Can double tax treaties take a 'bite' out of the US Net Investment Income Tax?
8 November 2023 | Applicable law: US | 4 minutes
On October 24, 2023, the United States Court of Federal Claims issued a decision on the parties' cross-motions for summary judgment in the case of Christensen v. United States. In that decision, the court held that a US citizen couple residing in France could, in principle, use Article 24(2)(b) of the 1994 US-France Double Tax Treaty (as amended by multiple subsequent Protocols, the "France Treaty") to claim French income tax paid or accrued as a foreign tax credit ("FTC") against their tentative US Net Investment Income Tax ("NIIT") liability.
In the short term, the Christensen holding is welcome news for US citizens residing in high-tax foreign countries who up to now have faced significant technical and procedural obstacles in claiming FTCs against the NIIT. More broadly, the holding may offer opportunities for US citizens to take "treaty-based" FTC positions unmoored from some of the hyper-technical requirements and limitations of the US domestic FTC rules found in United States Internal Revenue Code ("Code") sections 901 et seq and the accompanying Treasury Regulations.
By way of background, the Code very generally allows a taxpayer to claim certain foreign "income, war profits, and excess profits" taxes paid or accrued during the year as a dollar-for-dollar credit against his or her tentative US federal income tax liability, subject to a host of technical limitations and caps. The NIIT, introduced as part of the Affordable Care Act legislation in 2010, is effectively a 3.8% additional US federal income tax on unearned income. It applies to US citizens and US federal tax residents whose Modified Adjusted Gross Income exceeds certain minimum thresholds. While the NIIT is unambiguously a tax on some subset of "income" as conventionally understood, the Code's internal rules do not allow a US citizen or tax resident to offset his or her tentative NIIT liability with FTCs. Specifically, the Code draws a distinction between the NIIT and the regular US federal income tax, expressly forbidding a taxpayer from claiming FTCs to reduce the former while allowing FTCs to be claimed against the latter.
The plaintiffs in Christensen argued that Article 24 of the France Treaty provides an independent legal basis for claiming FTCs against the NIIT, notwithstanding the clear proscription under US domestic tax law against doing so.
In their recent summary judgment motion, plaintiffs made two distinct arguments in support of that central claim, both based on Article 24 (Relief from Double Taxation) of the France Treaty. First, the plaintiffs pointed to Article 24(2)(a), which generally requires the United States to provide an FTC against "United States income tax" in respect of "French income tax" imposed on income that France is permitted to tax under the terms of the treaty. The plaintiffs claimed that Article 24(2)(a) effectively requires the Internal Revenue Service (the "IRS") to allow them to claim the French income tax imposed on the French-source portion of the NIIT earnings base as an FTC against the NIIT. The Christensen court rejected that contention, observing that even if the NIIT falls within the France Treaty's definition of "United States income tax," any FTC entitlement derived from Article 24(2)(a) is by its own terms cabined by "the provisions and [is] subject to the limitations of the law of the United States (as it may be amended from time to time without changing the principles hereof)." In the Christensen court's view, that limiting phrase essentially subordinates any theoretical FTC right embedded within Article 24(2)(a) to the Code's clear proscription on claiming FTCs against the NIIT, and therefore precludes the Christensen plaintiffs from reducing their NIIT liability on that basis. That view is consistent with United States Tax Court's decision in Toulouse v. Commissioner, 157 T.C. 49 (2021), where the taxpayer made and lost a similar argument (also based in part on the France Treaty).
The plaintiffs separately argued that Article 24(2)(b) of the France Treaty offers a freestanding basis for claiming French income tax as an FTC against the NIIT. Article 24(2)(b)—referred to in the Christensen decision as the "Three Bite Rule"—sets out a detailed FTC coordination scheme for US citizens who are also French tax residents. The Three Bite Rule purports to delineate when and under what circumstances a US citizen-French resident must claim French tax as a US FTC, on the one hand, versus claiming US tax as a French FTC, on the other. The basic purpose of the Three Bite Rule is to address some of the collateral consequences resulting from the so-called "saving clause" principle contained in the France Treaty (as well as most other US double tax treaties). The saving clause prevents a US citizen—but not necessarily a US green card holder or presence-based US tax resident—from invoking Article 4 of the applicable double tax treaty to "tie-break" his or her tax residence away from the United States to another tax treaty jurisdiction in the standard way. A US citizen who resides full-time in another high-tax treaty jurisdiction may therefore be faced with concurrent worldwide tax liability in two different countries; that double tax situation must be managed and mitigated primarily through the use of FTCs. For affected individuals, the Three Bite Rule represents an effort to coordinate which taxing jurisdiction is entitled to keep the income tax revenue imposed on each respective slice of that individual's worldwide income and gains. Under the Three Bite Rule, the United States effectively has the first claim on a narrow slice of the individual's US-source income, with France generally responsible for providing the FTC on that "First Bite." The "Second Bite" of tax revenue—French tax on all worldwide income and gains that France is purporting to tax on a residency basis (other than the narrow slice of First Bite income)—ultimately goes to the French tax authorities, with the United States generally obligated to provide an FTC to that individual for his or her tentative US federal income tax attributable to that Second Bite.
Crucially, the Christensen court observed that the text of the Three Bite Rule as it appears in the France Treaty lacks the same kind of limiting language as the general FTC language in Article 24(2)(a). The court thought it instructive that the Three Bite Rule does not state that a taxpayer's FTC right under that provision applies only with regard to "the provisions and subject to the limitations of the law of the United States." The Christensen court seized on that distinction to conclude that the plaintiffs could claim an independent, treaty-based FTC against on the NIIT on the basis of the plain text of the Three Bite Rule, notwithstanding the US domestic rules that would otherwise forbid it.
The Christensen decision is helpful and interesting in a number of different ways. First, the decision could provide a supportable legal basis for high-net worth US citizen taxpayers residing in treaty countries with similar Three Bite Rule provisions—including UK resident US citizens, where the equivalent Three Bite Rule is found in Article 24(6) of the US-UK Income Tax Treaty—to claim FTCs against the NIIT, thus meaningfully reducing their overall cross-border tax bill. Second, the Christensen decision represents a novel interpretation of the Three Bite Rule which could have ramifications beyond its narrow holding. To our knowledge, Christensen is the first time in which a court has interpreted the Three Bite Rule as offering a fully independent basis for claiming treaty-based FTCs, rather than treating that provision as a mere gloss on, or modification of, the basic Article 24(2)(a)-equivalent treaty credit provision (which, as explained above, states explicitly that the US FTC obligation is subject to the "provisions … and limitations of the law of the United States").
The court's dicta also seems to open the door for using the Three Bite Rule to advance other varieties of freestanding treaty-based foreign tax credit arguments. These kinds of arguments might be appealing to US citizens who face difficulties in fully utilizing their FTCs due to the various technical constraints of the US domestic FTC rules—for instance, the "basketing" system under Code section 904 that seeks to limit cross-crediting of foreign taxes paid on certain kinds of income against US tax incurred on other income types. If the Christensen holding does indeed stand for the proposition that there is a separate, freestanding, treaty-based FTC derived from the Three Bite Rule, then at least some of the limitations of US domestic law might fall away for US citizens residing in those treaty jurisdictions, ultimately allowing those kinds of taxpayers to engage in more efficient cross-border double tax planning.
While the Christensen dispute is still likely years away from a full resolution, the October 24 decision is a promising initial salvo. We closely await further developments in the case.
Withers LLP has extensive experience in complex, cross-border US income tax planning. We would be pleased to discuss how the Christensen decision might impact your or your client's tax situation.