by John Anthony Castro, J.D., LL.M.
One of the most common and frequent questions we get from clients outside of the U.S. is “why do I have to pay the Net Investment Income Tax (NIIT) on passive income despite having already paid a higher effective income tax rate in another country?” The short answer is that you’ve been receiving bad tax advice. The long answer is this article.
The United States Code, Title 26 “Internal Revenue Code,” Subtitle A “Income Taxes” has six chapters. Chapter 1 is “Normal Taxes and Surtaxes.” Chapter 2 is “Tax on Self-Employment Income.” Chapter 2A is the “Unearned Medicare Contribution.”
Both the self-employment tax as well as the Unearned Medicare Contribution have separate chapters because they are not normal income taxes. They are allocated to a specific government benefit: social security and Medicare.
Here’s something even more interesting: there’s no such thing as the Net Investment Income Tax (NIIT). That’s a name made up by the tax industry for the Section 1411 Unearned Income Medicare Contribution. This name was born from the use of the phrase “net investment income” in the statute. Others brush this off as semantics, but we’ll explain below why the distinction between an income tax and a social security tax is absolutely critical.
Internal Revenue Code section (“Section”) 901 grants taxpayers a credit against the “tax imposed by this chapter” for income taxes paid to other countries. Being that Section 901 is located in Chapter 1 “Normal Taxes,” the Foreign Tax Credit is limited to offsetting normal income taxes; not the self-employment tax or the unearned Medicare contribution under Chapters 2 and 2A, respectively.
Just as income tax treaties were designed to prevent taxpayers from being exposed to double income taxation, Social Security Totalization Agreements were specifically designed to prevent taxpayers from being exposed to social security taxes in both countries.
For example, the U.S.-Australia Social Security Totalization Agreement, Article 2, Paragraph 1, states that “For the purpose of this Agreement, the applicable laws are... As regards the United States, the laws governing the Federal old-age, survivors and disability insurance program... Chapter 2 and Chapter 21 of the Internal Revenue Code of 1986 and regulations pertaining to those chapters.” There is no mention of Chapter 2A, but that’s because Chapter 2A was not created until March 30, 2010. An annotation to the Social Security Totalization Agreement clarified that “[a]lthough the Agreement does not apply to Medicare, a worker who is subject only to Australian laws by virtue of Part II of the Agreement will be exempt not only from U.S. retirement, survivors and disability insurance contributions but also from health insurance contributions under the Federal Insurance Contributions Act (FICA) and the Self Employment Contributions Act (SECA).”
To eliminate all uncertainty and confusion, the drafters of the Totalization Agreement thankfully added Article 2, Paragraph 4, that reads “[t]his Agreement shall also apply to future laws which amend or supplement the laws specified in paragraph 1 of this Article.” Chapter 2A contains Section 1411, which was specifically enacted to supplement the existing FICA and SECA taxes to finance the expansion of the U.S. Medicare system. That seals it.
The U.S. has Social Security Totalization Agreements with Australia, Austria, Belgium, Canada, Chile, Czech Republic, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Luxembourg, Netherlands, Norway, Poland, Portugal, Slovak Republic, South Korea, Spain, Sweden, Switzerland, and the U.K.
Therefore, if you are a current resident and taxpayer of one of the Totalization countries listed above, you are exempt from the Section 1411 Unearned Medicare Contribution; more commonly and incorrectly known as the Net Investment Income Tax. However, if you take this position on your tax return without proper disclosing it on IRS Form 8833, you’re risking severe tax penalties.
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About the Author
John Anthony Castro, J.D., LL.M., is the Managing Partner of Castro & Co., the author of International Taxation in Plain English, a graduate of Georgetown University Law Center in Washington DC, an OPM Fellow at Harvard Business School, and an internationally recognized tax attorney with offices in New York, Los Angeles, Washington DC, Miami, and Dallas.
 IRC §§ 1411(a)(1)(A), (a)(2)(A), (c)(1),(5), (6).
 See Agreement Between the Government of the United States of America and the Government of Australia on Social Security (Oct. 1, 2002).
 See Health Care and Education Reconciliation Act of 2010, PL 111-152, March 30, 2010, 124 Stat 1029.
 Let’s assume for argument’s sake that detractors are correct and that the Section 1411 Unearned Medicare Contribution is actually an income tax. Every U.S. Income Tax Treaty contains Article 2, Paragraph 1(a), that specifically extends the treaty to all “federal income taxed imposed by the Internal Revenue Code,” regardless of whether they are normal or not. And although the Technical Explanations specifically hold that social security taxes are not covered, as the Totalization Agreement explains, there is a difference between social security and Medicare, so the Section 1411 Unearned Medicare Contribution would be covered, especially if it’s accepted as an income tax by virtue of its characterization as a Net Investment Income Tax.