U.S. citizens living abroad may not be able to exclude the Net Investment Income Tax (NIIT) from their returns since there is insufficient guidance as to whether this new tax is a social security tax covered under a Totalization Agreement or an Income Tax to which regular foreign tax credits apply. However, there are certain significant items of income which are excluded from this tax.
Persons wishing to take a position that the NIIT is a social security tax should properly explain their departure from the IRS code by filing a complete explanation on forms 8833 and/or form 8275.
What is Net Investment Income Tax?
The Net Investment Income Tax (NIIT) is a new tax first introduced as of January 1, 2013. This is an additional tax of 3.8% of all investment income (dividends, interest, net rental income, royalties, S corporation income if there is no material participation and capital gains) reported on a US tax return, but only if an individual has modified adjusted gross income above $250,000 for a married couple filing jointly, $125,000 for married persons filing separately, and $200,000 for single persons. The tax is not levied on retirement plan distributions. Inclusions from controlled foreign corporations (CFC's) under subpart f of the Internal Revenue Code are not subject to the tax (unless one elects to have the tax apply), but distributions of investment income from CFC's are.
The NIIT applies to U.S. citizens and residents of the United States. Non resident aliens, including "dual status" aliens and aliens electing to be taxed as U.S. residents are excluded from the tax. However, there is little or no guidance from the Joint Committe on Taxation or the Treasury on how this tax affects U.S. citizens living outside of the United States. Although some large accounting firms have indicated that no protection from the NIIT is available to US citizen expatriates, there is a possibility that expatriates may be able to avoid the tax, depending upon what type of tax it is eventually ruled to be.
NIIT as a Social Security Tax
The United States has a Social Security Totalization Agreement (SSTA) with 24 countries, including Canada. These agreements provide that persons who are subject to the social security legislation in a Treaty country (such as the Canada Pension Plan) are therefore exempt from U.S. Social Security taxation. Accordingly if the NIIT is considered a social security tax, U.S. citizen expatriates covered under the social security legislation in a Treaty country would be exempt from the NIIT.
The SSTA indicates that the taxes covered are those assessed under Internal Revenue Code (IRC) chapter 2 - self employment tax, and 21 - Federal Insurance Contributions Act (FICA) tax. The SSTA, however also indicates that "[T]his Agreement shall also apply to laws which amend, supplement, consolidate or supercede the laws specified in paragraph (1)." (Article II(3).) Although the SSTA specifically mentions the additional Medicare tax of .9% of employment and self employment income over certain thresholds, the NIIT which is intended to apply additional tax to persons earning their income from investments rather than employment is not specifically mentioned. The NIIT is called an "Unearned Income Medicare Contribution" in the Health Care and Education Reconciliation Act of 2010 (Sec. 1402(a)(1)), and the Joint Committee on Taxation in its publication "Technical Explanation of the Revenue Provisions of the "Reconciliation Act of 2010"" refers to the NIIT as a Social Security or Medicare tax.
The NIIT is intended to provide funding for health care in conjunction with the requirement for persons to maintain minimum essential healthcare coverage. Notably, U.S. citizens living abroad are exempt from the requirement to maintain minimum essential coverage, and in many cases do not require and never use Medicare coverage.
NIIT As An Income Tax
When a U.S. citizen resides abroad in a Treaty country, provisions are in place to allow a foreign tax credit for taxes paid on income earned in the other country. Even though the provisions of the Canada U.S. Income Tax Convention provide rules for the elimination of double taxation, there is no specific credit available to apply against the NIIT. Since tax rates in Canada are typically higher than those in the U.S., a general foreign tax credit system would, if available, eliminate the NIIT. Generally when a U.S. citizen resides in Canada, Canada has the first right to tax income. In Article XXIV(1), the Treaty with Canada states that a U.S. citizen will be allowed "... as a credit against the United States tax on income the appropriate amount of income tax paid or accrued to Canada". At Article II(1) the Treaty indicates that "This Convention shall apply to taxes on income and on capital imposed on behalf of each Contracting State, irrespective of the manner in which they are applied." Article II(2)(iii) does allow a foreign tax credit for social security taxes but only to the extent required to eliminate double taxation under Article XXIV(2) of the Treaty.
Since the income giving rise to the NIIT for residents of Canada are generally not U.S. sourced, there is no provision to allow for a foreign tax credit in Canada for the NIIT. Even if the NIIT is based on investment income earned in the U.S., Canada is not required to provide a foreign tax credit on taxes in excess of those normally assessed, and not in cases where other individuals earning the same income, such as non resident aliens, are exempt from that tax.
What is Exempt From the NIIT?
To determine what types of income may be exempt from the NIIT, one must look at what types of income are included in the definition of "Net Investment Income" and therefore subject to the tax. By extension we can determine what is not included in the definition.
Among the other items mentioned in IRC 1411(c), most notable is the exclusion of income earned in an "active trade or business" which is "Derived in the Ordinary Course of a Trade or Business". Internal Revenue bulletin number (IRB) TD 9644 published on December 16, 2013 addresses some of the technical issues in defining these terms, but in summary the following income is excluded:
- Income from an active trade or business;
- Dividends from a company in which the income was earned in an active trade or business and distributed to the individual; and
- Gains from the disposition of the shares of a company engaged in an "active trade or business".
This is a key part of this section, since it effectively excludes from the NIIT any income earned from the operation of or disposition of an active trade or business. This would, for example, include dividends from a Controlled Foreign Corporation (CFC) or the proceeds of sale of the shares of a CFC.
Because this is a complex area we have reproduced the full text of Internal Revenue Code Section 1411(c) below:
1411(c) Net investment income
For purposes of this chapter—
(1) In general
The term ‘‘net investment income’’ means
the excess (if any) of—
(A) the sum of—
(i) gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business not described in paragraph (2),
(ii) other gross income derived from a trade or business described in paragraph (2), and
(iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business not described in paragraph (2),
(B) the deductions allowed by this subtitle which are properly allocable to such gross income or net gain.
(2) Trades and businesses to which tax applies
A trade or business is described in this paragraph if such trade or business is—
(A) a passive activity (within the meaning of section 469) with respect to the taxpayer,
(B) a trade or business of trading in financial instruments or commodities (as defined in section 475(e)(2)).
(3) Income on investment of working capital subject to tax
A rule similar to the rule of section 469(e)(1)(B) shall apply for purposes of this subsection.
(4) Exception for certain active interests in partnerships and S corporations
In the case of a disposition of an interest in a partnership or S corporation—
(A) gain from such disposition shall be taken into account under clause (iii) of paragraph (1)(A) only to the extent of the net gain which would be so taken into account by the transferor if all property of the partnership or S corporation were sold for fair market value immediately before the disposition of such interest, and
(B) a rule similar to the rule of subparagraph
(A) shall apply to a loss from such disposition.
(5) Exception for distributions from qualified plans
The term ‘‘net investment income’’ shall not include any distribution from a plan or arrangement described in section 401(a), 403(a), 403(b), 408, 408A, or 457(b).
(6) Special rule
Net investment income shall not include any item taken into account in determining self employment income for such taxable year on which a tax is imposed by section 1401(b).