top of page
Search
  • Writer's pictureDaniel Gray CPA

The evolving practitioner dilemma if NIIT is an Income or Social Security Tax or neither

See this 02-01-2023 article by Wooyoung Lee and Nina Krauthamer Ruchelman PLLC


BACKGROUND

Congress enacted the N.I.I.T. in 2012 as part of a 2010 law amending the Affordable Care Act ("A.C.A."), more popularly known as "Obamacare." Its creation corresponded to a 0.9% increase in the Medicare tax, which is imposed on wages and self-employment income. With the increase in tax on earned income, Congress wanted a parallel tax on unearned income and capital gains.


The N.I.I.T. is a 3.8% tax on a taxpayer's investment income, broadly equivalent to passive income. This includes income from interest, dividends, annuities, royalties, and rents. It also is imposed on capital gains. The, although the N.I.I.T. does not tax investment income that is not otherwise included in Federal gross taxable income. Individuals are subject to the tax if their income is above certain thresholds. For 2023, the thresholds are $200,000 for single filers and $250,000 for married taxpayers filing jointly.


The N.I.I.T. applies to individuals, estates, and trusts. Individuals who are neither U.S. citizens nor U.S. residents for income tax purposes of the U.S. are exempt from the tax.1 U.S. citizens who reside abroad are subject to the N.I.I.T. in addition to U.S. income tax. They also may be subject to income tax in the country where they reside. U.S. tax law provides no statutory relief from the N.I.I.T. for such taxpayers. The N.I.I.T. is due and the position of the I.R.S. is that the N.I.I.T. cannot be reduced by a foreign tax credit and may or may not be eliminated by a Social Security Totalization Agreement.


This article addresses recent experiences of U.S. citizens resident abroad when computer-generated tax returns provide no relief that can reduce the N.I.I.T


TAX TREATIES AND FOREIGN TAX CREDITS

U.S. citizens or green card holders who have connections to multiple countries through citizenship or residence may find themselves subject to tax in more than one country with regard to the same item of income. Where that occurs relief may be available under the foreign tax credit of U.S. domestic law or an applicable income tax treaty. Both provide for a foreign tax credit. With limited exceptions that vary among treaties, all U.S. treaties provide that the limitations of the foreign tax credit under U.S. tax law control the application of foreign tax credit relief under treaty. In either event, the principle is simple: U.S. taxpayers should be taxed only once on an item of income rather than twice or not at all.

Despite the N.I.I.T.'s name as well as its location in Subtitle A (Income Taxes), the foreign tax credit provisions of income tax treaties do not provide relief against the N.I.I.T. The mechanics of the foreign tax credit rules in the U.S. limit the scope of relief granted by tax treaties. U.S. tax law allows a foreign tax credit, but it provides relief only for taxes imposed by Chapter 1 of the Internal Revenue Code of 1986, as amended (the "Code").2 Regrettably for taxpayers, the N.I.I.T. is a tax that appears in Chapter 2A of the Code. Consequently, regulations issued by the I.R.S. under the N.I.I.T.3 disallow credits that can be taken against Chapter 1 taxes – specifically the foreign tax credit – from reducing the amount of N.I.I.T. due. Exceptions apply only if the Chapter 1 credit specifically states that it may be claimed to reduce the amount of N.I.I.T. due and payable. Currently no credit in Chapter 1 contains that language.


While domestic law does not provide a foreign tax credit, it is theoretically possible an income tax treaty provides such authority.4 Indeed, the Treasury Department and I.R.S. leave open this possibility. But in doing so, they caution that treaties with language substantially similar to Article 23(2) of the U.S. Model Income Tax Treaty do not provide a basis for taking the foreign tax credit against the N.I.I.T.5 In the 2016 version of the Model Treaty, that provision reads:

  1. In 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 United States shall allow to a resident or citizen of the United States as a credit against the United States tax on income applicable to residents and citizens:

    1. the income tax paid or accrued to __________ by or on behalf of such resident or citizen; and

    2. in the case of a United States company owning at least 10 percent of the voting stock of a company that is a resident of __________ and from which the United States company receives dividends, the income tax paid or accrued to __________ by or on behalf of the payor with respect to the profits out of which the dividends are paid.

For the purposes of this paragraph, the taxes referred to in subparagraph (a) of paragraph 3 and paragraph 4 of Article 2 (Taxes Covered) shall be considered income taxes.

The relevant paragraphs of Article 2 that identify taxes covered by the Model Treaty state the following:

  1. The existing taxes to which this Convention shall apply are:

    1. in the case of [name of treaty partner]: * * *[;]

    2. in the case of the United States: the Federal income taxes imposed by the Internal Revenue Code (which do not include social security and unemployment taxes) and the Fderal taxes imposed on the investment income of foreign private foundations.

  2. This Convention also shall apply to any identical or substantially similar taxes that are imposed after the date of signature of this Convention in addition to, or in place of, the existing taxes. The competent authorities of the Contracting States shall notify each other of any significant changes that have been made in their taxation laws or other laws that relate to the application of this Convention.

The U.S. Tax Court confirmed the position in Toulouse v. Commr.,6 where the I.R.S. disallowed a foreign tax credit claimed to reduce N.I.I.T., and the Court upheld the disallowance.


