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Treaties, Foreign Tax Credits and the Net Investment Income Tax

Nov. 8, 2021, 9:46 AM

A recent Tax Court decision dealt with the issue of whether and to what extent a treaty provision can be used to provide a foreign tax credit against the Net Investment Income Tax (NIIT) when a statute does not otherwise allow it.

A Look at NIIT

The NIIT is a 3.8% tax that is imposed on net investment income, generally defined as gross income from dividends, interest, rents, royalties, annuities, certain passive activities and gains from the disposition of such activities (less certain deductions). The NIIT was legislated back in 2010, effective for tax years after December 31, 2012.

Offsets Against the NIIT

May a taxpayer offset a foreign tax credit against the NIIT under the Internal Revenue Code? While the statute itself, §1411,1 does not indicate one way or another, the answer is “no” based on other statutory provisions (none of which answers the question quite directly either). In particular, §27 provides that taxes imposed by foreign countries shall be allowed as a credit against the tax imposed “by this Chapter” to the extent provided in §901.

Is the NIIT a tax imposed by the chapter in which §27 appears? Guess what: No. The chapter in which §27 appears is Chapter 1 (Normal Taxes and Surtaxes). The NIIT, §1411, appears in Chapter 2A (Unearned Income Medicare Contribution). The NIIT regulations button that one down as well. Reg. §1.1411-1(e) provides that amounts credited against Chapter 1 taxes “may not be credited against [the NIIT] imposed by Chapter 2A.”

Toulouse v. Commissioner

But what about foreign tax credit relief afforded by treaties? Can a treaty provision be relied upon to effectively override what the statute doesn’t allow? Is there an independent treaty basis for claiming a foreign tax credit against the NIIT? The Tax Court in Toulouse v. Commissioner ruled in the negative based on a reading of the two tax treaties in question.

In Toulouse, the taxpayer, a U.S. citizen residing in France, filed her 2013 tax return offsetting her NIIT by foreign tax paid to France and Italy. She did so by filing Form 8960, the form for reporting the NIIT, and adding lines on the form to accommodate her taking of the foreign tax credits. She also filed the Treaty Based Return Position Disclosure, Form 8833, and attached the Form 8275 Disclosure Statement setting forth her position regarding the application of the treaty to have the credits offset the NIIT.

In taking the credits against the NIIT, the taxpayer knew full well that the NIIT statute and regulations did not allow for this. Instead, she argued that the treaties provided an independent basis for allowing the crediting of foreign taxes against the NIIT.

The taxpayer first offered up a number of alternative arguments. For example, she noted that Reg. §1.1411-1(a) provides that all Code provisions that apply for Chapter 1 purposes in determining taxable income also apply in determining the NIIT, arguing that the foreign tax credits should be factored in as well. But the court observed that foreign tax credits are not taken into account in determining taxable income and, therefore, this regulation could not be relied upon for the taxpayer’s position. In fact, Reg. §1.1411-1(e) specifically rejects that argument.

The taxpayer then claimed that the Code is silent as to the applicability of the foreign tax credit to offset the NIIT and that the placement of the NIIT in Chapter 2A of the Code was a simple clerical choice that Congress made with no indication of an intent to override treaty provisions. But the court rejected that argument as well, pointing out that §1411 is the only section in Chapter 2A and surely Congress did not intend for that placement to be a mere clerical choice. That’s fundamental to the Code’s structure, the court noted.

Ultimately, the taxpayer argued that the treaties in question provided an independent basis for taking the foreign tax credit against the NIIT and that these treaties, in effect, trumped the Code’s provisions. In particular, the taxpayer relied on Article 24(2)(a) of the U.S.-France tax treaty and Article 23(2)(a) of the U.S.-Italy tax treaty. Each of those treaty articles does provide a basis for the relief of double tax through, in the case of the United States, the mechanism of the foreign tax credit, but each states quite clearly that it will do so “In accordance with the provisions and subject to the limitations of the laws of the U.S.”

Thus the court observed that it must give effect to the plain text of those particular articles which, while providing for the allowance of a foreign tax credit, make its availability subject to the provisions and limitations of the Code—that is, they provide no separate legal independent basis for the allowance of the foreign tax credit.

While the taxpayer argued that the placement of the NIIT in Chapter 2A is not a “limitation” as contemplated by the treaties, the court noted that the allowance under these treaties must also be “in accordance with” the Code and that Congress spoke clearly in not allowing the credit by placing §1411 in Chapter 2A. The court stated emphatically that the treaties’ protection against double tax is not absolute, and nothing in the articles of these treaties guarantees or promises full protection. In fact, the court cited the Technical Exploration under the U.S.-France treaty, which supports the general principle of allowing foreign tax credits but only in accordance with the provisions and subject to the limitations of U.S. law.

And, as a parting shot, the court cited to the preamble to the §1411 regulations, which acknowledges the interaction between the NIIT and treaties and which explains that an analysis of each treaty would be required to determine whether the United States has an obligation to allow a foreign tax credit against the §1411 tax and, as the court noted, such an analysis is exactly what the court provided.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Edward Tanenbaum is a tax partner in the Federal and International Tax Practice Group at Alston & Bird. He represents both foreign and U.S. multinational corporations and high-net-worth families in connection with cross-border tax structuring and planning.

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To contact the reporter on this story: Kelly Phillips Erb in Washington at kerb@bloombergindustry.com