Additional Comments on the Final §1411 Regulations

By Thomas S. Bissell, CPA  

Celebration, FL

As noted in a recent commentary by Kim Blanchard,1 Treasury and the
IRS issued final regulations under §1411 (the so-called "net
investment income tax" (NIIT)) in late November 2013. That
commentary discussed the applicability of the tax to controlled
foreign corporations (CFCs), passive foreign investment companies
(PFICs), and qualified electing funds (QEFs), and commented on the
regulations' failure to allow a foreign tax credit to be claimed
against the NIIT even in the context of an income tax treaty. This
commentary will outline most of the remaining international tax
issues that are covered by the final regulations.2 Apart from the
failure to allow a foreign tax credit under any tax treaty - a
failure that most commentators believe is patently incorrect - in
most instances the final regulations with respect to these other
international issues seem to conform fully with both the language
and the spirit of the statute.

Treaty Tie-Breaker Aliens  - Where an individual
is classified as a resident alien under §7701(b) but as a resident
of a foreign country under the "tie-breaker" rules in that
country's income tax treaty with the United States, Regs.
§301.7701(b)-7(a)(1) has provided for many years that the
individual is classified as a nonresident alien "for purposes of
computing that individual's United States income tax
liability."  The final regulations provide that this rule
applies for purposes of computing the NIIT. (The proposed
regulations had been silent on the issue.) As a result, the treaty
tie-breaker alien will be exempt from NIIT, because the NIIT is not
imposed on nonresident aliens.  (It is not absolutely clear
that this extremely pro-taxpayer result was compelled by the
language of §1411 itself.) Since Treasury and the IRS consider the
NIIT to be an "income tax" for purposes of the §7701(b)
regulations, it is difficult to see why it is not also an "income
tax" against which a foreign tax credit may be claimed under the
"relief from double taxation" provisions in U.S. income tax
treaties.

Part-Year Nonresident Aliens ("Dual-Status
Individuals")
- The final regulations provide that where an
individual is a nonresident alien during part of the year but a
U.S. citizen or resident alien for the balance of the year, the
NIIT is applied to the citizen/resident portion of the year,
without having to pro-rate the applicable dollar
threshold. Thus, if the individual is single, the $200,000
threshold is applied entirely to the portion of the year during
which he/she is a citizen or resident alien. The regulations state
that this is consistent with the rule elsewhere in the regulations
that does not require the threshold to be pro-rated where a
taxpayer has a taxable year of less than 12 months. However, the
Preamble to the final regulations states that "the Treasury
Department and the IRS may reconsider this rule if taxpayers are
applying it inappropriately."3

§6013(g) and (h) Elections - Subsections (g) and
(h) of §6013 allow a married couple to elect to file a joint return
in certain situations where at least one spouse is not a U.S.
citizen or resident alien for the entire year and the other spouse
is a U.S. citizen or resident alien at the end of the year. For
income tax purposes the effect is to impose U.S. tax on each
spouse's worldwide income. Because the drafters of the statutory
language of §1411 did not provide that a §6013(g) or (h) election
would also be effective for NIIT purposes, the final regulations
provide that the couple may elect, if they wish, for the §6013(g)
or (h) election to be effective for NIIT purposes as well. (The
proposed regulations had mentioned only §6013(g) taxpayers, but the
final regulations have extended this rule to cover §6013(h)
taxpayers as well.) The final regulations provide that if the
couple does not make the NIIT joint return election, a married
separate calculation must be done for each spouse. To the extent
that a spouse is a citizen or resident for part or all of the year,
NIIT may be imposed on that spouse after application of the
$125,000 married separate threshold.4

ForeignRetirement Plans - Because the proposed
regulations only exempted from NIIT distributions from
tax-qualified U.S. retirement plans, there was
concern that distributions from most foreign retirement plans might
be subject to NIIT as "annuities." The final regulations provide
that the term "annuities" does not include "amounts paid in
consideration for services rendered." They further clarify that
this exemption applies even though payments from the foreign plan
"include investment income that was earned by the plan." The term
"annuities" (which was not defined in the proposed regulations) is
defined in the final regulations to clarify that the term only
applies to investment-type products.

Foreign Social Security Payments -The final
regulations do not mention foreign social security payments, i.e.,
payments made directly or indirectly by a foreign government under
a system similar to the U.S. social security system. However,
presumably these payments will also be exempt from NIIT as amounts
paid by a foreign retirement plan in consideration for past
services.  This argument is bolstered by the fact that the
final regulations provide that U.S. social security
payments are exempt from NIIT. (The proposed regulations had not
mentioned U.S. social security payments.)

Social Security Totalization Agreements - Although
a U.S. citizen or resident alien may be exempt from U.S. social
security taxes under a social security "totalization" agreement,
those agreements only apply to "FICA" taxes under chapter 21 of the
Code (for employees) and to "SECA" taxes under chapter 2 (for
self-employed individuals). The final regulations are silent on the
applicability of U.S. totalization agreements to the NIIT,
presumably because Treasury and the IRS do not believe a
totalization agreement can exempt an individual from the NIIT
because it is imposed under chapter 2A, not under chapter 21 or 2.
In the future, however, it is possible that some foreign countries
having totalization agreements with the United States may seek to
renegotiate those agreements so as to cover the NIIT.

