Taxpayers Say Treaty Provides FTC Offset of Net Investment Income Tax

MATTHEW CHRISTENSEN AND KATHERINE KAESS CHRISTENSEN,
Plaintiffs-Appellees,
v.
UNITED STATES,
Defendant-Appellant

IN THE UNITED STATES COURT OF APPEALS
FOR THE FEDERAL CIRCUIT

ON APPEAL FROM THE JUDGMENT OF THE UNITED STATES COURT OF FEDERAL CLAIMS, NO. 20-935; SENIOR JUDGE MARIAN BLANK HORN

RESPONSE BRIEF FOR APPELLEES

STUART E. HORWICH
Counsel for the Appellees

20 Old Bailey, 5^th Floor
London EC4M 7AN
United Kingdom
+44 20 8057 8013

June 24, 2024

CERTIFICATE OF INTEREST

(1) The full name of all parties represented by counsel are: Matthew Christensen and Katherine Kaess Christensen.

(2) Each person named in Section (1) is a real party in interest.

(3) There are no affiliated entities associated with the persons listed in section (1) above.

(4) There are no other law firms, partners or associates who have not entered an appearance in the appeal who appeared in the Court of Federal Claims or are expected to appear in this Court.

(5) There are no related or prior cases, other than the case at bar, that meet the criteria under Federal Circuit Rule 47.5.

(6) No further disclosure is required under Federal Rules of Appellate Procedure 26.1(c) or (d).

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TABLE OF CONTENTS

STATEMENT OF THE ISSUES

SUMMARY OF ARGUMENT

ARGUMENT

CONCLUSION

TABLE OF AUTHORITIES

Constitution of the United States

Article VI, Paragraph 2 (Supremacy Clause)

Case Law

Air France v. Saks, 470 U.S. 392, 296-97 (1985)

Bacardi Corp of Am. v. Domenech, 311 U.S. 150 (1940)

BG Grp., PLC v. Republic of Argentina, 572 U.S. 25 (2014)

Bruyea v. United States, Fed. Cl. Docket No. 23-766-T

El Al Israeli Airlines v. Tseng, 525 U.S. 155 (1999)

Eshel v. Comm'r, 831 F.3d 512 (D.C. Cir. 2016), reversing 142 T.C. 197 (2014)

Filler v. Comm'r, 74 T.C. 406 (1980)

Haver v. Comm'r, 444 F.3d 656 (D.C. Cir. 2006)

Iceland Steamship Co. Eimskip v. U.S. Dep't of the Army, 201 F.3d 451 (D.C. Cir. 2000)

Jamieson v. Comm'r, 584 F.3d 1074 (D.C. Cir. 2009)

Jordan v. Tashiro, 278 U.S. 123 (1928)

Kappus v. Comm'r, 337 F.3d 1053 (D.C. Cir. 2003)

Kim v. United States, 2023 WL 2313547 (C.D. Cal. 2023)

Kolovrat v. Oregon, 366 U.S. 187 (1961)

Lozano v. Montoya Alvarez, 572 U.S. 1 (2014)

Medellin v. Texas, 552 U.S. 491 (2008)

National Westminster Bank v. United States, 512 F.3d 1347 (Fed. Cir. 2008)

North West Life Insurance Co. of Canada v. Comm'r, 107 T.C. 363 (1996)

O'Connor v. United States, 479 U.S. 27 (1986)

Olympic Airways v. Husain, 540 U.S. 664 (2004)

Rocca v. Thompson, 223 U.S. 317 (1912)

Snap-On Tools, Inc. v. United States, 26 Cl. Ct. 1045 (Cl. Ct. 1992), aff'd 26 F.3d 137 (Fed. Cir. 1994)

Sullivan v. Kidd, 254 U.S. 433 (1921)

Sumitomo Shoji America Inc. v Avagliano, 457 U.S. 176 (1982)

Toulouse v. Comm'r, 157 T.C. 49 (2021)

United States v. Butler, 297 U.S. 1 (1936)

United States v. Choctaw Nation, 179 U.S. 494 (1900)

United States v. Stuart, 489 U.S. 353 (1989)

Water Splash v. Menon, 581 U.S. 271 (2017)

Wright v. Henkel, 190 U.S. 40 (1903)

Xerox v. United States, 41 F.3d 647 (1994)

Treaties

Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion With Respect to Taxes on Income and Capital, Fr.-U.S., Aug 31, 1994, 1963 U.N.T.S. 67, as supplemented by Protocols dated Dec. 8, 2004 and Jan. 13, 2009

Convention Between the Government of the United States of America and the Government of the Republic of Croatia for the Avoidance of Double Taxation and the Prevention of Tax Evasion With Respect to Taxes on Income

Statutes

Internal Revenue Code (26 U.S.C.)

Code Section 59

Code Section 901

Code Section 904

Code Section. 1411

Technical and Miscellaneous Revenue Act of 1988, Pub. L. 100-647, 102 Stat. 3342, Sec. 1012(aa)(2)

Miscellaneous

Notice 2008-3, 2008-2 I.R.B. 253

The Department Technical Explanation of the Convention between the Government of the United States of American and the Government of the French Republic for the Avoidance of Double Taxation and the prevention of Fiscal Evasion with respect to taxes on Income and Capital signed at Paris on August 31, 1994

Department of the Treasury Technical Explanation of the Convention Between the Government of the United States of America and the Government of the Kingdom of Denmark for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income Signed at Washington, August 19, 1999

Joint Committee Explanation of the Proposed Income Tax Treaty and Protocol Between the United States and the Italian Republic, JPRT 106-9-99 (Oct 13, 1999)

Treasury Department Explanation of the Model Income Tax Convention — 2006

Other Materials

Blanchard, The Tax Court's Erroneous Decision in Toulouse, 50 Tax Mgm't Int'l J., No. 10 (Oct 1, 2021)

Gould, “The Tax Court's Flawed Analysis in Toulouse Should Be Challenged”, Tax Notes International, vol. 103, p. 1695-1696 (Sept 27, 2021)

Rosenbloom and Shaheen, “Toulouse: No Treaty-Based Credit?”, Tax Notes International, vol. 104, pp. 417-422 (Oct. 25, 2021)

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STATEMENT OF THE ISSUES

1. Whether the Court of Federal Claims erred in ruling that Article 24(2)(a) of the income tax treaty between the United States and France (the “French Treaty”)¹ does not allow a U.S. person to claim a treaty-based foreign tax credit against the net investment income tax (the “NIIT”) imposed by Section 1411 of the Internal Revenue Code of 1986 (26 U.S.C. — the “Code”).

2. Whether the Court of Federal Claims correctly determined that Article 24(2)(b) of the French Treaty allows a U.S. citizen residing in France to claim a treaty-based foreign tax credit against the NIIT.

SUMMARY OF ARGUMENT

A principal purpose of the French Treaty, as acknowledged by the Defendant (Br. at 47), is the avoidance of double taxation. Article 24 of the French Treaty, entitled “Relief from Double Taxation,” advances this purpose by providing that certain taxes imposed by each country are eligible for a foreign tax credit — a “treaty-based foreign tax credit” — even if otherwise not provided for by statute.

