Does foreign payroll tax qualify as a foreign tax credit? It depends.

An interesting decision came out of the United States Court of Appeals for the District of Columbia Circuit recently. The case was Ory Eshel and Linda Coryell Eshel vs. the IRS on appeals from the US tax court regarding taxation on international income earned abroad.

The difference between income taxes and social security, medicare taxes

US persons living and working overseas must understand something called the the ‘foreign tax credit‘. It is basically a credit for foreign income taxes paid (i.e. taxes on salaries, wages, and self-employed income). The credit cannot be used for, say, sales or VAT taxes paid, or payroll taxes. Why? Because technically, even though payroll taxes are calculated based on income, they are actually not income taxes.

Think of it like this. On your tax return you just don’t calculate your federal income taxes. Rather, you calculate your federal income taxes, your social security taxes and your medicare taxes. The government could require you to file three different returns, one for your federal income taxes, one for your social security taxes, and one for your medicare taxes. But fortunately (we suppose) all three types of taxes are rolled onto one IRS Form 1040. Again, even though two of the three taxes (social security and medicare) are not actually income taxes.

Payroll taxes are not income taxes.

Totalization Agreeents

A ‘Totalization Agreements‘ is like a tax treaty. If a payroll tax is included in a Totalization agreement between two countries, then it may not be allowed as a tax that qualifies for the Foreign Income Tax credit. If on the other hand, a tax is not mentioned in the Totalization Agreement, then it may qualify for a tax to apply toward the foreign tax credit.

Basically – “In” is a bad result for the taxpayer. “Out” is a good result for the tax payer.

So now, we have the backgrounds facts to discuss Eshel v Commissoner and why it is important in determining if a foregin tax paid qualified for the foreign tax credit.

Tax Court Background of Eshel v. Commissioner

How did this case end up going to court in the first place? The chain of events went something like this:

  • Eshels (Taxpayers) paid French payroll taxes.
  • France and the US entered into a Totalization Agreement in the late 1980s.
  • France enacted additional payroll taxes afterward (around the late 1990s).
  • Taxpayers paid French income and payroll taxes, including the additional payroll tax.
  • Taxpayers took as a credit against their US taxes the French income and payroll taxes paid.
  • IRS disallowed the entire credit.
  • IRS later allowed the credit for the French income taxes and kept the denial for the French payroll taxes.
  • Taxpayers went to Tax Court to say that they should get the credit cause the Totalization Agreement didn’t cover it, but the IRS said the Totalization Agreement did cover it, therefore the credit was disallowed.

The Tax Court ruled for IRS; they said the new(er) French payroll taxes were covered by the Totalization Agreement because they were “amended and supplemented”. To determine this, the Tax Court simply consulted regular English dictionaries to determine the meaning of “amend” and “supplement”.

Taxpayers appealed.

The DC Circuit Court Decision

Holding: The case was reversed and remanded to tax court to determine how the French would interpret the Totalization Agreement.

The DC Circuit Court ruled was that tax court erred by using the dictionary to define “amend and supplement.” The Court claimed that French law should have been consulted instead of the dictionary. That the Tax Court actually needs to look to the French law to determine if the newer laws “amend and supplement” the older French law, which was included in the Totalization Agreement.

Essentially, the Circuit Court did not decide if the French Payroll taxes were allowed for the foreign tax credit. What they did is they sent the case back to Tax Court for the Tax Court judge to articulate the reasons, under French law, why the newer French taxes are or are not covered by the Totalization Agreement.

This is not a pure win for the Taxpayer. While the Circuit Court did not uphold the unhelpful decision of the Tax Court,  the Tax Court could come back with another decision favorable to the IRS, as long as the reasons were based on French law.


Anthony gives his commentary on this case in the video below.


Shouldn’t all taxes based on income be allowed as a foreign tax credit? Isn’t claiming one is an income tax and one is a payroll tax a distinction without difference? We’d like to hear your comments below.