By Thomas S. Bissell, CPA
As noted by this author in a commentary that provided an overview on the international aspects of the new 3.5% "Additional Medicare Tax" on "net investment income" (NII) of certain individuals,1 the law does not provide that the tax may be reduced by a foreign tax credit (FTC) for the U.S. dollar value of the foreign income taxes that are imposed on NII. This commentary explores the possibility that a FTC might be claimed against the §1411 tax under the provisions of an income tax treaty.
There are three principal factual situations in which the issue as to the availability of a FTC might arise:
1. A U.S. individual resident in the United States realizes foreign-source NII (typically, interest or dividends) that is subject to foreign withholding tax under the laws of the foreign country where it arises. This income is subject to the 3.8% §1411 tax, as well as the regular §1 tax.2
2. A U.S. individual resident in a foreign country realizes foreign-source NII that is subject to a foreign income tax rate higher than the individual's effective U.S. income tax rate. Again, the income is subject to the 3.8% §1411 tax (as well as the §1 tax).
3. A U.S. individual resident in a foreign country realizes U.S.-source NII that is subject to the foreign country's income tax, as well as to U.S. income tax under §1. The income is also subject to the 3.8% §1411 tax.
Situation 1. In this example it is likely that a U.S. resident individual who is subject to the §1411 tax will be able to claim a full FTC against his regular §1 income tax for the foreign withholding tax imposed on his foreign-source NII, because the effective rate of his U.S. income tax is likely to be higher than the rate of the foreign tax on the same income. If the foreign tax is not fully creditable, however, the question arises as to whether the "excess" foreign tax may be credited against the §1411 tax on the same income.
Because §1411 does not include any FTC provisions, and because the §901 FTC may only be claimed against the regular income tax imposed under §1, under the Code it does not appear that any portion of the foreign tax could be claimed against the §1411 tax. However, if the NII is from a country having an income tax treaty with the United States, an argument may be available that the excess foreign taxes may be credited against the §1411 tax. It must first be determined whether the foreign tax may be credited against the §1411 tax under the terms of the applicable treaty and, if so, it must then be determined whether the enactment of the §1411 tax in 2010 "overrode" the provisions of all existing tax treaties that might otherwise have allowed the credit to be claimed.
In considering the first question, it must be determined whether the §1411 tax is a tax "covered" by the treaty and, if so, whether foreign taxes may be credited against it under the terms of the treaty. The U.S. Treasury's 2006 Model Income Tax Treaty (U.S. Model), which contains language that has been incorporated into most U.S. income tax treaties, provides that U.S. taxes that are "covered" by the treaty include "the Federal income taxes imposed by the Internal Revenue Code (but excluding social security and unemployment taxes)." Although the exclusion for "social security taxes" clearly includes the "FICA" tax on employers/employees and the "SECA" tax on self-employed individuals, it is not as clear whether it includes the §1411 tax (which is described in the statute as the "Additional Medicare Tax"), which is imposed under new chapter 2A of the Code (which is part of Subtitle A - Income Taxes) and does not directly or indirectly enhance the taxpayer's Social Security benefits that arise as the result of having paid FICA or SECA.3 If it is correct that the §1411 tax is in fact a tax "covered" by the model treaty, a FTC against the tax may well be provided under the "Relief from Double Taxation" provisions of Article 23(2), which provides that "the United States shall allow to a resident or citizen of the United States as a credit against the United States tax imposed on income applicable to residents and citizens (a) the income tax paid or accrued to [the treaty country] by or on behalf of such resident or citizen… ."
Although Article 23(2) of the U.S. Model in principle seems to allow a FTC against the §1411 tax in Situation 1, the paragraph also states that the credit is to be allowed "[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) … ." The Treasury's Technical Explanation expands on this language with a discussion of the provisions of §§901-908, which happen to provide for a FTC only against the regular §1 tax on the income of a U.S. citizen or resident alien. However, if a FTC is clearly available against the §1411 tax, presumably the IRS could adapt the FTC limitation principles of §904 so as to apply to both the §1 tax and the §1411 tax taken together.