In comparison, the I.R.S. recognizes that tax treaties with a dual-resident article can provide relief from N.I.I.T. for a dual-resident individual (other than a U.S. citizen) electing to be treated solely as a resident of the treaty partner country. That individual will be exempt from the N.I.I.T.7 When the dual resident individual is a green card holder, electing relief under the dual-resident article may not be attractive for reasons unrelated to the N.I.I.T.

S.S.T.A.'S


Another, less prominent form of international tax agreement is the Social Security Totalization Agreement ("S.S.T.A."). In broad terms, S.S.T.A.'s are to social security taxes as income tax treaties are to income taxes. S.S.T.A.'s generally allow covered taxpayers to eliminate exposure to double social security taxation, while aggregating coverage under the social security system of each country for purposes of qualifying for benefits. This enables an individual who pays social security taxes to one country for a period of time and then to the other country for a period of time to bundle the coverages for purpose of determining benefits. At that point, only a pro rata payment is made by a country based on the periods for which social security taxes were actually paid.


The default rule under S.S.T.A.'s is that employees are taxed by the country where they are employed, not the country where they reside or their employer is based. Self-employed individuals are taxed based on residence. An exception known as the detached-worker rule allows migrating workers who expect to return to their home country within five years to be taxed only by their home country.


From the U.S. side, S.S.T.A.'s explicitly cover taxation under the Federal Insurance Contributions Act ("F.I.C.A.") and the Self-Employed Contributions Act ("S.E.C.A."). These are known as "payroll taxes" because they are levied on wages. F.I.C.A. applying to employee payrolls and S.E.C.A. applying a mirror tax on the income of self-employed individuals. The S.E.C.A. tax is the sum of the employee's share of social security tax and a percentage of the employer's share of that tax. The base is generally net income from self-employment, and most of the tax is capped. Each tax is split into social security and Medicare portions that fund Social Security and Medicare benefits.


Some practitioners believe that S.S.T.A.'s cover the N.I.I.T. The scope of S.S.T.A.'s is not necessarily limited to the enumerated taxes. They also cover legislation which amends or supplements the listed taxes. To illustrate, Paragraphs 1 and 3 of Article 2 (Material Scope) of the Switzerland-U.S. Social Security Totalization Agreement provide:

  1. For the purpose of this Agreement, the applicable laws are:

    1. as regards the United States of America, the laws governing the Federal old-age, survivors, and disability insurance program:

      • Title II of the Social Security Act and regulations pertaining thereto, except sections 226, 226A and 228 of that title, and regulations pertaining to those sections,

      • Chapters 2 and 21 of the Internal Revenue Code of 1986 and regulations pertaining to those chapters.8

  2. Except as provided in the following sentence, this Agreement shall also apply to legislation which amends or supplements the laws specified in paragraph 1. This Agreement shall apply to legislation or regulations which extend the existing laws to other categories of beneficiaries or which involve a new branch of Social Security only if both Contracting States so agree.

CLAIMING A FOREIGN TAX CREDIT TO REDUCE N.I.I.T.

Congressional Intent

There seems little doubt that amending or supplementing the Medicare tax (i.e., the Medicare portions of F.I.C.A. and S.E.C.A.) was the Congressional intent for enactment of the N.I.I.T. That would place the N.I.I.T. within the literal language of most S.S.T.A.'s. The N.I.I.T. was brought into existence by the Health Care and Education Reconciliation Act of 2010 (H.C.E.R.A.). With the new health care law calling for an expansion of Medicare, Congress presumably believed increased funding was required. One of the first mentions of the N.I.I.T. is a 2010 legislative proposal of the Obama Administration to institute a 2.9% tax on unearned income for individuals reporting taxable income above certain thresholds. The proposed tax revenues were to fund Medicare.


As if to further underscore the point, Chapter 2A of the Code is entitled "Unearned Income Medicare Contribution," and Code §1411 is the only section that appears in Chapter 2A. This was an important distinction for the court in Toulouse, which looked to the location within the Code to conclude that the social security tax imposed by the foreign country was not an income tax that could be claimed as a foreign tax credit against taxable income. The court stated the following:


The Code is divided into subtitles, and subtitles are divided into chapters, which impose separate and distinct taxes. Section 1, which is in chapter 1, subtitle A, Income Taxes, of the Code, imposes a tax on the taxable income of individuals (regular tax). Compare ch. 1, sec. 26(b) (referring to tax imposed by section 1 as "regular tax liability") with ch. 23, sec. 3301 (imposing a tax on employers on wages that they pay to their employees).


Of relevance here, section 27 provides a credit for "[t]he amount of taxes imposed by foreign countries * * * against the tax imposed by this chapter to the extent provided in section 901." Section 901 provides a foreign tax credit against regular tax. It clearly states that "the tax imposed by this chapter [1] * * * [is] credited" with specified amounts. Thus, both sections 27 and 901 clearly provide that the foreign tax credit allowable under the Code reduces only tax imposed under chapter 1, such as the section 1 regular tax. See also sec. 61 (defining gross income for purposes of the section 1 regular tax); sec. 63(a) (defining taxable income for those purposes).


Section 1411 is in chapter 2A, subtitle A, Income Taxes. Thus, the foreign tax credit under section 27—which applies to "the tax imposed by this chapter [1]"—does not by its terms apply to offset net investment income tax.


