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By Thomas S. Bissell, CPA
The new 3.8% "Additional Medicare tax"1 imposed under §1411 on certain high-income individuals took effect at the beginning of 2013, and in an effort to clarify numerous issues, the Treasury issued a voluminous set of proposed regulations a month ahead of the effective date.2 Although the proposed regulations deal with most of the relevant international tax issues, a few very important international tax issues remain open for future clarification.
Because of the multiplicity of international tax issues that can arise under §1411, this commentary highlights the principal ones in the paragraphs below. Future commentaries will elaborate on some of these issues.
Section 911 Addback. The tax is imposed on "net investment income" that is realized by: (1) couples filing jointly who have a "modified adjusted gross income" (MAGI) exceeding $250,000; and (2) individuals having a MAGI exceeding either $125,000 (for married couples filing separately) or $200,000 (for single individuals). MAGI is defined as adjusted gross income (AGI) plus statutory addbacks. Surprisingly, the only statutory addback is a portion of the amount excluded under §911 by U.S. citizens and resident aliens claiming the foreign earned income exclusion. (The maximum dollar exclusion has been increased to $97,600 for 2013.)3 Even more surprising, the §911 addback is limited to income excluded under §911(a)(1). Thus, the "housing cost amount" (if any) that is excluded under §911(a)(2) is not added back for MAGI purposes.
No Section 931 or Section 933 Addback. There is no similar addback of possessions-source income that is excluded under §931 for residents of American Samoa or under §933 for Puerto Rican residents. Thus, a resident of those possessions would only be subject to the §1411 tax if he realized substantial income from sources outside the possession where he is resident, i.e., if he had MAGI from outside the possession that exceeded the dollar threshold amount. If his non-possession-source MAGI did exceed the threshold amount, however, it appears that his worldwide net investment income - including investment income from within the possession - would be subject to the §1411 tax (although it would remain excluded for §1 purposes).
Mirror Code Possessions. The regulations clarify that, in the case of residents of the other three U.S. possessions, all of which have so-called "mirror" Codes - Guam, the U.S. Virgin Islands, and the Northern Marianas - the §1411 tax will not apply because it has not been imposed by Congress on those three possessions, and because residents of those possessions pay income tax on their worldwide income to the government of the possession where they are resident.
Part-Year Nonresident Aliens. Section 1411(e)(1) exempts a "nonresident alien" from the §1411 tax. The proposed regulations confirm that the term "nonresident alien" is determined in accordance with the "resident alien" definitional rules of §7701(b). However, the regulations give no guidance on how to apply §1411 when an individual is a U.S. citizen or resident alien for part of the year, and a nonresident alien for the balance of the year. Presumably, only net investment income realized during the part of the year when he is a citizen or resident is potentially subject to the §1411 tax. In addition, presumably it will also be necessary in this situation to pro-rate the $200,000 or $125,000 threshold in some manner between the nonresident alien part of the year and the balance of the year.
Treaty Tie-Breaker Aliens. The regulations do not discuss the status of so-called "treaty tie-breaker aliens" who are classified as resident aliens under §7701(b), but who are also classified as income tax residents of a country having an income tax treaty with the United States under the "tie-breaker" rules of the treaty (under Article 4 of most income tax treaties and under Article 4 of the 2006 U.S. Model Income Tax Treaty). Regs. §301.7701(b)-7(a)(1) provides that a tie-breaker alien will be classified as a nonresident "for purposes of computing that individual's United States income tax liability under the provisions of the Internal Revenue Code and the regulations thereunder … ." Thus, whether a treaty tie-breaker alien is exempt from the §1411 tax probably depends on whether the §1411 tax is an "income tax" within the meaning of U.S. income tax treaties.
Income Tax Treaties. Most U.S. income tax treaties concluded since the 1970s have provided that "social security taxes" are not considered to be "income taxes" for treaty purposes. The U.S. Treasury's Technical Explanation of the 2006 U.S. Model confirms that this exclusion covers the "SECA" tax under §1401 and the "FICA" taxes under §§3101 and 3111, and it explains that the reason for excluding U.S. social security taxes as taxes "covered" by U.S. income tax treaties is that exclusions for those taxes are instead dealt with in the United States' social security "totalization" agreements.
