Can U.S. Taxpayers Claim Foreign Tax Credits Against NIIT on Capital Gains?

Treasury Regulations Section 1.1411-1(e) states that no foreign tax credits are permitted to offset Net Investment Income Tax (“NIIT”) (emphasis added):

“Amounts that may be credited against the tax imposed by Chapter 1 of the Internal Revenue Code may not be credited against the Section 1411 tax imposed by Chapter 2A of the Internal Revenue Code unless specifically provided in the Internal Revenue Code. For example, the foreign income, war profits, and excess profit taxes that are allowed as a foreign tax credit by Section 27(a), Section 642(a), and Section 901, respectively, are not allowed as a credit against a Section 1411 tax.”

Although the Treasury Regulations do not permit foreign tax credits to offset the NIIT. Income tax treaties have their own tax credit provisions. Income tax treaties are valid federal law to the same extent as the Internal Revenue Code and its regulations. Sometimes provisions of the Internal Revenue Code and tax treaties conflict and tax litigation follows.

In Toulouse v. Commissioner, 157 T.C. 119 (2021), Christensen v. United States, 169 Fed. CL. 566 (2023), and Bruyea v. United States, 175 Fed. Cl. 148 (2024) the Tax Court and Court of Federal Claims addressed the issue if tax treaties permit a foreign tax credit against NIIT.

In Christensen v. United States, the Court of Federal Claims held that U.S. citizens living outside the United States can claim a foreign tax credit against their U.S. federal NIIT  under the U.S.- France income tax treaty. The NIIT applies at a rate of 3.8% to certain net investment income of individuals, estates, and trusts that have income above the statutory threshold amounts. The Court of Claims opinion contradicts a 2021 decision Tax Court decision in Toulouse v. Commissioner, 157 T.C. 49 (2021). In Toulouse, the Tax Court reached an opposite conclusion.

In Toulouse, a U.S. citizen residing in France claimed a foreign tax credit to offset NIIT. The NIIT is imposed by Section 1411 of the Internal Revenue Code. Toulouse claimed foreign tax credits from Italy and France to offset her NIIT under the U.S. tax treaties with Italy and France. Toulouse took the position that both treaties state they cover all federal income taxes imposed by the Internal Revenue Code and the addition of the NIIT to the Internal Revenue Code did not change the “general principles of U.S. tax laws.”

The Tax Court held that foreign tax credits are provided under Sections 27 and 901 of the Internal Revenue Code. Section 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 tax imposed by this chapter shall … be credited” essentially with taxes paid to foreign countries. Sections 27 and 901 are both part of Chapter 1 of the Internal Revenue Code. However, the NIIT is imposed under Internal Revenue Code Section 1411, which is part of Chapter 2A of the Internal Revenue Code. As a result, the Tax Court determined that the foreign tax credit of Section 901 is not avoidable to offset non-Chapter 1 taxes.

Toulouse attempted to argue around this statutory barrier by claiming that the tax treaties with France and Italy provide an independent basis for applying a foreign tax credit against the NIIT. Article 24(a) of the U.S.-France income tax treaty and Article 23(2)(a) of the U.S.-Italy income tax treaty that “[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).” Toulouse believed the wording of the treaties provided an independent basis for a credit against NIIT tax provided for in Section 1411. The Tax Court disagreed.

The individuals in Christensen were U.S. citizens residing in France claimed a foreign tax credit against their NIIT liability on an amended tax return. The Internal Revenue Service (“IRS”) denied the foreign tax credit against the NIIT because it falls outside of Chapter 1 of the Internal Revenue Code. Treasury Regulation 1.1411-1(e) provides that no foreign tax credit is permitted against NIIT because Sections 27 and 901 restrict foreign tax credits to income tax found under Chapter 1. The Court of Claims analyzed whether the U.S.-France income tax treaty provided for a foreign tax credit.

The U.S.-France income tax treaty applies to “income taxes imposed by the Internal Revenue Code” and provides for foreign tax credits under two separate paragraphs in Article 24. Under Article 24(2)(a), foreign tax credits are permitted only “in accordance with the provisions” and “subject to the limitations of the law of the United States.” The Court of Claims agreed with the Tax Court and conceded that these restrictions would preclude a foreign tax credit a foreign tax credit against NIIT because a foreign tax credit is only permitted against a Chapter 1 tax. However, the Court of Federal Claims determined that a foreign tax credit should be permitted under Article 24(2)(b) because Article 24(b)(2) does not include any restriction that the credit be permitted “in accordance with the provisions” and “subject to the limitations of the law of the United States.”

The Court of Claims’ decision can be interpreted to permit U.S. persons that are residents of France (and possibly Italy) to claim a foreign tax credit under the U.S.- France income tax treaty for French income tax assessed on passive income to offset U.S. NIIT.

The court dismissed arguments that such a ruling went against Congressional intent in putting NIIT in a separate chapter, ruling that there are two separate regimes for allowing foreign tax credits: the statutory credits allowed under Sections 27 and 901 and treaty-based foreign tax credits that are not subject to the limitation of the Internal Revenue Code unless the terms of the treaty mentions as such.

In 2024, the Court of Claims held in Bruyea v. United States that the taxpayer can utilize the U.S.-Canada income tax treaty to claim a foreign tax credit against his NIIT liability.

The Department of Justice has appealed both decisions of the Court of Claims. In the meantime, the Christensen and Bruyea cases create a split of authority between the United States Tax Court and Court of Federal Claims. The Christensen and Bruyea cases are on appeal before the Court of Appeals for the Federal Circuit.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. As a domestic and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.