Applicability Of Foreign Tax Credit Against The Net Investment Income Tax Under U.S., France, And Italy Tax Treatries

Applicability Of Foreign Tax Credit Against The Net Investment Income Tax Under U.S., France, And Italy Tax Treatries
Catherine S. Toulouse v. Comm’r, 157 T.C.| August 16, 2021 | Goeke, J. | Dkt. No. 19122-19

Short Summary:  The case discussed the applicability of the foreign tax credit (FTC) against the Net Investment Income Tax (NIIT) under the tax treaties between the U.S. and France and Italy. The Court concluded that under the text of such treaties, the foreign tax credit cannot be applied against the NIIT.

Catherine Toulouse (the petitioner), a U.S. citizen residing in a foreign country, filed her tax return for 2013 claiming FTC paid to France and Italy to offset her income tax. She also reported a carryover of FTCs to offset her income tax. Despite having NIIT in the amount of $11,540.00 USD, the petitioner claimed that her NIIT was zero. This calculation resulted because the petitioner added two lines to the return: the first to claim an FTC against the NIIT and the second resulting in NIIT due in the amount of zero. The petitioner disclosed her tax position by filing forms 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b), and form 8275, Disclosure Statement, where she explained that under article 24(2)(a) of the U.S.-France tax treaty, and article 23(2)(a) of the U.S.-Italy tax treaty, she was allowed to apply FTC against the NIIT.

The IRS issued a notice of math error to the petitioner adjusting the NIIT amount owed and eventually disallowed the FTC and issued an assessment. Upon the issuance of the notice of intent to levy and notice of a right to a hearing, the petitioner timely filed a Collection Due Process (CDP) request. Appeals sustained the assessment and issued a notice of determination.

The Tax Court determined that the FTC is not applicable to offset the NIIT, under the text of the tax treaties between the U.S. and France and Italy respectively and in accordance with the provisions of the Code.

Key Issues: Whether under the tax treaties between the U.S. and France and Italy, a U.S. taxpayer is allowed to apply a FTC against the NIIT.

Primary HoldingsThe petitioner is not allowed to apply the FTC against the NIIT under the tax treaties between the U.S. and France and Italy.

Key Points of Law:

Section 6330 of the Code provides that a taxpayer that timely requests a CDP is entitled to a hearing, where the taxpayer can challenge can raise any relevant issue related to the unpaid tax or proposed levy, and also, can challenge the underlying tax liability. When the underlying tax liability is at issue on a CDP hearing, the Court reviews the liability de novo. See Davis v. Commissioner, 115 T.C. 35, 39 (2000). In this case, petitioner challenged the underlying liability, and the Court reviewed such assessment de novo.

Section 27 of Chapter 1 of the Code allows the taxpayers to apply a credit for the amount of taxes imposed by foreign countries against the tax imposed by “this chapter” to the extent provided in section 901. Section 901 establishes a FTC against regular tax. These two provisions state that the FTC reduces only tax imposed under chapter 1 of the Code.

The NIIT is in chapter 2A, subtitle A, Income taxes. Consequently, the FTC under section 27 (applicable only for taxes under chapter 1), does not apply by its terms to offset the NIIT. Treas. Reg. 1.411-1(a) provides that all the IRC provisions that apply for chapter 1 purposes in determining taxable income, as defined in section 63(a), also apply in determining the NIIT. Section 63(a) does not include credits to determined taxable income, thereby, the FTC (a credit) is not applicable to the NIIT.

Article 24(2)(a) of the tax treaty between the U.S. and France provides respectively the following: “In accordance with the provisions and subject to the limitations of the law of the U.S, the U.S. shall allow to a citizen… of the U.S. as a credit against the U.S. income tax:(i) the French income tax paid by or on behalf of such citizen…”. Art. 23(2)(a) of the tax treaty between U.S.-Italy is in similar terms.

Such treaties must be interpreted using their ordinary meaning, and must be construed liberally to give purpose of the treaty. Under this approach and under the express terms of the treaties, the Court stated that any allowable foreign tax credit must be determined in accordance with the Code and is limited to by the Code’s provision of a credit. Accordingly, if the Code provides for a credit, then such credit will be allowable under the treaty. Because section 1411(c)(1)(B) expressly provides for deductions to compute the NIIT, but does not provide for credits, it is clear that the FTC is not applicable against the NIIT.

This interpretation is supported by additional arguments. First, the purpose of the treaties is to provide general protection against double taxation, not to provide absolute protection. Nothing in the text of the tax treaty between the U.S. and France and Italy, respectively, provide for the elimination of all double taxation. Second, the Court’s interpretation is affirmed by the contemporary explanation provided by the Treasury Department of both treaties, which basically states that the credits under the “Convention are allowed in accordance with the provisions and subject to the limitations of U.S. law”… “thus, although the Convention provides for a foreign tax credit, the terms of the credit are determined by the provisions of the U.S. statutory credit at the time the credit is given”.

Based on the previous, the Court concluded that the FTC, applicable only to the tax under section 1 (income tax) is not applicable to the NIIT, under the terms of the texts of the U.S.-France and the U.S.-Italy tax treaties.

Insight Tax treaties are relevant when determining the tax implications of international taxpayers. Careful consideration must be given to the text of each treaty because relevant differences are usually found among the multiple treaties. In this particular case, there was an express provision in the Code that limited the FTC to income tax disallowing its application to the NIIT.

More problematic is the application of a treaty for newly enacted measures, for example, a unilateral measure on digital taxation imposed by the other treaty jurisdiction. This case is relevant in the short-term for the prospective tax reform and the implementation of Pillar 1 & 2 currently in development by the OECD.

Have a question? Contact Jason Freeman, Freeman Law, Texas.

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Mr. Freeman is the founding and managing member of Freeman Law, PLLC. He is a dual-credentialed attorney-CPA, author, law professor, and trial attorney. Mr. Freeman has been recognized multiple times by D Magazine, a D Magazine Partner service, as one of the Best Lawyers in Dallas, and as a Super Lawyer by Super Lawyers, a Thomson Reuters service.
He was honored by the American Bar Association, receiving its “On the Rise – Top 40 Young Lawyers” in America award, and recognized as a Top 100 Up-And-Coming Attorney in Texas. He was also named the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas” by AI.

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1 comment on “Applicability Of Foreign Tax Credit Against The Net Investment Income Tax Under U.S., France, And Italy Tax Treatries”

  • An interesting but not surprising decision. Although this notion was rejected by the Judge, the decision underscores the principle that it is the Internal Revenue Code that allows the credit and not the treaty. To put it another way, the purpose of US tax treaties is NOT to prevent double taxation, but rather (because of the “saving clause” and carveouts in treaties like this) to facilitate double taxation. Obviously the taxpayer was taxed by the United States (the country of citizenship) and the country of real residence (France). Clear double taxation.

    Notably Article 2 of the US France treaty specifically says that the treaty applies to taxes under the Internal Revenue Code (which the NIIT clearly is). One would think that a fair reading of the purpose of the treaty would be to include investment income subject to the NIIT as income and therefore taxes covered by the treaty.

    Article 2 says that Treaty applies to the complete Internal Revenue Code; and

    Article 24 says that the United States can exclude the application of the Treaty from any part of the Internal Revenue Code that it wants to.

    In other words, with respect to tax credits, the US is not obligated to do anything at all under the treaty.

    I would also point out that this is one more of a growing list of US laws that attack the tax base of other countries.

    Finally, idea of Americans abroad being required to pay a tax that is specifically designed to pay for the health care of US residents when the US government does not assist in health care for Americans abroad is really offensive.

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