Worried About Double Taxation? Court Affirms Protections for Dual Residents

Posted on January 27th, 2025 in Cross-border Tax

Executive summary

The U.S.-Canada Income Tax Treaty offers relief from double taxation for dual citizens and residents. This court case demonstrates the treaty’s ability to protect taxpayers and shows how its provisions can operate independently and override U.S. tax laws in certain instances.

U.S. citizen Paul Bruyea, who is also a Canadian resident, sold his Canadian property in 2015 and reported $7 million US in capital gains from the sale.

Bruyea paid roughly $2 million in capital gains tax to the federal government — but he is also subject to taxation on his worldwide income as a U.S. citizen. As a result, Bruyea reported this gain on his U.S. tax return and owed the Internal Revenue Service (IRS) roughly $1.6 million on this income.

The U.S.-Canada Income Tax Treaty offers relief from double taxation for dual citizens and residents by permitting taxpayers to claim a foreign tax credit (FTC) for income taxes paid in either country, subject to certain conditions.

It would be reasonable to conclude that if you paid roughly $2 million in taxes to Canada and your total U.S. liability was approximately $1.6 million, you wouldn’t owe any additional U.S. taxes.

In Bruyea’s case, he was able to virtually eliminate all income taxes (under Chapter 1 of the Internal Revenue Code which accounted for roughly $1.4 million of his total tax liability) through the FTC mechanism. However, he couldn’t use his FTC to offset the $263,523 of Chapter 2A taxes also known as the Net Investment Income Tax (NIIT).

Historically, the IRS views the NIIT as a surtax rather than a traditional income tax and disqualifies the use of FTCs against the NIIT. Bruyea was therefore unable to offset his NIIT liability using FTCs and owed an additional $263,523 to the IRS — leaving him with a $2.2 million total tax bill on his $7 million gain from the sale.

Bruyea decided to file an amended tax return with the IRS on Nov. 7, 2016, to claim a refund for the NIIT taxes paid. He argued that the U.S.-Canada Income Tax Treaty entitled him to a foreign tax credit against the NIIT.

The IRS rejected this claim and said the treaty did not support the independent basis for an FTC to offset the NIIT. In this instance, it argued an FTC was not allowed under the U.S. statutory foreign tax credit rules.

Bruyea decided to invoke the Simultaneous Appeal Procedure and sought advisory opinions from relevant U.S. and Canadian authorities after the IRS denied his claim. The Canadian Competent Authority agreed that Canada as the country of source had the right to tax the gain while the U.S. must provide relief under the U.S.-Canada Income Tax Treaty.

He also filed a lawsuit in the U.S. Court of Federal Claims, where he claimed he was entitled to the FTC under the treaty. The U.S. government filed a cross-motion for summary judgment and response in opposition to Bruyea’s motion.

The court ruled in Bruyea’s favour on Dec. 5, 2024, after it heard oral arguments on Sept. 19. This win may pave the way for U.S. citizens living in Canada to utilize FTCs generated in Canada on investment income to offset NIIT.

Max Reed, the Vancouver-based tax counsel for Bruyea, said the court’s opinion is strong and can have “wide ranging implications for Canadian individuals and businesses that go beyond the NIIT.”

“This case is far from over and the United States will likely appeal, but for now double taxation has been dealt a serious blow,” Reed said.

Case highlights

The IRS defended its position on the basis that:

The Code generally only provides a credit for foreign taxes paid against taxes within Chapter 1 (income taxes). Since NIIT is not classified as an income tax, it should be disqualified for FTC purposes.

If a statute conflicts with a treaty, the latter of the two enactments prevails — also known as the last-in-time rule, which dictates that the latter-enacted statute takes precedence over the earlier one. Since the NIIT came into effect in 2013 as part of Obamacare, the IRS asserted that under the last-in-time rule, the statute would take precedence over the treaty.

Bruyea, the taxpayer, argued that:

NIIT is an income tax and is a covered tax under the treaty.

The U.S. is obligated to provide an FTC under the treaty and failure to which violates the spirit of the treaty that specifically aims to eliminate double taxation. He cited Article XXIV of the treaty, the title of which is Elimination of Double Taxation.

The court based its decision in favour of Bruyea on the basis that:

The Canada-U.S. Tax Treaty aims to eliminate double taxation and emphasized the importance of interpreting treaties liberally to uphold their intent. When the treaty provisions are ambiguous, the court may look beyond the written words, the history of the treaty, the negotiations and the practical construction of the parties to understand the intent. Thus, the court looked through the intent of the treaty rather than its plain text.

The last-in-time rule was not applicable here as there was no conflict between the Internal Revenue Code and the treaty provision for this rule to apply. While later-enacted statutes can override a treaty if U.S. Congress intends to do so, it did not intend an override when enacting the NIIT.

The court also held that the U.S. Law Limitation does not preclude Bruyea from claiming FTC to offset the NIIT.

Conclusion

Bruyea’s case demonstrates the court’s expansive perspective on the ability to claim an FTC against the NIIT. This ruling highlights the power of international tax treaties to protect individuals from double taxation and shows that treaty provisions can operate independently and override U.S. tax laws in certain cases.

U.S. citizens in Canada will be able to utilize FTCs generated in Canada on investment income against the NIIT in the U.S. — but the outcome of this case may not fully represent the latest position of the IRS.

It would be prudent to see how this case and others such as Christensen v. United States develop in the future and whether this relief proves to be permanent. It could be a risky position to take at this time, but if the tax is large enough, it may warrant the cost of defending the position. As a practical matter, the tax forms aren’t currently set up to allow claiming this refund and would need to be re-designed if this case is upheld.

Although Reed expects the U.S. to appeal this decision in the next few months, he feels optimistic that this case has more credibility than the past cases on this matter. As more cases are decided, the legal framework surrounding FTCs and NIIT could offer tax relief by reducing double taxation.

Source: RSM Canada LLP.
Reprinted with permission from RSM Canada LLP.
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