Treaty-based foreign tax credit and net investment income tax

Editor: Mary Van Leuven, J.D., LL.M.

The U.S. Court of Federal Claims, a court of national jurisdiction, issued two rulings in favor of U.S. citizens living abroad by allowing a treaty–based foreign tax credit (FTC) to offset the net investment income tax (NIIT) (Bruyea, 174 Fed. Cl. 238 (2024), and Christensen, 168 Fed. Cl. 263 (2023)). Both cases are pending appeal in the Federal Circuit (Bruyea, No. 25–1563 (Fed. Cir. 3/20/25) (appeal docketed); Christensen, No. 24–1284 (Fed. Cir. 12/22/23) (appeal docketed)). If upheld, the outcome of these cases could help alleviate the burden of double taxation for many U.S. citizens living abroad. This item explores practical considerations for taxpayers while these cases are being litigated.

Background

U.S. citizens are subject to U.S. federal income tax on their worldwide income regardless of their country of residence or source of income and may be subject to double taxation (Sec. 1; Regs. Sec. 1.1–1(b)). Double taxation is generally mitigated by claiming an FTC provided either under the domestic rules or a provision of an applicable treaty providing relief from double taxation (Secs. 27 and 901-909; see, e.g., 2006 and 2016 United States Model Income Tax Convention, Article 23). In addition to federal income tax, U.S. citizens and residents are subject to the NIIT, which is imposed on certain net investment income, such as interest, dividends, capital gains, and rents (Sec. 1411). Under the domestic FTC rules, a credit for foreign taxes cannot offset the NIIT, codified in Chapter 2A of the Internal Revenue Code, because the credit may only be applied against taxes codified in Chapter 1(Secs. 27, 901, and 1411).

One of the questions presented in Christensen and Bruyea is whether the treaty–based FTC is subject to the same limitations imposed by the FTC domestic rules. The taxpayers in both cases argue that the treaty–based FTC at issue is not subject to the same limitations of the Code; thus, the treaty–based FTC can be used to offset the NIIT. In contrast, the U.S. government asserts that the relevant treaty provisions require the credit to be in accordance with the provisions of and subject to the same limitations of U.S. law. Therefore, the treaty–based FTC is limited to Chapter 1 taxes and cannot be used to offset the NIIT.

The Court of Federal Claims held in favor of the taxpayers in both cases. However, the court took different paths to reach its decisions, with different implications (for a discussion of both cases, see also Brennan et al., “Current Developments in Taxation of Individuals: Part 2,” 56–4 The Tax Adviser 36 (April 2025)). If upheld by the Federal Circuit, the holding in Christensen would apply to a small number of U.S. citizens relying on a specific paragraph of the U.S.-France income tax treaty provision, while the holding in Bruyea would have a broader impact on taxpayers seeking a treaty–based credit. In addition to the potential for refunds and the reduction of a future tax liability, any future taxpayer–favorable appellate decision could provide much–needed clarity for U.S. citizens residing abroad with respect to a treaty–based FTC and its applicability to the NIIT.

Practical considerations

A taxpayer–favorable decision by the Federal Circuit would provide support for individual taxpayers claiming a treaty–based credit provided under an applicable treaty against the NIIT. However, the government could appeal to the Supreme Court, prolonging the final judgment for years. In the interim, the IRS is likely to reject the claims of individual taxpayers taking such a position. With this in mind, a taxpayer could choose to (1) claim a treaty–based FTC against their NIIT on their current return; (2) file a protective refund claim for open years approaching the end of the statute of limitation; or (3) take no action until the law is settled. With the exception of the wait–and–see approach, the taxpayer will face both procedural and practical obstacles and should weigh the options carefully before taking a position.

Option 1. Claim the treaty–based FTC on a current U.S. return: A taxpayer keen on offsetting the NIIT with a treaty–based FTC should be made aware that there is no clear process allowing for such a position to be taken on a U.S. return. To claim a treaty–based FTC on a U.S. return, the taxpayer may have to modify Form 8960, Net Investment Income Tax — Individuals, Estates, and Trusts, by adding additional lines to show the reduction of the NIIT by a treaty–based FTC (see, generally, Toulouse, 157 T.C. 49 (2021)). In addition to modifying Form 8960, a disclosure on Form 8833, Treaty–Based Return Position Disclosure Under Section 6114 or 7701(b), would be required, as claiming an FTC against the NIIT is a treaty position that modifies U.S. law, and it is not specifically waived from the disclosure requirement (see Sec. 6114 and Regs. Sec. 301.6114–1). As indicated above, the IRS is likely to disallow the credit while the cases are being litigated in court. If the claim for the credit is denied, the taxpayer may appeal the denial to the IRS but ultimately may not have much recourse other than to file their own refund suit in a federal court.

Option 2. File a protective refund claim: The statute of limitation on a refund claim related to an FTC is 10 years rather than the general three–year period (Sec. 6511(d)(3); Regs. Sec. 301.6511(d)-3(a)). A taxpayer may choose to file a protective refund claim for open tax years to preserve their right to a refund before the refund period expires. A protective refund claim is a claim that is “contingent on future events and may not be determinable until after the statute of limitations expires” (Chief Counsel Advice memorandum 200848045). The IRS will generally accept a protective claim even if a specific refund amount is not stated, so long as the claim is sufficiently clear to inform the Service of the nature of the claim and for which year(s) a refund is sought. However, the IRS has discretion in deciding how to process protective claims. The IRS may delay action on the protective claim until the contingency (pending litigation, in this case) is resolved or simply process the claim and disallow the refund (id.).

If the latter, the IRS will issue a certified notice of disallowance to the taxpayer that will start a two–year clock on the taxpayer’s right to file suit in U.S. district court or the Court of Federal Claims (Secs. 6532(a)(1) and 7422(a)). If this two–year period expires without a refund suit being filed and the taxpayer has not obtained an extension on the two–year clock by getting the IRS to sign a Form 907, Agreement to Extend the Time to Bring Suit, the taxpayer loses their right to obtain the refund, even if the taxpayer’s position ultimately prevails (Secs. 6532(a)(2) and 7422(a)).

Option 3. Wait and see: The last option for the taxpayer is to take no action other than to have the patience and willingness to wait out the judicial process. If a taxpayer–favorable ruling is decided, then the taxpayer may be allowed to claim a treaty–based FTC on their current return or amend a prior return for any tax year that is within the 10–year statute of limitation to claim a refund (see Sec. 6511(d)(3) and Regs. Sec. 301.6511(d)-3(a)).

Beyond Christensen and Bruyea

If the lower court’s rulings are upheld in the Federal Circuit and the government acquiesces, the IRS must modify certain forms and schedules to provide a way for taxpayers to claim a treaty–based FTC against the NIIT. Additionally, because a taxpayer’s NIIT is determined based on the lesser of the net investment income or the amount in excess of the statutory threshold (based on filing status), clarity around which category of FTC (e.g., general, passive, or a combination of both) applies to offset the NIIT would be needed (see Secs. 904 and 1411(a)(1); Regs. Secs. 1.861–20 and 1.904–6). Thus, even with a resolution of the controversy, until the IRS issues guidance concerning the treatment of a treaty–based FTC, uncertainty around proper application of the credit is likely to continue.

Editor Notes

Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.

For additional information about these items, contact Van Leuven at mvanleuven@kpmg.com.

Contributors are members of or associated with KPMG LLP.

The information in these articles is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of Section 10.37(a)(2) of Treasury Department Circular 230. The information contained in these articles is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. The articles represent the views of the authors only and do not necessarily represent the views or professional advice of KPMG LLP.