The U.S. State Department estimates that approximately 7.2 million U.S. citizens live abroad, plus an indeterminate number of green card holders. 1 The United States has social security totalization agreements (SSTAs) with 24 countries 2 and income tax treaties with 67. 3 The vast majority of Americans abroad live in these countries.
When the Sec. 1411 net investment income tax was passed, little thought was given to how it would affect Americans living abroad, and with no guidance issued on the topic, its effect is unclear. This article describes how the net investment income tax may affect Americans living abroad.
The tax essentially raises two questions:
- Are these individuals 4 subject to this tax?
- If an individual
is subject to the tax,
would a foreign tax
credit (FTC) be
available where the
underlying income that
gives rise to the tax
(a) Foreign (non-U.S.) source?
It is also unclear whether the tax is a social security tax for purposes of the U.S.–Canada SSTA. 5
Net Investment Income Tax in General
To help fund 2010’s health care reform legislation, 6 the United States instituted the net investment income tax, 7 which is designed to affect high-income people. The tax amounts to 3.8% of a U.S. person’s net investment income, 8 to the extent the person’s modified adjusted gross income is above:
- For a married couple filing jointly, $250,000;
- For a married person filing separately, $125,000; and
- For a single taxpayer, $200,000. 9
Roughly, investment income includes interest, dividends, rent, royalties, and most net gains. It includes income from passive activities. 10 It does not include distributions from qualified retirement plans. 11
For owners of controlled foreign corporations and passive foreign investment companies, it does not include corporate income that is imputed to the shareholder (subpart F and qualified electing fund income), as they are not dividends. Instead, actual distributions are subject to the tax. 12 It is possible to make an election to have the tax apply at the same time as the subpart F income is recognized for ordinary income tax purposes. 13
A U.S. person is a citizen or resident, defined in the same manner as for income tax. 14 The tax does not apply to nonresident aliens, 15 including those whose residency is determined under a result of a tax treaty. 16
The tax went into effect Jan. 1, 2013, and is not withheld at the source, so it is a material issue for high-income earners in this filing season.
Little Guidance to This Point
The Joint Committee on Taxation report did not address the above questions about Americans living abroad, 17 nor did the proposed regulations. 18 In November 2013, the author had the opportunity to ask staff from both the Joint Committee and Treasury, and neither was aware of these questions having been raised in the course of drafting the law or regulations. After the author’s discussion with Treasury (including providing a draft of this article), Treasury did address the second question regarding an FTC, in the preamble to the final regulations issued Dec. 2, 2013. However, it did so in the broadest terms, saying only that the regulations were not an appropriate venue for such answers. 19
The author could find no discussion of these questions in the academic literature, but some commentators from large accounting firms have suggested in their public materials that no protection from this tax is available. 20 There simply is no meaningful guidance in this area.
To address the question of whether Americans living abroad are subject to it, one must determine which type of tax the net investment income tax is. Is it a social security tax or an income tax?
Is the Net Investment Income Tax a Social Security Tax?
For an individual who lives in Canada (as an example), the U.S.–Canada SSTA governs coverage under Social Security and Medicare, as well as the Canadian equivalent, the Canada Pension Plan (CPP). Individuals employed primarily in Canada and self-employed individuals who reside in Canada are subject to the provisions of the CPP, not U.S. Social Security. 21 Consequently, if the net investment income tax is a social security tax, then an individual who lives in Canada and is subject to the CPP would be exempt from it.
But is the net investment income tax a social security tax? Under the SSTA, the covered taxes are listed as those imposed by Internal Revenue Code chapters 2 (self-employment tax) and 21 (Federal Insurance Contributions Act (FICA) tax). 22 The net investment income tax is contained in a new chapter (2A) of the Code, which is not specifically covered by the SSTA. However, the SSTA anticipates this possibility:
[T]his Agreement shall also apply to laws which amend, supplement, consolidate or supersede the laws specified in paragraph (1). 23
Most U.S. SSTAs Have Similar Provisions
The net investment income tax is designed to pay for an expanded Medicare. In the statute, it is called a “Medicare contribution.” 24 The Joint Committee report addresses the tax in a Social Security/Medicare context, not an income tax context. 25
The tax was imposed in parallel with an increased Medicare tax, a 0.9% surtax on wages and self-employment income in excess of thresholds identical to those applying to the net investment income tax. 26 The objective of the net investment income tax was to ensure that individuals with similarly high income levels who derive income from nonwage sources contribute to the newly expanded health care program in a similar manner.
It is noteworthy that the additional Medicare taxes on wages and self-employment income are specifically identified as ones to be covered by SSTAs. No similar guidance was provided for the net investment income tax. Whether this means that the tax was intended to be covered is anybody’s guess.
However, the author’s inquiries to the Joint Committee and Treasury indicate that the question was simply never addressed. Furthermore, although Treasury addressed the FTC question when it issued final regulations (see below), it did not consider the SSTA issue.
