Court allows Canada-US tax treaty credit against investment tax

Allan Lanthier, a retired partner of an international accounting firm, has been an adviser to both the Department of Finance and the Canada Revenue Agency.

MONTREAL – U.S. citizens residing in Canada face a number of cross-border tax challenges, including the risk of double taxation if income tax paid to one of the countries is not eligible for credit in the other. The recent Bruyea decision[1] of the United States Court of Federal Claims[2] — which allowed a tax treaty credit against U.S. tax on investment income, even though no credit was available under the U.S. Internal Revenue Code[3] — is therefore welcome. 

The U.S. Tax on Investment Income 

In 2013, the U.S. introduced a special 3.8 percent tax on investment income earned by higher-income U.S. citizens, residents and trusts. The tax — the net investment income tax (“NIIT”) — was part of the Affordable Care Act, colloquially known as “Obamacare”. Under section 1411 of the Code, U.S. individuals and trusts are liable to a 3.8 percent tax on investment income that exceeds an annual threshold.[4] 

Whether by oversight or design, there is no credit under the Code if foreign tax is owing on the investment income: this is because the NIIT was introduced as Chapter 2A of the Code, while the rules governing foreign tax credits are in Chapter 1. The fact that this could lead to double taxation has been commented on by other tax practitioners.[5] 

A Taxpayer Caught in the Crossfire 

Paul Bruyea, a dual citizen of the United States and Canada and a resident of Victoria, British Columbia, realized a capital gain of approximately US $7 million in 2015 on the sale of real property located in Alberta. He had a regular U.S. tax liability of about US $1.4 million on this income, virtually all of which was eliminated by a credit for the Canadian tax he paid on the gain. In addition, the taxpayer owed NIIT of US $263,523. While his Canadian federal-provincial tax was more than enough to eliminate this tax as well, the taxpayer did not claim a credit on his 2015 U.S. personal tax return. 

In November, 2016, Mr. Bruyea filed an amended U.S. tax return (U.S. form 1040-X) seeking a refund of US $263,523 on the basis that, while the Code allowed no credit for Canadian tax paid on the capital gain, article XXIV of the U.S.-Canada tax treaty[6] did. The battle was on. 

The Internal Revenue Service (“IRS”) concluded that relief from double taxation did not apply, and the taxpayer filed a “competent authority” request pursuant to the mutual agreement procedures of the US-Canada Treaty asking the tax authorities of the two countries to seek to resolve the double taxation issue. More than four years after the request was filed, the Canadian competent authority informed the taxpayer that its view was that the U.S. must provide tax credit relief under the treaty, but that “discussions with [the IRS] to obtain relief from double taxation are ongoing and our respective positions remain far apart”. 

The taxpayer filed a refund claim of US $263,523 with the Court and, in September, 2023 — almost seven years after the amended return 1040-X was filed — the IRS issued a formal notice disallowing the claim. 

The Issue in Dispute 

The issue in dispute is, on its face, a simple one. The Code does not provide a credit for foreign taxes paid on the income in question: however, article XXIV of the US-Canada Treaty does. So which enactment prevails — the Code or the treaty? 

Paragraph 1 of article XXIV of the treaty states, in relevant part, that, “in accordance with the provisions and subject to the limitations of the law of the United States”, the U.S. shall allow a United States citizen or resident a credit against U.S. tax for “the appropriate amount of income tax paid or accrued to Canada”. The position of the IRS is that the reference to provisions and limitations of U.S. law — which the Court called the “U.S. Law Limitation” — means that, if the Code does not allow a credit, neither can the treaty. In other words, there is no treaty-based credit that is independent of the Code. The taxpayer disagreed, and argued that article XXIV creates a treaty-based credit applicable to the NIIT, irrespective of whether the Code provides a credit or not. 

Paragraph 4 of article XXIV modifies the rules in paragraph 1 for U.S. citizens who are resident in Canada, and also allows a United States citizen a credit against U.S. tax for income tax paid or accrued to Canada.[7] While not free from doubt, the U.S. Law Limitation in paragraph 1 may apply to paragraph 4 as well: in fact, in Bruyea the Court concluded that it does.[8] And so, the question under both paragraphs of article XXIV was whether the US-Canada Treaty provides a credit against the NIIT even though the Code does not. 

The Court Decision

The case was decided by Judge Matthew Solomson, who began by summarizing the principles of treaty interpretation that apply in the U.S. — principles that align closely with those in Canada. 