In 2010, Congress enacted the net investment income tax, the NIIT, which imposes a 3.8 percent tax on certain investment income generated by U.S. citizens and residents. Code Sec. 1411. The NIIT is imposed on U.S. citizens living in France, such as the Appellees in this case, Matthew and Katherine Kaess Christensen (the “Taxpayers”). In the case at bar, France imposed income tax on the Taxpayers' investment income at higher rates than the sum of the U.S. regular income tax and the NIIT. As the Code does not provide a foreign tax credit — a “Code-based foreign tax credit” — against the NIIT,² the IRS also imposed the NIIT on that same investment income, resulting in double taxation. In the case at bar, the Taxpayers claim entitlement to a treaty-based foreign tax credit under Article 24(2) of the French Treaty.

Article 24(2) contains two separate paragraphs that by their plain terms allow for a treaty-based foreign tax credit that is separate from the credit available under the Code. The amount of the treaty-based foreign tax credit allowed under Article 24(2)(a) is determined “in accordance with the provisions and subject to the limitations” of U.S. law (i.e., the Code) “as it may be amended from time to time without changing the general principle hereof”. Article 24(2)(b) allows a treaty-based foreign tax credit for U.S. citizens resident in France, who are otherwise subject to two worldwide taxing regimes (the United States by virtue of citizenship and France by virtue of residence) without importing any Code-based rules.

The Court of Federal Claims held that the consequence of the language cited above is that because the Code itself does not provide a foreign tax credit against the NIIT, a treaty-based foreign tax credit is not available under Article 24(2)(a). In reaching that conclusion, the lower court misinterpreted key provisions within Article 24(2)(a) and failed to consider how its terms fit within the larger context of the Treaty, let alone the Treaty's terms and explicit purpose of avoiding double taxation. This holding was plain error and the Taxpayers should have received a treaty-based tax credit pursuant to Article 24(2)(a).

The Court of Federal Claims correctly ruled that Article 24(2)(b) allows for a treaty-based foreign tax credit to offset the NIIT. The plain language of that Treaty article provides for a treaty-based foreign tax credit, which accords with a principal purpose of the Treaty: the avoidance of double taxation. The Defendant's argument that the provisions of Article 24(2)(b) should be read to import the “limitations” wording (as erroneously interpreted by the Defendant) in Article 24(2)(a) is not supported by the Treaty's text, its purpose or any of the caselaw cited by the Defendant. Thus, even if this Court were to conclude that the Taxpayers could not claim a treaty-based foreign tax credit pursuant to Article 24(2)(a), the Taxpayers would still be entitled to the relief they requested pursuant to Article 24(2)(b) in accordance with the Court of Federal Claims' judgment.

ARGUMENT

I. The Standards of Treaty Interpretation Favor a Result That Avoids Double Taxation.

This is a treaty interpretation case. The proper interpretation of Article 24(2)(a) and (b) of the French Treaty “must begin * * * with the text of the treaty and the context in which the written words are used.” Air France v. Saks, 470 U.S. 392, 296-97 (1985). The goal is to achieve an outcome that accords with the shared expectations of the sovereign nations entering into the treaty. Treaties should be liberally interpreted to establish their intended purpose, Kolovrat v. Oregon, 266 U.S. 187 (1961), which in the case of the French Treaty is the avoidance of double taxation. Where there are two equally plausible interpretations, the more liberal interpretation is preferred. As such, even if this Court finds the Defendant's interpretation plausible (it is not), the Taxpayers' interpretation, which achieves a principal purpose of the Treaty to avoid double taxation, should be preferred.

Although the views of the Executive Branch agency responsible for negotiating and administering a treaty are normally accorded significant deference, where the Government-advocated position does not reflect the shared expectations of the treaty partners, such deference withers. Where the Government's position is directly contrary to an interpretation of the treaty that achieves its explicit purpose — the avoidance of double taxation — under Supreme Court precedent, as well as this Court and other court's precedents, its views are accorded no deference at all.

A. The Shared Expectations of the Treaty Partners at the Time the Treaty is Signed Control the Interpretation of its Provisions.

The principal rule governing the interpretation of treaties in the United States is well established: a treaty is a contract between nations such that its interpretation is first and foremost “a matter of determining the parties' intent.” See BG Grp., PLC v. Republic of Argentina, 572 U.S. 25, 37 (2014) (citing Air France v. Saks, 470 U.S. at 399; Sullivan v. Kidd, 254 U.S. 433, 439 (1921); Wright v. Henkel, 190 U.S. 40, 57 (1903)); Lozano v. Montoya Alvarez, 572 U.S. 1, 11 (2014) (citing Medellin v. Texas, 552 U.S. 491, 505 (2008); United States v. Choctaw Nation, 179 U.S. 494, 535 (1900)). It is therefore the Court's “responsibility to read the treaty in a manner consistent with the shared expectations of the contracting parties.” Lozano v. Montoya Alvarez, 572 U.S. at 12 (quoting Olympic Airways v. Husain, 540 U.S. 664, 650 (2004)).

In United States v. Stuart, 489 U.S. 353 (1989), the Supreme Court specifically declined to look to U.S. internal law constraints in determining when the Internal Revenue Service (the “IRS”) could serve a document request for documents to a third-party recordkeeper by Canadian officials made under certain treaty provisions in the U.S./Canada tax treaty. In refusing to allow Code-based provisions to trump the plain language of the treaty, the Court held, “[t]he clear import of treaty language controls unless application of the words of the treaty according to their obvious meaning effects a result inconsistent with the intent or expectations of its signatories.” United States v. Stuart, 489 U.S. at 365-66 (quoting Sumitomo Shoji America, Inc. v. Avagliano, 457 U.S. 176 (1982)).

The parties agree that a principal purpose of the French Treaty is to avoid double taxation, and a necessary corollary to achieving that goal is to interpret the Treaty's text to achieve that purpose. Xerox v. United States, 41 F.3d 647, 652 (Fed Cir. 1994) (“[i]n construing a treaty, the terms thereof are given their ordinary meaning in the context of the treaty and are interpreted, in accordance with that meaning, in the way that best fulfills the purpose of the treaty.”). As the Supreme Court has ruled numerous times: “where a provision of a treaty fairly admits of two constructions, one restricting, the other enlarging, rights that may be claimed under it, the more liberal interpretation is to be preferred.” United States v. Stuart, 489 U.S. at 368, quoting Bacardi Corp of American v. Domenech, 311 U.S. 150, 163 (1940); Jordan v. Tashiro, 278 U.S. 123, 128 (1928); Kolovrat v. Oregon, 366 U.S. at 190 (“[t]his Court has many times set its face against treaty interpretations that unduly restrict rights a treaty is adopted to protect.”).

The Defendant argues that its interpretation of the French Treaty “is consistent” with the Treaty's purpose (Def. Br. at 47), but then states that the avoidance of double taxation does not mean that the Treaty's purpose was to “eliminate double taxation in every instance.” (Emphasis in original.) This statement highlights the Defendant's error: while there may remain some unavoidable instances of double taxation despite the intended purpose of the Treaty, that is not a reason to interpret the French Treaty in a way that gives rise to the very evil that the Treaty seeks to avoid. By contrast, the Taxpayers' interpretation avoids double taxation; it is a more logical and purposeful reading of the Treaty's words and should be adopted.

