1. Basics of double taxation
The NIIT applies to a US citizen’s investment income if the US citizen has income above a certain threshold (modified adjusted gross income of USD $125,000-250,000, depending on filing status). Unlike regular income tax that is imposed under Chapter 1 of the Internal Revenue Code, the NIIT is imposed under Chapter 2A. Because the normal foreign tax credit only applies to Chapter 1 taxes, the Code does not provide any foreign tax credit that can reduce the NIIT.
For US citizens in Canada, most investment income subject to the NIIT is sourced to Canada under Article XXIV of the Canada-US Tax Treaty (the “Canada Treaty”), with the exception of US-source dividends and US rental income. That means that Canada has the primary right to tax the investment income. If the US does not permit a credit against the NIIT, the NIIT is effectively double taxation. It sits on top of the Canadian tax, even though the Canadian tax rate is generally higher than the US rate.
2. Canadian foreign tax credit against the NIIT
The denial of the foreign tax credit in the US would not be an issue if Canada instead granted a foreign tax credit for the NIIT paid to the US. For some types of income, Canada’s domestic sourcing rules differ from the Canada Treaty rules described above (under which most investment income subject to the NIIT is Canadian-source). The Canadian domestic sourcing rules outlined in CRA Folio S5-F2-C1 provide a substantially broader range of income that is US-source than the Canada Treaty does.
Therefore, by sourcing the investment income pursuant to the Canadian domestic rules, a Canadian credit for the NIIT would theoretically be available in some cases.
However, although dated, our understanding of the Canada Revenue Agency position regularly applied at CRA Appeals is that Canada Treaty Article XXIV(4)(a) precludes the creditability of the NIIT on US-source income in Canada. This position seems wrong given that the general purpose of the Canada Treaty is ameliorative, and that the express text of Canada Treaty Article XXIX(1) instructs that the Canada Treaty is not to restrict credits or benefits that would otherwise be available under domestic law. Nevertheless, the CRA seems intent on adhering to its position, and for most US citizens in Canada it will be Canadian-source NIIT that is the biggest double tax exposure. That would be improved with the US offering a foreign tax credit.
3. US tax relief from the NIIT
Shortly after the NIIT’s enactment, Kevyn Nightingale of MNP published an article putting forward two strategies to exempt US citizens abroad from the NIIT.
1. Canadian-resident US citizens are exempt from the NIIT under the US-Canada Social Security Totalization Agreement (SSTA) (the “SSTA Position”)
Or alternatively
2. Canadian resident US citizens can claim a foreign tax credit for foreign-source NIIT (the “FTC Position”)
We have spent significant effort expanding on and developing the arguments made in Kevyn’s original article with respect to both the SSTA Position and the FTC Position.
The IRS’ position since at least January 1, 2019, if not earlier, is to disagree with both positions. They have taken that position consistently in various litigation and at IRS Appeals (which has in our experience only sided with the IRS on this issue). Recent court decisions muddy the IRS’ position.
a. The SSTA Position
The only published authority on the SSTA Position is the Paul Yong Kim v. United States opinion. This case considered the US-Korea SSTA. After extensive reasoning, the Court concluded that it was “plausible” that the US-Korea SSTA provided an exemption from the NIIT. The conclusion was left open for the parties to provide further evidence on the shared expectations of the parties to the SSTA. Alas, despite a thorough search, there is simply no evidence available as to the intention of the parties. And so the litigation in the Kim case was withdrawn by consent of the parties.
Our firm assisted Guy Glaser with the development of the arguments in this case which go significantly beyond the position originally outlined by Kevyn nearly 10 years ago. Despite the Court in Kim leaving the matter open for another day, our view is that ultimately the US government will prevail on this issue under all SSTAs. Worse, the exemption position under the US-Korea SSTA is stronger than under the Canada-US SSTA. Regardless, the Kim case provides enterprising taxpayers, who are not afraid of a dispute with the IRS, some support for the SSTA position.
b. The FTC Position
The second position is that the Canada Treaty requires the provision of a US foreign tax credit against the NIIT. Overly simplified, the logic in support of this conclusion is as follows:
A. The NIIT is an income tax and is a “covered tax” under Canada Treaty Art. II.
B. The US is obliged to provide a foreign tax credit under Canada Treaty Art. XXIV(1) because a failure to do so violates the “general principle” that the foreign tax credit rules should alleviate double taxation.
