US Income Tax Retaliation Against Australian Taxpayers

The US House of Representatives has just passed the One Big Beautiful Bill Act 2025. It threatens serious tax pain for Australian taxpayers with direct and indirect investments in the US. The Bill may yet fail to pass the Senate, but this measure is probably uncontentious and likely to survive the compromises expected on other matters in the Bill.

The target and the weapon

It is no secret that the US Congress has been unhappy for some time with projects at both the OECD and the UN to adjust the current inter-nation allocation of taxing rights on the profits of multi-national enterprises. A particular focus has been the undertaxed profits rule (UTPR) component of the OECD’s Pillar Two and the imposition of Digital Services Taxes (DSTs), given that the OECD’s Pillar One was dead-on-arrival. Republican members of the House of Representatives introduced Bills in the prior Congress, and re-introduced them in the current Congress, to impose higher taxes on the US income of taxpayers from countries which imposed “extra-territorial” or “discriminatory” taxes. These efforts culminated in the proposal in the One Big Beautiful Bill Act 2025 to add a new measure in the Internal Revenue Code to retaliate against countries enacting such taxes. Australia is obviously a potential target as we have enacted both a UTPR and diverted profits taxes which substitute for DSTs but still target US tech companies.

In other words, Australian taxpayers are to be the casualties in a tax war being fought by the US Government against the Australian Government. The US has also decided to make the Australian Government and agencies that form part of the Australian Government targets as well.

The proposed s. 899 will operate to increase certain US tax rates (a “specific rate of tax”) being paid by certain taxpayers (an “applicable person”) who are residents of a “discriminatory foreign country” (a country which “has one or more unfair foreign taxes”). Affected tax rates ratchet up by 5 percentage points each year (capped at 20 points) unless the offending measure is removed.

Australia’s unfair taxes

The reference to “unfair foreign tax” is not just to a discrete tax (like Australia’s Diverted Profits Tax) but extends to individual measures which increase an existing tax.

The definition of “unfair foreign tax” contains both per se and discretionary aspects. Three tax measures are, by definition, an “unfair foreign tax”:

• an “undertaxed profits rule (UTPR)”,
• a “digital services tax”, and
• a “diverted profits tax”.

Australia has enacted a UTPR which commenced for income years starting from 1 January 2025, subject to the 1-year transitional safe harbour. And we have another tax specifically called a “diverted profits tax.” The Multinational Anti Avoidance Law (MAAL) is more interesting as it could be viewed as a “diverted profits tax” (it is part of the DPT in the UK) or as a “digital services tax,” albeit in disguise. (But, as discussed below, it may not be necessary to come to a conclusion on this question.)

In addition, the Secretary of the Treasury may designate other measures to be an unfair foreign tax:

• an “extraterritorial tax”,
• a “discriminatory tax”,
• “any other tax enacted with a public or stated purpose indicating the tax will be economically borne, directly or indirectly, disproportionately by United States persons.”

The most relevant of these is “discriminatory tax”. It is defined in various ways, but three particular aspects of the definition are important for Australian taxpayers. A tax measure will be “discriminatory” if:

• it is imposed on income which the US would not regard as sourced in Australia under their source rules;
• the measure applies “predominantly” to non-residents because of the application of revenue thresholds, exemptions or exclusions; or
• the measure is placed outside the scope of double tax agreements.

There are then further exceptions to the relevant tests.

It remains to be seen which Australian regimes the Secretary will designate, but some measures which might face difficulty under these tests include the deemed source rule in Div 764 ITAA 1997, the proposed expansion to the scope of the CGT regime for non-residents to assets only tenuously connected to land, some of the views on the meaning of “royalties” expressed in the ATO’s draft ruling (TR 2024/D1), and the special obligations and penalties imposed on Significant Global Entities. The MAAL will fail the third test and must be a prominent candidate. The possible designation of Australia’s general anti-avoidance provisions in Part IVA is somewhat surprising. Part IVA does not have its origin in the OECD’s BEPS projects, but the decision to try to make it treaty-proof has obviously offended someone. The News Bargaining Incentive is also a target. Interestingly, Australia’s GST, which has previously been criticised as both a barrier to imports and a subsidy to exports, is defined not to be a discriminatory tax measure.