Social Security Totalization Agreements. The United States has a number of social security totalization agreements in effect with other countries, but those agreements provide that the only U.S. taxes covered by the agreements are the SECA tax in chapter 2 (§§1401 ff.) and the FICA taxes in chapter 21 (§§3101 ff.).4 Because the new "Additional Medicare tax" in §1411 is imposed under new chapter 2A of the Code, it is not covered by the social security totalization agreements. Based on the language of the U.S. Treasury's Technical Explanation for excluding social security taxes from coverage under U.S. income tax treaties, therefore, a strong argument can be made that the §1411 tax should be classified as an "income tax" for treaty purposes, and thus that a treaty tie-breaker alien should be exempt from the tax.
Foreign-Source Pensions. The term "net investment income" is defined in §1411(c)(1)(A)(i) to include "annuities," but §1411(c)(5) provides an exception for distributions from tax-qualified retirement plans under §§401 ff.. Because it is extremely unusual for a foreign pension plan to qualify under §§401 ff., this raises the question as to whether periodic payments from a foreign pension plan can be taxed under §1411. The proposed regulations seem to take an extremely narrow "pro-taxpayer" position to the effect that the term "annuities" includes only payments pursuant to annuity contracts issued by an insurance company. Thus, it is possible that a periodic pension (either for life or for a term certain) from a foreign pension plan that is not U.S.-tax-qualified will only be taxable under §1411 if it is paid by a foreign insurance company. However, the vagueness of the term "annuities" in the statute itself may give the IRS scope to expand the term to include periodic payments made out of other types of foreign funding vehicles (such as pension trust funds). The proposed regulations do state, however, that deferred compensation paid directly by an employer is not net investment income. Thus, in an international context this exception would probably include "top-up" payments made directly as a retirement annuity by a foreign employer, or pensions paid from a "book reserve" plan that is treated for U.S. tax purposes as if made directly by the employer itself.
Foreign Government Pensions. If a foreign pension is paid by the government of a tax treaty country but is paid in a manner that the IRS considers to be taxable under §1411, the pension might nevertheless be exempt from tax under an income tax treaty. Under Articles 1 and 19 of the 2006 U.S. Model Treaty, a pension paid by a foreign government to a U.S. citizen or resident is exempt from U.S. income tax if certain tests are met. Whether the pension paid by the foreign government would be excluded under §1411 as well as under §1 would thus depend on whether the §1411 tax was a tax "covered" by the treaty, as discussed above.
Foreign Social Security Benefits. The question also arises as to whether social security benefits paid by a foreign government might be taxed under §1411 as "annuities." The proposed regulations do not provide that U.S. social security benefits are classified as taxable "annuities." However, the manner in which social security benefits are disbursed by particular foreign countries could make them potentially subject to the §1411 tax. In this regard, a number of tax treaties provide that social security benefits paid by the treaty country to a U.S. citizen or resident are exempt from U.S. income tax.5 Thus, this issue seems to be the same as that discussed immediately above with respect to pensions paid by foreign governments, i.e., whether a treaty exemption from the §1 tax will also exempt the same income from the §1411 tax.
Other Treaty Income. The author is unaware of any U.S. income tax treaties that provide for an exclusion of other types of "net investment income" (primarily interest, dividends, annuities, royalties, rents, and gains from non-business assets) where the income is realized by a U.S. citizen or resident alien. Thus, those types of foreign-source income seem to be subject to the §1411 tax, whether realized from a treaty country or from a non-treaty country.
Foreign Real Estate. Where an individual owns real property in a foreign country, whether "rents" or gains from the sale of the property are subject to the §1411 tax is determined under the regular income tax rules. Thus, if foreign-source rental income is not actually subject to §1 tax because allowable deductions exceed the gross rents, no §1411 tax should be imposed. If the property is sold at a gain, whether the gain would qualify for the "trade or business" exemption in §1411(c) would depend on the precise facts. If the gain is deemed to be "passive," it should be subject to the §1411 tax.