If a FTC may be claimed against the §1411 tax under Articles 2 and 23(2) of the U.S. Model, it is more difficult to determine whether Congress may have overridden the FTC provisions of the treaties when it enacted the §1411 tax in 2010. There was certainly no discussion of the treaty issue in the legislative history. Thus, the only guidance on the issue appears to be in the very general language of §7852(d)(1) (as amended in 1988), which provides that neither the Code nor a treaty is to have "preferential status" - thus giving rise to the so-called "later in time" doctrine, such that where the intention of Congress whether or not to override a treaty cannot be determined, the language of the most recently enacted or ratified provision should prevail. This "rule" would suggest that because the legislative history of §1411 is silent on the FTC issue, Congress may have intended to override all pre-existing treaties that might have been construed as allowing a FTC to be claimed against the §1411 tax.4
Situation 2. In this example a U.S. citizen is resident in a tax treaty country5 and realizes NII that is sourced in that country and taxed by it. Because most tax treaty countries impose personal income tax rates at effective rates that are higher than the U.S. income tax rates, it is assumed that the effective rate of the treaty country's tax on the NII is more than the combination of the individual's §1 income tax and his 3.8% §1411 tax on the item of NII. Thus, the individual realizes "excess" FTCs against his §1 tax that he would like to credit against his 3.8% §1411 tax.
The analysis for this example is the same as for Situation 1. Thus, if the §1411 tax is a tax "covered" by the treaty and is available to be reduced by the treaty country's income tax on the item of NII (under the treaty's version of U.S. Model Article 23(2)), and if it is concluded that Congress did not override the treaty when it enacted §1411, then the FTC may be claimed against the §1411 tax as well as against the §1 tax. So long as the effective foreign tax on the item of NII is more than the combined U.S. tax rate (i.e., the combination of the effective rate under §1 plus the 3.8% rate under §1411), full relief against the §1411 tax would be available.
Situation 3. This example is more complex, because the U.S. citizen who is resident in the treaty country realizes NII that is sourced within the United States. Although most countries having income tax treaties with the United States tax their residents on their worldwide income, a number of countries have so-called "expatriate" tax regimes that may often be utilized by U.S. citizens resident in those countries to avoid the country's income tax on their U.S.-source investment income.6 It is assumed in this example, however, that the U.S. citizen is subject to the treaty country's income tax on his U.S.-source NII. It is also assumed (as noted above) that because most treaty countries impose personal income tax on their residents at higher effective rates than does the United States, the income tax imposed by the treaty country on the individual's U.S.-source NII is at a high enough rate so as to generate excess FTCs that the U.S. citizen would like to credit against the 3.8% §1411 tax on the NII.
Calculating the U.S. citizen's FTC under the treaty in this example can be quite complex. It is assumed for discussion purposes that the applicable treaty has incorporated the rules contained in Article 23(4) of the 2006 U.S. Model. Those rules provide in effect that the United States may collect the amount of withholding tax (if any) that would have been imposed on the U.S.-source income if it had been realized by a non-U.S. citizen resident in the treaty country (thus, in the case of U.S.-source interest or portfolio capital gains, that rate will usually be zero, and in the case of dividends it will usually be 15%). The treaty then permits the foreign country to impose its full income tax on the item of U.S.-source income, but minus a FTC for the amount of hypothetical withholding tax that the United States may collect. If the treaty country's pre-credit effective tax rate is higher than the effective U.S. rate under §1 (as would usually be the case), the United States may not collect additional tax on the item, but if the treaty country's effective rate is lower than the effective U.S. rate, the United States may collect additional tax to the extent that it exceeds the effective foreign rate. A complex "re-sourcing" calculation is done in order to achieve this result.
