Tax credit did not independently arise under treaties

Editor: Greg A. Fairbanks, J.D., LL.M.

Taxpayer Catherine Toulouse, a U.S. citizen residing in France, timely filed her 2013 federal income tax return reporting tax on line 44 of her Form 1040, U.S. Individual Income Tax Return, of $63,632, offset by foreign tax credits in the same amount shown on line 47. Toulouse also submitted a modified Form 8960, Net Investment Income Tax — Individuals, Estates, and Trusts, where she properly reported $11,540 in net investment income on line 17 but also added lines to the form to show a foreign tax credit of $11,540 and the amount of net investment income tax due as $0.

Toulouse included two Forms 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b), disclosing her position using carryover foreign tax credits from Italy and France to offset her net investment income tax liability. The position disclosed included a detailed explanation claiming treaty benefits under both Article 24(2)(a) of 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) (United States–France treaty) and Article 23(2)(a) of 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) (United States–Italy treaty).

In February 2015, the IRS issued a math error notice, proposed an adjustment of $11,540, and on the same day assessed tax in that amount under Sec. 6213(b). Toulouse did not pay the assessment and sent the IRS a letter reiterating her position that a foreign tax credit could be used to offset her net investment income tax liability. In February 2016, the IRS informed Toulouse by letter that her claim for a foreign tax credit had been disallowed because the foreign tax credit does not apply against the net investment income tax.

In August 2018, the IRS assessed a Sec. 6651(a)(2) failure-to-pay penalty of $2,885 against Toulouse for 2013. In September 2018, the IRS issued Toulouse a final notice of intent to levy and a Notice of a Federal Tax Lien filing. Toulouse requested a Collection Due Process (CDP) hearing with respect to both notices, challenging her underlying liability for the net investment income tax. While reasserting that her net investment income tax was offset by foreign tax credits under the U.S.–France and U.S.–Italy tax treaties, Toulouse also objected to the IRS’s failure to issue her a notice of deficiency.

A CDP hearing was held by phone in March 2019, and in September 2019 the settlement officer issued a determination sustaining the proposed levy action but not the filing of the federal tax lien. According to the notice of determination, the settlement officer determined that Toulouse was not entitled to a foreign tax credit against her net investment income tax.

Toulouse ultimately filed a petition in Tax Court in October 2019 requesting a review of the IRS’s determination from the CDP hearing. Toulouse and the IRS filed cross-motions for summary judgment with the court, primarily on the issue of whether Toulouse was entitled to a foreign tax credit against the net investment income tax based on the provisions of the U.S.–France and U.S.–Italy tax treaties. Because the validity of Toulouse’s case was a collection review proceeding and her underlying tax liability was properly at issue, the Tax Court reviewed Toulouse’s liability de novo.

Tax Court discussion

In evaluating the cross-motions, the Tax Court first observed that there was no dispute that the Code and its associated regulations do not permit a foreign tax credit against the net investment income tax (Toulouse, 157 T.C. No. 4 (2021)). Foreign tax credits are provided under Secs. 27 and 901. Sec. 27 provides that “[t]he amount of taxes imposed by foreign countries and possessions of the United States shall be allowed as a credit against the tax imposed by this chapter to the extent provided in section 901.” Sec. 901 similarly states that the “tax imposed by this chapter shall … be credited” essentially with taxes paid to foreign countries. Secs. 27 and 901 are both part of Chapter 1 of the Code. However, the net investment income tax is imposed under Sec. 1411, which is part of Chapter 2A of the Code. As the court noted, by its terms, the foreign tax credit of Sec. 901 is not available to offset non-Chapter 1 taxes.

Recognizing this statutory barrier, Toulouse argued that both the U.S.–Italy and U.S.–France treaties provide an independent basis for applying a foreign tax credit against her net investment income. The relevant language of each treaty is identical and provides a foreign tax credit “[i]n 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).” However, the Tax Court held that the plain text of the treaties necessarily subjected any credit to being within the provisions and limitations of the Code.

In so holding, the court rejected several arguments from Toulouse. First, the court noted that the fact that the net investment income tax of Sec. 1411 was instituted after the enactment of the treaties was not determinative. Both treaties state that they cover all federal income taxes imposed by the Code, and the addition of the net investment income tax to the Code was not a change to the “general principles of U.S. tax laws.”

The Tax Court then addressed Toulouse’s arguments premised on the “subject to the limitations of the law of the United States” language in the treaties. While Toulouse argued that the Code provided no limitation on a foreign tax credit as applied to net investment income because the Code was simply silent on the matter, the court noted that her argument ignored the other treaty language that such credit must be “in accordance with the provisions” of the Code. Worldwide income of U.S. residents is taxable absent an express affirmative credit or deduction stated in the Code. Thus, the court found that it is immaterial that the Code does not state that a credit is unavailable or is merely silent on the matter; the Code must provide a credit for one to exist.

The Tax Court was also unconvinced by Toulouse’s argument that the placement of the net investment income tax in Chapter 2A of the Code (instead of Chapter 1) was a clerical choice or happenstance and that the intention of the treaties to eliminate double taxation should prevail in the absence of evidence that Congress considered whether to provide a foreign tax credit against the net investment income tax. The court found that congressional creation of an entirely new chapter of the Code when enacting the net investment income tax evidenced a structural choice. The court also cited cases and a technical explanation associated with the U.S.–France treaty in noting that, while the general purpose of treaties is to preclude double taxation, treaties do not provide absolute protection, as the terms of credits are determined by the limitations of U.S. law.

Survival of the idea of independent tax credits under treaties?

Arguably, the most interesting aspect of this case is neither the holding nor the discussion but the opening expressly highlighted by the court for potential future argument. Multiple times in the opinion, the court observed that while Toulouse’s argument based on Article 24(a) of the U.S.–France treaty and Article 23(2)(a) of the U.S.–Italy treaty was unpersuasive, tax treaties could potentially provide credits outside of the Code:

[Toulouse] questions the purpose of the Treaties if there is no independent, treaty-based credit and a credit is allowable only if it is provided in the Code. But we do not so hold. Other provisions of the Treaties may well provide for credits that are unavailable under the Code. [Toulouse], however, relies on provisions that by their express terms do not.

The language in the articles of the U.S.–France and U.S.–Italy treaties relied upon by Toulouse continues to be part of model U.S. tax treaty language on relief from double taxation, including model years 2006 and 2016. In its final regulations related to the net investment income tax, the IRS stated that all treaties with similar language “would not provide an independent basis for a credit against the section 1411 tax.” In the same regulations, in stating that treaties must be analyzed to determine whether the United States has to provide a credit (if they do not contain the model language), the IRS left open the possibility that treaties currently exist or could exist to allow such a credit.

However, given the proliferation of use of the model treaty language, most U.S. citizens living abroad will continue to find a foreign tax credit unavailable against their net investment income, even when that income is taxed by other countries. In view of the IRS’s position and the Toulouse case, the best course of action for affected citizens seems to be to encourage legislative action to amend Sec. 901 to include taxes under Chapter 2A as creditable. Such an amendment would bring a credit against the net investment income tax squarely within the existing model treaty language “in accordance with the provisions … of the law of the United States.”

EditorNotes

Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Contributors are members of or associated with Grant Thornton LLP.