The trigger is the existence of any “unfair foreign tax” measure in Australian tax law (and we have at least two per se regimes). There is an exception if the tax does not “apply” to US persons or the local subsidiaries of US entities, but it is likely that this would require all US taxpayers to be explicitly removed from the scope of the tax; it is unlikely to be sufficient that no US taxpayer currently happens to meet the criteria which trigger the measure, or doesn’t trigger it in a particular year.

The affected US tax rates

The proposed section lists the various heads of tax which are affected. In general terms they are:

• tax on business profits: income effectively connected with a US trade or business carried on by a non-resident company (21%) or by a non-resident individual (tax at marginal rates); and
• tax on other US-source income: fixed or determinable annual or periodic income such as interest, dividends, rents, royalties and certain capital gains (30%).

Withholding. The increased rates flow through to the obligation of US payers to withhold from certain payments to non-residents (30%).

Sovereign immunity. Proposed s.899 also removes the current exemption from US tax for certain US sourced income if it is earned by the Government of a “discriminatory foreign country” such as Australia, and by Government-owned entities which are regarded as part of the Government.

Interaction with treaties. The proposal increases the tax rates listed in the Code for various items of income “or any rate of tax applicable in lieu of … [the] statutory rate.” The second phrase seems intended to mean, the rate applicable under a treaty. In other words, while interest paid by a US company to its Australian parent is prima facie taxable at 30%, that rate is ordinarily reduced to 10% under the Australia-US treaty, and so the 5% uplift is added to the treaty rate of 10% rate, not the domestic rate of 30%. This drafting initially respects the treaty, and then overrides it, which seems more than a little odd.

FITO. There must be a question whether Australia would give a FITO for US tax collected at the elevated rates. A Note to s.770-15 ITAA 1997 says a FITO is only available for “foreign income tax [that] has been correctly imposed in accordance with [the relevant] tax treaty.”

Affected Australian taxpayers

Only some Australian taxpayers with US source income will be affected by the new regime. The Bill lists the targets as –

• the Australian government, and agencies which amount to the government;
• any Australian resident individual (unless they are also a citizen of the US or dual resident);
• any Australian resident corporation (unless it is owned from the US);
• a corporation formed outside Australia and the US but owned by Australian residents (unless it is publicly traded); and
• any foreign private foundation formed in Australia or a trust owned by Australian residents.

The Secretary can also add Australian partnerships and other entities to the list.

The implication of the list is that the new tax will affect:

• Australian entities directly carrying on business in the US, most obviously, Australian banks with branches in the US;
• Australian entities holding US assets such as land; for example, Australian listed trusts holding commercial property in the US
• Australian managed funds holding US infrastructure assets
• Australian investors earning passive income from the US such as interest, dividends, royalties, etc. This will most obviously affect superannuation funds, charities, and Australian multinational entities.

BEAT. At first glance, it seems the regime affects the tax rate on dividends paid by US-incorporated subsidiaries to their Australian parent, but the subsidiaries themselves are not directly affected. However, modifications are made to the base erosion and anti-abuse tax (BEAT) and these modifications are definitely directed at the US subsidiaries of parent entities resident in a “discriminatory foreign country” such as Australia. They may have the effect of driving up subsidiaries’ US tax liabilities quite substantially – there is no guarantee the increases will be 5% per annum, or capped at 20%.

BEAT operates as a minimum tax at a specified rate on a tax base which adds back to the usual tax base certain base-eroding payments (most commonly, interest, royalties, rent, payments for services, and payments to purchase property which qualifies for depreciation or amortization) made by a US resident to related entities offshore, above a stated threshold.

For the US subsidiaries of parent entities in offending countries, proposed s.899 will relax some of the BEAT preconditions meaning BEAT is more likely to be triggered and at a higher rate:

• BEAT will apply to these companies regardless of their turnover; other US companies are within the scope of BEAT only if their annual turnover, averaged over the 3 prior years, exceeds USD 500m;
• BEAT will apply to these companies regardless of the amount of their base-eroding payments to related entities; other US companies are only within scope if their base-eroding payments exceed 3% of their total deductible payments (or 2% for some financial entities);
• amounts (other than the cost of inventory) which the US company does not deduct but capitalizes instead will be treated as if they had been deducted; and
• the rate of BEAT will be 12.5%; the rate for other companies is currently 10%.