Congress has allowed a foreign tax credit only against taxes imposed under chapter 1. There is no Code provision for a foreign tax credit against the net investment income tax. * * * [The relevant income tax treaties] do not provide an independent basis for a foreign tax credit against the net investment income tax.


The provision is generally understood to require that a tax be a social security tax to be covered by an S.S.T.A. Whether the N.I.I.T. can be considered a social-security tax is at the heart of this ambiguity. In the context of Switzerland, the N.I.I.T. appears in Chapter 2A of the Code, not Chapter 2 or 21 tax.


CLAIMING A FOREIGN TAX CREDIT TO REDUCE N.I.I.T.

Congressional Inten

There seems little doubt that amending or supplementing the Medicare tax (i.e., the Medicare portions of F.I.C.A. and S.E.C.A.) was the Congressional intent for enactment of the N.I.I.T. That would place the N.I.I.T. within the literal language of most S.S.T.A.'s. The N.I.I.T. was brought into existence by the Health Care and Education Reconciliation Act of 2010 (H.C.E.R.A.). With the new health care law calling for an expansion of Medicare, Congress presumably believed increased funding was required. One of the first mentions of the N.I.I.T. is a 2010 legislative proposal of the Obama Administration to institute a 2.9% tax on unearned income for individuals reporting taxable income above certain thresholds. The proposed tax revenues were to fund Medicare.


As if to further underscore the point, Chapter 2A of the Code is entitled "Unearned Income Medicare Contribution," and Code §1411 is the only section that appears in Chapter 2A. This was an important distinction for the court in Toulouse, which looked to the location within the Code to conclude that the social security tax imposed by the foreign country was not an income tax that could be claimed as a foreign tax credit against taxable income. The court stated the following:


The Code is divided into subtitles, and subtitles are divided into chapters, which impose separate and distinct taxes. Section 1, which is in chapter 1, subtitle A, Income Taxes, of the Code, imposes a tax on the taxable income of individuals (regular tax). Compare ch. 1, sec. 26(b) (referring to tax imposed by section 1 as "regular tax liability") with ch. 23, sec. 3301 (imposing a tax on employers on wages that they pay to their employees).


Of relevance here, section 27 provides a credit for "[t]he amount of taxes imposed by foreign countries * * * against the tax imposed by this chapter to the extent provided in section 901." Section 901 provides a foreign tax credit against regular tax. It clearly states that "the tax imposed by this chapter [1] * * * [is] credited" with specified amounts. Thus, both sections 27 and 901 clearly provide that the foreign tax credit allowable under the Code reduces only tax imposed under chapter 1, such as the section 1 regular tax. See also sec. 61 (defining gross income for purposes of the section 1 regular tax); sec. 63(a) (defining taxable income for those purposes).


Section 1411 is in chapter 2A, subtitle A, Income Taxes. Thus, the foreign tax credit under section 27—which applies to "the tax imposed by this chapter [1]"—does not by its terms apply to offset net investment income tax.


Congress has allowed a foreign tax credit only against taxes imposed under chapter 1. There is no Code provision for a foreign tax credit against the net investment income tax. * * * [The relevant income tax treaties] do not provide an independent basis for a foreign tax credit against the net investment income tax.


In Practice

While the N.I.I.T.'s initial purpose is unambiguous, it is much less clear whether the N.I.I.T. is functionally a social-security tax. A distinctive feature of payroll taxes is that their revenues flow to specially earmarked funds for Social Security and Medicare. By contrast, the U.S. Federal income tax feeds into the Treasury Department's general fund. Despite the recommendation of the Obama Administration, the N.I.I.T. does so as well. This may have been a result of congressional mandates for new legislation to be revenue neutral, leading to the need to treat the N.I.I.T. as an increase in general income tax in order to match expenditures.9


In its 2021 Greenbook announcing a legislative agenda for the year, the Treasury Department acknowledged that the N.I.I.T. feeding into the Treasury Department's general fund is inconsistent with the fact that F.I.C.A., S.E.C.A., and N.I.I.T. are intended for the same purpose.10 Nonetheless, the effect is that, today, the N.I.I.T. looks less like a social-security tax and more like an income tax.


APPLICATION OF S.S.T.A.'S TO N.I.I.T.

The N.I.I.T. also differs from F.I.C.A. and S.E.C.A. mechanically. The latter two laws include statutory provisions that allow overrides by S.S.T.A.'s.11 None exists for the N.I.I.T. This could prove a technical barrier to claiming an exemption from the N.I.I.T. under an applicable S.S.T.A. instead of claiming a foreign tax credit against the N.I.I.T.


Government Position

It is more likely that the I.R.S. views the N.I.I.T. as an income tax for which no foreign tax credit is allowed and not a social-security tax. As cited earlier, the I.R.S. did not rule out the idea that income-tax treaties might provide relief against the N.I.I.T. If the I.R.S. thought the N.I.I.T. was not an income tax, it would presumably eliminate this possibility. Internal agency documents also indicate that the I.R.S. does not think the N.I.I.T. is covered by S.S.T.A.'s.12

Most S.S.T.A.'s predate the N.I.I.T., and some practitioners surmised that the failure of S.S.T.A.'s to explicitly cover the N.I.I.T. was merely a timing issue. But no S.S.T.A. that was signed or came into force after March 2010 (when the H.C.E.R.A. was enacted) or December 2012 (when the N.I.I.T. came into force) mentions the N.I.I.T.


