'Interpretive Puzzles': Bruyea v. United States and the Net Investment Income Tax

On December 5, 2024, the United States Court of Federal Claims (the 'Claims Court') issued a partial summary judgment decision in the case of Bruyea v. United States, No. 23-766T (Dec. 5, 2024).  

The Claims Court held that Article XXIV of the US-Canada Income Tax Treaty (the 'Canada Treaty') permits a US citizen living in Canada to claim Canadian income taxes as a US foreign tax credit against the Net Investment Income Tax (the 'NIIT').

The Bruyea holding represents the latest and most taxpayer-friendly salvo in the long-running debate about the relationship between the NIIT and the United States's double tax treaty network.  

Background

The NIIT, enacted in 2010 and first taking effect in 2013, is a 3.8% tax imposed on certain passive investment income earned by individuals, estates, and trusts who are tax resident in the United States or are US citizens (together, 'US Persons').

Under the US Internal Revenue Code (the 'Code'), US Persons are generally subject to US federal income tax on their worldwide income and gains.  A US Person is broadly permitted to offset his or her tentative US federal income tax liability by any creditable foreign income taxes he or she pays or accrues during the year, subject to various technical requirements and limitations.  However, the Code expressly forbids taxpayers from claiming foreign tax credits against the NIIT.  Section 901 of the Code generally states that a person may claim foreign income taxes paid or accrued as a credit only against the US federal tax imposed by 'this chapter' i.e. Chapter 1 of the Code.  The NIIT legislation—codified at section 1411 of the Code—is located in Chapter 2A of the Code.  By implication, it seems that no foreign tax credit is allowed against the NIIT because section 1411 of the Code is located in Chapter 2A rather than Chapter 1.  To the extent there were any doubt about this inference, the Treasury Regulations confirm explicitly that under internal US federal tax law no foreign tax credit is allowed against the NIIT.  

This feature of the NIIT rules increases the likelihood that a person will suffer economic double tax on the NIIT income tax base.

In recent years, some US Persons living abroad have tried to overcome this problem by arguing that even if the Code prohibits them from claiming foreign tax credits against the NIIT, they should nonetheless be entitled to claim such a credit under the terms of a double tax treaty in effect between the United States and their country of residence or income source—specifically, that double tax treaty's 'Relief from Double Taxation' or 'Elimination of Double Taxation' article (hereinafter referred to generically as the 'Double Taxation' article).   

A typical Double Taxation article will provide that the United States must allow a foreign tax credit for income taxes paid or accrued by a US treaty resident to the treaty partner country (or in some cases, as discussed below in the context of the so-called 'Three Bite Rule', income taxes paid by a United States citizen who is a resident of that other country to that other country) against that person's tentative US federal income tax liability.  The treaty partner country is usually required to provide some of reciprocal double tax relief in respect of US federal tax imposed on income earned by residents of that country.   The policy aim of the Double Taxation article is, very generally speaking: (i) to ensure that where a particular item of income can plausibly by taxed under the treaty by both the country of source and the country of residence, the 'source country' should have the primary taxing right and the 'residence country' should provide a foreign tax credit (or other form of double tax relief) to alleviate the potential double tax burden; and (ii) in the case of treaties that include some version of the so-called 'Three Bite Rule', as discussed below, to ensure that US citizens living in the treaty partner country should not suffer double taxation by virtue of being subject to two different residency-based worldwide tax systems at the same time.  

Case law to date – Christensen and the Three Bite Rule distinction

Individuals claiming treaty-based foreign tax credits against the NIIT have thus far had only narrow and sometimes pyrrhic successes.

