Americans living abroad and the net investment income tax.

• Author: Nightingale, Kevyn

The U.S. State Department estimates that approximately 7.2 million U.S. citizens live abroad, plus an indeterminate number of green card holders. (1) The United States has social security totalization agreements (SSTAs) with 24 countries (2) and income tax treaties with 67. (3) The vast majority of Americans abroad live in these countries.

When the Sec. 1411 net investment income tax was passed, little thought was given to how it would affect Americans living abroad, and with no guidance issued on the topic, its effect is unclear. This article describes how the net investment income tax may affect Americans living abroad.

The tax essentially raises two questions:

1. Are these individuals (4) subject to this tax?

2. If an individual is subject to the tax, would a foreign tax credit (FTC) be available where the underlying income that gives rise to the tax is:

(a) Foreign (non-U.S.) source?

(b) U.S.-source?

It is also unclear whether the tax is a social security tax for purposes of the U.S.--Canada SSTA. (5)

Net Investment Income Tax in General

To help fund 2010's health care reform legislation, (6) the United States instituted the net investment income tax, (7) which is designed to affect high-income people. The tax amounts to 3.8% of a U.S. person's net investment income, (8) to the extent the person's modified adjusted gross income is above:

* For a married couple filing jointly, $250,000;

* For a married person filing separately, $125,000; and

* For a single taxpayer, $200,000. (9)

Roughly, investment income includes interest, dividends, rent, royalties, and most net gains. It includes income from passive activities. (10) It does not include distributions from qualified retirement plans. (11)

For owners of controlled foreign corporations and passive foreign investment companies, it does not include corporate income that is imputed to the shareholder (subpart F and qualified electing fund income), as they are not dividends. Instead, actual distributions are subject to the tax. (12) It is possible to make an election to have the tax apply at the same time as the subpart F income is recognized for ordinary income tax purposes. (13)

A U.S. person is a citizen or resident, defined in the same manner as for income tax. (14) The tax does not apply to nonresident aliens, (15) including those whose residency is determined under a result of a tax treaty. (16)

The tax went into effect Jan. 1, 2013, and is not withheld at the source, so it is a material issue for high-income earners in this filing season.

Little Guidance to This Point

The Joint Committee on Taxation report did not address the above questions about Americans living abroad, (17) nor did the proposed regulations. (18) In November 2013, the author had the opportunity to ask staff from both the Joint Committee and Treasury, and neither was aware of these questions having been raised in the course of drafting the law or regulations. After the author's discussion with Treasury (including providing a draft of this article), Treasury did address the second question regarding an FTC, in the preamble to the final regulations issued Dec. 2, 2013. However, it did so in the broadest terms, saying only that the regulations were not an appropriate venue for such answers. (19)

The author could find no discussion of these questions in the academic literature, but some commentators from large accounting firms have suggested in their public materials that no protection from this tax is available. (20) There simply is no meaningful guidance in this area.

To address the question of whether Americans living abroad are subject to it, one must determine which type of tax the net investment income tax is. Is it a social security tax or an income tax?

Is the Net Investment Income Tax a Social Security Tax?

For an individual who lives in Canada (as an example), the U.S.--Canada SSTA governs coverage under Social Security and Medicare, as well as the Canadian equivalent, the Canada Pension Plan (CPP). Individuals employed primarily in Canada and self-employed individuals who reside in Canada are subject to the provisions of the CPP, not U.S. Social Security. (21) Consequently, if the net investment income tax is a social security tax, then an individual who lives in Canada and is subject to the CPP would be exempt from it.

But is the net investment income tax a social security tax? Under the SSTA, the covered taxes are listed as those imposed by Internal Revenue Code chapters 2 (self-employment tax) and 21 (Federal Insurance Contributions Act (FICA) tax). (22) The net investment income tax is contained in a new chapter (2A) of the Code, which is not specifically covered by the SSTA. However, the SSTA anticipates this possibility:

[T]his Agreement shall also apply to laws which amend, supplement, consolidate or supersede the laws specified in paragraph (1). (23) Most U.S. SSTAs Have Similar Provisions

The net investment income tax is designed to pay for an expanded Medicare. In the statute, it is called a "Medicare contribution." (24) The Joint Committee report addresses the tax in a Social Security/Medicare context, not an income tax context. (25)

The tax was imposed in parallel with an increased Medicare tax, a 0.9% surtax on wages and self-employment income in excess of thresholds identical to those applying to the net investment income tax. (26) The objective of the net investment income tax was to ensure that individuals with similarly high income levels who derive income from nonwage sources contribute to the newly expanded health care program in a similar manner.

It is noteworthy that the additional Medicare taxes on wages and...