B. The Defendant's Interpretation of the French Treaty Is Not Entitled to Deference.

As a general rule, the meaning attributed to a treaty by the Executive Branch agencies that negotiated and enforce the treaty terms is entitled to significant deference. The deference shown to the responsible Executive Branch agency derives from the negotiating history, past practices or diplomatic communications showing the shared understanding of the treaty partners. See, e.g., El Al Israeli Airlines v. Tseng, 525 U.S. 155, 168 (1999). Here however, the Defendant's reliance on numerous Supreme Court precedents to this effect (Br. 40-41) is misplaced as in the cited cases, the counterparties to each of the treaties affirmatively agreed or at least acquiesced to the views espoused by the responsible Executive Branch agency.³

The Executive Branch's interpretation of a treaty, however, is not accorded deference where the Executive Branch argues for an interpretation in isolation, without regard or contrary to, the views of its treaty partner. National Westminster Bank v. United States, 512 F.3d 1347 (Fed. Cir. 2008); Iceland Steamship Co. Eimskip v. U.S. Dep't of the Army, 201 F.3d 451 (D.C. Cir. 2000); Eshel v. Comm'r, 831 F.3d 521 (D.C. Cir. 2016) (where the IRS asserts a meaning of a treaty without analysis of the shared expectations of the two sovereigns, its position “is the legal equivalent of trying to clap with one hand”); see also, North West Life Insurance Co. of Canada v. Comm'r, 107 T.C. 363, 379 (1996) (“There is no authority for the proposition that a court construing a convention must follow the interpretation suggested by our Government when that interpretation runs contrary to what the Court concludes was the intent of the contracting parties.”).⁴

At the time the French Treaty was ratified, the only United States income taxes against which a French (or other foreign) tax could be credited already benefited from a Code-based foreign tax credit. Ipso facto, no evidence at the time of signing or ratification, whether in the Technical Explanation⁵ or elsewhere, provided any extrinsic guidance as to the Treaty partners' shared expectations regarding the availability of a treaty-based foreign tax credit for the NIIT, that is, a subsequently enacted U.S. tax that (i) was a “United States income tax” covered by the terms of the Treaty and (ii) did not fall within Chapter 1 of the Code. Thus, the Defendant cannot fairly rely on the Technical Explanation or point to anything in the Technical Explanation that covers the situation before this Court.

Moreover, there were no discussions between the Department of Treasury and the French Government about the NIIT at the time that the NIIT was enacted, nor have there been at any time since.⁶ It is important to bear in mind that the Technical Explanation was drafted in 1994, at the time the French Treaty was adopted, and that this predates by nearly twenty years the legislation giving rise to the NIIT. Unilateral assertions today about the meaning of the French Treaty in relation to the NIIT, relying on the Technical Explanation, cannot establish the shared expectations of the Treaty partners at the time of adoption. See, e.g., Snap-On Tools, Inc. v. United States, 26 Cl. Ct. 1045 (Cl. Ct. 1992), aff'd 26 F.3d 137 (Fed. Cir. 1994) (unilaterally issued U.S. statements do not assist in ascertaining the treaty partners' shared expectations where no evidence shows that the treaty partner agreed to such U.S. statements).

In summary, and as the Court of Federal Claims correctly stated (Appx. 89), the shared expectations of the Treaty partners control and a liberal reading of Articles 24(2)(a) and 24(2)(b) should be adopted to fulfil the explicit aim of the Treaty — the avoidance of double taxation. The Court of Federal Claims correctly gave no “deference to the defendant's interpretation” in analyzing Articles 24(2)(a) and 24(2)(b) and instead indicated that it would “apply the liberal interpretation of treaties rule announced in United States v. Stuart” to establish “the shared expectation of the United States and French Governments with respect to [Articles 24(2)(a) and 2(b) * * *.” Appx. 83. Application of these interpretive rules to Article 24 supports the conclusion that the Taxpayers are entitled to a treaty-based foreign tax credit to avoid double taxation.

II. The Court of Federal Claims Erred in Denying a Treaty-Based Foreign Tax Credit Pursuant to Article 24(2)(a) of the French Treaty.

Article 24(2)(a) of the French Treaty provides:

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 citizen or a resident of the United States as a credit against the United States income tax:

(i) the French income tax paid by or on behalf of such citizen or resident * * *.”

(Emphasis added.) The Court of Federal Claims held that because a foreign tax credit to offset the NIIT is not allowed under the Code, the allowance of a treaty-based foreign tax credit would not be “[i]n accordance with the provisions and subject to the limitations” of U.S. law. Appx. 86. In support of its holding, the Court of Federal Claims cited the Tax Court's decision in Toulouse v. Comm'r, 157 T.C. 49 (2021), which held that a French resident taxpayer could not offset the NIIT using a treaty-based foreign tax credits.⁷ See also, Kim v. United States, 2023 WL 2313547 (C.D. Cal. 2023) (no South Korea treaty-based foreign tax credit to offset the NIIT).

The Court of Federal Claims dismissed the italicized parenthetical phrase “as it may be amended from time to time without changing the general principle hereof”, stating:

The 'provisions' and 'limitations' language incorporates I.R.C. [Code] statutory restrictions on the availability of foreign tax credits, and the 'general principle' language, although modifying this incorporation, does not nullify the immediately preceding incorporation of the 'provisions' and 'limitations' of United States law.

Appx. 86. Although the Court of Federal Claims recognized that the “general principle” is the “allowance of a credit”, it failed to discuss how the allowance of such a credit actually modifies the “provisions” and “limitations” language. Instead, the lower court held that the allowance of a credit is conditioned “upon compliance with the 'provisions' and 'limitations' of United States tax laws * * *.” Id. Simply put, the Court of Federal Claims erroneously nullified the general principle language of the Treaty despite its statement to the contrary quoted above.

In reaching this conclusion, the Court of Federal Claims, like the Tax Court in Toulouse, failed to engage in a textual analysis of the French Treaty and interpreted Article 24(2)(a) in a manner that renders it, and a number of other provisions, superfluous. Far from reading the provisions of Article 24(2)(a) liberally to effect a principal purpose of the Treaty, the lower court adopted a narrow interpretation, resulting in double taxation, the very evil the Treaty was designed to eliminate or at least to avoid. Such a result is inconsistent with other U.S. tax treaties that have substantially identical language and do allow for a treaty-based foreign tax credit where no credit would be allowed under the Code.

The Court of Federal Claims erred in denying the Taxpayers a treaty-based foreign tax credit under Article 24(2)(a). The lower court correctly found in favor of the Taxpayers based on Article 24(2)(b) and its judgment should be affirmed not only for that reason, but also because Article 24(2)(a) allows for a treaty-based foreign tax credit against the NIIT.

A. The Text of Article 24(2)(a) Supports Taxpayers' View That a Treaty-Based Foreign Tax Credit Should Be Allowed To Offset the NIIT.