In a 2023 case called Christensen v. United States, 168 Fed. Cl. 263 (2023), the Claims Court issued a limited holding concluding that a US citizen couple living in France could potentially claim a foreign tax credit against the NIIT based on Article 24(2)(b) of the US-France Income Tax Treaty (the 'France Treaty').  The introductory clause of the relevant provision in the France Treaty's Double Taxation—Article 24(2)(a)—states that the 'United States shall allow to a citizen or a resident of the United States as a credit against the United States income tax . . . the French income tax paid by or on behalf of such citizen or resident' but also states that this entitlement is subject to '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 latter provision, the 'US Law Limitation').   According to the Christensen court, Article 24(a)(2) cannot reasonably be construed to support a treaty-based foreign tax credit offset of the NIIT because: (i) the operative foreign tax credit language in Article 24(2)(a) is subject by its terms to the US Law Limitation; and (ii) the Code expressly forbids taxpayers from reducing the NIIT through the use of foreign tax credits.  Other courts that have grappled with this issue have reached the same or similar conclusions:  In 2021, the United States Tax Court in Toulouse v. Commissioner, 157 T.C. 49 (2021) came to the same view.  Likewise, in Kim v. United States, 664 F. Supp. 3d 1062 (C.D. Cal. 2023), a US federal district court reached the same determination in the context of the US-South Korea Income Tax Treaty.

Nevertheless, the taxpayers in Christensen ultimately prevailed because the court found that a separate sub-clause of the France Treaty's Double Taxation Article—the 'Three Bite Rule' in Article 24(2)(b)—offered independent support for their claim.   Three Bite rule provisions are found in various forms in the Double Taxation articles of 12 tax treaties to which the United States is a party (Including Australia, Canada, Finland, France, Germany, Israel, Mexico, the Netherlands, New Zealand, Portugal, Sweden, and the UK). They aim to address the unique foreign tax credit problems faced by US citizens who live in the treaty partner country.  By virtue of the United States's citizenship-based tax system, US citizens living abroad may be subject to worldwide or residency-based income tax in two different jurisdictions at once, with no general background principle of international tax law as to which country should get to keep the revenue and which country should be required to provide a foreign tax credit to alleviate double taxation. Three Bite Rule clauses will typically try to solve this issue by allocating taxing rights with respect to various items of income and gains as between the United States, as the country of citizenship, versus the treaty partner country as the country of residence.  Under this framework, the United States is generally permitted to keep the tax revenue attributable to a narrow slice of the US citizen's US-source income ('First Bite' income), with the residence country responsible for providing double tax relief in respect of that First Bite income.   The 'Second Bite' encompasses all income other than First Bite income that the residence country is purporting to tax under its own residency-based tax system.  The residence country is generally entitled keep its tax revenue on Second Bite income, with the United States generally required to provide a foreign tax credit in respect of any residence-country tax imposed on that income.  The 'Third Bite' represents the US citizen's remaining US federal tax liability, if any, on whatever income is left over after the Second Bite; this may include income that the residence country has either declined to tax or does not regard as taxable income in the first place.   

Consistent with this framework, the France Treaty's Three Bite Rule in Article 24(2)(b) gives the US Internal Revenue Service ('IRS') the primary taxing rights as to the slim First Bite of circumscribed US-source income, while the French tax authorities have the primary taxing right on the Second Bite, i.e. all other income subject to French tax, whether sourced from a Code perspective in the United States, France, or some third country.   

The plaintiffs in Christensen argued that based on the text and structure of France Treaty's Double Taxation article, the Three Bite Rule in Article 24(2)(b) is ostensibly not subject to the US Law Limitation language contained in Article 24(2)(a)'s general foreign tax credit language.  The court ultimately agreed with this argument and permitted the taxpayers to claim treaty-based relief against the NIIT partly on that basis.

While tax advisors initially greeted the Christensen holding with measured optimism, many have struggled to determine whether and to what extent that holding may extend to other double tax treaties—particularly those treaties lacking a Three Bite Rule or containing a Three Bite Rule that differs meaningfully from the France Treaty's language.  In addition, because the scope of the Three Bite Rule is generally limited to US citizens living abroad, the decision is not especially helpful to US tax residents or US business entities hoping to claim foreign withholding taxes or other source-based foreign tax liabilities as foreign tax credits against the NIIT.

Bruyea – Freed from the bite of the Three Bite Rule?