The Treasury Explanation of Article 23(4) contains two very helpful examples that illustrate all steps in this calculation. Both examples assume that the hypothetical U.S. withholding tax on a treaty country alien is 15%, and that the effective U.S. tax rate under §1 is 35%. The first example then assumes that the effective foreign tax rate is 25%, and the second example assumes that it is 40%. In both examples the United States is permitted to collect and keep 15% from the U.S. citizen who resides in the treaty country, but only in the first example is the United States permitted to impose additional tax on the income (at the effective rate of 10%, which equals the 35% U.S. rate minus the 25% foreign rate). In the second example, the balance of the U.S. tax (which equals 20%, calculated as the 35% U.S. rate minus the 15% hypothetical U.S. withholding tax) is eliminated by a credit for the treaty country's tax on the income.
If a FTC may be claimed against the §1411 tax in this example, the two examples in the Treasury Explanation would simply be revised so as to increase the effective U.S. tax rate from 35% to 38.8%. Thus, in the first example (where the foreign rate is 25%), no FTC could be claimed against the §1411 tax, although possibly excess foreign taxes could be carried back and forward.7 However, in the second example (where the foreign rate is 40%), the foreign tax could be fully credited against the combined §1 and §1411 taxes.
Alternatives If No FTC Is Available. As discussed above, if a treaty FTC may be claimed against the §1411 tax, the FTC is primarily likely to benefit individuals in Situations 2 and 3 (i.e., U.S. individuals who are resident in the treaty country rather than in the United States). If the FTC may not be claimed - for example, either because the treaty language does not support the FTC argument or because the treaty was overridden by the §1411 legislation - there is probably little that the U.S. individual who is resident in the treaty country can do so as to reduce the effect of the new tax. If he chose to "lobby" the government of the foreign country to amend its tax law so as to allow a FTC against its personal income tax on U.S.-source NII in Situation 3, the country's tax authorities are unlikely to be interested, because the §1411 tax will not affect its residents unless they happen to be U.S. citizens.8 Alternatively, he might request the treaty country to renegotiate its treaty with the United States so as to expressly allow a FTC to be claimed against the treaty country's own income tax for the §1411 tax in both Situations 2 and 3. However, many countries may be reluctant to do that simply in order to make the country's international tax regime slightly more hospitable to U.S. expatriates. Thus, the most practical alternative available to the individual in Situations 2 and 3 may be to change his investment portfolio so as to reduce the amount of his income that is subject to the §1411 tax.
This commentary also will appear in the April 2013 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 See Bissell, "International Aspects of the New §1411 `Additional Medicare Tax' ", 42 Tax Mgmt. Int'l J. 95 (2/8/13). The tax is imposed generally on U.S. citizens and resident aliens with adjusted gross incomes exceeding certain threshold levels ($250,000 for a couple filing a joint return, $200,000 for a single individual, and $125,000 for a married individual filing separately). The tax is not imposed on nonresident aliens.
2 All references in this commentary to the "§1 tax", including in the discussion of FTCs claimed under §§27 and 901 against the §1 tax, should be read as also including the alternative minimum tax (AMT) imposed under §55.
4 In Gifford and Berg, "Americans Living Abroad Face Double Taxation in 2013," Tax Notes 869 (2/18/13), the authors point out correctly that §7852(d)(2) provides that treaties that were in effect in 1954 still prevail over all inconsistent U.S. legislation that has been subsequently enacted. They cite the example of the U.S. income tax treaty with Greece, which became effective in 1950 (and which has not been revised since then), and suggest that excess Greek income taxes may be credited against the §1411 tax under the provisions of that treaty. However, because the "taxes covered" language in Article I of that treaty and the FTC language in Article XIV are much more restrictive than the language in Articles 2 and 23 of the 2006 U.S. Model, this author questions whether excess Greek income taxes may in fact be credited against the §1411 tax under the terms of the U.S.-Greece treaty.
5 U.S. permanent residents (so-called "green card" holders) who are resident in a treaty country would usually be considered a resident of the treaty country under the treaty "tie-breaker" clause. Thus, only U.S. citizens are considered in Situations 2 and 3.
7 Because a FTC against the §1411 tax does not exist in the Code, details such as whether the carryback or carryforward of excess foreign taxes is allowed would need to be determined on the basis of the treaty language itself.
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