1. The Plain Language of Article 24(2)(a) Allows for a Treaty-Based Foreign Tax Credit to Offset the NIIT.

Article 24(2)(a) contains a number of key terms, including (1) “United States income tax”, (2) the “provisions” and “limitations” and (3) the “general principle hereof.” The Court of Federal Claims held, and the parties agree, that the NIIT qualifies as a “United States income tax” covered under Article 24(2) of the French Treaty. (Def. Br. at 13.) The parties further agree that the provisions and limitations of U.S. law generally refer to those found within the Code. (Def. Br. at 37.) Finally, the parties also agree that the “general principle hereof” referred to in Article 24(2)(a) is the allowance of a credit. (Def. Br. at 29.)

Despite agreeing to the basic understanding of the words in Article 24(2)(a), the parties disagree as to their interpretation. The Defendant argued, and the Court of Federal Claims held, that a treaty-based foreign tax credit can only be allowed under Article 24(2)(a) if it is allowed under the Code and that the “general principle hereof” language is a treaty-based requirement that the United States must only maintain a Code-based foreign tax credit system. This is plain error: the Defendant cannot seriously suggest that by this language, the United States bound itself to never eliminate the statutory provisions giving rise to a foreign tax credit system and that this is the only meaning and effect of this language. It is axiomatic that Congress can at any time pass legislation to override any treaty provision including the foreign tax credit system. Article VI(2) of the United States Constitution. The Defendant's interpretation of the “general principle hereof” language gives the Treaty provision all the binding effect of a New Year's resolution.

The Tax Court, in Toulouse, realized that its reading of Article 24(2)(a), which the Court of Federal Claims adopted, rendered the provision irrelevant. The Tax Court nevertheless tried to justify this reading as follows:

Petitioner questions the purpose of the Treaties if there is no independent, treaty-based credit and a credit is allowable only if it is provided in the Code. But we do not so hold. Other provisions of the Treaties may well provide for credits that are unavailable under the Code. Petitioner, however, relies on provisions that by their express terms do not.

157 T.C. at 61-62. The Tax Court erred: it is not that there may be a different article, such as Article 24(2)(b), that provides an independent treaty-based foreign tax credit. Article 24(2)(a) has no place or purpose in the French Treaty if its terms serve only to indicate the provision has no effect — an untenable proposition. See Water Splash v. Menon, 581 U.S. 271, 277-278 (2017). Further, it begs the question why, if Article 24(2)(a) simply mirrors the rules for a Code-based foreign tax credit, the United States and France would have drafted this complex provision seemingly intended to avoid double taxation.⁸ The Defendant's interpretation does not give effect to the Treaty's purpose and renders pointless the very existence of the provision itself.

The Technical Explanation, the central authority on which the Defendant relies, supports this conclusion, providing that “[t]he credits provided under the Convention are allowed in accordance with the provisions and subject to the limitations of U.S. law, as that law may be amended over time, so long as the general principle of this Article, i.e. the allowance of a credit, is retained.” (Emphasis added.)⁹ This Technical Explanation further provides that “the terms of the credit are determined by the provisions of the U.S. statutory credit at the time the credit is given. The limitation of law generally limits the credit against U.S. tax to the amount of U.S. tax due with respect to net foreign source income within the relevant foreign tax credit limitation category (see Code Section 904(a)).” (Emphasis added.)). “Limitations” refers to principles contained in the Code — chiefly Code Sec. 904 — regarding the amount of the foreign taxes that may be credited against United States income tax and not something broader.¹⁰

The Article 24(2)(a)'s “provisions” and “limitations” language, interpreted in accordance with the explicit purpose of the Treaty and the discussion in the Technical Explanation, invokes the Code to determine the quantum of the French tax that can be used to offset “United States income taxes”. The “general principle” language ensures that once the amount of French tax has been established pursuant to the Code-based rules, there is an allowance of a foreign tax credit to offset any “United States income tax” covered under the terms of the French Treaty. This textual interpretation achieves the purpose of avoiding double taxation by allowing a foreign tax credit, not just to offset taxes under the provisions of the Code, but more broadly to offset “United States income taxes” covered by the French Treaty, which the parties agree includes the NIIT.¹¹

2. The Taxpayers' Interpretation Accords with The Shared Expectations of the Treaty Partners.

As discussed in more detail below with respect to the Defendant's flawed interpretation of the Supreme Court's decision in O'Connor v. United States, 479 U.S. 27 (1986), the Defendant's interpretation cannot accord with the shared expectations of the Treaty partners. The O'Connor case highlights a central tenet of the rationale for sovereigns to enter into tax treaties: each sovereign relinquishes sovereign taxing rights (typically over income arising in its country) in exchange for reciprocal concessions on the part of the other country. See, e.g., Filler v. Comm'r, 74 T.C. 406, 409-410 (1980).¹² The shared expectation of each sovereign necessarily must be that whichever sovereign has primary taxing rights may impose its treaty-defined taxes and the other sovereign must allow an offset to its treaty-defined taxes.

For example, if the Taxpayers sell U.S.-situs real estate, the United States has primary taxing rights and levies capital gains tax plus NIIT on the sale. Pursuant to Article 24(1)(a)(iii), France must offset the full amount of United States income tax, including the NIIT, against any French tax, the obvious consequence of the NIIT being a “United States income tax” and a matter that is not disputed. It follows then, as a matter of bargained for treaty-reciprocity, that if the Taxpayers sell French-situs real estate, France has primary taxing rights and pursuant to Article 24(2)(a), the United States must offset the French taxes arising on that gain against all United States income tax (both the capital gains tax and the NIIT).

The Defendant's proposition that France surrenders taxing rights by allowing a credit against French taxes for the NIIT when the United States has primary taxing rights without a reciprocal obligation on the part of the United States when France has primary taxing rights does not represent an equilibrium that one would expect from a bargain between two sovereigns. Interpreting Article 24(2)(a) to provide for reciprocal allowances of foreign tax credits comports with the shared expectations of the Treaty partners that double taxation is avoided by each sovereign relinquishing taxation rights in exchange for a similar surrender of taxing rights by the other sovereign.

3. Other Federal Court Cases Interpreting the Provisions of Article 24(2)(a) Confirm that a Foreign Tax Credit is Allowed Under the Terms of the French Treaty.

Federal courts have already had the opportunity to consider the meaning of the Article 24(2)(a) phrase “as it may be amended from time to time without changing the general principle thereof”. In 1986, the Code was amended such that a taxpayer could only claim a foreign tax credit against 90 percent of his or her alternative minimum tax (AMT) obligation.¹³ Congress specifically overrode all treaty obligations to justify this restriction, stating that it “shall apply notwithstanding any treaty obligation of the United States in effect on the date of enactment of the [1986 law change].” See Technical and Miscellaneous Revenue Act of 1988, Pub. L. 100-647, 102 Stat. 3342, Sec. 1012(aa)(2). Thus, even if a taxpayer incurred foreign tax sufficient to offset 100 percent of his or her AMT liability, Code Section 59(a) expressly limited foreign tax credits such that a taxpayer would be required to pay no less than 10 percent of this U.S. tax liability.