The plaintiff in Bruyea was a United States citizen living in Canada.  He had filed a refund claim with the Internal Revenue Service (the 'IRS') contending that Article XXIV of the Canada Treaty allowed him to claim a US foreign tax credit for Canadian taxes paid or accrued during the year against $263,523 of tentative NIIT liability.   The IRS rejected the refund claim and the taxpayer sued for relief.  

The Claims Court ultimately sided with the plaintiff on grounds which are more sweeping and taxpayer-friendly than the ones underpinning the Christensen decision.  

To support his argument, the taxpayer in Bruyea relied on a combination of Article XXIV(1) of the Canada Treaty—which provides that, subject to the US Law Limitation, 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 …'—and the Canada Treaty's Three Bite Rule in Article XXIV(4), which states that 'where a United States citizen is a resident of Canada . . . the United States shall allow as a credit against United States tax the income tax paid or accrued to Canada.' A key threshold question was how to interpret the relationship between these two clauses in the broader context of the Canada Treaty—specifically, whether the US Law Limitation wording in the Article XXIV (1) is meant to bleed over into the Three Bite Rule in Article XXIV (4) or whether the Three Bite Rule provision is completely separated and unencumbered by the US Law Limitation language.  The court ultimately punted on this question; it concluded that even assuming for the sake of argument that the Three Bite Rule entitlement in Article XXIV (4) is subject to the US Law Limitation, that language should not stand in the way of claiming a treaty-based foreign tax credit against the NIIT.

Much of the Bruyea decision is devoted to grappling with the 'interpretive puzzles' arising out of the phrasing of the US Law Limitation--specifically, the difficulty of determining whether and to what extent the Canada Treaty's Double Taxation article might allow taxpayers to claim a foreign tax credit in ways that would not be permitted under regular Code rules.  According to the court, the government's briefs seemed to be arguing for an extremely broad construction of the US Law Limitation, suggesting that a treaty-based foreign tax credit claim should be allowed only to the extent the purported foreign tax credit claim adheres to 'the limitations of the law of the United States' in the most literal sense, i.e. that the claim would already be permitted by US federal tax law without regard to the treaty.  In the court's view, that interpretation is misplaced because it is arguably circular and also would make much of the Double Taxation article's language superfluous.  The court seemed more inclined to agree with the plaintiffs' narrower construction of the US Law Limitation—in particular that the purpose and effect of the US Law Limitation is merely to ensure that the 'basketing' rules found in section 904 of the Code still apply even where a taxpayer is making a treaty-based foreign tax credit claim that would not otherwise be countenanced under the Code.  

The Bruyea court concluded that although certain aspects of the US Law Limitation remain vague and unsettled, at the end of the day the US Law Limitation should not preclude a taxpayer from claiming treaty-based foreign tax credits against the NIIT.  It decided further that Article XXIV represented affirmative legal support for such a claim.  In justifying its holding, the court noted first that the term 'United States tax' as it appears in Article XXIV(1) and Article XXIV(4) of the Canada Treaty is defined indirectly to mean any tax 'on income' imposed by the United States 'irrespective of the manner in which [it is] levied.'  In the court's view, this definition is broad enough to encompass the NIIT and represents good evidence that the treaty negotiators would have intended for taxpayers to be able to claim treaty-based foreign tax credits against their tentative NIIT liabilities.  The court also canvassed evidence from the Treasury Department's Technical Explanation, the US Congress's Joint Committee Report, and the State Department's contemporaneous Letter of Submittal, all of which suggested in its view that the Canada Treaty's Double Taxation article can and should override the Code to allow a foreign tax credit claim against the NIIT notwithstanding the US Law Limitation language.

The Bruyea court also addressed and dispensed with a second argument raised by the government in its defense—the so-called 'last in time' principle of treaty interpretation.   This rule of US double tax treaty construction provides that a later-enacted Congressional statute supersedes an existing treaty provision if there is a direct conflict between the two.   The court generally concluded that because neither section 1411 of the Code nor any other provision of US internal law expressly states that a person cannot claim treaty-based foreign tax credits against the NIIT, the last in time rule does not apply and should not bar the plaintiffs' refund claim.