Expatriates Taxed Under §877A - If an individual
who gives up his/her U.S. citizenship or "green card" status is
classified as a "covered expatriate" under §877A, the individual is
treated as having sold certain assets at fair market value (i.e.,
on a "mark-to-market" basis) and as having received taxable
distributions from certain retirement plans. The final regulations
provide that the term "disposition" (which must exist in order for
an item to be potentially subject to NIIT) includes "a deemed
disposition, for example, under section 877A." (The proposed
regulations had not mentioned this issue.) The deemed disposition
that is taxed under §877A is imposed as of the last day on which
the individual is a citizen or resident; thus, it cannot be argued
that the NIIT cannot be imposed on an expatriating individual.
However, to the extent that a §877A individual is taxed on deemed
distributions from a U.S. or a foreign retirement plan (including a
U.S. Individual Retirement Account), presumably the broad exemption
for distributions from a U.S. tax-qualified plan and from most
foreign retirement plans would exempt those particular items from
NIIT.

§911 Exclusion and Possessions Exclusion - The
final regulations make no changes to the rules that apply to
individuals who claim the foreign earned income exclusion under
§911 or to the rules that apply to individuals resident in Puerto
Rico and the U.S. possessions (American Samoa, Guam, the Northern
Mariana Islands, and the U.S. Virgin Islands) (called "territories"
in the regulations). Thus, in calculating "modified adjusted gross
income" (MAGI), foreign-source earned income that is excluded under
§911(a)(1) must be added back (up to $99,200 for 2014), but the
housing exclusion of §911(a)(2) is not added back. With respect to
individuals resident in Puerto Rico and the U.S. possessions, the
final regulations make no changes. Thus, in practice the only
residents of Puerto Rico and the U.S. possessions who might be
subject to the NIIT are residents of Puerto Rico and American Samoa
who have significant income from outside their place of
residence.

This commentary also will appear in the March 2014 issue of
the
Tax Management International Journal.  For more
information, in the Tax Management Portfolios, see Klasing and
Francis, 918 T.M.
, Section 911 and Other International Tax
Rules Relating to U.S. Citizens and Residents,  and in Tax
Practice Series, see ¶3310, Computation of Tax -
Individuals.

 

  1 Blanchard, "International Aspects of the Final
§1411 Regulations," 43 Tax Mgmt. Int'l J. 120
(2/14/14). See also Blanchard and Bower, "The Application of §1411
to Income from CFCs and PFICs," 42 Tax Mgmt. Int'l
J.
 127 (3/8/13), which discusses the proposed regulations
under §1411 issued in December 2012. 

  2 The reader may wish to refer to this
commentator's outline of the principal international tax issues
that were covered (or not covered) by the proposed regulations, and
also to his comments on the foreign tax credit issue.
See Bissell, "International Aspects of the New §1411
`Additional Medicare Tax,'" 42 Tax Mgmt. Intl J. 95
(2/8/13), and Bissell, "Foreign Tax Credit Issues Under the New
§1411 `Additional Medicare Tax,'" 42 Tax Mgmt. Int'l
J.
 232 (4/12/13). 

  3 In the situation where an alien who owns highly
appreciated investment assets plans to move to the United States
and become a resident alien under §7701(b), the alien's U.S. tax
advisor often recommends that the alien sell some or all of the
appreciated securities in order to avoid the U.S. capital gains tax
that might otherwise be imposed if the sale takes place after the
move. (This recommendation assumes, however, that the alien will
not have to pay capital gains tax to a foreign country at a rate
that is equal to or higher than the U.S. tax rate.) In the reverse
situation where a resident alien who owns highly appreciated
investment assets plans to move out of the United States and become
a nonresident alien, the alien's U.S. tax advisor often recommends
that the alien postpone selling the appreciated securities until
after becoming a nonresident alien. (This, of course, assumes the
resident alien will not be subject to the expatriation regime of
§877A.) NIIT would not be imposed on the capital gains during the
nonresident alien portion of the year because that income would not
be included in the individual's adjusted gross income. However, a
pro-rating rule could expose additional income during the resident
alien portion of the year to the NIIT. 

  4 There are a number of fact patterns under both
subsections (g) and (h) of §6013 in which one or both spouses may
be a citizen or resident alien for only part of the year, and thus
potentially subject to NIIT for that portion of the year. 
Under §6013(g), one of the spouses must be a citizen or resident
alien at the close of the year (though not necessarily at the
beginning of the year), and in most (but not all) cases the other
spouse is a nonresident alien for the entire year (and thus exempt
from NIIT in the absence of the special NIIT joint return
election). Under §6013(h), one spouse must be a citizen or resident
alien at the close of the year (but not necessarily at the
beginning of the year) and the other spouse must be a resident
alien at the close of the year (and a nonresident alien at the
beginning of the year), so that NIIT might be imposed on both
spouses even in the absence of the special election.