The Federal Circuit Court of Appeals, in Estate of Paul Bruyea v. United States and Christensen v. United States, held a tax treaty does not allow a US citizen living abroad to claim foreign tax credits (FTCs) to offset net investment income tax (NIIT) under IRC Section 1411.

Facts

In both cases, US citizens lived abroad and sold property: in Christensen, the taxpayer sold stock of a French company, while the taxpayer in Bruyea sold Canadian real property. The sales resulted in gains on which they owed taxes to the foreign countries and the United States, including NIIT. The taxpayers paid the taxes owed to both countries, including the NIIT.

Each later filed suit in the Court of Federal Claims, seeking a refund for the NIIT paid. Each argued that the NIIT was offset by a treaty-based FTC under the respective treaties.

The taxpayers filed motions for summary judgment in both cases, which the Court of Federal Claims granted. The court held in each case that Article 24 of the respective treaties entitles the taxpayers to an FTC to offset the NIIT. In Christensen, the court held that the French treaty allows an FTC to apply against NIIT because Article 24(2)(b) of the French treaty permits taxpayers to claim an FTC (subject to income and FTC sourcing limitations) that is independent of the Code. In Bruyea, the court held that Article 24(1) of the Canada treaty does not limit the type of tax eligible for a credit, so long as it was a US income tax. The government appealed.

For more information on the Court of Federal Claims decision in Bruyea, see Tax Alert 2024-2350. For more on the Court of Federal Claims decision in Christensen, see Tax Alert 2023-1890.

Holdings

The Code does not allow FTC to offset NIIT

The Federal Circuit Court of Appeals first looked to the Code to determine whether an FTC could offset the NIIT. The court observed that the Code allows FTCs to offset taxes in Chapter 1. Because the NIIT is contained in Chapter 2A, the court determined that IRC Sections 27 and 901(a) do not allow US taxpayers to credit the taxes paid to the foreign country against the NIIT, even when the NIIT is based on income that was already taxed by the foreign country.

Treaties do not create credit independent of the Code

In general, Article 24 of the treaties includes two provisions that allow a citizen or resident of the United States a credit against the United States tax on income paid in the foreign countries. The first provision (i.e., Article 24(1) of the US-Canada treaty and Article 24(2)(a) of the US-France Treaty), however, is contextualized by language that narrows the scope of the credit such that it must be "in accordance with the provisions and subject to the limitations of the law of the United States … " — the so-called US Law Limitation.

Under IRC Section 904(a), the FTC can only offset US tax on the portion of the income that is foreign sourced. The court observed that the treaties contain limitations, so that the same income is not credited twice under the sourcing rules. The treaties also include re-sourcing provisions under which certain US income is deemed as income from the foreign countries.

The court observed, in both cases, that the re-sourcing provisions overcome the IRC Section 904(a) limit "against applying a foreign tax credit to income from [US] sources." The court pointed out that the re-sourcing provisions would not have been necessary if the drafters of the treaties believed that the "treaty-created foreign tax credit operates independently of the Code." As a result, the court found that, through the US Law Limitation, the Code limits both credit clauses in the treaties, including the treaty clause that does not include the US Law Limitation.

The court also found problematic that the Court of Federal Claims holdings about the treaties' resourcing provisions would produce different outcomes for US citizens living abroad versus those living in the United States. It reasoned this would occur because those outside the United States could claim a credit against NIIT under the re-sourcing provision while those within the United States could not.

Accordingly, the court reversed the Court of Federal Claims and held that the Code and treaties prohibit the taxpayers from offsetting the NIIT with an FTC for income taxes paid in Canada (Bruyea) and France (Christensen). It held that the US Law Limitation applies to both treaty provisions, which provide relief from double taxation for US citizens and residents, and the US Law Limitation does not allow for the creation of an independent treaty-based credit.

Implications

With the Federal Circuit's companion decisions in Bruyea and Christensen, the government has now prevailed in every appellate and trial forum that has squarely addressed whether a treaty-based FTC can offset the NIIT. These rulings join the two decisions EY has previously highlighted as strong support for the IRS's position: the Tax Court's holding in Toulouse v. Commissioner, 157 T.C. 49 (2021) (see Tax Alert 2021-1544), rejecting a treaty-based FTC against the NIIT under the U.S.-France and U.S.-Italy treaties, and the U.S. District Court for the Central District of California's holding in Kim v. United States, 664 F. Supp. 3d 1062 (C.D. Cal. 2023), which applied similar reasoning to deny the credit under the US-Korea treaty. Together with the reversal of the two taxpayer-favorable decisions from the Court of Federal Claims, the weight of authority now runs decisively in the government's favor.

Protective refund claims can no longer be perfected. Taxpayers who filed protective refund claims to hold the statute open pending Bruyea and Christensen can no longer perfect them. The Federal Circuit's reversal removes the legal foundation on which those claims relied. The IRS is expected to deny any pending, protective or amended claims premised on a treaty-based FTC against the NIIT, so affected taxpayers should revisit these positions with their advisors.

Supreme Court review appears unlikely. The Federal Circuit's holdings are consistent with Toulouse and Kim, and no court of appeals has reached a contrary result. Should the taxpayers seek certiorari, the prevailing view is that it is unlikely the Supreme Court would grant it, as there is no circuit split.

A renewed challenge would require a different venue. Because Court of Federal Claims decisions are appealable exclusively to the Federal Circuit, that forum is now closed. Taxpayers wishing to relitigate would instead need to pay the NIIT, pursue a denied refund claim and file suit in the US district court where they reside — with any appeal going to a regional circuit court of appeals rather than the Federal Circuit. These taxpayers could not, however, argue for relief under a treaty re-sourcing provision (e.g., Article 24(2)(b) of the French Treaty) as those provisions generally only apply to US citizens residing in a treaty country. Instead, they would have to argue (like the taxpayer in Bruyea) that the US Law Limitation only informs how FTCs are computed for US tax purposes (and not whether a US income tax may be creditable). Only a contrary ruling from a regional circuit would create the split most likely to prompt Supreme Court review. As such, taxpayers should proceed with caution and consult their advisors.