U.S. taxpayers with foreign income face a complex interplay of tax obligations, including the potential to offset foreign taxes paid against their U.S. tax liability through the foreign tax credit (FTC). However, the 2013 advent of the net investment income tax under the Affordable Care Act has added a layer of complexity to this scenario. The NIIT, a 3.8% surtax on certain net investment income for high-income individuals, raises questions about the eligibility of foreign taxes to offset the surtax. Recent legal cases have examined this issue, making decisions favorable to taxpayers. Let’s explore the background of these cases, their outcomes and the implications for U.S. taxpayers.
The Core Issue
The core issue revolves around whether foreign taxes can be credited against the taxpayer’s U.S. NIIT liability. The NIIT, codified under Internal Revenue Code Section 1411 (Chapter 2A), applies to individuals, estates and trusts with net investment income and adjusted gross income exceeding statutory thresholds. Net investment income includes dividends, interest, capital gains, rental income and other passive income. The FTC allows taxpayers to mitigate double taxation on foreign-sourced income. However, the IRS contends that the NIIT isn’t an “income tax” for purposes of the FTC. Citing language that’s common in many U.S. tax treaties, the Internal Revenue Service has denied taxpayers’ use of the FTC to offset NIIT, arguing that FTC can only be claimed against income described in Chapter 1 of the IRC. Because the NIIT was introduced under a new Chapter 2A of the IRC, this position effectively precludes taxpayers from using the FTC to offset their NIIT liability, resulting in potentially higher overall tax burdens on foreign-sourced investment income.
Legal Challenges and Case Outcomes
Taxpayers have challenged the IRS’ stance, arguing that the foreign taxes paid on income subject to the NIIT should be creditable. Three notable cases highlight this debate.
- Christensen v. United States No. 20-935T (Fed. Cl. Sept. 13, 2023). In 2023, the U.S. Court of Federal Claims ruled that Matthew and Katherine Kauss Christensen, American citizens living in France, could claim an FTC against the NIIT assessed on their U.S. federal income tax return. The Christensens argued for relief under Article 24(2)(b) of the U.S.-France Tax Treaty, which doesn’t contain the language requiring FTCs to be used “in accordance with the provisions and subject to the limitations” of the IRC. This argument was a departure from prior, unsuccessful attempts by U.S. taxpayers with foreign income to offset NIIT with FTCs, for example, in Toulouse v Commissioner, 157 T.C. 49 (2021).
- Bruyea v. United States (Ct. Claims Dec. 5, 2024). Most recently, in 2024, the Court of Federal Claims held that the U.S.-Canada Tax Treaty allows an FTC to offset the NIIT assessed on income that was also subject to Canadian income taxes. Paul Bruyea, a dual Canadian-U.S. citizen residing in Canada, paid Canadian taxes of approximately $2 million on the $7 million capital gains he had incurred in the sale of real property. Citing the U.S.-Canada tax treaty, he claimed an FTC against his regular U.S. income taxes and NIIT.
Although the government tried to deny the FTC on multiple grounds, including reliance on a key phrase, “subject to the limitations of US law,” the court ruled that this clause didn’t override the credits available under the treaty.
The Christensen and Bruyea courts rejected the IRS’ narrow interpretation of the FTC, emphasizing the intent behind the treaties and the economic substance of the taxes rather than their technical classification. Expanding on the Christensen ruling, the Bruyea court opined that “so long as the Net Investment Income Tax qualifies as a ‘United States tax’, the [US-Canada] treaty provides for the claimed credit….”
- Toulouse v. Comm’r, 157 T.C. 49 (2021). The contrasting decision in Toulouse highlights the nuances and potential pitfalls in applying the FTC. In 2021, the U.S. Tax Court held that a U.S. citizen resident abroad wasn’t entitled to claim an FTC against NIIT and denied the FTC offset for taxes paid on foreign investment income in Italy and France.
The court based this ruling on Article 24(2)(a), which doesn’t allow an FTC against the NIIT. It didn’t consider the application of Article 24(2)(b) of the French Treaty because the petitioner didn’t argue that she was entitled to relief under that provision.
Significant Development
The recent rulings addressing the applicability of the FTC to the NIIT represent a significant development for U.S. taxpayers with foreign investment income. The U.S. Court of Federal Claims has repeatedly rejected the IRS’ narrow interpretation of the FTC, underscoring an increasing judicial preference for interpreting the FTC and tax treaty provisions in a manner that aligns with the fundamental purpose of avoiding double taxation.
Nevertheless, the Tax Court’s denial in Toulouse serves as a cautionary tale when relying on FTC offsets to NIIT. To date, favorable taxpayer outcomes have been treaty-specific and limited to the Court of Federal Claims. Despite recent setbacks, the IRS may continue its fight to deny the FTC for NIIT through judicial and legislative avenues.