The fact that there is no FTC mechanism in the tax also suggests that the tax is designed to be a Medicare tax rather than an income tax. However, there is no specific requirement that funds from this tax be directed toward Medicare. Receipts simply go into general revenues. 27
A major purpose of this tax is to help finance health care subsidies under the Sec. 5000A individual mandate to maintain minimum essential coverage. American residents abroad are not subject to the mandate. 28 Additionally, they rarely access Medicare coverage.
It is unclear whether the net investment income tax is covered by the SSTA on the basis that it amends or supplements chapters 2 and 21 of the Code.
Individuals Who Are Neither Employed nor Self-Employed
SSTAs are designed according to the idea that individuals receive coverage through their work status. However, some people are neither employed nor self-employed. Into this category fall retirees, parents who do not work outside the home, and children. Independently wealthy individuals and those with interests in closely held corporations who are remunerated primarily through interest and dividends would also fall into this category.
To this point, social security coverage relating to this latter category has not been relevant. The net investment income tax, however, makes the issue germane. One could argue that in this case, where an individual has no foreign (non-U.S.) social security coverage, the SSTA has no effect, and the individual would then be subject to U.S. laws. 29
On the other hand, some individuals over the retirement age are exempt from contributions to the foreign social security program. Such individuals may have employment or self-employment income, but they are still treated by the Social Secu rity Administration as exempt from FICA taxes. 30 Again, because the SSTA is designed according to the idea that coverage is a function of providing services, it is inad equate to answer the question definitively.
Or Is It an Income Tax?
When a U.S. citizen resides abroad, he or she is still subject to U.S. tax on worldwide income. Most foreign countries tax their own residents on their worldwide incomes, and even those that do not do so still tax them on local-source income. So Americans living abroad are almost always subject to tax under at least two systems.
Double taxation is universally recognized to be a bad thing. It interferes with international business and individual mobility and is fundamentally unfair. Consequently, U.S. law and treaties include FTC mechanisms to mitigate this problem. If the net investment income tax is an income tax, then the question arises whether an FTC is available in respect of foreign tax paid.
Even with the net investment income tax, foreign-country income taxes where most Americans reside are typically higher than U.S. taxes. In most Organisation for Economic Co-operation and Development nations, top marginal tax rates range from 40% to 50%, with some (like France) much higher. U.S. brackets are generally wider, and the United States offers itemized deductions (e.g., mortgage interest and property taxes) that typically lower the income tax base materially compared with that of other nations. Thus, for most of the individuals described here, an FTC mechanism would effectively obviate the impact of the tax.
Where the Income Giving Rise to the Tax Is Not U.S.-Source
For Americans living abroad, the foreign country, as a general rule, has the first right of taxation with respect to income that is not U.S.-source. The normal mechanism to avoid double taxation is an FTC.
U.S. Foreign Tax Credit
There is no provision in the Internal Revenue Code or the regulations for an FTC against the net investment income tax. The domestic-rule FTC applies only to reduce regular income tax, not the net investment income tax. 31 Form 8960, Net Investment Income Tax—Individuals, Estates, and Trusts, for calculating net investment income tax contains no FTC calculation.
Treaty Foreign Tax Credit
Treaties often ensure that there is a supplementary FTC mechanism to mitigate double taxation. For a U.S. citizen resident in Canada, for example, the treaty 32 allows an FTC for Canadian tax in computing United States tax:
[D]ouble taxation shall be avoided as follows: In accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof), 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. 33
“United States tax” means the taxes referred to in Article II of the treaty, other than, inter alia, Social Security taxes. 34
The fact that the tax arises in a separate section of the Internal Revenue Code is not relevant to this determination:
This Convention shall apply to taxes on income . . . irrespective of the manner in which they are levied. . . . 35 The Convention shall apply also to any taxes identical or substantially similar to those taxes to which the Convention applies under [the above paragraph] . . . which are imposed after March 17, 1995, in addition to, or in place of, the taxes to which the Convention applies under [the same paragraph]. 36
Of course, the words “subject to the limitations of the law of the United States” could be interpreted to mean that there is no FTC, because there is no provision for one in the domestic law. The IRS commented in the preamble to the final regulations under Sec. 1411 that where such words are included, a treaty-based foreign tax credit would not be allowed. 37
Canada’s Foreign Tax Credit
Canada taxes non-U.S.-source income without regard to U.S. taxation and has no domestic mechanism to offer an FTC in respect of the net investment income tax. To qualify for Canada’s foreign tax credit, the qualifying income must have a source in one or more countries other than Canada. 38 Canada calculates FTCs separately by country. 39 The net investment income tax is deemed not to be creditable, because it is payable solely by virtue of U.S. citizenship (noting that the tax does not apply to nonresident aliens). 40 Under the treaty, Canada is not obliged to offer a credit. The credit required under the treaty is limited to the amount that would apply if the individual were not a U.S. citizen. 41
In the United States (unlike Canada and most other countries), a treaty does not automatically supersede domestic law. 42 Instead, “[t]he provisions of [the Code] shall be applied to any taxpayer with due regard to any treaty obligation of the United States which applies to such taxpayer.” 43 “For purposes of determining the relationship between a provision of a treaty and any law of the United States affecting revenue, neither the treaty nor the law shall have preferential status.” 44 These statements are of little help.
