Conventions, foreign tax credits and net investment income tax

A recent Tax Court ruling addressed the question 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 law does not allow it otherwise.

A look at the 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 those activities. (less some deductions). The NIIT was legislated in 2010, effective for tax years after December 31, 2012.

Compensation against NIIT

Can a taxpayer deduct an NIIT foreign tax credit under the Internal Revenue Code? While the law itself, §1411.1 does not indicate one way or another, the answer is “no” on the basis of other legal provisions (none of which directly answers the question no more). In particular, §27 provides that taxes imposed by foreign countries are allowed as a deduction from the tax imposed “by this chapter” to the extent provided for 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 surcharges). The NIIT, §1411, appears in Chapter 2A (Unarned Income Medicare Contribution). NIIT regulations also button it. Reg. §1.1411-1 (e) provides that amounts credited to chapter 1 taxes “cannot be credited to [the NIIT] imposed by Chapter 2A.

Toulouse v. Commissioner

But what about the foreign tax credit relief granted by the treaties? Can a treaty provision be invoked to effectively replace what the law does not allow? Is there an independent conventional basis for claiming a foreign tax credit from the NIIT? The Tax Court of Toulouse v. Commissioner ruled negatively on the basis of a reading of the two tax treaties in question.

In Toulouse, the taxpayer, an American citizen residing in France, filed her 2013 tax return offsetting her NIIT by the foreign tax paid to France and Italy. She did this by filling out Form 8960, the NIIT declaration form, and adding lines to the form to allow her to take the foreign tax credits. She also filed the treaty-based return position statement, Form 8833, and attaches the Form 8275 disclosure statement outlining her position regarding the application of the treaty to have the credits offset the NIIT.

By charging the credits to the NIIT, the taxpayer knew very well that the law and regulations of the NIIT did not allow it. Instead, she argued that the treaties provided an independent basis for allowing the foreign tax credit on the NIIT.

The taxpayer first put forward a number of alternative arguments. For example, she noted that Reg. §1.1411-1 (a) provides that all the provisions of the Code that apply for the purposes of Chapter 1 to determine taxable income also apply to the determination of the NIIT, arguing that foreign tax credits must also be taken into account. 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 on for the taxpayer’s position. In fact, Reg. §1.1411-1 (e) specifically rejects this argument.

The taxpayer then asserted that the Code is silent on 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 mere administrative choice that Congress made without any indication of ‘an intention to go beyond the provisions of the treaty. But the court also rejected this argument, pointing out that § 1411 is the only section of Chapter 2A and that Congress certainly did not intend this placement to be a mere clerical choice. This is fundamental to the structure of the Code, the court noted.

Ultimately, the taxpayer argued that the treaties in question provided an independent basis for charging the foreign tax credit to the NIIT and that those treaties, in fact, overrode the provisions of the Code. In particular, the taxpayer relied on Article 24 (2) (a) of the United States-France tax treaty and section 23 (2) (a) of the United States-Italy tax treaty. Each of these treaty articles provides a basis for double taxation relief through, in the case of the United States, the foreign tax credit mechanism, but each states very clearly that it will do so “In accordance with the as provided and subject to the limitations of the laws of the United States ”

Thus, the court observed that it must give effect to the clear text of the particular articles which, while providing for the granting of a foreign tax credit, subject its availability to the provisions and limitations of the Code, i.e. say that they do not provide any independent legal basis for the abatement 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 those treaties must also be “in accordance” with the treaty. Code and that Congress made it clear not to allow credit by placing §1411 in Chapter 2A. The tribunal insisted that the protection of treaties against double taxation is not absolute and that nothing in the articles of those treaties guarantees or promises complete protection. In fact, the court cited Technical Exploration under the US-France Treaty, which supports the general principle of allowing foreign tax credits but only in accordance with and subject to the limitations of US law.

And, as a farewell, the court cited the preamble to Rule §1411, which recognizes the interaction between the NIIT and treaties and which explains that an analysis of each treaty would be necessary to determine whether the United States has the requirement to allow a foreign tax credit on §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 Info

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

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