Morgan Stanley Warns of 20% Tax Hike on Foreign Investments in U.S.

Morgan Stanley has issued a warning about the potential impact of the 899th clause in the Trump administration's "Big Beautiful" bill, officially known as the Tax Cuts and Jobs Act. This clause, titled "Enforcement of Remedies for Unfair Foreign Tax Practices," proposes significant tax increases for investments from countries deemed to have discriminatory tax policies by the U.S. The clause could potentially apply to a wide range of assets, including U.S. Treasury bonds, corporate bonds, and securitized products, raising concerns about increased costs for foreign investors.

The clause's "incremental penalty tax" design could impose an additional 5% tax rate initially, increasing by 5% each year up to a maximum of 20%. This could affect not only corporate and individual investors but also foreign central banks and sovereign wealth funds that previously enjoyed tax exemptions. The broad scope of the clause has led to debates among experts about whether financial assets could be considered "real assets" and thus subject to the tax.

If the Senate does not clarify the scope of the 899th clause, the market could face multiple challenges. The yield curve for U.S. bonds could steepen, the dollar could weaken, and credit spreads could widen. The potential impact on the U.S. bond market is particularly concerning, as foreign official investors hold a significant portion of U.S. debt. Private investors, who tend to hold longer-term bonds, could react more quickly to increased tax costs, leading to further steepening of the yield curve.

Europe could be one of the most affected regions, as it is the largest holder of U.S. fixed-income and equity securities. The U.S. relies heavily on foreign capital inflows to finance its current account deficit, and the 899th clause could make investing in the U.S. less attractive. This could lead to further weakness in the dollar against safe-haven currencies like the euro, yen, and Swiss franc.

In the corporate bond market, foreign investors hold approximately 25% of U.S. corporate debt. If the additional tax cost is applied to these bonds, the market could face liquidity pressures and short-term volatility. If U.S. Treasury bonds are exempt from the tax while corporate bonds are not, the credit spread could widen significantly, with investment-grade bonds potentially being more affected than high-yield bonds.

In the securitized products market, foreign investors have a stronger demand for agency bonds than for securitized credit. If the tax policy is unfavorable for non-government-guaranteed assets, GNMA mortgage-backed securities could benefit relatively more. However, changes in tax policy could have a more significant impact on the valuation of commercial real estate, where foreign buyers account for 5-10% of the market, compared to residential real estate, where their share is less than 2%.

Hedge funds could also face risks under the 899th clause. If a non-U.S. company is more than 50% owned by "applicable persons," it could be classified as such, even if no single shareholder owns more than 50%. An increase in the tax rate by 20 percentage points could eliminate any arbitrage or relative value opportunities, potentially disrupting the business models of quantitative hedge funds that rely on cross-border arbitrage in the U.S. market.

However, the worst-case scenario of the 899th clause coming into effect is still uncertain. If the clause were to apply to all financial assets, the Congressional Budget Office's estimate of 116 billion in ten-year revenue would be significantly underestimated. The primary goal of the clause is to provide the U.S. with leverage in tax and trade negotiations, and the House Ways and Means Committee Chairman has stated that it is hoped the clause will never be enforced. The market is hoping that the Senate will clarify the scope of the 899th clause in the final legislation, including specifying the income range, adjusting the applicable entities, and delaying the effective date. Until the Senate provides guidance, investors with assets likely to be included in the scope may become increasingly anxious.