Tax treaties do not provide a foreign tax credit against net investment income tax

A U.S. taxpayer living abroad was not entitled to take a foreign tax credit against her net investment income tax based on provisions in the United States-France and United States-Italy tax treaties.

Background

Catherine Toulouse is a U.S. citizen who resides outside the United States. For the 2013 tax year, she timely filed Form 1040, U.S. Individual Income Tax Return, filing married filing separately. On page 2 of Form 1040, she reported tax of $63,632 and claimed a foreign tax credit of $63,632. On Form 1116, Foreign Tax Credit, she reported that she had paid $51,456 in tax to Italy and France for 2013, as well as a carryover of foreign tax credits of approximately $340,000.

Toulouse had net investment income for 2013. With her 2013 return, she included Form 8960, Net Investment Income Tax — Individuals, Estates, and Trusts, reporting net investment income tax of $11,540 on line 17 of Form 8960. Apparently, Toulouse was aware that, in general, the IRS’s position was that a taxpayer could not offset her net investment income tax with a foreign tax credit. However, she (as described below) believed she could, and added two new lines to the bottom of Form 8960 to do so. She labeled the first added line “Less: Foreign Tax Credit” and entered $11,540. She labeled the second added line “Net Investment Income Tax Due” and entered an amount of zero. She did not transfer the $11,540 net investment income tax from line Form 8960, line 17, to Form 1040, line 60, as taxpayers are told to do by the instructions on line 17.

To explain her offset of the net investment tax with a foreign tax credit and her unsanctioned modifications to Form 8960, she included with her return two Forms 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b), disclosing that she used the foreign tax credit carryover to offset the net investment income tax. She also attached Form 8275, Disclosure Statement, which explained in detail her position that Article 24(2)(a) of the U.S. income tax treaty with France (the Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion With Respect to Taxes on Income and Capital (Aug. 31, 1994), as supplemented by protocols dated Dec. 8, 2004, and Jan. 13, 2009 (U.S.-France Treaty)) and Article 23(2)(a) of the U.S. income tax treaty with Italy (the Convention for the Avoidance of Double Taxation With Respect to Taxes on Income and the Prevention of Fraud or Fiscal Evasion (Aug. 25, 1999), as supplemented by a protocol dated Aug. 25, 1999 (U.S.-Italy Treaty)) permit a foreign tax credit against the net investment income tax.

The IRS did not agree that she could take the foreign tax credit against her net investment income tax. However, probably due to her modification of Form 8960, instead of immediately challenging the $11,540 foreign tax credit she took on Form 8960, the IRS sent her on Feb. 16, 2015, a notice of a math error informing her of an $11,540 adjustment to her 2013 return. On the same day, the IRS assessed tax of $11,540 pursuant to Sec. 6213(b).

Toulouse did not pay the assessed amount. She sent a letter to contest the assessment, asserting that no math error occurred and a foreign tax credit offset her liability for the net investment income tax. The IRS replied by telling her that, despite its earlier notice claiming a math error, her foreign tax credit of $11,540 had been disallowed because a foreign tax credit cannot be taken against the net investment income tax.

Toulouse filed a written protest with the IRS Appeals Office (Appeals). After a conference, Appeals sent her a letter stating that she was not entitled to a foreign tax credit against the net investment income tax and that it treated her protest as a claim for a refund.

In 2018, the IRS assessed an addition to tax under Sec. 6651(a)(2) of $2,885 against Toulouse for 2013 for a failure to pay tax shown on a return. Later that year, it issued her a final notice of intent to levy and notice of a right to a hearing and a notice of a federal tax lien filing and right to a hearing for the unpaid, assessed tax and the addition to tax.

Toulouse, undaunted, timely requested a CDP hearing with respect to both notices and challenged her underlying liability for the net investment income tax. She again asserted that the foreign tax credit provided under Article 24(2)(a) of the U.S.-France tax treaty and Article 23(2)(a) of the U.S.-Italy tax treaty fully offset her net investment income tax and objected to the lack of issuance of a notice of deficiency. She did not propose any collection alternatives.

After a CDP hearing was held, the IRS issued a notice of determination that sustained the proposed levy action but not the filing of the federal tax lien. The notice stated that the IRS settlement officer determined that Toulouse was not entitled to a foreign tax credit against the net investment income tax. Toulouse then took her fight to the Tax Court.

In Tax Court, Toulouse, while conceding that the Code does not provide a foreign tax credit against the net investment income tax, continued to argue that the U.S.-France and U.S.-Italy tax treaties provide a foreign tax credit independent of the Code. The IRS made a motion for summary judgment on the point.

The Tax Court’s decision

The Tax Court held that Toulouse was not entitled to take a foreign tax credit against the Sec. 1411 net investment income tax under either the U.S.-France or the U.S.-Italy tax treaty and granted the IRS’s motion for summary judgment.