RESOLUTION

Some tax advisers have reportedly advised taxpayers to take the position that an applicable S.S.T.A. exempts U.S. citizens and green card holders from the N.I.I.T., provided the individuals reside outside the U.S. and expressly identify the issue on an income tax return on Form 8833 (Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b)). Some of those advisers report that tax returns on which the treaty-based position was taken were reviewed in the course of I.R.S. examinations, and the issue was not raised. One case where the I.R.S. did not ignore this position as to S.S.T.A.'s is now the subject of refund litigation. A taxpayer who was a U.S. citizen and South Korean resident paid $600,000 in N.I.I.T. before later filing an amended return claiming a refund, based on the S.S.T.A between the U.S. and Korea. The I.R.S. has proposed disallowing the claim.


Taxpayers are not the only ones to have noticed the discrepancy between intent and practice, as the 2021 Greenbook indicated. The Greenbook proposed redirecting N.I.I.T. funds into the same Medicare fund as F.I.C.A. and S.E.C.A. Were this step taken, the N.I.I.T. would seem to be the functional equivalent of a social security tax. However, coverage by an S.S.T.A. may not be automatic. Each S.S.T.A. contains its own provisions calling for extension of the agreement to reflect new categories of beneficiaries. As mentioned above, the Switzerland-U.S. S.S.T.A. requires both countries to agree on the extension. In comparison the Netherlands-U.S. S.S.T.A. provides for automatic extension unless notification is given to the other country within three months of enactment that extension of the agreement is not intended.13


The U.S.-U.K. S.S.T.A. provides that it applies to:

* * * any identical or substantially similar taxes that are imposed after the date of signature of this Convention in addition to, or in place of, the existing taxes.* * *13

Whether the N.I.I.T. would be viewed to be an identical or substantially similar tax is an open question.


Footnotes

1. Treas. Reg. §1.411-2(a)(1)

2. Code §27

3. Treas. Reg. §1.1411-1(e).

4. See the preamble published by the I.R.S. at the time Treas. Reg. §1.1411-1 was adopted, T.D. 9644.

5. E.g., Switzerland-U.S. Income Tax Treaty Art. 23(2).

. 157 T.C. 49 (2021). For a full discussion of the issues addressed in Toulouse, see Andreas A. Apostolides and Wooyoung Lee, "Toulouse or not Toulouse? N.I.I.T.-Picking the Reach of the U.S. Foreign Tax Credit," Volume 8 No. 6 Insights (November 2021): p.28.

7. Treas. Reg. §1.1411-2(a)(2).

8. Chapters 2 and 21 contain S.E.C.A. and F.I.C.A., respectively. The N.I.I.T. is located in Chapter 2A.

9. Changes to other taxes during the H.C.E.R.A.'s drafting meant that its final projected revenue was far lower than initially projected, which was a problem because certain congressional rules require legislation to be revenue neutral. Congress added the N.I.I.T. to the H.C.E.R.A. but had to direct its revenue toward the general fund in order to make up the shortfall. Kofsky and Schmutz, "What a Long Strange Trip It's Been for the 3.8% Net Investment Income Tax," 78 Md. L. Rev. Online 14 (2019): p. 26-32.

10. General Explanations of the Administration's Fiscal Year 2022 Revenue Proposals.

11. Code §§3101(c), 3111(c), 1401(c).

13. Netherlands-U.S. S.S.T.A. Art. 2(3).

14. U.K.-U.S. S.S.T.A. Art. 2(4).


Read John Richardson's August 7, 2016 comments:

The 3.8% Obamacare surtax (assuming it’s applicability to Americans abroad) is considered to be:

§ a form of pure double taxation when applied to Americans abroad

§ more likely to be paid by Americans abroad than by Homeland Americans

§ a way to force Americans abroad to pay for the medical care of Homeland Americans

§ a costly compliance nightmare

§ an example of “Boldly Go, where no regime of citizenship taxation has ever gone before”

Does Article 22 the U.S. Australia Tax Treaty require the United States to allow U.S. citizens a foreign tax credit against the 3.8% Obamacare Surtax?

Part I: A purely “U.S. centric perspective” – The Obamacare Surtax under the U.S. Internal Revenue Code

The Internal Revenue Code – A “Bird’s Eye View”

It is significant that the Obamacare Surtax is Internal Revenue Code Section 1411 which is Chapter 2A and Chapter 2A is part of Subtitle A which deals with INCOME TAXES! The Obamacare surtax falls under the “Income Tax” regime of the Internal Revenue Code.

I have written about the Obamacare surtax and double taxation before. The key points are:

A. The Net Investment Income Tax is in Section 1411 of the Internal Revenue Code

B. Section 1411 is NOT found in Chapter 1 of Subtitle A of Title 26 of the Internal Revenue Code. This means that it is NOT (under U.S. law) considered to be a “Normal” Tax (whatever that means). It is found in Chapter 2A which appears to be part of the Social Security Tax section of Subtitle A.

C. Because Section 1411 is NOT found in Chapter 1, the Foreign Tax Credit Provisions in Internal Revenue Code Section 901 (which is also part of Chapter 1) do NOT apply

D. This leads to the result UNDER THE INTERNAL REVENUE CODE that Americans abroad cannot use taxes paid in other nations as a foreign tax credit, under Section 901, in calculating their U.S. tax liability for the Obamacare surtax.