The courts have determined that, as a general rule, the provision that came later in time prevails. 45 Double taxation can result from the application of this rule. One example of this phenomenon was the arbitrary limitation of the alternative minimum tax (AMT) FTC to 90% of the AMT otherwise payable, even in cases where the foreign-source income was greater than 90% of all income. 46 However, one of the critical elements in this case was that legislators had indicated they were conscious of the treaty override. With the net investment income tax, this intent is not evident from the legislation or the committee reports. As noted, in the rush to finalize legislation, the question was simply not addressed. How does one address an implicit treaty override when there is no expression of that intent? This is a critical factor that distinguishes this tax from the AMT FTC limitation.
The IRS, by noting in the preamble to the regulations that a treaty credit may be allowed and that residency determined under a treaty will be respected, 47 implicitly acknowledged that this new tax is not intended to be a treaty override.
The author suggests that in light of the wording of the U.S.–Canada treaty, especially Article II anticipating the enactment of additional taxes, an FTC should be allowed, notwithstanding Treasury’s comments.
Where the Income Giving Rise to the Tax Is U.S.-Source
As with most countries, Canada ordinarily provides an FTC for U.S. tax properly levied against U.S.-source income. 48 This provision is reinforced by the treaty. 49 This is true even where the tax is a social security tax. 50
However, Canada is not required to provide an FTC for U.S. tax in excess of that properly allowed under the treaty. Where the treaty limits the U.S. tax to an amount lower than the ordinary U.S. statutory rate, that treaty limit forms an upper bound on the creditable tax. 51
Furthermore, if a U.S. citizen is taxable but a nonresident alien would not be on the same type of income, Canada is not required to provide an FTC. 52 As noted above, a U.S. nonresident alien is exempt from this tax. Consequently, Canada would not offer an FTC in respect of the net investment income tax.
Where the statutory calculation results in higher tax than the treaty allows, the United States is required under the treaty to offer a special tax credit to reduce its own tax to the treaty level. 53
Provided the Canadian tax is sufficient, this credit should offset the net investment income tax. Given that Canadian effective tax rates for high-income earners are typically considerably higher than U.S. rates, this should be the case almost universally.
For an individual living in a country with an SSTA, if the net investment income tax is a social security tax, it should be excluded from applicability because:
- The net investment income tax supplements existing Social Security taxes;
- It is designed to fund an expanded Medicare;
- Americans abroad are exempt from the Patient Protection and Affordable Care Act’s individual mandate, and this tax is designed to fund subsidies for that mandate;
- It is described as a Medicare tax in the legislative text;
- Its location in the Code is consistent with that status;
- The tax mechanism dovetails with the increased ordinary Medicare taxes on earned income; and
- The absence of an FTC mechanism is consistent with a social security tax, not an income tax.
This position is not without risk:
- SSTAs do not explicitly cover the tax;
- An individual who is not covered by foreign social security (by reason of not earning income from employment or self-employment) may be excluded from the SSTA; and
- Funds are not earmarked directly for Medicare.
If the net investment income tax is not a social security tax, there is a good argument that an FTC should be allowed under a treaty. This is true whether the income in question is U.S.-source or not:
- Tax treaties generally contemplate additional income taxes being levied;
- It is hard to argue that the tax is neither a social security tax nor an income tax; and
- There is no express limitation in U.S. law on the use of an FTC under a treaty.
Again, this position is not without risk. The Code has no provision for an FTC in respect of this tax. That omission may be sufficient to deny the treaty credit. The result would be unforeseen double taxation.
An overwhelming majority of Americans abroad live in countries with SSTAs and/or tax treaties. In most or all of these countries, the tax treaty FTC mechanism applicable to U.S. citizens is similar to that in the Canadian treaty, so similar conclusions would likely apply.
How to File Returns
Of course, it is quite possible that the IRS would view either approach as incorrect (that the tax is covered by the SSTA or that there is a treaty-based FTC available in a specific jurisdiction).
Taking such a position would not be for the faint of heart. Because such a position would be contrary to the design of the IRS form and Treasury has not indicated support for broad-ranging treaty FTCs, it would be important, at the very least, to make proper disclosure to mitigate the likelihood of imposition of preparer 54 and taxpayer 55 penalties.