CFCs and PFICs. The proposed regulations contain detailed rules that apply to controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs). In effect, income of a CFC that is included in a U.S. shareholder's gross income as Subpart F or similar income under §951 is not taxed as such under §1411 because it does not constitute a "dividend." When the CFC's income is subsequently paid out as a dividend, however, it is subject to the §1411 tax, even though it may be excluded from gross income for §1 purposes as "previously taxed income" under §959. (The proposed regulations also include conforming provisions for §1248 purposes.) In addition, the upward basis adjustment in the CFC stock (to reflect the Subpart F inclusion) is ignored for §1411 purposes, so that the subsequent sale of the CFC stock can generate taxable capital gain for §1411 purposes but not for §1 purposes. Similar rules are applied for PFIC purposes where the U.S. shareholder in a PFIC makes a so-called "qualified electing fund" (QEF) election and thus includes the PFIC's underlying income in his gross income for §1 purposes, but receives no current income from the PFIC in the form of dividends or gains from the sale of the PFIC stock. Thus, where a QEF election is made, the resulting inclusion in income is not treated as income subject to the §1411 tax. The proposed regulations provide, however, that the taxpayer may make an election to treat Subpart F and related income, and/or QEF income, as if it were subject to §1411, and thereby pay the §1411 tax currently before an actual dividend is paid.
CFC Planning. The CFC rules under §1411 may offer some limited tax planning for resident aliens who may plan to move out of the United States in a future year and resume their nonresident alien status, provided that they can avoid the anti-expatriation rules of §877A. If the alien realizes substantial foreign-source interest income that is exempt from foreign withholding tax, the interest income might be exempted from the §1411 tax if it is realized in the form of Subpart F income of a CFC and is not distributed as a dividend to the owner of the CFC until after he has resumed nonresident alien status.6
Section 6013(g) Elections. The proposed regulations provide very interestingly that if a nonresident alien spouse makes a so-called joint return election under §6013(g), the election will not be effective for §1411 purposes unless the nonresident alien spouse also elects to be subject to §1411. If the nonresident alien spouse does not make a §1411 election, then the other spouse (who is a U.S. citizen or resident alien) would be subject to a married filing separate filing threshold of only $125,000, but if the nonresident alien spouse does make a §1411 election, the regular $250,000 threshold for joint filers would apply.
Section 6013(h) Elections. Although the proposed regulations contain detailed rules on §6013(g) joint return elections, they do not discuss joint return elections under §6013(h). That subsection allows a joint return election to be made for the year if one spouse is a citizen or resident at the end of the year, and the other spouse was a nonresident alien at the beginning of the year but is a resident alien at the end of the year. Because a §6013(h) election is not effective for §1411 purposes, the "split year" issue discussed above for part-year nonresident aliens will arise - unless, of course, the IRS provides in future regulations that the couple may elect for the §6013(h) election to be effective also for §1411 purposes (and the couple makes such an election).
Foreign Tax Credit Issues. Section 1411 does not provide that a foreign tax credit may be claimed for any foreign tax imposed on foreign-source net investment income. If the §1411 tax is in fact "covered" by some (or all) U.S. income tax treaties, it is possible that an argument can be made under those tax treaties that a foreign tax credit should be allowed. In many cases, however, any foreign withholding tax imposed on an individual's foreign-source investment income would be fully credited under §901 against his regular §1 tax.
This commentary also will appear in the February 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 The new tax is officially called the "Unearned Income Medicare Contribution", which is the title of new chapter 2A of the Code, under which the tax is imposed. The tax was enacted by §9015 of the Patient Protection and Affordable Care Act, P.L. 111-148. The IRS website refers to the tax as the "Additional Medicare tax," and much of the financial press refers to it simply as the "Medicare tax on unearned income."
3 Section 1411(d) provides that the addback is equal to the amount excluded under §911(a)(1) minus the amount of any deductions or exclusions that were disallowed under §911(d)(4) as the result of claiming the §911(a)(1) exclusion.
6 Such an arrangement would work less well with respect to investments in the stock of foreign companies, however, because realizing dividends or capital gains through a CFC would result in: (1) the possible loss of a lower treaty rate on dividends; (2) the loss of a direct foreign tax credit for any foreign dividend withholding tax (and its replacement with a "dividend effect"); and (3) the likely conversion of long-term capital gain income into ordinary income, taxable as ordinary Subpart F income instead of as long-term capital gain eligible for the lower U.S. capital gains rate. See the discussion in Bissell, 903 T.M., Tax Planning for Portfolio Investment into the United States by Foreign Individuals, at VIII, B, 2.
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