The Double Tax Trap: How the IRS Used a Table of Contents to Win a Lawsuit
Living the expat dream sounds fantastic, sipping espresso at a café in Paris, or enjoying the crisp air of the Canadian Rockies. But there’s one uniquely American problem that follows you no matter where in the world you move, the IRS.
Recently, a few American expats learned a hard lesson about international tax treaties, double taxation, and the government’s unparalleled ability to win a fight using a technicality.
The setup was fairly common. An American expat living in Canada and an American couple residing in France both decided to sell some foreign assets. Naturally, they paid foreign taxes to their respective host countries on the profits of those sales. But because they are U.S. citizens, the IRS also wanted its cut. Specifically, the IRS wanted the 3.8% Net Investment Income Tax (NIIT), which is a special surcharge that applies to investment income.
The taxpayers cried foul. “Wait a minute!” they argued. “The United States has tax treaties with Canada and France! Those treaties specifically say you can’t double-tax us on the exact same income. We already paid our taxes over there, so we should get a foreign tax credit over here to offset the NIIT.”
It sounded perfectly logical. In fact, it sounded so logical that when the taxpayers took the IRS to the Court of Federal Claims, they won. The lower court basically said, “They’re right. Double taxation is exactly what these treaties are supposed to prevent.”
The expats likely popped the champagne. But the IRS appealed the decision to the Federal Circuit Court of Appeals, bringing with them an argument so wildly bureaucratic, you almost have to respect it.
The government didn’t argue that double taxation was a myth. Instead, they pointed to the literal layout of the Internal Revenue Code. The IRS argued that the treaty’s foreign tax credit rules only apply to the main income tax section of the law (Chapter 1). The 3.8% NIIT, however, was written into a completely different section of the tax code.
It’s the legal equivalent of a landlord saying, “Your rent includes all utilities!” but then sending you a separate bill for water because it’s technically a “hydration surcharge.”
Because the tax treaties state that foreign tax credits are granted “subject to the limitations” of U.S. law, the Federal Circuit sided with the government. By intentionally placing the NIIT in a different legislative bucket, lawmakers successfully bypassed the treaty’s reach.
The court rejected the taxpayers’ backup arguments, noting that the specific language limiting these credits is standard boilerplate that appears in U.S. tax treaties all over the world. (In fact, other courts have recently made the exact same ruling regarding tax treaties with countries like South Korea).
The Takeaway
If you’re a U.S. citizen living abroad, or a stateside taxpayer holding foreign investments, the rules just got much less forgiving. You cannot use foreign tax credits to wipe out your 3.8% Net Investment Income Tax. Even if you paid a small fortune in taxes to a foreign government on your asset sale, Uncle Sam is still going to collect that extra 3.8% if your income clears the statutory thresholds.