On August 16, 2021, the U.S. Tax Court denied a U.S. citizen living abroad from claiming a foreign tax credit to offset their U.S. Net Investment Income Tax (“NIIT”) liability.
Foreign tax credits are granted in order to shelter taxpayers from double taxation by different taxing jurisdictions on the same income. This is both equitable and economically efficient. There is no reason this relief should be limited to one type of income tax and not another. However, the relevant legislation and tax treaties are drafted narrowly and the Court, taking a literal view of the treaty, rejected this equitable position. As a result, the taxpayer was not allowed to rely on the treaty to claim a foreign tax credit against her NIIT liability.
The Net Investment Income Tax
The NIIT was created as a funding source for the Affordable Care Act and has applied since January 1, 2013. Individual taxpayers with adjusted gross incomes above a certain threshold pay 3.8% on their interest, dividends, capital gains, rental and royalty income, and non-qualified annuities.
To clarify the issue, the NIIT is imposed by Section 1411 within Chapter 2A of the Internal Revenue Code (“Code”). NIIT might be viewed as an extension of the Medicare Tax (which is in Chapter 2 of the Code). The more regular income tax is imposed under Chapter 1 of the Code.
Foreign Tax Credits
Under domestic law, the Internal Revenue Service (IRS) has taken the positon that no foreign tax credit is available to offset the NIIT. The IRS interprets the foreign tax credit rules as only providing relief against Chapter 1 income taxes. NIIT is a Chapter 2A tax. When the Treasury wrote regulations interpreting NIIT, they stated that “amounts that may be credited against only the tax imposed by Chapter 1 of the code may not be credited against the Section 1411 tax imposed by Chapter 2A of the code unless specifically provided in the code.”
However, while taxpayers generally rely on the domestic rules to claim foreign tax credits, reliefs within most U.S. tax treaties require the United States to grant a foreign tax credit to some extent. However, NIIT is a relatively new tax that is not typically referenced in tax treaties.
Toulouse v. Commissioner
Catherine S. Toulouse was a U.S. citizen and a French tax resident qualifying for the benefits of the U.S.-French tax treaty when she filed her 2013 tax return. She had carryforward foreign tax credits for taxes paid to France and Italy. The taxpayer filed her 2013 U.S. federal income tax return clearly disclosing that she was taking a foreign tax credit against her NIIT liability, so the NIIT liability was offset. This credit was denied.
Toulouse accepted that the foreign tax credit would not be available under the Code but claimed it should be available under the French and Italian tax treaties.
While the Tax Court agreed that both the French and Italian tax treaties with the United States are “intended to limit the effects of double taxation,” both treaties also included language that allows the credit following the applicable U.S. laws. As a result, the court held that the foreign tax credit’s availability would be “limited by the code’s provision of a credit.”
While the Tax Court’s interpretation comports with a literal reading of the treaties, it likely deepens concerns about other foreign tax credit issues that are currently evolving. For example, many countries are introducing Digital Service Taxes (“DST”), and many U.S. technology companies are likely to have to pay these taxes. A narrow reading of the foreign tax credit rules in this context would probably result in the denial of a foreign tax credit for the DST, which will likely lead to double taxation of profits and commercial inefficiencies.
The Toulouse decision is a significant loss for U.S. persons residing outside the United States. Sadly, it puts to rest arguments that a foreign tax credit should be available to offset NIIT while providing greater certainty about the application of the NIIT to foreign investment income.
Contact your Friedman LLP advisor today if you have any questions on the NIIT, foreign tax credits or the U.S. international tax regime generally and how you can adapt your tax strategy in the face of evolving case law.