In Haver v. Comm'r, 444 F.3d 656 (D.C. Cir. 2006), the taxpayer argued that the AMT limitation violated the terms of a tax treaty between the United States and Germany. The operative provision of the German treaty was substantially identical to Article 24(2)(a) in the French Treaty. The court held that as the AMT limitation was enacted in 1986 and the German Treaty was ratified in 1991, the Code Section 59(a) limitation on creditability of German tax was implicitly agreed by the two treaty partners. The court wrote:

[The taxpayer] argues that the Government's position would allow the United States to deny the foreign tax credit to an unlimited extent, and thus effectively eviscerate the benefits of [the equivalent of Article 24(2)(a) of the French Treaty]. Whether or not a more substantial [AMT] would conflict with the Treaty is a question we need not answer here. As we have explained, [the AMT] was in place when the [German] Treaty was adopted, so the parties to the Treaty had reason to know that the United States surely would impose a 10% minimum tax. Therefore, it is unnecessary for us to decide what more might have been contemplated by the provision in [the equivalent of Article 24(1)] that conditions the tax credit limitations of U.S. law 'as it may be amended from time to time without changing the general principles' of the Treaty.”

Id. at 660. In so holding, the court distinguished between limitations that existed at the time the treaty was ratified and after-enacted provisions that required consideration of the general principle that a foreign tax credit shall be allowed.

The Congressional override to allow the 90 percent AMT limitations notwithstanding treaty provisions to the contrary explicitly recognized that the “as it may be amended from time to time without changing the general principle thereof” language expands foreign tax credit relief beyond that contained in the Code. Courts have pointed to this Congressional override to explain why the “as may be amended from time to time without changing the general principle” language did not allow for a foreign tax credit without application of the 90 percent AMT limitation. E.g., Jamieson v. Comm'r, 584 F.3d 1074, 1076 (D.C. Cir. 2009); Kappus v. Comm'r, 337 F.3d 1053, 1058 (D.C. Cir. 2003).

These cases stand for the proposition that where a Congressional override of a provision in multiple treaties is present, sovereigns entering into a treaty can expect that a comparable provision in a new treaty will be interpreted in accordance with the existing override because of the “provisions” and “limitations” language. The corollary to this is that the Treaty partners' shared expectations would naturally be that, short of a later treaty override (which is not present in the case of the NIIT), the “general principle hereof” language ensures a treaty-based foreign tax credit against a newly enacted United States income tax, such as the NIIT.

B. Many U.S. Treaties Provide that Foreign Levies Qualify as Creditable Taxes Notwithstanding U.S. Domestic Rules.

The Court of Federal Claims, quoting from the unsound Tax Court decision in Toulouse, held that “any allowable foreign tax credit must be determined in accordance with the Code and is limited by the Code's provision of a credit. Toulouse, 157 T.C. at 58; Appx. 85. And yet, there are numerous instances where the terms of a bilateral treaty having substantially identical language give a different result than would be achieved exclusively under the Code.

For example, the income tax treaty between the United States and Denmark allows for a foreign tax credit for the Danish Hydrocarbon Tax. See Section 23(c)(i) of the Danish treaty (Danish Hydrocarbon Tax Act a creditable tax); Technical Explanation to the Danish Treaty (“subparagraph (c) refers to taxes paid to Denmark by residents or nationals of the United States under the Danish Hydrocarbon Tax Act, and may allow for greater foreign tax credits than allowed under U.S. statutory law.”)¹⁴ Emphasis added.

Similarly, the United States tax treaty with Italy is allows for a foreign tax credit for the imposta regionale sulle attivita produttive (the “IRAP”). See Article 2(b)(iii) of the Italy Treaty; see also Joint Committee Explanation of the Italian Treaty¹⁵ (“Because the IRAP tax base does not permit deductions for labor and, in certain cases, interest, it is not likely to be a creditable tax under U.S. internal law. The proposed treaty provides that a portion of the taxes imposed under the IRAP will be considered to be a creditable income tax under this article.”). See also Notice 2008-3, 2008-2 I.R.B. 253 (Mexican impuesto empresarial a tasa ūnica creditable under the United States/Mexico tax treaty pending further study without regard to whether that tax meets the definition of an income tax under Code Section 901.)

In each of these cases, if the “provisions” and “limitations” language limited the allowance of a foreign tax credit to what the Code allows, a treaty-based foreign tax credit would not be available. Yet, in each of these treaties, where a specific definition in the treaty incorporates a tax that is otherwise not creditable, a treaty-based foreign tax credit is specifically allowed. This logic extends to the case at bar. The NIIT is a “United States income tax” covered under the French Treaty. That it would otherwise fall outside the foreign tax credit provisions of the Code is not dispositive, as treaty provisions may give results not otherwise obtainable under the Code.

C. The Defendant's Convoluted Logic Renders Article 24(2)(a) Without Meaning or Effect within the French Treaty

The interpretation of any article in the French Treaty necessarily requires consideration of the Treaty as a whole. Article 1 states that, except as otherwise provided, the French Treaty applies only to persons who are residents of the United States or France. Article 4 defines the term “resident” and includes any fiscal resident of France (including U.S. citizens such as the Taxpayers). Article 4(3)(a) and (b). However, the so-called “saving clause” contained in Article 29(2) provides that “[n]otwithstanding any provision of the Convention, except the provisions of [Article 29(3)], the United States may tax * * * its citizens as if the Convention had not come into effect.” The effect of a tax treaty's saving clause is to nullify the application of the treaty by the United States for a U.S. citizen, other than for articles specifically excluded from the terms of the saving clause. See, e.g., Filler v. Comm'r, 74 T.C. at 409-410 (1980).

Article 29(3) of the French Treaty allows U.S. citizens and residents certain benefits notwithstanding the saving clause. In particular, Article 29(3) states that the saving clause “shall not affect: (a) the benefits conferred * * * under Article 24 (Relief From Double Taxation) * * *.” As indicated in the Technical Explanation, the purpose of this carve out is to prevent the saving clause “from applying where it would contravene provisions of the Convention that are intended to extend U.S. benefits to U.S. citizens and residents.”

As discussed above, it is the Defendant's position that only credits that are available to taxpayers are “Code-based foreign tax credits,” i.e., those credits that are provided for under the Code. If it had indeed been the shared expectations of the Treaty partners that only the terms of the Code would determine entitlement to foreign tax credits, then there would have been no need for an elaborate set of provisions in the French Treaty entitling a U.S. citizen to claim a foreign tax credit, including Article 24(2)(a). Not having that provision at all or having it be subject to, rather than excluded from, the saving clause would have achieved the result advanced by the Defendant. To achieve this result for Article 24(2)(a) in its opinion, the Court of Federal Claims provides for an elaborate charade by which:

• The saving clause in Article 29(2) operates to deny a U.S. citizen any rights other than those provided in the Code;

• An exception to Article 29(2) applies under Article 29(3) offering the U.S. citizen the ability to claim a foreign tax credit under Article 24(2)(a); but

• The wording of Article 24(2)(a) would restrict foreign tax credit relief to that allowed under the Code.

This convoluted logic would have the effect of rendering these French Treaty provisions meaningless, without purpose or effect, which cannot be a serious proposition. See United States v. Butler, 297 U.S. 1, 65 (1936) (“words cannot be meaningless, else they would not have been used”).

