Bruyea v. United States (Ct. Claims Dec. 5, 2024), is the latest in a series of cases concerning whether a U.S. double tax treaty, in this case Canada's, allows a foreign tax credit for Canadian income taxes against the 3.8% net investment income tax (NIIT). The Court of Federal Claims held that the Canadian treaty allows such a foreign tax credit, despite the lack of a corresponding foreign tax credit in the Code. 

Beyond the specific issue of the ability of individuals to offset the NIIT with creditable foreign taxes, the decision is notable for a narrow interpretation of the Treaty's key phrase that the foreign tax credit is “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 contrast to the Tax Court's decision in Toulouse v. Commissioner, 157 T.C. 49 (2021), the Court of Claims in Bruyea viewed “subject to the limitations” as playing a narrower role. This rationale has important implications beyond the individual taxpayers subject to the NIIT.

Background on the Tax Treaty credit and NIIT

Tax treaties serve to avoid double taxation of the residents of each state. U.S. tax treaties typically have a “double taxation” article, which provides rules for each state to avoid double taxation through a credit or exemption. The treaty foreign tax credit is similar to, but independent of, the U.S.'s direct and indirect credit mechanisms, IRC Sections 901 & 960. As illustrated by Bruyea, the application of the tax treaties to claim foreign tax credits or re-source income can be complex.

Section 1411 imposes a tax of 3.8% on certain individual taxpayers' net investment income (the so-called NIIT). Net investment income may be derived from foreign sources, or the individual may be resident abroad. In each of these cases, a foreign country may also tax the same net investment income as is subject to the NIIT.

As the taxpayer conceded in Bruyea, the Code does not allow a foreign tax credit against the NIIT. Section 27, which allows the foreign tax credit, applies to income taxes in Chapter 1 of the Code. Section 1411, by contrast, is found in Section 2A of the Code. Thus, foreign income taxes may not be claimed as a credit against the NIIT.

Tax treaties, however, provide their own foreign tax credit in the Double Taxation Article. For example, Article 23(2) of the 2016 U.S. Model Treaty provides that the U.S. will provide a tax credit against U.S. tax on income for the foreign country's income taxes that are “covered taxes” under the treaty, but that such credit will be granted “[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 ….)”

The Parties' Arguments on the Double Tax Article

In Bruyea, the government attempted to deny the treaty-based FTC on several grounds. Of particular importance here is the Court's rejection of the government's use of the treaty's lead-in phrase, “subject to the limitations of US law….” as a basis for denying the credit.

Under Article XXIV (1) of the U.S.-Canada tax treaty, the U.S. agrees to allow “as a credit against the United States tax on income … the appropriate amount of income tax paid or accrued to Canada…." The NIIT, on its face, constitutes a “United States tax on income.” Reinforcing this interpretation, Article II(2)(b) provides that the U.S. taxes covered by the convention are “the Federal income taxes imposed by the Internal Revenue Code.” The location of the credit in a different chapter of the Code than Chapter 1, a key issue for the Code-based credit, would seem to be irrelevant for purposes of the Treaty's double taxation article.

The government argued, however, that by locating the NIIT in different Chapters of the Code, Congress modified the treaty under the later-in-time principle and that the Treaty's foreign tax credit was “subject to” this limitation. However, prior interpretations of the later-in-time rule, both in the tax and non-tax context, held that treaty overrides must be explicit and that “legislative silence is not sufficient to abrogate a treaty.” Bruyea (citing Trans World Airlines v. Franklin Mint Corp, 466 U.S. 243, 252 (1984)). The Court rejected the argument, concluding that the location of the NIIT in a different chapter was not explicit enough to override the treaty.

The IRS also argued that the lead-in-phrase, or what the Court termed the “US Law Limitation,” subordinated the Treaty credit to the Code. In other words, since the Code did not allow a credit for the NIIT, and Article XXIV (1) made the Treaty credit “subject to the limitations” of the Code, the Treaty did not allow a credit for NIIT. The government maintained this position, even though it conceded that the NIIT was an income tax and thus covered by the treaty.

The Court rejected this position, stating:

“The fatal problem for the government is that the government simultaneously (and variously) contends that the U.S. Law Limitations means that the IRC always trumps the Treaty and – try to wrap your head around this – that the Treaty sometimes does trump the IRC.”

Other parts of the treaty, such as the so-called “three bites" rule, took priority over the Code's limitations, as conceded by the government. However, reconciling this position with the IRS's position on the NIIT was impossible – what the court termed “an effort to nail jello to a wall.”

Accordingly, the Court of Claims ruled that the Canada treaty did allow a foreign tax credit against the NIIT. The Court viewed the “subject to the limitations” clause as providing that U.S. law would govern the computations of the credit (e.g., the section 904 limitation), but not itself override the Treaty's credits based on the circumstances of the case.

Implications of the Bruyea Decision

Apart from the NIIT, the meaning of the “subject to the limitations” language is relevant to other tax treaty articles. This language is also found in the U.S. model tax treaty, as noted above.

As one example, Article 25(3) of the U.S.-India income tax treaty provides for Treaty-based resourcing of income that the Treaty permits India to tax, such as gains from the sale of stock of an Indian corporation. Article 25(3) (flush language) states that "[n]otwithstanding the [Treaty resourcing rules], the determination of the source of income for purposes of this Article shall be subject to such source rules in the domestic laws of the Contracting States as apply for the purpose of limiting the foreign tax credit." Bruyea's analysis would seem to support a narrow interpretation of “subject to such source rules." As in the case of the NIIT issue addressed in Bruyea, it would improperly negate the purpose of the double tax article to read this “subject to” provision to make treaty re-sourcing entirely subject to the Code's resourcing provisions.

The Court of Claims in Bruyea is one of only several decisions on the NIIT. The Court's decision drew guidance from Federal Circuit precedent construing treaties broadly to achieve their intent. See, e.g., Xerox Corp v. United States, 41 F.3d 647, 652-53 (Fed. Cir. 1994). Other Courts have been less favorable on the question of whether a double tax treaty allows a foreign tax credit against the NIIT, including the Tax Court's decision in Toulouse v. Commissioner, 157 T.C. 49 (2021). This illustrates that the choice of venue may be relevant for the credibility of Tax treaty issues more broadly.

Summary

The Court of Claims decision in Bruyea allowing foreign taxes to offset the NIIT as a credit is the latest in a series of decisions on this issue. Additionally, it has implications for claiming credits under a double taxation article of an income tax treaty, which the changes brought by the TJCA have made more relevant.