The Net Investment Income Tax (NIIT) went into effect January 1, 2013, affecting tax years beginning on or after January 1, 2013. The NIIT applies to US persons with modified adjusted gross income above the following thresholds:
- $125,000 for filing status married filing separately;
- $200,000 for filing status single or head of household; and
- $250,000 for filing status married filing jointly.
If a US person is subject to the NIIT, then the NIIT will apply at a rate of 3.8% on the lesser of the US person’s net investment income for such year or the excess of the US person’s modified adjusted gross income for such tax year over the applicable filing threshold.
The purpose of the NIIT is to ensure that individuals with high income levels earned from non-wage sources contribute to the expanded health care program in a similar manner as individuals subject to withholding tax on their wages. In other words, the NIIT is designed to cover the cost for expanded Medicare coverage. The NIIT could be a significant additional US tax to a US citizen living abroad.
The issue is whether the NIIT is a Medicare tax, subject to exemption under a totalization agreement, or an income tax, against which foreign tax credits can be applied.
The US has totalization agreements with 24 countries. The purpose of totalization agreements is to avoid double taxation of income with respect to Social Security and Medicare taxes. Thus, a US citizen living abroad in a country that has entered into a totalization agreement with the US is exempt from US Social Security and Medicare taxes on their earnings.
As mentioned above, the purpose of the NIIT is to pay for expanded Medicare coverage. Indeed, it is referred to as a “Medicare contribution” in the enacting statute. However, the NIIT was passed under a new chapter of the US tax code making it unclear whether totalization agreements exempt the NIIT. It seems sensible that, if a US citizen living abroad is exempt from US Social Security and Medicare taxes, he or she should also be exempt from a tax passed to expand Medicare coverage.
If the NIIT is not a Medicare tax, it would seem logical that it is an income tax that could be offset by foreign tax credits. US persons subject to income tax in a foreign jurisdiction on foreign source income are allowed to credit foreign tax paid against their US income tax due on that foreign source income.
However, the US tax code allows foreign tax credits to be applied only against taxes imposed under Chapter 1 and the NIIT was enacted under a different chapter of the code. The Internal Revenue Service has provided guidance that the NIIT is a tax that is not subject to offset by the foreign tax credit. It is noteworthy that the NIIT is added to an individual’s income tax return on a line after the foreign tax credit is entered, implying that the NIIT is not subject to offset by the foreign tax credit.
As with many laws that affect US citizens living abroad, Congress simply did not contemplate the effect of the NIIT on them. It is unduly harsh that the NIIT is neither tax exempt under totalization agreements nor subject to offset by foreign tax credits. Thus, we intend to take the position that the NIIT is tax exempt under an applicable totalization agreement and to disclose that position on the return.