Court Decision Might Mean Foreign Tax Credits can be used against U.S. tax

A federal court ruling could allow expats to use their foreign tax credits to offset U.S. NIIT liability.

U.S. taxes for American citizens living abroad include the Net Investment Income Tax (NIIT), 3.8% to certain net investment income of individuals, estates and trusts that have high income. Foreign tax credits from various specific countries have not usually been widely usable in offsetting NIIT liability.  

But the U.S. Court of Federal Claims has decided, in Paul Bruyea v. United States, that foreign tax credits might be used to offset NIIT in U.S. tax treaties with more than a few nations. 

Canada Treaty

The case stems from a tax refund complaint that Bruyea filed two years ago against the United States. He paid nearly $2 million in taxes to Canada and claiming a foreign tax credit of $1,398,683 to offset the regular U.S. tax liability for the 2015 tax year. At that time, Bruyea did not claim a foreign tax credit to offset the NIIT. In November 2016, Bruyea filed an amended U.S. tax return (Form 1040X) with the Internal Revenue Service, claiming a refund of $263,523 by virtue of a foreign tax credit that offsets the NIIT.

Bruyea argued that he was entitled to a foreign tax credit based on Article XXIV of the Convention between Canada and the United States with Respect to Taxes on Income and on Capital (aka, the “Canada Tax Treaty”).

The IRS rejected the refund claim, concluding that “the Canada Tax Treaty did not provide an independent basis for a foreign tax credit to offset the NIIT and that such a foreign tax credit is not allowed under U.S. statutory foreign tax credit rules.” Bruyea then invoked the Simultaneous Appeal Procedure to obtain the opinions of the U.S. and Canadian authorities to resolve the double taxation.  – Canadian income tax and U.S. NIIT – on the same items of income and gain with no foreign tax credit offset available.

The Canadian tax authority agreed with Bruyea: “Canada, as the country of source, has the right to tax the gain, while the U.S., as the country which has residual taxation rights, must provide relief in accordance with Article XXIV of the Convention.”

After the IRS’s denial of his tax refund claim, Bruyea filed a complaint in the Court of Federal Claims, asserting that he was entitled to a refund of the NIIT that he paid, $263,523, for tax year 2015. On Feb. 14, 2024, he moved for partial summary judgment; the U.S. government filed a cross-motion for summary judgment and response.

Treaty Interpretation

“Interpreting a treaty is similar to interpreting a statute or a contract,” writes Federal Claims Judge Matthew H. Solomson in the Bruyea decision. “When it comes to a treaty, however, there is a notable difference from other legal instruments: Courts are encouraged to consider a treaty’s purpose, as well as extrinsic evidence of the intent of the parties to the treaty.”

In citing Article XXIV of the Convention, the opinion points out that in the case of the United States, double taxation shall be avoided and “the United States shall allow to a citizen or resident of the United States … as a credit against the United States tax on income the appropriate amount of income tax paid or accrued to Canada.” The opinion also points out that paragraph four of the Article specifies that “the United States shall allow as a credit against United States tax the income tax paid or accrued to Canada,” with some conditions.

The Court found that the U.S. government argument relied primarily on the U.S. Law Limitation clause of Article XXIV, that any Treaty-based credit must be “[i]n accordance with the provisions . . . of the law of the United States.”

“The government maintains that a Treaty-based credit simply cannot exist independently of the [U.S. Internal Revenue Code, or IRC] – the ‘law of the United States’,” the Court writes. “The government contends that the NIIT … precludes the Treaty-based tax credit Mr. Bruyea claims.”

The Court calls the basic interpretive problem “readily apparent. On the one hand, the Canada Tax Treaty plainly provides for a foreign tax credit in Mr. Bruyea’s favor … On the other hand, a literal reading of the U.S. Law Limitation arguably takes back what Article XXIV otherwise giveth (because the IRC, by its terms, certainly does not provide for the Treaty-based tax credit Mr. Bruyea claims).”

The Court noted, though, that Bruyea agreed with the foundational axiom that the IRC does not provide the foreign tax credit he seeks to apply against the NIIT, arguing instead that the IRC cannot and does not answer the critical interpretative question posed by his complaint: “As the NIIT falls outside [C]hapter 1 [of the IRC], the parties agree that no credit is allowed under domestic law, but Plaintiff’s view is that the NIIT is covered by the foreign tax credit rules of the Canada Treaty.

“The government’s interpretation has a glaring consistency problem: The government takes an ad-hoc approach to the U.S. Law Limitation,” Solomson wrote. “The interpretative puzzle is complicated, but ultimately Mr. Bruyea’s approach makes more sense.”

Implications

Observers to Bruyea note that Americans claiming treaty-based foreign tax credits against the NIIT have succeeded in only a few cases and that other cases’ decisions have been against the taxpayer or narrowly applied to the specific language of a U.S. tax treaty with one country.

Bruyea, on the other hand, based a ruling on general language that applies to many tax treaties. The decision could be reversed or modified on appeal, but the case should still encourage Americans who incur foreign taxes on NIIT-related income.

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Alicea Castellanos is the CEO and Founder of Global Taxes LLC. Alicea provides personalized U.S. tax advisory and compliance services to high-net-worth families and their advisors. Alicea has more than 20 years of experience. Prior to forming Global Taxes, Alicea founded and oversaw operations at a boutique tax firm, worked at a prestigious global law firm and CPA firm. Alicea specializes in U.S. tax planning and compliance for non-U.S. families with global wealth and asset protection structures which include non-U.S. trusts, estates, and foundations that have a U.S. connection.

Alicea also specializes in foreign investment in U.S. real estate property and other U.S. assets, pre-immigration tax planning, U.S. expatriation matters, U.S. persons in receipt of foreign gifts and inheritances, foreign accounts and assets compliance, offshore voluntary disclosures/tax amnesties, and foreign companies wanting to do business in the U.S. Alicea is fluent in Spanish and has a working knowledge of Portuguese.

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