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A pair of U.S. tax cases decided this week confirmed that high-income U.S. citizens living in Canada (including dual citizens) could face an effective marginal tax rate of more than 57 per cent on any investment income they earn. Both cases dealt with the ability of U.S. citizens to claim a foreign tax credit against the dreaded net investment income tax (NIIT). One of the cases involved a Canadian resident taxpayer.

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Before delving into the details of these landmark decisions, a bit of background on U.S. tax law is in order. The NIIT took effect in 2013 under the Affordable Care Act, known informally as Obamacare. The NIIT applies to high-income U.S. tax filers making more than US$200,000 (for single filers) annually, and imposes a 3.8 per cent surtax on net investment income, including interest, dividends and capital gains.

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The problem is that it also applies to U.S. citizens resident in Canada who already face punitive combined top federal and provincial tax rates of more than 50 per cent (in eight out of ten provinces) on their investment income. That’s because, under U.S. law, citizens are required to file an income tax return reporting worldwide income no matter where they reside, which is why U.S. citizens living in Canada are required to file U.S. tax returns each year. By contrast, Canada, like most countries in the world, generally only taxes individuals based on residency.

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In the majority of cases, however, U.S. citizens don’t end up owing U.S. federal tax due to offsetting foreign tax credits. The problem for dual income tax filers since 2013 has been that, under U.S. domestic law, foreign tax credits are not available to offset the 3.8 per cent NIIT, meaning that high-income, dual-filers, have been paying an extra 3.8 per cent U.S. tax on their worldwide investment income. The lack of a foreign tax credit meant that investment income is punitively taxed since tax is paid on that income in a foreign jurisdiction (such as Canada) which is not being fully credited against the NIIT paid in the U.S.

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That’s why two taxpayers, one in France and one in Canada, each, separately, took the U.S. government to court, arguing that, regardless of the U.S. domestic law that restricts claiming a foreign tax credit against the NIIT, the respective tax treaties signed between their countries of residence and the U.S. should work to eliminate this double taxation of investment income.

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The first case involved a French couple who were U.S. citizens living in Paris in 2015 who sold shares of a French company, and paid tax in both France and the U.S., including $3,851 of NIIT. They sued the U.S. Internal Revenue Service, demanding a refund of the NIIT and arguing that the France-U.S treaty should eliminate this double tax.

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They were initially successful in their 2023 case at the U.S. Court of Federal Claims, which found that the treaty did allow a foreign tax credit against the NIIT. But the U.S. government appealed the decision, and on Aug. 31 the U.S. Court of Appeals for the Federal Circuit reversed the lower court’s decision, ruling that the NIIT is not covered by the treaty, so no foreign tax credit applies.