Broader implications

Before Bruyea, taxpayers living in some Three Bite Rule treaty jurisdictions could marshal the Christensen holding to support a treaty-based foreign tax credit claim against the NIIT.   Yet many taxpayers would have struggled to apply Christensen's narrow holding to treaties other than the France Treaty.   First, as noted above, only twelve (12) treaties currently contain any kind of Three Bite Rule language.  Second, the Three Bite Rule clauses differ from one another in important respects.  For instance, while the France Treaty's Three Bite Rule seems to fall entirely outside the scope of the US Law Limitation, the Bruyea court seemed to regard the Canada Treaty's Three Bite Rule in XXIV(4) as being more inextricably bound up with the US Law Limitation language in Article XXIV(1).  The Bruyea holding helps taxpayers in this regard by taking the focus off of the idiosyncrasies of each particular Three Bite Rule clause.  Importantly, it also opens the door for US resident taxpayers or US business entities other than US citizen individuals residing abroad to claim foreign tax credits against the NIIT, particularly in instances where the NIIT income base has been subjected to a withholding or similar source-based tax in the other treaty country.

Bruyea is especially welcome news for US citizens living in the United Kingdom who will have felt hemmed in by Christensen's limitations. The US-UK Income Tax Treaty ('UK Treaty')'s Three Bite Rule is uniquely complicated and more limited in scope than equivalent provisions in some other treaties.  Article 24(6)(c), the core operative provision in that treaty's Three Bite Rule framework, generally requires the IRS to allow a foreign tax credit for some UK income tax liabilities incurred by US citizens residing in the UK.  As with the corresponding provision in the France Treaty, this provision is not subject to the US Law Limitation.  Unusually, however, Article 24(6)(c) seems to apply only to the portion of the US citizen's UK tax liability which is attributable to US-source Second Bite income—for instance, interest income received from a US-resident debtor.  In contrast, the equivalent Three Bite Rule provision in the France Treaty seems to apply to all Second Bite income regardless of source.  The France Treaty's Three Bite Rule framework implies that the United States must grant a foreign tax credit to a French resident US citizen in respect of the French tax imposed on—for example—a French-source or German-source dividend.  In contrast, the UK Treaty's Article 24(6)(c) is conspicuously silent as to whether the United States must give a foreign tax credit to a UK resident US citizen for UK tax imposed on a UK-source or German-source dividend.  The upshot of this distinction is that if a UK-resident US citizen were relying solely on Christensen to claim a treaty-based foreign tax credit against the NIIT, the UK Treaty's Three Bite Rule would seem to support that argument only to the extent of UK tax imposed on the US-source portion of Second Bite income.  If the UK Treaty offers any treaty-based foreign tax credit relief against the NIIT for the 'foreign-source' portion of Second Bite income, that relief would presumably derive from the more general Double Taxation relief language found in Article 24(1) of the UK Treaty, which provides that 'in accordance with [the US Law Limitation], the United States shall allow to a resident or citizen of the United States as a credit against the United States tax on income . . . the income tax paid or accrued to the United Kingdom by or on behalf of such citizen or resident.' In the pre-Bruyea era, the US Law Limitation wording in this clause would have immediately undercut any attempt to invoke it as support to claim foreign tax credits against the NIIT.  The Bruyea decision, however, has opened up a host of possibilities for marshalling this clause to support such an argument.  

Conclusion

While Bruyea is encouraging for US Persons incurring foreign taxes on NIIT-related income, caution is still warranted at this stage.   First, the Bruyea decision could be reversed or modified on appeal.  Second, the holding stands in direct contradiction to the Toulouse and Kim holdings, both of which found that Double Taxation provisions subject to the US Law Limitation could not be used to claim treaty-based foreign tax credit against the NIIT.  

For individuals with some appetite for risk, the Bruyea holding may be enough to mount a defensible return provision or refund claim asserting that the NIIT can be offset with treaty-based foreign tax credits.

Withers LLP has a large team of US-qualified tax lawyers based in London and across our offices in the United States, Europe, and Asia.  The US team works closely with the firm's UK solicitors to provide seamless cross-border advice as well as innovative US/UK tax structuring solutions to individuals, their businesses, and their families.