D. The Court of Federal Claims' Opinion Does Not Properly Address the Function of Article 24(2)(a) in the French Treaty.

In the final analysis, the Court of Federal Claims failed to consider that its reading of Article 24(2)(a) made no sense in the overall context of the Treaty and raised more questions than it answered about the function of Article 24(2)(a). The Taxpayers' reading of this provision, which provides an independent treaty-based credit in this situation gives the Treaty language substance and fulfills a principal purpose of the French Treaty — to avoid double taxation.

The Taxpayers' interpretation of Article 24(2)(a) has a number of advantages compared to the Court of Federal Claims' erroneous alternative:

For these reasons, Article 24(2)(a) provides the Taxpayers the relief they have requested, in addition to the treaty-based foreign tax credit the Court of Federal Claims correctly allowed for under Article 24(2)(b), and the lower court erred in not allowing the treaty-based credit under Article 24(2)(a) as well.

III. The Court of Federal Claims Correctly Allowed Taxpayers a Treaty-Based Foreign Tax Credit Under Article 24(2)(b) Of the French Treaty.

Article 24(2)(b) of the French Treaty provides:

In the case of an individual who is both a resident of France and a citizen of the United States:

(i) the United States shall allow as a credit against the United States income tax the French income tax paid after the credit referred to in subparagraph (a)(iii) of subparagraph [1]. * * *

(ii) Income referred to in paragraph [1] and income that, but for the citizenship of the taxpayer, would be exempt from United States income tax under the Convention, shall be considered income from sources within France to the extent necessary to give effect to the provisions of subparagraph (b)(i). The provisions of this subparagraph (b)(ii) shall apply only to the extent that an item of income is included in gross income for purposes of determining French tax. * * *

Breaking down the constituent parts of the provisions shows that a credit is allowed:

• The Taxpayers are U.S. citizens resident in France;

• The parties agree that the NIIT is a “United States income tax” that is covered by the French Treaty;

• The Taxpayers' paid tax to France on the relevant sale of French shares in a French company.¹⁶

Recognizing the straightforward application of the plain text, the Court of Federal Claims found that Article 24(2)(b) provides for a treaty-based foreign tax credit and ruled in favor of the Taxpayers.

Despite the plain, unequivocal wording of Article 24(2)(b), the Defendant nonetheless challenges the Court of Federal Claims' ruling. First, the Defendant argues that language in Article 24(2)(b)(ii) that treats U.S.-source income as if it is French-source income (a mechanism known as “re-sourcing”) implicitly imports Article 24(2)(a)'s “provisions” and “limitations” language (and the suspect meaning that the Defendant attributes to this language) into Article 24(2)(b). The Defendant further maintains that the Taxpayers' plain textual interpretation produces “anomalous results” that could not have been intended by the Treaty partners.

Next, the Defendant cites O'Connor v. United States, supra, interpreting the income tax treaty between the United States and Panama (the “Panama Treaty”), for the proposition that it would be “implausible” to interpret Article 24(2)(b) without reference to the “provisions” and “limitations” language. (Def Br. at 32.)

Neither component of the Defendant's argument withstands scrutiny. For the reasons set forth below, this Court should affirm the Court of Federal Claims correct holding that Article 24(2)(b) provides for the treaty-based foreign tax credit claimed by the Taxpayers.

A. Article 24(2)(b)'s Plain Terms Does Not Subject a Treaty-Based Foreign Tax Credit to the Provisions and Limitations of United States Law.

Article 24(2)(b) implements the so-called “three-bite” rule of the French Treaty, in which the priority of taxation is:

The parties agree that in the case at bar the United States does not have source-based taxing rights on the Taxpayers' sale of shares in a French company and that French residence-based taxation exceeds the entire amount of United States income tax, including the NIIT. As a result, the plain language of Article 24(2)(b) provides that the French taxes offset all United States income tax (which by definition includes the NIIT), and the United States cannot collect any citizenship-based tax from the Taxpayers.

The Court of Federal Claims agreed, holding that the operation of the three-bite rule in this case provides the relief the Taxpayers' requested. The lower court noted that this plain textual reading of the French Treaty avoids double taxation — a principal purpose of the Treaty. This analysis should end the inquiry and a treaty-based foreign tax credit should be allowed in this case. Air France v. Saks, supra.

The Defendant nonetheless argues that Article 24(2)(b)(i) implicitly imports the Article 24(2)(a) “provisions” and “limitations” language (and the meaning the Defendant attributes to this language) and that this is necessary to “avoid anomalous results” — such as allowing unlimited cross-crediting — that could never have been intended by the Treaty partners.¹⁷ The Defendant asserts that the resourcing rule contained in Article 24(2)(b)(ii) shows “unmistakenly” (Def. Br. at 28) that the Article 24(2)(a) language must have been intended to apply to Article 24(2)(b)(i) and further quotes from the Technical Explanation to support its position. In fact, the Treaty prevents, by application of its own terms, the unlimited cross-crediting that is the Defendant's contrived bugaboo.

B. Article 24(2)(b)(ii) Does Not Import Code-Based Rules for Determining the Tax Credit Allowed to U.S. Citizens Residing in France.

Recognizing that the plain text of Article 24(2)(b)(i) provides a treaty-based foreign tax credit for the Taxpayers, the Defendant has no choice but to claim that the re-sourcing provision of subparagraph (b)(ii) justify the importation of Code-based rules to override Article 24(2)(b)(i)'s text. The Defendant argues that the only reason for the Article 24(2)(b)(ii) re-sourcing rule is that the Treaty partners believed that any treaty-based credit “was in the first place subject to the Internal Revenue Code's source-based limitation in §904(a)” (Def. Br. at 27) to prevent cross-crediting. A close examination of the French Treaty and the Technical Explanation of the re-sourcing rule, however, demonstrates the fallacy of the Defendant's position.

1. Article 24(2)(b)(ii) Limits the Scope of the Three-Bite Rule Contained in Article 24(2)(b)(i) Without Reference to the Code-Based Provisions and Limitations.

Article 24(2)(b)(i) describes the ordering rules for U.S. citizens resident in France pursuant to which the United States may impose tax on the certain types of U.S.-source income and France may impose tax on the basis of residence (the first two bites of the three-bite rule) before determining the U.S. citizenship-based taxation (the third bite). France may impose a tax (the second bite) after crediting any U.S. source-based taxation (the first bite) and “the United States shall allow as a credit against the United States income tax” any French residence-based tax against the United States' residual citizenship-based tax (the third bite).

Article 24(2)(b)(i)'s text, read in isolation, might in theory allow a French resident U.S. citizen to offset without limitation the second bite French taxes against any third bite U.S. citizenship tax. For example, Article 24(2)(b)(i) in isolation could potentially offer a French resident U.S. citizen the ability to offset the French income tax arising on French-source salary income against U.S.-source interest income — a broad ability to cross-credit to reduce or eliminate any U.S. citizenship-based taxation.

Article 24(2)(b)(ii) ensures that such broad-based cross-crediting does not occur by introducing a source-based limitation. Article 24(2)(b)(ii) provides that income “shall be considered from sources within France to the extent necessary to give effect to the provisions of subparagraph (b)(i).” (Emphasis added.) Pursuant to Article 24(2)(b)(ii)'s “to the extent necessary to give effect” language, it is not possible for a French resident U.S. citizen to credit any French taxes arising on one item of income (e.g., French salary income) to offset United States income taxes arising on a different item of income (e.g., U.S.-source interest income).

