August 20, 2021
Tax Court rejects assertion that tax treaties allow foreign tax credits to offset US net investment income tax
The Tax Court has held (Catherine S. Toulouse v. Commissioner, 157 T.C. No.4, No. 19076-19L) that US tax treaties with France and Italy do not enable a US citizen who lives abroad to use foreign tax credits (FTCs) to offset IRC Section 1411 net investment income tax (NIIT).
Catherine Toulouse is a US citizen who timely filed a Form 1040 for 2013, reporting tax of $63,632 (Line 44), offset by a $63,632 FTC (Line 47), which represented a portion of an approximately $340,000 carryover FTC. Line 60, where NIIT would be reported, was left blank.
Toulouse filed several other forms along with her 2013 Form 1040:
In February 2015, the IRS notified Toulouse of an $11,540 math error on her 2013 return and assessed tax in the same amount under IRC Section 6213(b). Toulouse contested the assessment, asserting that the FTC offset her tax liability. Following an Appeals conference, the IRS informed Toulouse that she was not entitled to offset NIIT with an FTC. In August 2018, the IRS assessed $2,885 in failure-to-pay penalties under IRC Section 6651(a)(2). Toulouse challenged both assessments in a collection due process (CDP) hearing in March 2019, and she was again told she was not entitled to an FTC.
Law and analysis
The court first found that Toulouse did not have the opportunity to challenge the underlying tax liability before the CDP hearing; therefore, the court reviewed liability for the tax de novo.
Citing Crow v. Commissioner, 85 T.C. 376 (1985), the court noted that US citizens "are generally taxed on their worldwide income regardless of where they reside." Looking at what types of taxes the FTC may offset, the court stated that IRC Sections 27 and 901 "clearly provide that the foreign tax credit allowable under the Code reduces only tax imposed under chapter 1, such as the section 1 regular tax" and IRC Section 1411 is found in chapter 2A. "Thus, the foreign tax credit under [IRC S]ection 27 — which applies to 'the tax imposed by this chapter ' — does not by its terms apply to offset net investment income tax," the court concluded. Further, the court noted that Treas. Reg. Section 1.1411-1(e) "specifically addresses the issue of a foreign tax credit against the net investment income tax and explains that the Code does not provide a foreign tax credit against the [IRC S]ection 1411 tax."
Turning to Toulouse's assertion that the US tax treaties with France and Italy provide for an FTC, the court considered the plain meaning of the treaties and found that they allow an FTC only in accordance with the IRC. The court rejected Toulouse's contention that the IRC "is silent as to whether there is a foreign tax credit against the net investment income tax" because IRC Section 1411's placement in chapter 2A is merely "happenstance and a clerical choice." Pointing out that Congress created chapter 2A when it enacted the NIIT, and IRC Section 1411 is the only section in the chapter, the court found that "placement of [IRC S]ection 1411 in a newly created chapter was not happenstance. An enumerated chapter of the Code to impose a distinct and separate tax is part of the Code's fundamental structure." The court also rejected her contention that because the treaties are generally intended to protect against double taxation, the offset is permitted under them. This protection is not absolute, the court stated.
Finally, the court found that genuine issues of material fact exist regarding whether Toulouse is liable for penalties under IRC Section 6651(a)(2). She reported zero tax on her Form 1040, so the IRC Section 6651(a)(2) addition to tax for failure to pay the tax shown on the return would also be zero. Noting that the IRS seeks the penalty on the $11,540 Toulouse reported on her Line 17 of Form 8960, the court concluded that the IRS "appears to rely on the failure to pay that reported tax to impose the [IRC S]ection 6651(a)(2) addition to tax and disregard the lines that petitioner added to the Form." Therefore, a genuine dispute of material fact exists regarding whether Toulouse had reasonable cause for her failure to pay timely, the court concluded.
Unfortunately for US citizens or residents living outside the US, this fully reviewed Tax Court opinion came to the correct conclusion. Although the court found that the placement of IRC Section 1411 in a newly created chapter of Subtitle A of Title 26 was not happenstance, Toulouse's policy argument had merit. It is unlikely the statutory drafters considered the implication of putting a new tax in a separate chapter of the Code. But given the location of IRC Section 1411 in a new chapter, coupled with limiting the IRS to only drafting regulations using IRC Section 7805 interpretative authority (as opposed to granting them legislative regulation-writing authority), the hands of the IRS were figuratively tied with regard to overruling the express language in IRC Sections 27 and 901 and the treaties at issue. Treasury had the opportunity to modify the 2016 U.S. Model Income Tax Treaty to address the NIIT, but it chose not to. Even so, a modification in 2016 would not have helped Toulouse because it could have only covered newly enacted treaties. The IRC Section 27 limiting language in the model treaty explanation that was also found in the US/French Treaty at issue in Toulouse is found in most US treaties enacted over the last generation or two. So, it's likely that taxpayers taking the same position as Toulouse under treaties similar to the US/French Treaty will likely meet the same fate.
It is also important to note that the design of the Form 8960 allowed the IRS to identify this issue. The fact that there was no mechanism to reduce the tax by credits, of any type, was not happenstance either. Additionally, the placement of the tax on the second page of the Form 1040 (and Form 1041) below the line for foreign tax credits enables the IRS to easily flag taxpayers attempting to claim tax credits against the NIIT.
Finally, recall that Treasury's Green Book released in May 2021 includes a proposal that "Rationalizes Net Investment Income and Self Employment Contributions Act (SECA) taxes." As part of that proposal, the Administration recommended that all of the revenue from the NIIT (raised under current law and to be raised by the proposed expansion) would be directed to the Hospital Insurance Trust Fund, just as revenue from the 3.8% tax under FICA and SECA is. This is actually beneficial to cross-border taxpayers, especially US citizens or residents living outside the US like Toulouse, where the NIIT would presumably be covered by Totalization Agreements once it is designed as a social insurance-type tax. Presumably, this change would also come with language similar to that in the self-employment-tax regime found in IRC Section 1401(c). Although fewer countries are covered by Totalization Agreements than by income tax treaties, this might be the only viable option to remedy the NIIT result in this case for US citizens or residents living outside the US like Toulouse.