The U.S. and Canada have very close ties, given their proximity. Many U.S. citizens live, work, invest, and buy property in Canada.  To ensure such expats do not have to pay double tax on the same income in both the U.S. and Canada, the two countries signed a tax treaty that allows expats to claim Foreign Tax Credits (FTC) on the income tax amount they paid in the other country. If a U.S. expat paid $50,000 in tax in Canada, they can reduce this amount from their U.S. income tax liability under the FTC, assuming other criteria are met.   

However, the U.S. Internal Revenue Service (IRS) has been disallowing treaty-based FTC against net investment income tax liability (NIIT) as there is no credit available in the U.S. Internal Revenue Code (IRC). The ambiguity around the NIIT has been debated in many lawsuits. However, a recent ruling in Bruyea v. US, the Claims Court allowed that treaty-based credit. 

What is NIIT, and what does this latest ruling mean to a U.S. expat taxpayer?  

Understanding the U.S. Net Investment Income Tax and Foreign Tax Credit  

In 2013, the U.S. introduced a 3.8% tax on net investment income above a certain threshold. Whether a clerical oversight or by design, the U.S. introduced NIIT as Chapter 2A of the Internal Revenue Code (IRC), and the FTC rules are stated in Chapter 1. Interpretations of this have led to several cross-border tax challenges.

According to the IRS interpretation, domestic law prohibits the FTC on NIIT because the FTC applies only to taxes within Chapter 1, and the NIIT is in Chapter 2A. Article 24 of the 1984 US-Canada Tax Treaty provides for FTC against the NIIT even though the Code does not. However, the credit must be “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) … “.

The Ambiguity in the Foreign Tax Credit Claim  

The ambiguity arises because the domestic Code prohibits foreign tax credit while the Treaty allows it. So, which one should apply – the Code or the treaty? 

This ambiguity also arises because the IRS and the Competent Authority of Canada have not reached a common understanding. The latest foreign tax ruling by the Claims Court addressed this issue with an analysis of how to approach such grey areas.   

The Case:

Paul Bruyea is a dual citizen of the U.S. and Canada, living in Canada. He sold a property in Alberta for a capital gain of ~US$7 million in 2015, on which he paid Canadian tax and offset its US$1.4 million regular U.S. tax liability.  

He also owed NIIT of US$263,523, on which he did not claim FTC in the 2015 U.S. tax returns. He later submitted an amended U.S. tax return in November 2016, claiming a refund on the NIIT amount, as he had paid tax to both Canada and the U.S. on the same capital gain. However, the IRS rejected the refund claim.  

So, the taxpayer filed a “competent authority” request. The Canadian competent authority stated that Canada has the right to tax the capital gain; however, the U.S. must provide tax relief under Article 24 of the Treaty, and discussions are ongoing. 

The taxpayer also filed a complaint with the Claims Court. The Court heard the arguments of both parties and issued its order on December 5, 2024.

The Claims Court’s Ruling  

The Court ruling gave a broader perspective on dealing with ambiguity. Courts may look beyond the text and into the history of the treaty, why it was created, the negotiations, the views of the parties, and the opinions of the sister signatory. The primary purpose of the U.S.-Canada tax treaty is to prevent double taxation.  

The IRS argued with the “last-in-time rule”, under which the last updated law applies, in this case, NIIT. However, the Court stated that this rule only applies when there is a conflict between the statute and the Treaty. Had the domestic tax law explicitly stated that the NIIT denies any treaty-based credit, the claim could be denied. Since there is no such conflict of interest, you cannot rule out the credit claim.

Hence, the court ruled that the FTC claim is applicable, and the IRS should process the request after calculating the refund amount.

This does not mean that the Treaty supersedes the Code. It depends on a case-by-case basis and a review of extrinsic evidence.

Other Foreign Tax Credit Rulings   

Bruyea’s court ruling is fundamentally different from the other foreign tax credit rulings.

• The 2021 U.S. Tax Court ruling in Toulouse v. Commissioner interpreted the treaty as limited by U.S. law, meaning the Code supersedes the Treaty.   
• The 2023 U.S. Claims Court ruling in Christensen v. US interpreted that the U.S. Law Limitation could prevent a treaty-based FTC.  
• The 2024 U.S. Claims Court ruling in Bruyea v. US interpreted that the U.S. Law Limitation only informs how FTCs are computed for U.S. tax purposes. 

What Does the New Foreign Tax Ruling Mean to Taxpayers

Bruyea’s court ruling provides a broader insight into interpreting the rules beyond the text, paving a potential way for taxpayers to claim a foreign tax refund against NIIT paid.  

If you paid NIIT and filed amended returns with the IRS claiming refunds, you can prevent the expiry of the statute of limitations on potential refunds if the rulings are upheld. However, you should consult a tax advisor before filing amended returns, as the matter won’t be resolved just by approaching the IRS or Competent Authorities. There is a high likelihood that the IRS will deny FTC claims on timely filed returns or amended returns. We await guidance from the IRS on how they will implement this court ruling into their operations, and whether the 2025 income tax forms and returns will incorporate changes from this decision.

Contact Edelkoort Smethurst CPAs LLP in Burlington to Help with Cross-Border Tax Filing      

Tax laws are ambiguous and complicated, and should be handled with caution. A professional U.S. tax consultant well-versed in both U.S. and Canadian tax laws can help you navigate them efficiently. They will examine each transaction from a tax perspective and suggest ways to perform the transactions with the least tax liability and a better chance of securing tax benefits. At Edelkoort Smethurst CPAs LLP, our cross-border tax advisors offer services including cross-border tax filing and tax planning. To learn more about how Edelkoort Smethurst CPAs LLP can provide you with the best tax expertise, contact us online or by telephone at 905-517-2297.