July 2024 - Monthly Newsletter

Recently, U.S. courts have made some major decisions on tax issues that can directly affect U.S. expats. Below, we summarize four such cases:

1) The Moore Supreme Court Decision - Constitutionality of the Section 965 Transition Tax

Last month, the U.S. Supreme Court upheld the constitutionality of the Sec. 965 transition tax. Sec. 965, as amended by the TCJA, imposed a one-time transition tax on untaxed foreign earnings — either at 8% or 15.5%. The tax applies whether or not the foreign earnings are distributed — they are deemed repatriated. The tax is imposed on U.S. persons owning at least 10% of a CFC. Undistributed earnings from after 1986 and prior to 2018 were deemed distributed and taxable in tax year 2017.

The Moores challenged the constitutionality of the transition tax, arguing that it is an unapportioned direct tax and not a tax on income because income must be realized before it can be taxable.

In brief, the Court upheld the constitutionality of the transition tax as applied to the facts of the case, but also found that in doing so, it was not required to address whether it is a constitutional requirement that income must be realized before it can be taxed.

2) The Farhy Appeals Decision - IRS Authority to Assess 5471 Penalties

Last year, the Tax Court surprisingly concluded in the Farhy case that there is no statutory provision, under Section 6038 or otherwise, that specifically authorizes the assessment of the Form 5471 penalties. Therefore, the IRS must collect the penalties through a civil action, a more arduous and costly process.

The impact of the Farhy decision was seen as far-reaching, as it significantly limited the IRS’ penalty assessment capabilities. Further, it was speculated that the Tax Court’s reasoning and analysis would seem to apply equally to penalties associated with other international forms, such as Forms 5472, 8938, 926 and, in certain instances, Form 8865.

This year, the D.C. Circuit Court of Appeals reversed the Tax Court decision, holding that the text, structure, and function of section 6038 of the Internal Code, which contains the provisions regarding international information returns, support the IRS’s assessment authority for those penalties.

While it’s unlikely that the Farhy case is taken up by the U.S. Supreme Court, it’s not out of the question. Further, there may be other suits relating to this issue that are appealed to other circuit courts that disagree with the D.C. Circuit Court. For now, however, the IRS should be significantly bolstered by this decision in its ability to assess international information return penalties.

3) The Aroeste Decision - Treaty Non-Residence and the FBAR

In a recent intriguing decision, the U.S. District Court for the Southern District of California tackled the issue of whether a taxpayer is required to file an FBAR if he has the status of a non-US tax resident by virtue of the tie-breaker provisions of a tax treaty.

In analyzing the issue at hand, the Court cited the definition of a “United States person” in the FBAR regulations, which includes a “resident of the United States,” which in turn is defined to include any individual who is a resident alien under Section 7701(b) the Code. Thus, the FBAR regulations incorporate by reference the definition of a resident individual used for income tax purposes. Under this definition, any individual who is a lawful permanent resident (i.e., a green card holder) is a resident of the United States.

The Court then noted that Section 7701(b)(6) of the Code states that an individual ceases to be treated as a lawful permanent resident if he or she commences to be treated as a resident of a foreign country under the provisions of an income tax treaty between the United States and a foreign country, does not waive the benefits of such treaty, and notifies the IRS of the commencement of such treatment.

As such, given that utilizing the treaty caused Mr. Aroeste to cease to be treated as a lawful permanent resident under the Code, he should not have had an FBAR filing requirement.

While the Aroeste decision at first glance seems to be a major taxpayer win, it remains to be seen exactly what impact the decision will have moving forward for a couple of reasons. This is because there is some ambiguity surrounding Section 7701(b)(6) of the Code and to what extent a green card holder’s tax residence truly “ceases” upon a taxpayer claiming to be a treaty nonresident. Arguably, only a so-called long-term resident’s tax residence in fact ceases when taking a treaty position as this triggers an expatriation that ends the individual’s U.S. tax residence (in brief, a “long-term resident” is a green card holder who has had permanent resident status for at least 8 of the previous 15 years). In contrast, other green card holders continue to technically have a filing obligation (even if a treaty position is taken) until they have abandoned their green cards, so the FBAR analysis should arguably be different. The Court did not analyze this aspect in its decision.

4) The Christensen Decision - Taking a Treaty Position Against the NIIT

This complex decision by the U.S. Court of Federal Claims involved married U.S. expats living in France. In the case, the Christensens filed a refund claim for the amount of net investment income tax ("NIIT") previously paid on their foreign-source passive income, which they argued should be offset by foreign tax credits ("FTCs") in accordance with Article 24 of the U.S.-France income tax treaty (the “French Treaty” or the “Treaty”).

At the outset of its ruling, the Court stressed that it was limiting its decision to the parties’ cross-motions for partial summary judgment on whether the Treaty in fact overrides domestic law and provides for an FTC against the NIIT. Whether the taxpayers properly applied the Treaty was a factual issue to be decided at a later date.

In brief, the Court concluded that a certain provision of the Treaty could be used to offset a certain type of foreign-source income, namely income subject to the so-called "three-bite rule" under the Treaty. Under this rule, the taxpayer pays U.S. tax on certain passive U.S.-source income to the extent permitted under the Treaty if the individual is a resident of France (the “first bite”). France can then tax the individual as a French resident but must provide a credit for the U.S. tax paid (as determined under the first bite) on such income (the “second bite”). The individual must pay U.S. residual tax, if any, on the basis of citizenship (the “third bite”), but the U.S. under Article 24(2)(b) must allow a credit for French income tax paid in the second bite (but only for the French income tax paid after the credit that is allowed for U.S. tax in the first bite). The U.S.-source income subject to French income tax in the second bite may be re-sourced as foreign-source income to the extent necessary for FTC purposes to utilize the credit for the French income tax.

Given that Article 24(2)(b) is not self-limiting (i.e., it does not require itself to conform to the U.S. domestic rules), the Court reasoned that it should provide justification for allowing the FTC to offset the NIIT.

While the Christensen decision at first glance seems to be a major taxpayer win with potentially significant implications, it remains to be seen exactly what impact the decision will have moving forward because of the terseness of the written decision, its seemingly limited scope, and because it may be appealed in the near future.