intention is to drive up the cost of borrowing in the United States.”