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As a preliminary, I am a dual citizen of New Zealand and United States, resident in the United States, but I have New Zealand source passive income.

Under the New Zealand tax system, interest is taxable, but MOST capital gains and losses are not taxable (nor tax deductible). So, no matter if my New Zealand capital losses exceed my New Zealand sourced interest income, I would still owe income tax on, and (per tax treaty) have tax withheld on that interest income.

On the other hand, under the US tax system, capital losses are (in general) tax deductible, so I worry that my net passive foreign source income might work out to zero or a loss, when foreign source capital losses exceed my foreign source interest income. (What about the $3,000 capital loss limitation, would that be supposed to apply when figuring form 1116? I don't know).

So, if I followed Form 1116 instructions....

Normally even though I paid tax on the interest income in New Zealand, the tax credit would limited to an amount which is proportional to the fraction of my income which is foreign source, and that proportion could appear to be zero, or negative, if I have a net foreign source loss. [Or perhaps just $3,000 less than my foreign source interest income, if you are supposed to apply the limitation on total capital losses that is used for schedule D, again I am unclear on this.]

But then if I understand this right, it means that I will be subject to double taxation! Why? Well, first, in the United States, I cannot deduct any of the tax already paid, as a tax credit. And then in the New Zealand, I cannot use any of the capital loss to offset my interest income, so I must pay tax on the full amount of interest income. And so I could be taxed on my foreign interest income at the same marginal rate as if it had been US ordinary income without any foreign capital loss, and without any way to credit foreign tax paid against it. In other words my marginal tax rate on the foreign interest is not reduced by the tax paid, like it should be if I'm getting relief from double taxation!

So how do I avoid double taxation on the foreign earned interest income here? Seems like I should file form 8833, and claim that the calculations on form 1116, are causing double taxation of interest income. But which actual provision of the US tax code is being overruled?

(And also, is relief from double-taxation on interest covered by the treaty provisions? It certainly seems so to me, but maybe I misunderstood something.)

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    I'm not an expert, but my understanding is that even in the US capital losses can only be used to offset capital gains. So you couldn't use your capital losses to offset interest income even in the US. Jul 6, 2023 at 12:30
  • @DJClayworth Using capital losses to offset interest income was definitely not what I was trying to do. On the contrary, I'm trying to avoid that happening, to the extent it would appear to wipe out my ability to realize a foreign tax credit on my tax on interest withheld at the source. The difficulty arose while trying to understand Form 1116 which I understand lumps these separate categories of income together as 'passive' income. Jul 7, 2023 at 20:22

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Seems to me now that I was just misunderstanding what the source of capital gains income actually is.

In the specific case of New Zealand, capital gains on sales of New Zealand assets, as long as they are not real property, or certain other things (out of the scope of this quesiton) are not income 'resourced by treaty' nor even 'foreign sourced income'.

There are some tiny hints on the text of Paragraph 7 (new Paragraph 8 after the amending protocol) of Article 13 'Alienation of Property' (i.e. related to capital gains):

Income or gains from the alienation of any property other than property referred to in the preceding paragraphs of this Article shall be taxable only in the Contracting State of which the alienator is a resident.

(The preceding paragraphs are limited to discussing various variations on the theme of 'real property'.)

So, though I am no tax lawyer, I guessed the gist of this Article to be saying in essence that the main kind of capital gains which are to be considered to be exclusively taxable in the state where the taxpayer is not resident, because it is sourced there, are the ones related to real property (like a house or whatever). Then that income is sourced in, and primarily taxable in, the state where that real property is/was.

[Note that you do have to be a bit careful with which property is counted as real property, since shares or partnerships or investments do with real property may be counted as real property also. And ships, aircraft etc. get special treatment. And don't ask me about expatriation tax...]

So how do you normally know the source of income, anyway?

The 'source' of income appears to be mainly defined in US Section 861 and 862. The interesting thing to note from my point of view about these sections is that when it comes to gains on the sale of property, its mainly only gains on the sale of 'real property' that have a definite 'source'; either the US, or foreign.

[The Bloomberg Tax site helped me track down the sourcing rules "The source of income rules are applied in conjunction with the rules governing the allocation and apportionment of expenses between domestic and foreign sources in order to determine foreign-source taxable income for purposes of the foreign tax credit limitation prescribed for each separate limitation category under §904. The source of income rules are contained largely in §861, §862, §863 and §865."]

Finally, a key point of section 865 is rather simple

I.R.C. § 865(a) General Rule — Except as otherwise provided in this section, income from the sale of personal property— I.R.C. § 865(a)(1) — by a United States resident shall be sourced in the United States, or I.R.C. § 865(a)(2) — by a nonresident shall be sourced outside the United States.

I.e. just because you're selling something that might nominally be 'foreign' , doesn't automatically mean that it is foreign-source income. What actually matters also includes where you reside, and then various other exceptional cases which have their own special rules. Of these, there are many... they often have something of a real estate, investment corporation, financial services, or trans-national flavor about them...

BTW these rules for capital gains (gains on disposal of personal property) are completely different to the rules for dividends, interest, etc.

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  • Capital gains on intangibles are sourced to residency. What did you sell?
    – littleadv
    Oct 9, 2022 at 18:56
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You should refer to the savings clause that the US puts in (almost?) all of its tax treaties which excludes US citizens from most of the treaty provisions. That includes the interest. See the section 1(3) of the treaty. So form 8833 wouldn't help since treaty provisions don't apply to you here.

So you cannot, unfortunately, avoid double taxation in this case. This is not unusual. Technically, you're not being double taxed, you're only being taxed by New Zealand.

The US form 1116 makes an implicit assumption that the whole world taxes income the same way the US does, but it is not true. In your example of New Zealand, capital gains are ignored for the purposes of income tax, and as such you end up with only interest showing up on your NZ tax return. On form 1116 you also have capital losses, which would have offset the interest income, and as such the US doesn't allow credit for the NZ tax paid, since that income is not taxed in the US.

The US is very aggressive when it comes to taxing foreign sourced income of individuals. I'm not asking you what exactly you invested in for the capital gains part, but if you're not familiar with the term PFIC - familiarize yourself.

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    The savings clause in the tax treaty only provides the permission for the US to tax its citizens on worldwide income - not to double tax them. So that is mostly irrelevant. Oct 8, 2022 at 23:05
  • It also doesn't make sense to say that the US shouldn't allow credit for tax paid on interest income. In fact the tax treaty, especially Article 22, actually provides that it WILL allow credit for tax paid on income, including interest income (in general). Oct 8, 2022 at 23:07
  • @TimLovell-Smith the savings clause still allows you to use the avoidance of double taxation article, but in this case you're not double taxed because the US doesn't tax you on the income. On your US tax return your interest income was offset by the capital loss. So you only paid tax in NZ. The NZ savings clause (you are NZ citizen, aren't you?) protects their rights in this case.
    – littleadv
    Oct 9, 2022 at 18:54

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