The U.S. Court of Federal Claims recently determined that a U.S. couple living abroad could claim a foreign tax credit against the tax liability imposed by the net investment income (NII) tax. This is a significant decision for taxpayers living outside of the U.S., as it means those with foreign tax credits could be able to use them to offset their NII tax liability going forward.
What is the Net Investment Income Tax?
The NII tax was created as part of the Health Care and Education Reconciliation Act to fund healthcare reform in 2010 and took effect in 2013. It is a 3.8% tax levied on certain net investment income of individuals, estates and trusts with income above a specific threshold. Investment income includes income from:
- Interest, dividends, capital gains, rental and royalties;
- Non-qualified annuities;
- The trade or business of trading of financial instruments or commodities;
- Businesses that are passive activities to the taxpayer; and
- Financial instruments, such as swaps.
Certain expenses that are allocable to gross investment income may be deducted against investment income to determine net income subject to the tax. Since the inception of the NII tax, the IRS has not allowed taxpayers with a foreign tax credit for U.S. income tax purposes to use this credit to offset the NII tax. Attempts to use the foreign tax credit against the NII tax has been rejected by the federal tax court as recently as 2021.
What’s in the 2023 NII Tax Court of Federal Claims Case?
In an October 24, 2023, decision in Christensen v. United States, the court determined that an article within the France-U.S. tax treaty allows for foreign taxes paid by U.S. taxpayers living in France to be used to offset the liability imposed by the NII tax.
The case argued that articles 24(2)(a) and 24(2)(b), specifically, of the tax treaty allow for treaty-based foreign tax credits that trump restrictions imposed by U.S. tax code. Under the code, foreign tax credits can be applied against taxes imposed under Chapter 1. However, the NII tax falls outside of Chapter 1. The court agreed with Christensen and determined that treaty-based foreign tax credits are not bound by restrictions imposed in the tax code.
What Does this Decision Mean for U.S. Taxpayers Living Abroad with Foreign Tax and NII Tax Obligations?
The provisions in the specific articles of the France-U.S. tax treaty that the court relied upon to make its decision are also included in many other U.S. tax treaties with other countries. Therefore, U.S. taxpayers living abroad in a treaty country with foreign tax credits could be able to use them to offset their NII tax liability going forward. Additionally, as was demonstrated in the court case, there could be opportunities to amend prior returns.
The IRS could appeal this decision. If it does not, or if the appeal is unsuccessful, changes to form 1040 presentation may be needed to allow taxpayers to appropriately reflect this result.
High net-worth-individuals living abroad with investment income from foreign sources, whether from direct investments in foreign securities or indirectly through RICs and private investment funds, such as hedge funds and private equity funds, should be aware of the additional benefit of foreign taxes paid on their investment income. Be sure to discuss with your tax advisers this opportunity to potentially lower your net NII tax liability.
Contact Dave Gonano at email@example.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.