The Tax Court explained that treaties are given the same force and effect as legislation enacted by Congress and that under Sec. 894(a)(1), “[t]he provisions of this title shall be applied to any taxpayer with due regard to any treaty obligation of the United States which applies to such taxpayer.” Courts generally construe a treaty liberally to give effect to the purpose of the treaty, and where a treaty and a statute relate to the same subject, they attempt to construe the treaty and statute to give effect to both. The intent of both the U.S.-France and U.S.-Italy tax treaties is to limit the effects of double taxation, and they contain provisions that govern each country’s obligations to grant a foreign tax credit to fulfill this general goal.

However, the Tax Court, after reviewing the applicable provisions of the two treaties, found that “the plain text of the treaty provisions on which [Toulouse] relies subject the terms of the Treaties, and thus any allowable credit, to the provisions and limitations of the Code.” The fact that Sec. 1411, which imposes the net investment income tax, was enacted after the treaties were signed was not determinative because both treaties contained provisions that state that they apply to taxes imposed by the Code and an identical or substantially similar tax imposed after the effective date of the treaties.

Toulouse maintained that the treaties do not conflict with the Code because the Code is silent as to whether there is a foreign tax credit against the net investment income tax. According to her, the placement of Sec. 1411 in its own chapter of the Code, Chapter 2A, Unearned Income Medicare Contribution, was “happenstance” and a “clerical choice.” Therefore, the legislative decision to place the tax in Chapter 2A should not override the treaties’ elimination of double taxation, especially in light of the lack of legislative intent to do so. She further pointed to the fact that there is no explanation in the legislative history for Congress’s decision to impose the net investment income tax under Chapter 2A or any indication that Congress considered whether to provide a foreign tax credit against the net investment income tax. The Tax Court, to the contrary, found that the placement of Sec. 1411 was not happenstance, noting that an “enumerated chapter of the Code to impose a distinct and separate tax is part of the Code’s fundamental structure.”

Toulouse also argued that the enactment of the net investment income tax in Chapter 2A is not a “limitation” as that term is used in the two tax treaties. Citing dictionary definitions of “limitation” and “limit,” she asserted that “limit” should be defined as “to assign certain limits to, prescribe, restrict the bounds or limits of, or curtail or reduce in quantity or extent.” Using this definition, she argued that any limitation of a foreign tax credit as set forth in the treaties requires some affirmative statement and should not be imposed on the basis of Congress’s silence on the issue.

The Tax Court found that Toulouse wrongly focused on the term “limitation” and ignored that the treaty provisions on which she relied require any foreign tax credit to be “in accordance with the Code.” Because the cited provisions in the treaties relied on by Toulouse must be “in accordance with the Code,” for her argument to prevail based on those provisions, the court reasoned that the Code must provide the credit if one exists. It was immaterial that the Code does not affirmatively state that a foreign tax credit against the net investment income tax is disallowed.

The Tax Court further explained that while the U.S.-France and U.S.-Italy treaties provide for general protection against double taxation, they do not provide absolute protection from it and, moreover, their purpose is not to provide absolute protection. The general purpose of the treaties is to reduce double taxation, but the specific provisions of each treaty must be applied as written. As there is nothing in either Article 24(2)(a) of the U.S.-France treaty or Article 23(2)(a) of the U.S.-Italy treaty that entitles U.S. taxpayers to an elimination of all double taxation, the court concluded that Toulouse could not rely on those provisions to support her position that the foreign tax credit is allowed against the net investment income tax.

The Tax Court observed that Treasury, the agency charged with the negotiation and enforcement of tax treaties, had taken the same position as the court in its Technical Explanation to the U.S.-France Treaty. The Technical Explanation states:

The credits provided under the [treaty] are allowed in accordance with the provisions and subject to the limitations of U.S. law, as that law may be amended over time, so long as the general principle of [Article 24(2)(a)], i.e., the allowance of a credit, is retained. Thus, although the [treaty] 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 a credit is given. [Treasury Dep’t, Technical Explanation of the Protocol Between the Government of the United States of America and the Government of the French Republic, Article 24, p. 39]

Reflections

In her arguments, Toulouse raised the general question of what was the purpose of the U.S.-France and U.S.-Italy tax treaties if there is no independent, treaty-based credit and a credit is allowable only if it is provided in the Code. The Tax Court, in response, pointed out that it was not holding that there could not be a treaty-based credit, and that “[o]ther provisions of the Treaties may well provide for credits that are unavailable under the Code.” The problem in Toulouse’s case was that she relied on treaty provisions that by their express terms did not provide for a credit.

The Tax Court noted that in the preamble to the Sec. 1411 regulations (T.D. 9644), the IRS stated that an analysis of each U.S. income tax treaty would be required to determine whether the United States has an obligation under the treaty to provide a foreign tax credit against the Sec. 1411 net investment income tax. Thus, while the Tax Court has weighed in about the credit’s availability against the tax with regard to France and Italy, it could possibly come to a different conclusion if a taxpayer raised the issue with respect to a credit due to foreign taxes of a different country that has a tax treaty with the United States.

Toulouse, 157 T.C. No. 4 (2021)