The Technical Explanation explains this result by an example in which a U.S. citizen resident in France receives a U.S.-source dividend of 100 over which the United States has source-based taxing rights of 15. The example assumes that France would impose 22 of residence-based tax before taking into account the provisions of the Treaty. Article 24(2)(b)(i) provides that the United States may impose tax of 15 and France may impose tax of 7 (its 22 statutory rate less a 15 credit for the U.S. taxes paid). Article 24(2)(b)(ii) re-sourcing is not necessary for this computation.

Article 24(2)(b)(ii) becomes relevant for the residual citizenship-based taxing rights retained by the United States (the third bite) — in other words, it may limit the French tax (in the example, 7) that can offset any United States income taxes. As the Technical Explanation explains, this re-sourcing results in a U.S. citizen resident in France incurring a total tax burden on that dividend to the “higher of the two taxes.” It does so by re-sourcing income “to the extent necessary to give effect” to the three-bite rule. In the example, the Technical Explanation assumes the United States would impose 28 of tax on that income (i.e. higher than the 22 of French taxes). To achieve a result in which the taxpayer incurs the higher of the two taxes, a credit must be allowed for the 7 of French tax actually imposed. Re-sourcing is limited to a fixed amount of the (otherwise U.S.-source) dividend as French-source (in the example 25 of the 100 is re-sourced from U.S. source to French source).¹⁸

Crucially, any re-sourcing is limited “to the extent necessary to give effect” to the three-bite rule and therefore only 25 of the dividend is re-sourced. If the taxpayer in the Technical Example received a second dividend subject to a tax rate of 20, the following results would obtain:

• The United States would collect the first 15 of source based tax

• France would collect 7 of residence-based tax (the “higher of the two taxes”)

• The excess by which the French taxes (22) exceeded the United States income taxes (20) could not be used to cross-credit the citizenship-based taxes with respect to the first dividend (as the dividend income giving rise to 6 of citizenship-based tax in the Technical Example remains U.S.-source over which no treaty-based credit is provided).

Article 24(2)(b)(ii)'s “to the extent necessary to give effect” text therefore mandates that each item of income that is subject to re-sourcing will be taxed at the higher of the two tax rates, and excess credits that may result (where French-based residency taxation exceeds any residual U.S. citizenship-based taxation) cannot be applied to other items of income. This is an “item-by-item” re-sourcing rule pursuant to which cross-crediting can never occur.¹⁹

The Defendant's argument that sourced-based limitations must have been imported into Article 24(2)(b) therefore confuses cause and effect. It is not, as the Defendant argues, that “the drafters believed that the credit against U.S. income tax referenced in subparagraph (b)(i) * * * was in the first place subject to the Internal Revenue Code's source-based limitations in §904(a).” Def. Br. at 27. To the contrary, Article 24(2)(b)(ii) instead applies a source-based limitation, like that contained Code Sec. 904(a), to prevent unlimited cross-crediting. The source-based rule contained in Article 24(2)(b) applies on an item-by-item basis.

2. The Technical Explanation Does Not Support The Defendant's Position that All Code-Based Rules Apply to Article 24(2)(b).

The Defendant quotes the Technical Explanation in support of its proposition that all Code-based foreign tax credit limitations apply to Article 24(2)(b):

The credits provided under the Convention are allowed in accordance with the provisions and subject to the limitations of U.S. law. . . . Thus, although the Convention provides for a foreign tax credit, the terms of the credit are determined by the provisions of the U.S. statutory credit at the time a credit is given. The limitations of U.S. law generally limit the credit against U.S. tax to the amount of U.S. tax due with respect to net foreign-source income within the relevant foreign tax credit limitation category (see Code section 904(a)).

* * *

Subparagraph 1(b) [now 2(b)] also provides that certain U.S.-source income will be treated as French Source income to permit the additional credit to fit within the foreign tax credit limitation of Code Section 904.

(Def Br. at 39 — Emphasis added.) Again, the Defendant confuses the method by which Article 24(2)(b)(ii) operates.

The first paragraph above quoted by the Defendant refers only to Article 24(2)(a) and indicates that the amount of French tax eligible for a treaty-based foreign tax credit in Article 24(2)(a) is “determined by” the “provisions” and “limitations” in the Code.²⁰ This set of rules, as discussed above, determines the amount of French tax that can be used to offset any United States income tax and involves various concepts including allowing for cross-crediting in certain situations.

The second paragraph quoted by the Defendant refers to Article 24(2)(b) and states that re-sourcing rules are designed to “fit within” the Code Section 904 limitation. “Fits within” is not synonymous with “determined by.” Article 24(2)(b)(ii) applies an item-by-item approach whereby French taxes may only offset income that is re-sourced to give effect to subparagraph (b)(i) — this “fits within” the Code Sec. 904 limitation as income not re-sourced remains U.S.-source against which no cross-crediting may occur. It does not, however, mean that there is a wholesale adoption of Code Sec. 904 rules.

The Technical Explanation does not support the Defendant's assertion that “Article 24(2)(b)(ii) would not have been necessary had the drafters believed the credit referenced in subparagraph (b)(i) was free of the restrictions of the Internal Revenue Code, as the [Court of Federal Claims] held.” To the contrary, the Technical Explanation shows that subparagraph (b)(ii) applies a standalone item-by-item approach to re-sourcing. Denying a treaty-based foreign tax credit against U.S.-source income “fits within” the Code Sec. 904 limitation; the “item-by-item” approach, however, conclusively demonstrates that Code-based rules, including the ability to cross-credit taxes, do not apply.

3. The Court of Federal Claims' Interpretation Does Not Produce Other Anomalous Results.

The Defendant also argues that a plain reading of Article 24(2)(b), “unmoored” from the Code provisions, would produce “anomalous results”. (Def. Br. 34-37.) The Defendant points to an “egregious example” where a U.S. citizen residing in France could claim the benefit of the “foreign earned income exclusion” contained in Code Sec. 911 yet “get a treaty-based credit for taxes on that excluded income — a credit the taxpayer can then use to offset U.S. tax on other income, including unrelated U.S. source income.” (Def. Br. at 34.) The Defendant would have this Court believe this result, is “unprecedented in any other U.S. income tax treaty and was not intended by the contracting parties.” Id.²¹

The Defendant confuses the purpose and scope of Article 24(2)(b)(ii)'s resourcing provisions. The “unrelated U.S. source income” to which the Defendant refers would either be exempt from French tax, in which case it falls completely outside the scope of Article 24(2)(b)(ii), or it is subject to limited re-sourcing “to the extent necessary give effect to” limited U.S. citizenship-based taxation.²² The Treaty does not allow for anomalous results; it is the Defendant's analysis that is flawed.²³

In summary, Article 24(2)(b) provides relief for U.S. citizens living in France by creating specific rules, including re-sourcing of income, to avoid double taxation. These rules are self-contained and do not import Code-based rules to achieve their explicit purpose of avoiding double taxation of U.S. citizens who are resident in France. The re-sourcing rules apply an “item-by-item” approach and, as a result, do not produce the anomalous results that the Defendant erroneously claims could arise. As the Court of Federal Claims correctly determined, the plain language of Article 24(2)(b) provides the Taxpayers the treaty-based foreign tax credit they have claimed to offset the NIIT, and that court correctly applied this provision to avoid double taxation, a principal purpose of the French Treaty.