The interpretation of a treaty begins with its text, he said, but that is not the end of the analysis. Courts are encouraged to consider a treaty’s purpose, as well as extrinsic evidence of the intent of the treaty parties. Courts may look beyond the text to the history of the treaty, the negotiations, and the views adopted by the parties, particularly when the text of a treaty provision is ambiguous. Also, the opinions of the sister signatory to the treaty (in this case, Canada) are entitled to considerable weight. 

Finally, a treaty should generally be construed liberally to give effect to its purpose. Accordingly, if the text of a treaty provision fairly admits of two interpretations, one that restricts rights which may be claimed and another that enlarges those rights, the more liberal interpretation is to be preferred. 

With these principles in mind, the Court turned to its analysis, and addressed the two determinative issues: the so-called “last-in-time rule”, and the U.S. Law Limitation. 

The last-in-time rule:

In the United States, if a statute conflicts with a treaty, the later of the two enactments prevails.[9] This is known as the “last-in-time rule”. While the NIIT was introduced after the treaty (including all of its protocols), the rule only applies if there is a direct conflict between the statute and the treaty, and the Court found that there was no direct conflict: that the NIIT did not expressly deny a treaty-based credit. 

The Court’s conclusion would have been different had Congress denied a treaty-based credit by including a provision to that effect in the Code,[10] but simply placing the NIIT in a separate chapter of the Code without any reference to the treaty, one way or the other, did not create a conflict. The Court stated that “The government has pointed to no express textual or extrinsic evidence — literally nothing — even remotely suggesting that Congress’s placement of the NIIT outside of Chapter 1 was intended to preclude a Treaty-based tax credit”. 

The U.S. Law Limitation: 

The taxpayer argued that the treaty reference to provisions and limitations of U.S. law — the U.S. Law Limitation — simply means that the detailed rules in the Code apply when computing the amount of the treaty-based credit. The IRS disagreed, and suggested that the limitation goes much further: that there is no treaty-based credit at all unless the Code allows it. 

There was a flaw in the government’s argument, the Court said. If by reason of the U.S. Law Limitation, article XXIV provides nothing beyond what is already allowed under the Code, the article would be inoperative and, in the words of the Court, “would have no independent purpose or effect in contravention of the fundamental rules of U.S. legal interpretation”. If on the other hand certain provisions of article XXIV do apply even though they are inconsistent with the Code (as the government conceded),[11] what is the interpretative principle that determines whether a particular provision of the treaty applies or not? 

The government suggested that the answer lies in specificity: that the Code governs, unless the treaty allows specific provisions of the Code to be altered. The Court didn’t buy it, and said that this was akin to saying that “the treaty governs unless it doesn’t”. 

Clearly, the plain text of the Code and the treaty would not determine the outcome. And while the general purpose of article XXIV is to avoid double taxation, that fact would not be determinative either. The Court stated that both parties had relied extensively on extrinsic evidence, “suggesting that neither party can throw a knock-out interpretive punch here”. And so the Court turned to a review of extrinsic evidence – a review that, in the view of the Court, favoured the taxpayer. 

First, the Court noted that the U.S. Treasury Department’s Technical Explanation of the treaty (with which Canada had concurred) states that the credit allowed by paragraph 1 of article XXIV is subject to the limitations of the Code, and therefore that various provisions in the Code apply “for purposes of computing” the allowable credit. In addition, with reference to the definition of “income tax paid or accrued” in paragraph 7, the explanation states that paragraph 1 provides a credit for qualifying taxes “whether or not they qualify as creditable under Code section 901 or 903”. 

Second, the Joint Committee on Taxation[12] also issued an explanation of the treaty which stated, in part, that the treaty rules “are used only if the taxes are not creditable under the Code”. 

Third, the technical explanation to the 2006 U.S. model treaty states that “the United States will allow a credit to its citizens and residents under the Article, even if such credit were to provide a benefit not available under the Code”. 

Finally, and as noted further above, the opinions of sister signatories to a treaty are to be given considerable weight, and the Court noted that here, the Canadian competent authority had concluded that the U.S. must provide the treaty relief sought by Mr. Bruyea. 

Having regard to all the above, and to the principle that, in the case of ambiguity, the more liberal interpretation of a treaty provision is to be preferred, the Court concluded that Mr. Bruyea was entitled to the treaty-based credit. 

Conclusion 

While the taxpayer prevailed, the government will likely appeal the decision to the U.S. Court of Appeals. In fact, there is another decision of the Court[13] involving the interaction of the NIIT and the U.S. France tax treaty which is already under appeal by the U.S. government (it lost that case as well at the Court of Federal Claims, but for reasons that differ — and conflict somewhat — from those in Bruyea). And so, the battle continues.

Footnotes