To put it another way, this result UNDER U.S. Law leads to PURE DOUBLE TAXATION.

Note that this is the result when ONLY the Internal Revenue Code AKA U.S. DOMESTIC LAW is considered!

Part II: An International Perspective – How is or should the Obamacare surtax issue be dealt with under U.S. Tax Treaties?

First, Totalization Agreements: Should Americans abroad be required to pay the Obamacare surtax AT ALL? Does the existence of a “totalization agreement” mean that Americans abroad are EXEMPT from the tax?

Totalization agreements are treaties that the United States has with other nations. A totalization agreements is a very specific kind of treaty that is designed to ensure that:

§ people are NOT required to pay Social Security (“type”) taxes twice; and

§ those whose work careers span more than one country can use their social security contributions in one country toward meeting the requirements for social security in another country.

A primer on “Totalization Agreements” is here.

But wait. If the Obamacare Surtax is really a “Social Security Tax” and totalization agreements exist to prevent the payment of “double security taxes”, then shouldn’t Americans abroad who live in a country with a “totalization agreement”, be exempt from the Obamacare surtax?

This issue has been thoughtfully explored by Toronto CPA Kevyn Nightingale here.

He suggests that the answer is YES. Americans abroad living in countries with a Totalization Agreement may be exempt from paying the 3.8% Obamacare surtax.

Second, general tax treaties: If Americans abroad are required to pay the Obamacare surtax, can the provisions of a tax treaty (in this cause Australia) be used to argue that the foreign tax credit DENIED under the Internal Revenue Code should be allowed under the treaty? This does NOT mean that Americans abroad are exempt from the Obamacare surtax. It would mean that taxes paid in Australia on the investment income, can be used as a credit against any Obamacare surtaxes levied against Americans abroad.

I suggest the answer (at least in the case of the U.S. Australia tax treaty) is YES!

Here is my reasoning:

First: International tax treaties are to be interpreted NOT ONLY by U.S. law, but by the expectations of BOTH Treaty Partner Countries. This is the significance of the Esher case.

Significance: This means that in considering whether a tax should be a “creditable tax” under a treaty, the expectations of both countries must be considered. One might ask: Would Australia expect that the Obamacare surtax could be used to impose a separate 3.8% tax on Australian citizens and residents (particularly when the investment income was from Australian sources)?

Second: The “savings clause” (found in ARTICLE I (3)) does not apply to ARTICLE 22 (Relief from Double Taxation).

Significance: This is an exception to the “savings clause”. We interpret the treaty as though the Savings Clause did NOT exist. U.S citizens living in Australia DO have the ARTICLE 22 protection against double taxation.

Third: ARTICLE 2 states that in the case of the United States, the treaty applies to: (1) “the Federal income taxes imposed by the Internal Revenue Code, but excluding the accumulated earnings tax and the personal holding company tax;”, and (2) “any identical or substantially similar taxes which are imposed by either Contracting State after the date of signature of this Convention in addition to, or in place of, the existing taxes.”

Significance: Chapter 2A (Section 1411) is found in Subtitle A which is the Income Tax section of the Internal Revenue Code. The fact that a tax credit is not allowed under U.S. domestic law is irrelevant. In addition, the Obamacare surtax is a tax on investment income which is the kind of tax that both countries would expect to be contemplated by ARTICLE 2. Investment income is income. The Obamacare surtax is an additional tax on investment INCOME. In other words, it seems reasonable to conclude that the Obamacare surtax, by definition and expectation, is the kind of tax that is within the scope of the treaty.

Fourth: “ARTICLE 22 Relief From Double Taxation” states:

(1) Subject to paragraph (4) and in 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), in the case of the United States, double taxation shall be avoided as follows:

(a) the United States shall allow

to a resident or citizen of the United States as a credit against United States tax the appropriate amount of income tax paid to Australia; …

Such appropriate amount shall be based upon the amount of income tax paid to Australia. For purposes of applying the United States credit in relation to income tax paid to Australia the taxes referred to in sub-paragraph (1) (b) and paragraph (2) of Article 2 (Taxes Covered) shall be considered to be income taxes. No provision of this Convention relating to source of income shall apply in determining credits against the United States tax for foreign taxes other than those referred to in sub-paragraph (1)(b) and paragraph (2) of Article 2 (Taxes Covered).

Significance: The issue is whether the Obamacare Surtax is an “Income Tax” within the meaning of the U.S. Australia Tax Treaty. The issue is NOT whether the Obamacare Surtax is an “Income Tax” under narrow definitions of U.S. law. In any case, when U.S. law is considered, it is notable that Internal Revenue Code S. 1411 is under the “Income Tax” section of the Internal Revenue Code. In addition, it strikes me that the Obamacare surtax falls squarely withing the type of tax on income that would be reasonably expected to be contemplated by Article 22 of the treaty.

Conclusion: I believe that an argument can be reasonably made that Americans abroad in Australia who are subject to the 3.8% Obamacare surtax are entitled to a tax credit for taxes paid on that investment income to Australia.

Obviously this is NOT legal advice. It is an attempt to explain a treaty position that may or may not be successful.


See Kevyn Nightingale's April 01, 2014 comments:

If it is a social security tax, Americans living in countries that

have social security totalization agreements (SSTAs) with

the United States may be exempt. If it is an income tax,

then taxpayers would look for a foreign tax credit.

