On December 5, 2024, the U.S. Court of Federal Claims issued an opinion in Bruyea v. United States (Case No. 23-766T) that confirms the availability of treaty-based foreign tax credits (FTCs) under U.S. bilateral tax treaties and separate from domestic tax law. While this case focuses on the U.S.-Canada bilateral tax treaty (the Canada Treaty), the central language in dispute is present in most U.S. bilateral tax treaties. Many U.S. citizens may be in a position to benefit from the key holdings in Bruyea: that the Canada Treaty does in fact provide a treaty-based FTC and that such a credit is allowable against the U.S. Net Investment Income Tax (NIIT) under the "Three-Bite Rule" (which governs the application of the FTC to U.S. citizens that reside in, and thus are subject to residence-based taxation by, the treaty partner).

Mr. Bruyea is a U.S. citizen and lived in Canada during the 2015 tax year. He claimed a treaty-based FTC against his NIIT for taxes paid to Canada pursuant to Article XXIV of the Canada Treaty, which aims to eliminate double taxation. Paragraph 1 of the article in general obligates the U.S. to provide an FTC to accomplish this goal, and Paragraph 4 discusses the availability of an FTC in the context of the Three-Bite Rule. The government argued such a treaty-based FTC was precluded by the "U.S. Law Limitation" in Paragraph 1, which states that double taxation shall be avoided "[i]n 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)." Under domestic tax law in the Internal Revenue Code (IRC) (exclusive of IRC section 894, which incorporates tax treaty obligations into domestic law), the NIIT is not a tax against which an FTC can be applied. The government argued that the U.S. Law Limitation precluded Mr. Bruyea from receiving a treaty-based FTC against the NIIT, because U.S. taxpayers could only be allowed treaty-based FTCs to the extent that such credits were permitted under domestic tax law.

The Court of Federal Claims rejected the government's position and held that Article XXIV creates a treaty-based FTC applicable to the NIIT irrespective of whether the IRC otherwise permits such a credit. The Canada Treaty provides rights that are not in the IRC and sometimes are in direct conflict with the IRC. It also broadly defines the types of U.S. taxes that can be offset by an FTC, which on its face includes the NIIT. This holding was not upset by the "Last-In-Time Rule," which will cause latter-in-time legislation (here the NIIT) to supersede a prior treaty if the two are in direct conflict. The court found no such conflict, however, in part because Congress did not explicitly direct that the insulation of the NIIT against FTCs should override treaty obligations. Long-standing precedent requires courts to harmonize treaties and domestic legislation to the extent possible and that tax treaties should be read liberally to give effect to their meaning. The court held that these objectives could be accomplished by allowing a treaty-based FTC for the NIIT, even though the NIIT is not eligible for a domestic FTC under the IRC, to avoid double taxation. Other language in the Canada Treaty and extrinsic evidence on how the U.S. and Canada have interpreted Article XXIV supported this conclusion.

The Court of Federal Claims in Bruyea reached the same outcome as its prior opinion in Christensen v. United States, 168 Fed. Cl. 263 (2023), pending appeal. In Christensen, the court concluded that the Three-Bite Rule in the U.S.-France tax treaty (Article 24(2)(b)) allowed a treaty-based FTC for the NIIT. That court also found, however, that the general allowance of a treaty-based FTC (Article 24(2)(a)) was barred by the U.S. Law Limitation. This later holding was consistent with the Tax Court's analysis in Toulouse v. Commissioner, 157 T.C. 49 (2021), which reached the opposite ultimate result and denied a treaty-based FTC for the NIIT. See also Kim v. U.S., 131 A.F.T.R.2d 2023-1394 (C.D. Ca. 2023) (adopting the view of the Tax Court in a case involving the U.S.-South Korea tax treaty). The Court of Federal Claims in Bruyea rejected this broad interpretation of the U.S. Law Limitation. The government conceded that the U.S. Law Limitation does not always preclude a treaty-based credit unless implemented in the IRC, and it was unable to articulate a logical reason why the limitation should apply to the Three-Bite Rule in the case of the NIIT but not in other circumstances (e.g., the allowance of a treaty-based FTC against U.S. tax on U.S. source income) or with respect to the other provisions under Article XXIV. As a result, the court held that the U.S. Law Limitation in Paragraph 1 did not preclude a treaty-based FTC for the NIIT under the Three-Bite Rule in Paragraph 4.

Bruyea is a well-reasoned opinion in a court of national jurisdiction that aligns the plain language of the Canada Treaty with its purpose of eliminating double taxation. U.S. citizens who reside in foreign countries and are subject to the NIIT are well advised to continue to follow developments in this area and to preserve their remedies. The government appealed the similar outcome in Christensen and may do the same in Bruyea.

For more information, please contact:

Rocco V. Femia, rfemia@milchev.com, 202-626-5823

Jaclyn Roeing, jroeing@milchev.com, 202-626-5929

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