In a case representing a major win for taxpayers, the U.S. Court of Federal Claims (Claims Court), in Bruyea v. United States, has concluded that the provisions of a U.S. tax treaty can in fact be used to allow a foreign tax credit (“FTC”) to apply against the net investment income tax (“NIIT”).
As further explained below, it remains to be seen exactly how the IRS will respond to the decision, and if it will continue to push forward with its position that FTCs cannot be used to offset the NIIT in any circumstance.
Background on the Foreign Tax Credit
As a general rule, foreign taxes are creditable only if they are taxes on income. In this regard, it is important to note that a number of foreign taxes appear as “income” taxes, but do not qualify for purposes of taking the foreign tax credit. For instance, foreign real estate taxes, sales taxes, luxury taxes, turnover taxes, value-added taxes, and wealth taxes, are generally not creditable.
The amount of foreign tax credits that can be claimed is limited to the amount of one’s foreign-source taxable income (meaning, income that is generated outside the United States).
More technically speaking, your foreign tax credit cannot be more than your total U.S. tax liability multiplied by a fraction. The numerator of the fraction is your taxable income from sources outside the United States, while the denominator is your total taxable income from U.S. and foreign sources.
Background on the Net Investment Income Tax
The NIIT, introduced as part of the Affordable Care Act legislation in 2010, is a 3.8% additional U.S. federal tax on unearned income when one’s modified adjusted gross income exceeds certain minimum thresholds. Like other federal income taxes, it applies to U.S. citizens and tax residents.
Under U.S. domestic law, as delineated in U.S. Treasury regulations, the foreign tax credit cannot be used to reduce the NIIT.
Consequently, a U.S. expat who otherwise has 100% foreign-source income and sufficient foreign tax credits to credit against such income, can still end up paying U.S. federal income taxes, at least in accordance with the U.S. domestic rules.
Previous Decisions on This Issue
The Bruyea case comes on the heels of several other court cases addressing this issue, including the following:
In the Toulouse case, the Tax Court rejected the taxpayer’s claim that the US-France Income Tax Treaty (French Treaty) allows a credit against the NIIT as a result of taxes paid to France. The Tax Court relied primarily on the assertion that the NIIT resided in Chapter 2A of the Internal Revenue Code — a chapter that was created exclusively for the NIIT. The Tax Court held that the treaty credit provisions applied only to “regular taxes” found in Chapter 1.
In the Christensen case, the Claims Court held that the French Treaty allows the FTC to apply against the NIIT, but seemingly only in limited circumstances, i.e., only with respect to taxes paid under the so-called three bite rule (in brief, this refers to using FTCs to offset the residual U.S. tax liability triggered by virtue of one's U.S. citizenship, after applying a first bite U.S. tax and then a second bite foreign tax on U.S. source passive income). The Court reasoned that although Article 24(2)(a) of the French Treaty (i.e., the general FTC provision) includes a self-limiting clause (i.e., it cannot supersede U.S. law), Article 24(2)(b) of the treaty (i.e., the provision allowing the credit on a third bite) does not include such language.
The Bruyea Decision – A Big Victory for Taxpayers
In the Bruyea case, the taxpayer, a U.S. citizen and resident of Canada, reported $7 million in capital gains from the sale of real property in Canada, and paid approximately $2 million in taxes to Canada. He first claimed an FTC of approximately $1.4 million against his regular US income taxes imposed under Chapter 1 of the Code, but not against the NIIT. He later amended his return to make the claim and request a refund of $263,523, based on the assertion that Article 24 of the US-Canada income tax treaty (Treaty) allows Bruyea to claim Canadian tax paid as an FTC that offsets the NIIT. The IRS rejected the refund claim, stating that the Treaty did not contain an independent basis for an FTC to offset the NIIT.
Bruyea filed a complaint with the Claims Court, claiming that he was entitled to the refund, and moved for partial summary judgment, asserting that he was entitled to an FTC under the Treaty. The government filed a cross-motion for summary judgment.
The Claims Court held in favor of Bruyea, reasoning that the Treaty should not be read so narrowly so as to disallow the FTC merely because there is a self-limiting clause whose purpose is to prevent the abuse of a treaty-based FTC.
The Court also rejected the government’s argument that the placement of the NIIT in Chapter 2A, as opposed to Chapter 1, was sufficient grounds for denying the FTC because the Treaty “guarantees that any future amendment to United States law will not change the general principle” of the Treaty. The Court also considered the “last-in-time rule” and determined it must harmonize the Treaty and the Code, ultimately concluding that nothing in the NIIT language was inconsistent with a treaty-based FTC.
Ultimately, the Claims Court concluded that, “so long as the NIIT qualifies as a ‘United States tax’, the Treaty provides for the claimed credit.” Therefore, the Claims Court ruled the Treaty allowed Bruyea to claim the credit to offset the NIIT. Accordingly, the Claims Court granted Bruyea’s motion for partial summary judgment, finding that Bruyea was entitled to a treaty-based foreign tax credit against the NIIT.
Implications for Expats Moving Forward
The Bruyea decision is certainly a major win for taxpayers, particularly for those who live abroad.
In contrast to the Toulouse decision, which disallowed a treaty-based FTC claim, and the Christensen decision, which allowed the claim but under seemingly limited circumstances, the Bruyea decision offers broad treaty-based relief.
With that being said, we would like to note the following caveats:
First, while the decision is a victory for taxpayers living in treaty countries, it still leaves expats in non-treaty countries without the ability to claim foreign tax credits against the NIIT.
Second, the Bruyea decision was made at the lower court level, and the IRS may appeal the case to a circuit court, and then ultimately to the Supreme Court. It remains to be seen if the IRS will find more success at the higher court levels.
Third, although the IRS lost the Bruyea case in the Claims Court, it was victorious in the Tax Court (in the Toulouse case), so it will likely continue to maintain its position that FTCs can’t be claimed against the NIIT. Therefore, given the current U.S. Treasury regulations prohibiting the credit, and the favorable holding for the government in the Tax Court, the IRS is unlikely to concede this issue administratively, and will likely continue to fight claims that are taken to court. Taxpayers should therefore consider the practical challenges that may come with making a claim, whether on a timely-filed return or on an amended return. Expats wanting to preserve their right to a refund can consider making protective refund claims.
