Foreign Tax Credit Ruling Would Reduce US Expat Burden if Upheld

The Department of Justice’s April 22 appeal of a case involving foreign tax credits could potentially bring groundbreaking news for US expats. If the appeal is denied, the court’s decision could translate into significant refunds for many US taxpayers living abroad.

The US Court of Federal Claims ruled in 2023 that the IRS wrongly denied taxpayers Matthew and Katherine Christensen from using the US-France income tax treaty to claim the foreign tax credit to offset their net investment income tax liability.

The ruling in Christensen v. United States is the first time a court has agreed that the NIIT can be offset by the foreign tax credit. The NIIT is one of the few taxes imposed by the US that often leads to double taxation for US citizens living abroad, as the Internal Revenue Code doesn’t allow the NIIT to be offset by the foreign tax credit.

While regular refunds may only be claimed for three years past the original filing date, refunds based on foreign tax credits may be claimed for up to 10 years. Although the IRS likely won’t issue any refunds while the appeal is ongoing, taxpayers and practitioners should still consider filing amended returns to prevent the statute of limitations from running out on the refunds owed to them if the ruling is upheld.

Toulouse v. Commissioner

For over a decade, taxpayers have tried other ways to reduce their NIIT liability without success.

In the 2021 case Toulouse v. Commissioner, for example, the US Tax Court denied a claim nearly identical to the one in Christensen. Both Toulouse and Christensen claimed that Article 24, Relief from Double Taxation, of the US-France income tax treaty allowed them to use the foreign tax credit to reduce their NIIT liability.

However, the taxpayers in Toulouse based their claim on paragraph 24(2)(a), which is limited to the conditions dictated by the US tax code. The taxpayers in Christensen, however, used paragraph 24(2)(b), which doesn’t mention the same limitation. The court based its decision on its understanding that paragraph 24(2)(b) isn’t limited to the conditions imposed by the Code.

Government’s Argument

The DOJ said the decision in Christensen missed the forest for the trees, noting that it’s clear from context that paragraph 24(2)(b) is subject to the same limitation as paragraph 24(2)(a).

Paragraph 24(2)(b) outlines the procedure for splitting income taxes between the two countries known as the “three-bite rule,” which includes re-sourcing US source income to France. The DOJ argued that re-sourcing income is only necessary when addressing the source-based limitation in Section 904(a) of the tax code.

If paragraph 24(2)(b) wasn’t subject to the limitations set forth in the tax code, as interpreted by the court in Christensen, the source-based limitation in Section 904(a) also wouldn’t apply—there would be no need to re-source.

The government also cited the Treasury’s technical explanation of the treaty, which it argued should be given deference regarding the interpretation of the treaty provisions. Paragraph 24(2)(b) allows for re-sourcing “to fit within the foreign tax credit limitation of Code Section 904,” according to the technical explanation.

Claiming the Refund

If the Christensen decision is upheld, the IRS would need to redesign its tax forms to allow for properly claiming the credit. In its current design, Form 1040 doesn’t allow the foreign tax credit to reduce the NIIT. If practitioners want to use the foreign tax credit to reduce NIIT, they must figure out how to report it on the tax return.

The Christensens added their own lines and calculations to Form 8960, which computes the NIIT, and reduced it directly on Form 8960. Other reporting options may include reducing the amount of the NIIT reported on Form 1040, Schedule 2 and attaching an accompanying statement to detail the calculation.

Another reporting issue arises in connection with Form 1116, which computes the foreign tax credit. The amount reported on Part III, line 20 would need to be overridden to include the NIIT in the total taxes eligible to be reduced by the foreign tax credit.

Outlook

The tax treaty language at issue in Christensen isn’t exclusive to the US-France income tax treaty. If upheld, this decision could affect US taxpayers living in many other countries with which the US has an income treaty in force.

As the Christensen case illustrates, international taxation is incredibly complex—small differences in interpretation can result in large changes to US tax liabilities. US taxpayers with foreign income should consult with a trusted tax adviser to remain in compliance but avoid overpaying Uncle Sam.

The case is Christensen v. United States, Fed. Cl., 1:20-cv-00935, opinion filed 9/13/23.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Josh Pittleman is a tax senior in EisnerAmper’s financial services group, providing tax services to private equity, hedge fund, and individual clients.

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