• There is no provision in the Internal Revenue Code for a foreign tax credit against this tax.

Therefore, any credit would have to be based on the terms of the income tax treaty

between the United States and the individual’s country of residence or citizenship.

Because none of these treaties currently address the net investment income tax directly

and no other authoritative guidance exists, whether these treaties will be considered to

allow a foreign tax credit for the net investment income tax is an open question.

• Because of the lack of guidance on the issue, a taxpayer claiming exemption under an

SSTA or credit under a treaty should fully disclose the position.

The U.S. State Department estimates that approximately 7.2 million U.S. citizens live abroad,

plus an indeterminate number of green card holders. The United States has social security

totalization agreements (SSTAs) with 24 countries and income tax treaties with 67. The vast

majority of Americans abroad live in these countries.

When the Sec. 1411 net investment income tax was passed, little thought was given to how it

would affect Americans living abroad, and with no guidance issued on the topic, its effect is

unclear. This article describes how the net investment income tax may affect Americans living

abroad.

The tax essentially raises two questions:

1. Are these individuals subject to this tax?

2. If an individual is subject to the tax, would a foreign tax credit (FTC) be available where the

underlying income that gives rise to the tax is:

(a) Foreign (non-U.S.) source?

(b) U.S.-source?

It is also unclear whether the tax is a social security tax for purposes of the U.S.–Canada

SSTA.

Net Investment Income Tax in General

To help fund 2010’s health care reform legislation, the United States instituted the net

investment income tax, which is designed to affect high-income people. The tax amounts to

3.8% of a U.S. person’s net investment income, to the extent the person’s modified adjusted

gross income is above:

• For a married couple filing jointly, $250,000;

• For a married person filing separately, $125,000; and

• For a single taxpayer, $200,000.

Roughly, investment income includes interest, dividends, rent, royalties, and most net gains. It includes income from passive activities. It does not include distributions from qualified

retirement plans.11

For owners of controlled foreign corporations and passive foreign investment companies, it does

not include corporate income that is imputed to the shareholder (subpart F and qualified electing

fund income), as they are not dividends. Instead, actual distributions are subject to the tax. It

is possible to make an election to have the tax apply at the same time as the subpart F income is

recognized for ordinary income tax purposes.

A U.S. person is a citizen or resident, defined in the same manner as for income tax. The tax

does not apply to nonresident aliens, including those whose residency is determined under a

result of a tax treaty.

The tax went into effect Jan. 1, 2013, and is not withheld at the source, so it is a material issue

for high-income earners in this filing season.

Little Guidance to This Point

The Joint Committee on Taxation report did not address the above questions about Americans

living abroad, nor did the proposed regulations. In November 2013, the author had the

opportunity to ask staff from both the Joint Committee and Treasury, and neither was aware of

these questions having been raised in the course of drafting the law or regulations. After the

author’s discussion with Treasury (including providing a draft of this article), Treasury did

address the second question regarding an FTC, in the preamble to the final regulations issued

Dec. 2, 2013. However, it did so in the broadest terms, saying only that the regulations were not

an appropriate venue for such answers.

The author could find no discussion of these questions in the academic literature, but some

commentators from large accounting firms have suggested in their public materials that no

protection from this tax is available. There simply is no meaningful guidance in this area.

To address the question of whether Americans living abroad are subject to it, one must

determine which type of tax the net investment income tax is. Is it a social security tax or an

income tax?

Is the Net Investment Income Tax a Social Security Tax?

For an individual who lives in Canada (as an example), the U.S.–Canada SSTA governs

coverage under Social Security and Medicare, as well as the Canadian equivalent, the Canada

Pension Plan (CPP). Individuals employed primarily in Canada and self-employed individuals

who reside in Canada are subject to the provisions of the CPP, not U.S. Social Security.

Consequently, if the net investment income tax is a social security tax, then an individual who

lives in Canada and is subject to the CPP would be exempt from it.

But is the net investment income tax a social security tax? Under the SSTA, the covered taxes

are listed as those imposed by Internal Revenue Code chapters 2 (self-employment tax) and 21

(Federal Insurance Contributions Act (FICA) tax). The net investment income tax is contained

in a new chapter (2A) of the Code, which is not specifically covered by the SSTA. However, the

SSTA anticipates this possibility:

[T]his Agreement shall also apply to laws which amend, supplement, consolidate or

supersede the laws specified in paragraph (1).

The net investment income tax is designed to pay for an expanded Medicare. In the statute, it is

called a “Medicare contribution.” The Joint Committee report addresses the tax in a Social

Security/Medicare context, not an income tax context.

The tax was imposed in parallel with an increased Medicare tax, a 0.9% surtax on wages and

self-employment income in excess of thresholds identical to those applying to the net investment

income tax. The objective of the net investment income tax was to ensure that individuals with

similarly high income levels who derive income from nonwage sources contribute to the newly

expanded health care program in a similar manner.

It is noteworthy that the additional Medicare taxes on wages and self-employment income are

specifically identified as ones to be covered by SSTAs. No similar guidance was provided for the

net investment income tax. Whether this means that the tax was intended to be covered is

anybody’s guess.

However, the author’s inquiries to the Joint Committee and Treasury indicate that the question

was simply never addressed. Furthermore, although Treasury addressed the FTC question when

it issued final regulations (see below), it did not consider the SSTA issue.