For an SSTA exemption, safe tax practice would suggest that filing Form 8275, Disclosure Statement, is a good idea. For a treaty position, it might still be advisable. There is little downside with such an approach. The presence of Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b), and absence of Form 8960, combined with a high income, will alert the IRS to the issue even in the absence of Form 8275. These positions are not likely to “slide through.”
Because of the sparse IRS guidance, the fact that no court has pronounced on the issue, and that there has been no meaningful discussion in the literature, it would be very difficult to argue that a taxpayer has substantial authority 56 for either position. However, the author submits that there is a reasonable basis 57 for either position, on the basis of the arguments discussed above.
Editor’s note: A version of this article was published in Canada in the International Tax newsletter.
1 Saunders, “Overseas Americans: Time to Say ‘Bye’ to Uncle Sam?” The Wall Street Journal (Aug. 17, 2013).
4 All references to “individuals” henceforth are to U.S. citizens living abroad, except as specifically noted. Because of the large number of such people in Canada, and the author’s familiarity with the country, the Canadian situation is used as illustrative.
6 Patient Protection and Affordable Care Act, P.L. 111-148, and Health Care and Education Reconciliation Act of 2010, P.L. 111-152.
7 Health Care and Education Reconciliation Act of 2010, §1402.
8 Sec. 1411(a)(1).
9 Sec. 1411(b).
10 Secs. 1411(c)(1) and (2).
11 Sec. 1411(c)(5).
12 Regs. Sec. 1.1411-10(b).
13 Regs. Sec. 1.1411-10(g).
14 Regs. Sec. 1.1411-2(a)(1).
15 Sec. 1411(e)(1).
16 Regs. Sec. 1.1411-2(a)(2)(i).
17 Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the “Reconciliation Act of 2010,” as Amended, in Combination With the “Patient Protection and Affordable Care Act” (JCX-18-10) (March 21, 2010).
19 T.D. 9644, Summary of Comments and Explanation of Provisions 1(C), “Availability of Tax Credits to Reduce Section 1411 Tax.”
20 E.g., PwC, “United States: Will Your Mobility Costs Increase as a Result of the Net Investment Income Tax?” Global Watch (August 2013).
21 SSTA Art. V.
22 SSTA Art. II(1)(a)(ii).
23 SSTA Art. II(3).
24 The full name is “Unearned Income Medicare Contribution” (Health Care and Education Reconciliation Act of 2010, §1402(a)(1)).
25 Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the “Reconciliation Act of 2010,” as Amended, in Combination With the “Patient Protection and Affordable Care Act” (JCX-18-10) (March 21, 2010), at 134.
26 Secs. 1401(b)(2)(A) and 3101(b)(2)(A).
27 Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 111th Congress (JCS-2-11) (March 24, 2011), at 363.
28 Sec. 5000A(f)(4)(A). This residency test is the same as for the foreign-earned-income exclusion.
29 SSTA Art. V(8).
31 Secs. 27(a) and 901(a).
32 U.S.–Canada Income Tax Treaty (1980), as amended.
33 Treaty Art. XXIV(1). See also Art. XXIV(4)(b).
34 Treaty Art. III(1)(d).
35 Treaty Art. II(1).
36 Treaty Art. II(3).
37 T.D. 9644, Summary of Comments and Explanation of Provisions 1(C), “Availability of Tax Credits to Reduce Section 1411 Tax.”
38 Canada Income Tax Act (ITA), R.S.C. 1985 (5th Supp.), ch. 1, §126(7), definition of “non-business-income tax.”
39 ITA §126(6)(b).
40 ITA §126(7), “non-business income tax,” (d).
41 Treaty Art. XXIV(4)(a).
42 Sec. 7852(d)(1).
43 Sec. 894(a).
44 Sec. 7852(d)(1).
45 Whitney v. Robertson, 124 U.S. 190 (1888).
46 Sec. 59(a)(2), as it read for years prior to 2005; Lindsey, 98 T.C. 672 (1992), aff’d without opinion, 15 F.3d 1160 (D.C. Cir. 1994).
47 T.D. 9644, Summary of Comments and Explanation of Provisions 3(A), “Dual-Resident Individuals.”
48 ITA §126(1).
49 Treaty Arts. XXIV(2)(a) and (4)(a).
50 Treaty Art. XXIV(2)(b); Canada Revenue Agency, Tax Bulletin IT-122R2¶5 (canceled); Canada Revenue Agency, Income Tax Technical News No. 31R2 (May 16, 2006).
51 Meyer, 2004 D.T.C. 2393.
52 Treaty Art. XXIV(4)(a).
53 Treaty Art. XXIV(4)(b).
54 Sec. 6694(a)(1).
55 Sec. 6662, especially.
56 Regs. Sec. 1.6662-4(d)(3).
57 Regs. Sec. 1.6662-3(b)(3).
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