C. Separate and apart from the general credit in Canada Treaty Art. XXIV(1), the provisions in Arts. XXIV(4), XXIV(5), and XXIV(6) require the provision of an FTC against the NIIT for US citizens who are also Canadian tax residents.
There are three reported decisions on the foreign tax credit for the NIIT: Toulouse v. Commissioner, Paul Yong Kim v. United States, and Christensen et al. v. United States. Toulouse and Christensen involve the US-France Tax Treaty and Kim addresses the US-Korea Tax Treaty. There are no reported cases involving the Canada-US Tax Treaty.
Distilled to their essence, and reconciling the conclusions in each case:
A. The IRS concedes in all three cases that the NIIT is a covered income tax subject to the various tax treaties.
B. All three reported decisions stand for the proposition that the provision in the treaties at issue that is equivalent to the Canada Treaty Art. XXIV(1) does not provide an independent credit against the NIIT.
C. The Christensen case stands for the proposition that there is an independent credit against the NIIT under the provisions equivalent to Arts. XXIV(4), XXIV(5), and XXIV(6) of the Canada Treaty.
Technically, each treaty requires a separate interpretation to accomplish the intent of the respective treaty partners, but the US courts seem content to simply replicate the logic of Toulouse with respect to the general foreign tax credit provision (point B). As many esteemed commentators have pointed out, that conclusion is flawed and leads to absurd results. If the general treaty foreign tax credit is simply a carbon copy of the foreign tax credit under the Code, then what is the point of the treaty? If Congress simply eliminated the foreign tax credit altogether, would that mean that the treaty would not guarantee any foreign tax credit? That is an absurd result and yet it is the extension of the reasoning developed in Toulouse and followed exactly in Kim and Christensen. One hopes that eventually an appellate court will step in and clean up this absurd result.
Christensen stands alone in addressing the treaty provisions specifically applying to US citizens resident abroad. Those provisions were not discussed in Toulouse or Kim, and other related cases such as Kappus v. Commissioner and Jamieson v. Commissioner (both regarding the application of foreign tax credits to the alternative minimum tax) leave their interpretation unaddressed. The provisions in France Treaty Art. XXIV(2)(b)(i) are substantially similar to the provisions in Canada Treaty Art. XXIV(4). As such, Christensen, combined with the multitude of other authority including the text and context of Canada Treaty Art. XXIV(4), the Letter of Transmittal to the Canada Treaty, the technical notes to the various protocols, and other lesser authority, provide a reasonable, and uncontradicted, basis for a US citizen in Canada to take a foreign tax credit against the NIIT on foreign-source income. Almost certainly, the IRS will not agree and will dispute the position. Christensen will be appealed. And so the landscape remains uncertain.
4. Conclusion – The way forward
The landscape for Canadian-resident US citizens facing double taxation due to the NIIT is frustrating and confusing. But the above discussion yields the following general principles:
1. The fight against double taxation caused by the NIIT is far from over.
2. For US citizens in Canada with NIIT on US-source income (under the Canadian domestic sourcing rules) there is the potential for a Canadian foreign tax credit. Given the frequency with which CRA reviews foreign tax credit claims and the firm position of CRA Appeals, this position is probably not that practical unless the amount is large enough to warrant litigating.
3. The SSTA Position will ultimately likely not prevail in the fullness of time, but the current authorities provide some support for taking the position.
4. For US citizens resident in Canada with NIIT on foreign-source income, the technical case for a foreign tax credit under the Canada Treaty is strong. Given that the IRS will contest the position, the effort is likely best made on a refund claim to reduce risk. The refund claim can potentially go back 6 years under certain Canada Treaty-based processes.
5. Our firm is actively involved in multiple efforts to try and secure double taxation relief for US citizens in Canada, but there is more work to do on this front.