The fact that there is no FTC mechanism in the tax also suggests that the tax is designed to be a

Medicare tax rather than an income tax. However, there is no specific requirement that funds

from this tax be directed toward Medicare. Receipts simply go into general revenues.

A major purpose of this tax is to help finance health care subsidies under the Sec. 5000A

individual mandate to maintain minimum essential coverage. American residents abroad are not

subject to the mandate. Additionally, they rarely access Medicare coverage.

It is unclear whether the net investment income tax is covered by the SSTA on the basis that it

amends or supplements chapters 2 and 21 of the Code.

SSTAs are designed according to the idea that individuals receive coverage through their work

status. However, some people are neither employed nor self-employed. Into this category fall

retirees, parents who do not work outside the home, and children. Independently wealthy

individuals and those with interests in closely held corporations who are remunerated primarily

through interest and dividends would also fall into this category.

To this point, social security coverage relating to this latter category has not been relevant. The

net investment income tax, however, makes the issue germane. One could argue that in this

case, where an individual has no foreign (non-U.S.) social security coverage, the SSTA has no

effect, and the individual would then be subject to U.S. laws.

On the other hand, some individuals over the retirement age are exempt from contributions to

the foreign social security program. Such individuals may have employment or self-employment

income, but they are still treated by the Social Security Administration as exempt from FICA

taxes. Again, because the SSTA is designed according to the idea that coverage is a function

of providing services, it is inadequate to answer the question definitively.

Or Is It an Income Tax?

When a U.S. citizen resides abroad, he or she is still subject to U.S. tax on worldwide income.

Most foreign countries tax their own residents on their worldwide incomes, and even those that

do not do so still tax them on local-source income. So Americans living abroad are almost

always subject to tax under at least two systems.

Double taxation is universally recognized to be a bad thing. It interferes with international

business and individual mobility and is fundamentally unfair. Consequently, U.S. law and treaties

include FTC mechanisms to mitigate this problem. If the net investment income tax is an income

tax, then the question arises whether an FTC is available in respect of foreign tax paid.

Even with the net investment income tax, foreign-country income taxes where most Americans

reside are typically higher than U.S. taxes. In most Organisation for Economic Co-operation and

Development nations, top marginal tax rates range from 40% to 50%, with some (like France)

much higher. U.S. brackets are generally wider, and the United States offers itemized deductions

(e.g., mortgage interest and property taxes) that typically lower the income tax base materially

compared with that of other nations. Thus, for most of the individuals described here, an FTC

mechanism would effectively obviate the impact of the tax.

Where the Income Giving Rise to the Tax Is Not U.S.-Source

For Americans living abroad, the foreign country, as a general rule, has the first right of taxation

with respect to income that is not U.S.-source. The normal mechanism to avoid double taxation

is an FTC.

U.S. Foreign Tax Credit

There is no provision in the Internal Revenue Code or the regulations for an FTC against the net

investment income tax. The domestic-rule FTC applies only to reduce regular income tax, not the

net investment income tax. Form 8960, Net Investment Income Tax—Individuals, Estates, and

Trusts, for calculating net investment income tax contains no FTC calculation.

Treaties often ensure that there is a supplementary FTC mechanism to mitigate double taxation.

For a U.S. citizen resident in Canada, for example, the treaty allows an FTC for Canadian tax

in computing United States tax:

[D]ouble taxation shall be avoided as follows: In 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 United States shall allow to a citizen or

resident of the United States . . . as a credit against the United States tax on income the

appropriate amount of income tax paid or accrued to Canada.

“United States tax” means the taxes referred to in Article II of the treaty, other than, inter alia,

Social Security taxes.

The fact that the tax arises in a separate section of the Internal Revenue Code is not relevant to

this determination:

This Convention shall apply to taxes on income . . . irrespective of the manner in which they

are levied. . . . The Convention shall apply also to any taxes identical or substantially

similar to those taxes to which the Convention applies under [the above paragraph] . . .

which are imposed after March 17, 1995, in addition to, or in place of, the taxes to which the

Convention applies under [the same paragraph].

Of course, the words “subject to the limitations of the law of the United States” could be

interpreted to mean that there is no FTC, because there is no provision for one in the domestic

law. The IRS commented in the preamble to the final regulations under Sec. 1411 that where

such words are included, a treaty-based foreign tax credit would not be allowed.

Canada’s Foreign Tax Credit

Canada taxes non-U.S.-source income without regard to U.S. taxation and has no domestic

mechanism to offer an FTC in respect of the net investment income tax. To qualify for Canada’s

foreign tax credit, the qualifying income must have a source in one or more countries other than

Canada. Canada calculates FTCs separately by country. The net investment income tax is

deemed not to be creditable, because it is payable solely by virtue of U.S. citizenship (noting that

the tax does not apply to nonresident aliens). Under the treaty, Canada is not obliged to offer

a credit. The credit required under the treaty is limited to the amount that would apply if the

individual were not a U.S. citizen.

In the United States (unlike Canada and most other countries), a treaty does not automatically

supersede domestic law. Instead, “[t]he provisions of [the Code] shall be applied to any

taxpayer with due regard to any treaty obligation of the United States which applies to such

taxpayer.” “For purposes of determining the relationship between a provision of a treaty and

any law of the United States affecting revenue, neither the treaty nor the law shall have

preferential status.” These statements are of little help.