C. The Supreme Court's Decision in O'Connor Supports the Court of Federal Claims' Decision to Allow a Treaty-Based Foreign Tax Credit Pursuant to Article 24(2)(b).

The Defendant argues that the Supreme Court's decision in O'Connor supports its position that “express limiting language in the first paragraph of a treaty article addressing taxation [is] applied to the entire article.” (Def Br. at 30.) The Defendant's argument is wrong. The issue in O'Connor was the interpretation of the Panama Treaty with respect to U.S. tax on income of U.S. citizens working for the Panama Canal Commission, even where unrelated to their employment. The operative Panama Treaty language was:

The taxpayers in O'Connor argued the text of the Panama Treaty exempted them from U.S. income tax (including on U.S.-source income wholly unrelated to their work for the Commission). Paragraph 1, the taxpayers noted, specifically provided an exemption from “the payment in the Republic of Panama of all taxes” while paragraph 2 did not limit the exemption to such Panamanian taxes. The taxpayers reasoned that such an omission meant that a U.S. citizen employed by the Panama Canal Commission must therefore be exempt from all worldwide taxes, including U.S. taxes arising on U.S.-source investment income wholly unrelated to their work for the Commission.

The Supreme Court noted that the taxpayer's literal reading of the text of paragraph 2 could support a claim that a U.S. citizen working for the Panama Canal Commission would be exempt from all worldwide taxes. Nevertheless, the overall context of the Panama Treaty would be “implausible” if paragraph 2 were also not limited to an exemption from taxes imposed by the Panamanian Government.

While, as the petitioners assert, there might have been some reason why Panama would insist that its inability to tax United States citizen Commission employees upon their earnings in Panama be matched by a detraction from the United States' sovereign power to tax those same earnings, there is no conceivable reason why this hypothetical "your-sovereignty-for-mine" negotiating strategy would escalate into a demand that the United States yield more sovereign prerogatives than it was asking Panama to forgo — and no imaginable reason why the United States would accept such an escalation, producing tax immunity of unprecedented scope.

479 U.S. at 31.

Thus, while it might be plausible that pursuant to the first sentence of paragraph 2, the United States would surrender residual citizenship-based taxing rights over income a U.S. citizen resident in Panama received from the Panama Canal Commission, it was wholly implausible that the United States would agree to surrender taxing rights over all other income, including for example, U.S.-source investment income. Accordingly, the Supreme Court read paragraph 2 as limited to exempting the taxpayer from taxes payable to Panama, effectively importing into paragraph 2 the “payment to the Republic of Panama” language in paragraph 1.

The issue arising in the Panama Treaty is in stark contrast to the issue arising in the case at bar. In O'Connor, the taxpayers were arguing for an interpretation of treaty language that could not be reconciled with a bargain between sovereign nations in which each surrenders sovereign taxing rights for an equivalent concession by the other nation. It was “implausible” that, in the bargaining between the two countries, the United States would agree to surrender taxing rights on wholly unrelated income (“more sovereign prerogatives than it was asking Panama to forgo”) in a situation where such income was not subject to tax elsewhere.

This reasoning, however, cannot be assimilated to the Taxpayers' interpretation of Article 24(2)(b). In the Taxpayers' interpretation, the United States is not surrendering “more sovereign prerogatives” than it asks France to forgo (nor does it involve France surrendering more sovereign prerogatives than it asks the United States to forgo, which is inherent in the Defendant's flawed interpretation). Instead, the Taxpayers' interpretation corresponds exactly to a “your-sovereignty-for-mine” negotiation, providing for precisely the treaty-based tax credit result adopted by the Court of Federal Claims in this case, and reflects the proper hierarchy of the three-bite rule. Pursuant to the French Treaty, when the United States has primary sourced-based taxing rights (the first bite of the three-bite rule), France surrenders taxing rights on United States income by providing a credit for such United States taxes, including the NIIT, to offset a corresponding amount of French residence-based tax (i.e., France reduces the “second bite” tax to account for the United States' “first bite” tax, including the NIIT). When, however, France exercises residence-based taxing rights, the bargained for quid pro quo is for the United States to surrender its residual citizenship-based taxing rights and to do so, it must allow for such taxes, including the NIIT, to be offset by foreign tax credits (i.e., the United States reduces the “third bite” tax to account for France's “second bite” of tax).

In summary, O'Connor was a case of drafting omission, and no such drafting omission has occurred in the French Treaty. It is a perfectly logical bargain that (a) France will offset all United States income taxes, including the NIIT, against French taxes when the United States has superior taxing rights and (b) the United States will offset French tax against all United States income taxes, including the NIIT, when France has superior taxing rights. The Court of Federal Claims' decision, following Article 24(2)(b)'s plain text, is correct and guarantees a treaty-based foreign tax credit to the Taxpayers in this case, consistent with the French Treaty's purpose to avoid double taxation.

D. The Court of Federal Claims Correctly Determined That a Treaty-Based Foreign Tax Credit is Allowed Pursuant to Article 24(2)(b).

The Court of Appeals entered judgment on behalf of the Taxpayers based on its conclusion that the text of Article 24(2)(b) allows for a treaty-based foreign tax credit against the NIIT. This provision does not import the “provisions and limitations” language of Article 24(2)(a) and, therefore, its erroneous interpretation of Article 24(2)(a) has no effect on its judgment.

The Defendant asserts that Article 24(2)(b)(ii) shows “unmistakably” that the Article 24(2)(b) three-bite rule does not operate independently of the Code. However, a careful reading of Article 24(2)(b)(ii) shows that the Treaty and the Code operate in different unrelated ways, including the Treaty's application of an “item-by-item” approach which, at the time of the Treaty's ratification, had no Code-based equivalent.

The Defendant's argument that the Technical Explanation supports its interpretation is equally flawed. The example in the Technical Explanation shows that cross-crediting is not permitted under Article 24(2)(b) and the use of the term “fit within” rather than the “determined by” description used in the case of Article 24(2)(a) confirms that Article 24(2)(b) did not import Code-based rules limiting the availability of a treaty-based foreign tax credit. Moreover, such re-sourcing rules do not give rise to anomalous results; rather, it is the Defendant's implausible interpretation that would give rise to double taxation, contrary to a principal purpose of the French Treaty.

The Taxpayers' interpretation, in accordance with the plain language of the Treaty to achieve its principal purpose should control. The French Treaty should be interpreted liberally to achieve its goals rather than in a contrived, narrow way to thwart its purpose.

CONCLUSION

For the reasons set forth above, the Court of Federal Claims judgment should be affirmed as Articles 24(2)(a) and 24(2)(b) each independently allow the Taxpayers a treaty-based foreign tax credit to offset the NIIT.

Respectfully submitted,

Stuart E. Horwich
Horwich Law LLP
20 Old Bailey, 5^th Floor
London EC4M 7AD
011 44 20 8057 8013
seh@horwichlaw.co.uk
Counsel for Plaintiffs

June 24, 2024