Foreign Tax Credit: Foreign Income Tax on Net Investment Income

By ZM Ishmurzina

American expats living abroad use the foreign income exclusion, foreign housing exclusion or foreign tax credit to minimize US tax liability. However, 3.8% Medicare tax on net investment income might expose US expats to double taxation on net investment income (NII) effective in a tax year 2013. Specifically, the foreign income tax paid on NII may not reduce the tax imposed by Obamacare.

This is an email from one of our clients, American expats living abroad. “I read about 3.8% Medicare tax on net investment income. My gross income will be over $300,000. I pay foreign income tax on my investment income. Could you clarify whether I will have to pay an additional 3.8% Medicate tax and whether I can utilize foreign tax credit to offset this tax?”

Let’s review the key developments in regards to foreign income tax and net investment income.

Foreign Tax Credit and Foreign Income Tax

American expats living abroad are aware that foreign tax credit and foreign income tax are interlinked. Per the section 27 of the IRC “The amount of taxes imposed by foreign countries and possessions of the United States shall be allowed as a credit against the tax imposed by this chapter to the extent provided in section 901.” The chapter referred in the section 27 is chapter 1 of the code that includes sections 1-1400U. 3.8% Medicare tax on income from investments is reflected in section 1411 that is a part of new chapter 2a of the IRC. Consequently, foreign income tax paid on net investment income by American expats will not reduce the tax on NII resulting in double taxation.

Tax Treaty Agreements

The United States has tax treaty agreements with 66 countries. One of the primary purposes of these treaties is to eliminate double taxation and to introduce foreign tax credit regime. Per article 23 (1) “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 without changing the general principle hereof), the United States shall allow to a resident or citizen of the United States as a credit against the United States tax on income applicable to residents and citizens” certain foreign taxes. Article 3(b) doesn’t indicate that the treaties do not cover section 1411 tax. However, the United States does not recognize the primacy of treaties over domestic law. On January 18, 2013 at an American Institute of Certified Public Accountants webcast the IRS official confirmed that 3.8% Medicare tax on net investment income is not creditable to foreign tax credit.

Conclusion

American expats living abroad must evaluate their tax situation and determine whether they are required to make estimated payments to cover US expat tax liability on net investment income. American expats are advised to contact an expat tax CPA who can help them understand any deductions or exemptions that they might be eligible for. An expat tax preparer that specializes in international tax preparation can also help understand different tax treaty provision and their impact on US tax liability. International tax experts at Artio Partners are here to help you.