In 2013, the net investment income tax (NIIT) found in Internal Revenue Code (IRC) Section 1411 went into effect. Since then, United States taxpayers residing outside of the US have lived with uncertainty as to whether the taxes they pay in their local country can be used as a tax credit to offset the NIIT. A recent court decision held that certain tax treaties may allow for US foreign tax credits (FTCs) to be applicable, allowing eligible taxpayers to seek refunds for potentially up to 10 years of paid NIIT.
On October 23, 2023, in Christensen v. United States, the US Court of Federal Claims ruled that two US citizens residing in France were permitted, under a tax treaty between the US and France, to use FTCs arising from French income tax liability to offset NIIT liability. Christensen is the first case to hold that, although FTCs cannot be used to offset NIIT liability under US domestic law, this restriction can be overridden by a US-France tax treaty provision, which is replicated in many US tax treaties, that provides broader FTC coverage for US citizens residing abroad.
The taxpayers in Christensen were married US citizens residing in France. The taxpayers earned income that was subject to both French income tax and (by virtue of their US citizenship) US federal income tax, including the NIIT. On their US federal income tax return, the taxpayers netted the FTCs arising from their French income tax liability against their NIIT liability, relying on Articles 24(2)(a) and 24(2)(b) of the US-France tax treaty for support.
Article 24(2)(a) of the treaty is a general provision that provides that the US shall grant its citizens a credit against US federal income tax for French income taxes paid “[i]n accordance with the provisions and subject to the limitations of the law of the United States.” In Christensen, the Court of Federal Claims noted that the NIIT was a tax imposed by IRC Chapter 2A and that the FTC provisions in IRC Section 901 et seq. restricted FTCs from offsetting US federal income tax liability arising under IRC Chapter 1. Therefore, the Court held that Article 24(2)(a) did not permit the taxpayers to use FTCs to offset NIIT liability because granting FTCs under Article 24(2)(a) was “subject to the limitations of the law of the United States,” including the limitation that FTCs could not offset liability incurred pursuant to Chapter 2A. This holding was consistent with holdings in two other recent cases that also addressed the interaction of FTCs and NIIT: Toulouse v. Commissioner, 157 T.C. 49 (2021), and Kim v. United States, 2023 WL 3213547 (C.D. Cal. Mar. 28, 2023).
However, Article 24(2)(b) of the treaty contains a special provision applicable to US citizens residing in France. This provision generally provides that, when applying the “three bites” rule for determining the order in which US and French FTCs are applied with respect to such persons, the US shall grant such persons a credit against US federal income tax for French income taxes paid. Importantly, Article 24(2)(b) does not include the “[i]n accordance with the provisions and subject to the limitations of the law of the United States” clause present in Article 24(2)(a). The Court of Federal Claims, applying principles of treaty interpretation, held that Article 24(2)(b) did not incorporate Article 24(2)(a)’s limitation and was not otherwise bound by the restriction in the IRC against using FTCs to offset US tax liabilities outside of Chapter 1. Therefore, the Court held that Article 24(2)(b) permitted the taxpayers to use their FTCs to offset their NIIT liability.
Many countries have also entered social security totalization agreements with the US. In appropriate circumstances, these totalization agreements may provide an alternative argument that the NIIT is inapplicable to residents of the treaty country.
Practice Point: Provisions similar to Article 24(2)(b) of the US-France tax treaty (i.e., provisions that generally grant US treaty-based FTCs without an “in accordance with U.S. law” limitation to US citizens residing abroad) are present in several other US tax treaties, including treaties with the United Kingdom, the Netherlands and Germany. Therefore, in light of Christensen, taxpayers and practitioners should pay careful attention to the NIIT’s exposure of US clients residing abroad. If a client resides in a tax treaty jurisdiction, practitioners should carefully analyze the associated treaty. If the treaty contains a provision similar to Article 24(2)(b), taxpayers should discuss the possibility of using FTCs to offset their NIIT liability with their advisor. Additionally, taxpayers should consider filing amended returns seeking the offset. The normal three-year statute of limitations on filing an amended return to claim a refund is extended to 10 years in cases where the refund is related to overpayments attributable to the payment or accrual to a foreign country of taxes for which a credit is allowed against US income.