In a recent intriguing decision, the U.S. Court of Federal Claims tackled the issue of whether the provisions of an applicable U.S. tax treaty can be used to allow a foreign tax credit (“FTC”) to apply against the net investment income tax (“NIIT”).
While the Court’s conclusion seems very taxpayer favorable at first glance, given the terseness and arguably limited scope of the decision’s conclusion, it remains to be seen exactly what impact the decision will have moving forward.
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.
Background on the Christensen Case
The Christensen decision (No. 20-935T (Fed. Cl. Sept. 13, 2023)) involved married U.S. expats living in France. For 2015, they reported U.S.-source passive income of $7,976 and foreign-source passive income of $101,353.
They paid NIIT of 3.8% on the $7,976 of U.S.-source passive income and the $101,353 of foreign-source passive income, for a total NIIT of $4,155. Additionally, the Christensens paid French income tax of approximately $26,653 on their passive income.
In 2020, the Christensens filed a refund claim for $3,851 plus interest which, importantly, was the amount of NIIT on their foreign-source passive income, which they claimed was offset by foreign tax credits 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.
The Christensen Decision
To understand the Court’s decision, it’s important to first understand the relevant provisions of the Treaty that the Court analyzed.
First, the Court analyzed the taxpayer’s argument that Article 24(2)(a) of the French Treaty allows the FTC to offset the NIIT. That provision generally requires the United States to provide an FTC against U.S. tax paid in respect of “French income tax” imposed on income that France can tax under the terms of the Treaty. The Court rejected this argument on the basis that the provision is self-limiting in stating that it is “subject to the limitations of the law of the United States (as it may be amended from time to time without changing the principles hereof).” In the Court’s view, this prevents the use of the FTC to offset the NIIT, because under the U.S. domestic rules, the offset is not allowed, as mentioned above.
Interestingly, in another recent case, the Tax Court came to the same reasoning and conclusion in rejecting a taxpayer’s claim that the French Treaty allows an FTC to offset the NIIT (See Toulouse v. Commissioner, 157 T.C. 49 (2021)). We note that some commentators criticized the decision for being too technical, thereby losing sight of the overall purpose of tax treaties.
The Court then analyzed the taxpayer’s second argument that Article 24(2)(b) of the French Treaty offers another basis for claiming French income tax as an FTC against the NIIT, except that this provision is not self-limiting like 24(2)(a). In brief, 24(2)(b) sets out what is known as the “three bite rule,” a rule which is particularly relevant for U.S. citizens living abroad. The main purpose of the rule is to address some of the collateral effects resulting from the so-called “saving clause” of the Treaty, which allows the U.S. to tax its citizens under certain circumstances as if the Treaty were not in effect.
Under the three-bite rule of the French Treaty, 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 like 24(2)(a) (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.
Analyzing the Impact of the Christensen Decision
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 for several reasons.
First, the terseness of the Court’s conclusion leaves readers of the case without a clear idea of the scope of the decision. After a careful reading of the decision, one could seemingly argue that unless one is in a situation in which foreign taxes are utilized under the three-bite rule (namely, you’re a U.S. citizen living in a treaty country and you’ve generated U.S.-source passive income that has been taxed by the treaty country), then you cannot utilize the FTC against the NIIT. This would exclude the more common situation in which foreign taxes have been paid on one’s foreign-source income. Without further elaboration, this is arguably the more natural interpretation of the decision given that the Court emphasized that it was limiting its ruling to the narrow legal issue of whether 24(2)(b) (which relates to a three-bite situation) can be used to allow FTCs to offset the NIIT.
We note that if this narrow interpretation is correct, then the Christensens would seemingly ultimately lose their suit, given that under the facts, they claimed foreign taxes on their foreign passive income against their NIIT, which is not a situation that falls under 24(2)(b) (as pointed out by the government in its brief to the Court). It therefore remains to be seen how the Christensen case ultimately pans out if and when the Court rules on the facts of the case at a later date.
Second, it remains to be seen whether the U.S. government will appeal the Court’s decision. A higher court may or may not affirm the Court of Federal Claims’ conclusion. It’s perhaps telling that the Tax Court (in the Toulouse case) ruled against the notion that the French Treaty allows FTCs to be used to offset the NIIT, although admittedly the decision was limited to an analysis of Article 24(2)(a) of the Treaty. Given the small amount of tax at stake, some expect that the case may be settled out of court, which would leave taxpayers, unfortunately, without a clear understanding of the scope of the decision.
Lastly, we note that in the Christensen case, the provisions of the French Treaty were the subject of the decision. Therefore, individuals residing in other countries should tread carefully in relying on the decision. Other tax treaties may or may not have provisions similar to the French Treaty, so each treaty should be carefully analyzed on its own terms.
