Foreign Tax Credits Under Treaty May Reduce Net Investment Income Tax

In a decision that could benefit U.S. citizens living abroad, a recent U.S. court ruling has further opened the door for using treaty-based foreign tax credits (FTCs) to reduce Net Investment Income Tax (NIIT) liability. While the outcome is promising, the issue remains unsettled, and taxpayers should proceed cautiously. 

Court Sides with U.S. Taxpayers in Canada 

On December 5, 2024, the U.S. Court of Federal Claims ruled in favor of a U.S. citizen residing in Canada who sought to apply for foreign tax credits—under the U.S.-Canada tax treaty—against his NIIT liability for the 2015 tax year. The taxpayer had already paid substantial income tax to Canada and successfully argued that, under Article XXIV of the treaty, foreign taxes should offset regular U.S. income tax and the additional 3.8% NIIT. 

This is significant because, under U.S. domestic law, FTCs cannot be used to reduce NIIT.  

The background of NIIT 

The NIIT is governed by Section 1411 of the Internal Revenue Code, which falls outside the provisions (Sections 27 and 901) that usually allow FTCs. However, recent court cases have  successfully utilized tax treaties as a workaround to the restriction. 

The most recent case, Bruyea v. The United States, found that the treaty’s purpose—avoiding double taxation—supports allowing FTCs against the NIIT, even if the Internal Revenue Code doesn’t. In this case, the Court determined that Article XXIV of the U.S.-Canada treaty provides a self-executing credit that isn’t limited by U.S. domestic law in the way the IRS claimed. 

Why This Matters 

This decision could reduce exposure to double taxation on investment income for U.S. citizens living abroad in treaty countries. The ruling provides a potential path for high-net-worth individuals, especially those in tax-equalized employment arrangements, to reduce their overall U.S. tax liability by applying FTCs more broadly than previously allowed. 

Importantly, this only applies when the taxpayer resides in a country with an income tax treaty that supports this interpretation, such as Canada or France. In this case, the taxpayer was a U.S. citizen and Canadian resident who had paid nearly $2 million in Canadian taxes. When he amended his return to apply the FTC to NIIT, the IRS denied it, prompting a legal challenge that has now succeeded in court. 

However, the IRS is expected to appeal. Until that process plays out, refund claims based on this argument may be delayed or denied. 

Other Relevant Cases 

This is not the only recent court case exploring this issue. In Christensen v. United States, the Court ruled in favor of a U.S. couple living in France who used the U.S.-France income tax treaty to reduce their NIIT liability. In this case, the Court found that specific language in Article 24(2)(b) of the treaty does not limit FTCs to domestic tax rules. This opened the door for treaty-based FTCs to offset the NIIT for U.S. citizens living in France. 

In the Toulouse v United States decision, the Tax Court sided with the IRS, rejecting the use of FTCs against the NIIT under Article 24(2)(a) of the U.S.-France treaty. A clear distinction to note is that the application of Article 24(2)(b) of the French Treaty was not considered as a route for relief by the petitioner. 

Important Takeaways for Taxpayers 

• There is no provision in the Internal Revenue Code for a foreign tax credit against NIIT. 

• Forms 1116, Foreign Tax Credit, and 8960, Net Investment Income Tax Individuals, Estates, and Trusts, do not have designated areas to allow for a FTC against NIIT. 

• Certain tax treaties may provide an exception, depending on the specific language of the treaty and the taxpayer’s residency. 

• U.S. citizens residing in Canada and France may be open to reducing NIIT with treaty-based FTCs—at least for now. 

• The IRS is appealing these cases, and outcomes may change. 

What Should You Do? 

If you are a U.S. citizen living abroad and believe this may apply to you, consider speaking with a qualified tax advisor.  Each treaty is different, and whether you can benefit depends on your residency and the specific language in the applicable treaty. 

We will continue monitoring the developments and providing updates as the appeals progress. If the courts continue to side with taxpayers, this could significantly shift how international tax credits are applied under treaty law.