U.S. Taxpayers Living Abroad May Have Opportunities to Claim Tax Refunds for Foreign Tax Credits Applied Against Net Investment Income Tax by Andrew Leonard, CPA
A recent decision by the U.S. Court of Federal Claims may open the door to a potential deluge of requests for tax refunds from U.S. citizens and resident aliens living or working in foreign countries with which the U.S. has an income tax treaty. In Christensen v. United States, the court interpreted the U.S.-France Income Tax Treaty to allow a U.S. couple living in Paris to apply a foreign tax credit (FTC) for taxes paid on foreign-source income against the net investment income tax (NIIT) liability assessed on their federal income tax returns.
Background
U.S. citizens and resident aliens are subject to U.S. tax on their worldwide income. To avoid the risk of double taxation, taxpayers may receive a credit for foreign income taxes they accrue and pay to a foreign country and, in turn, apply the FTC against their U.S. income tax liabilities. By contrast, the NIIT, also referred to as the unearned income medicare contribution tax, is a 3.8 percent U.S. tax on certain investment income, such as dividends, capital gains, rental and royalty income, non-qualified annuities and income from passive business activities in which the taxpayer does not materially participate. It is an additional tax that applies to U.S. taxpayers, dual-status individuals and certain trusts and estates with net investment income and modified adjusted income that exceeds specific thresholds.
In 2021, the U.S. Tax Court was tasked with considering whether an expatriate could use a tax credit for foreign income tax paid in France and Italy to offset their net investment income tax. The court in Toulouse v. Commissioner rejected the claimant’s request on the basis that the Internal Revenue Code (IRC) clearly states the FTC “reduces only tax imposed under Chapter 1,” or income tax. Moreover, the court referred to the Treasury’s final NIIT regulations, citing that “foreign income taxes are not creditable against United States taxes other than those imposed by chapter 1 of the Code. Section 1.1411–1(e) of the final regulations clarifies that amounts that are allowed as credits only against the tax imposed by Chapter 1 of the Code, including credits for foreign income taxes, may not be credited against the section 1411 tax,” which is the NIIT.
What is Different in the Christensen Matter?
A recent decision by the U.S. Court of Federal Claims may open the door to a potential deluge of requests for tax refunds from U.S. citizens and resident aliens living or working in foreign countries with which the U.S. has an income tax treaty. In Christensen v. United States, the court interpreted the U.S.-France Income Tax Treaty to allow a U.S. couple living in Paris to apply a foreign tax credit (FTC) for taxes paid on foreign-source income against the net investment income tax (NIIT) liability assessed on their federal income tax returns.
Background
U.S. citizens and resident aliens are subject to U.S. tax on their worldwide income. To avoid the risk of double taxation, taxpayers may receive a credit for foreign income taxes they accrue and pay to a foreign country and, in turn, apply the FTC against their U.S. income tax liabilities. By contrast, the NIIT, also referred to as the unearned income medicare contribution tax, is a 3.8 percent U.S. tax on certain investment income, such as dividends, capital gains, rental and royalty income, non-qualified annuities and income from passive business activities in which the taxpayer does not materially participate. It is an additional tax that applies to U.S. taxpayers, dual-status individuals and certain trusts and estates with net investment income and modified adjusted income that exceeds specific thresholds.
In 2021, the U.S. Tax Court was tasked with considering whether an expatriate could use a tax credit for foreign income tax paid in France and Italy to offset their net investment income tax. The court in Toulouse v. Commissioner rejected the claimant’s request on the basis that the Internal Revenue Code (IRC) clearly states the FTC “reduces only tax imposed under Chapter 1,” or income tax. Moreover, the court referred to the Treasury’s final NIIT regulations, citing that “foreign income taxes are not creditable against United States taxes other than those imposed by chapter 1 of the Code. Section 1.1411–1(e) of the final regulations clarifies that amounts that are allowed as credits only against the tax imposed by Chapter 1 of the Code, including credits for foreign income taxes, may not be credited against the section 1411 tax,” which is the NIIT.
What is Different in the Christensen Matter?
In Christensen v. United States, the federal claims court agreed that the Internal Revenue Code (IRC) and Article 24(2)(a) of the U.S.-France income tax treaty limit the use of foreign tax credits to offset income taxes. However, it liberally interpreted Article 24(2)(b) of the treaty and its absence of restriction and provisional language requiring “any foreign tax credit . . . be ‘in accordance with the Code.’” In doing so, the court held that applicable taxpayers could claim a treaty-based FTC against the NIIT imposed on their passive foreign-source income provided they reside in a foreign country, such as France, with a U.S. income tax treaty that does not explicitly limit the use of claiming FTCs against foreign income tax.
On December 18, 2023, the U.S. filed a notice appealing the lower court decision.
What Does This Mean to Taxpayers?
The U.S.’s appeal of the claims court’s decision creates an uncertain environment for expatriates seeking refunds of previously paid NIIT based on treaty provisions. Taxpayers should first recognize that the narrow application of the Christensen ruling limits the use of FTCs to offset only the portion of the NIIT paid on passive income sourced from France. It does apply to NIIT on passive income sourced in the U.S.
In addition, taxpayers must understand the ruling’s narrow application to residents in foreign countries with U.S. income tax treaties that contain similar, non-limiting language as the U.S.-France treaty. This currently includes the United Kingdom, the Netherlands, Germany and India. It is critical that taxpayers work with their advisors to assess the language of the U.S. income tax treaties with their countries of residence and determine whether a valid claim for a retroactive refund is a viable and smart decision based on the taxpayer’s unique circumstances.
About the Author: Andrew Leonard, CPA, is a director with Berkowitz Pollack Brant’s International Tax Services practice, where he provides tax structuring, pre-immigration planning and a wide array of international tax and consulting services to international companies, entrepreneurs, families and foreign trusts. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or info@bpbcpa.com.
. However, it liberally interpreted Article 24(2)(b) of the treaty and its absence of restriction and provisional language requiring “any foreign tax credit . . . be ‘in accordance with the Code.’” In doing so, the court held that applicable taxpayers could claim a treaty-based FTC against the NIIT imposed on their passive foreign-source income provided they reside in a foreign country, such as France, with a U.S. income tax treaty that does not explicitly limit the use of claiming FTCs against foreign income tax.
On December 18, 2023, the U.S. filed a notice appealing the lower court decision.
What Does This Mean to Taxpayers?
The U.S.’s appeal of the claims court’s decision creates an uncertain environment for expatriates seeking refunds of previously paid NIIT based on treaty provisions. Taxpayers should first recognize that the narrow application of the Christensen ruling limits the use of FTCs to offset only the portion of the NIIT paid on passive income sourced from France. It does apply to NIIT on passive income sourced in the U.S.
In addition, taxpayers must understand the ruling’s narrow application to residents in foreign countries with U.S. income tax treaties that contain similar, non-limiting language as the U.S.-France treaty. This currently includes the United Kingdom, the Netherlands, Germany and India. It is critical that taxpayers work with their advisors to assess the language of the U.S. income tax treaties with their countries of residence and determine whether a valid claim for a retroactive refund is a viable and smart decision based on the taxpayer’s unique circumstances.
About the Author: Andrew Leonard, CPA, is a director with Berkowitz Pollack Brant’s International Tax Services practice, where he provides tax structuring, pre-immigration planning and a wide array of international tax and consulting services to international companies, entrepreneurs, families and foreign trusts. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or info@bpbcpa.com.
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