The courts have determined that, as a general rule, the provision that came later in time

prevails. Double taxation can result from the application of this rule. One example of this

phenomenon was the arbitrary limitation of the alternative minimum tax (AMT) FTC to 90% of the

AMT otherwise payable, even in cases where the foreign-source income was greater than 90%

of all income. However, one of the critical elements in this case was that legislators had

indicated they were conscious of the treaty override. With the net investment income tax, this

intent is not evident from the legislation or the committee reports. As noted, in the rush to finalize

legislation, the question was simply not addressed. How does one address an implicit treaty

override when there is no expression of that intent? This is a critical factor that distinguishes this

tax from the AMT FTC limitation.

The IRS, by noting in the preamble to the regulations that a treaty credit may be allowed and that

residency determined under a treaty will be respected, implicitly acknowledged that this new

tax is not intended to be a treaty override.

The author suggests that in light of the wording of the U.S.–Canada treaty, especially Article II

anticipating the enactment of additional taxes, an FTC should be allowed, notwithstanding

Treasury’s comments.

Where the Income Giving Rise to the Tax Is U.S.-Source

As with most countries, Canada ordinarily provides an FTC for U.S. tax properly levied against

U.S.-source income. This provision is reinforced by the treaty. This is true even where the

tax is a social security tax.

However, Canada is not required to provide an FTC for U.S. tax in excess of that properly

allowed under the treaty. Where the treaty limits the U.S. tax to an amount lower than the

ordinary U.S. statutory rate, that treaty limit forms an upper bound on the creditable tax.

Furthermore, if a U.S. citizen is taxable but a nonresident alien would not be on the same type of

income, Canada is not required to provide an FTC. As noted above, a U.S. nonresident alien

is exempt from this tax. Consequently, Canada would not offer an FTC in respect of the net

investment income tax.

Where the statutory calculation results in higher tax than the treaty allows, the United States is

required under the treaty to offer a special tax credit to reduce its own tax to the treaty level.

Provided the Canadian tax is sufficient, this credit should offset the net investment income tax.

Given that Canadian effective tax rates for high-income earners are typically considerably higher

than U.S. rates, this should be the case almost universally.

Conclusions

For an individual living in a country with an SSTA, if the net investment income tax is a social

security tax, it should be excluded from applicability because:

• The net investment income tax supplements existing Social Security taxes;

• It is designed to fund an expanded Medicare;

• Americans abroad are exempt from the Patient Protection and Affordable Care Act’s

individual mandate, and this tax is designed to fund subsidies for that mandate;

• It is described as a Medicare tax in the legislative text;

• Its location in the Code is consistent with that status;

• The tax mechanism dovetails with the increased ordinary Medicare taxes on earned

income; and

• The absence of an FTC mechanism is consistent with a social security tax, not an income

tax.

This position is not without risk:

SSTAs do not explicitly cover the tax;

• An individual who is not covered by foreign social security (by reason of not earning income

from employment or self-employment) may be excluded from the SSTA; and

• Funds are not earmarked directly for Medicare.

If the net investment income tax is not a social security tax, there is a good argument that an

FTC should be allowed under a treaty. This is true whether the income in question is U.S.-source

or not:

• Tax treaties generally contemplate additional income taxes being levied;

• It is hard to argue that the tax is neither a social security tax nor an income tax; and

• There is no express limitation in U.S. law on the use of an FTC under a treaty.

Again, this position is not without risk. The Code has no provision for an FTC in respect of this

tax. That omission may be sufficient to deny the treaty credit. The result would be unforeseen

double taxation.

An overwhelming majority of Americans abroad live in countries with SSTAs and/or tax treaties.

In most or all of these countries, the tax treaty FTC mechanism applicable to U.S. citizens is

similar to that in the Canadian treaty, so similar conclusions would likely apply.

How to File Returns

Of course, it is quite possible that the IRS would view either approach as incorrect (that the tax is

covered by the SSTA or that there is a treaty-based FTC available in a specific jurisdiction).

Taking such a position would not be for the faint of heart. Because such a position would be

contrary to the design of the IRS form and Treasury has not indicated support for broad-ranging

treaty FTCs, it would be important, at the very least, to make proper disclosure to mitigate the

likelihood of imposition of preparer and taxpayer penalties.

For an SSTA exemption, safe tax practice would suggest that filing Form 8275, Disclosure

Statement, is a good idea. For a treaty position, it might still be advisable. There is little downside

with such an approach. The presence of Form 8833, Treaty-Based Return Position Disclosure

Under Section 6114 or 7701(b), and absence of Form 8960, combined with a high income, will alert the IRS to the issue even in the absence of Form 8275. These positions are not likely to

“slide through.” Because of the sparse IRS guidance, the fact that no court has pronounced on the issue, and

that there has been no meaningful discussion in the literature, it would be very difficult to argue

that a taxpayer has substantial authority for either position. However, the author submits that

there is a reasonable basis for either position, on the basis of the arguments discussed above.

A version of this article was published in Canada in the International

Tax newsletter.










581 views0 comments

Recent Posts

See All

Tax AI vs Tax Pro

I tested out IRS's new Form 1042-S Data Integrity Tool at https://1042sdi.for.irs.gov/Account/LogIn?ReturnUrl=%2F This software program provides a no-cost standalone tool to assist in complying with

Kommentare


bottom of page