What's New for 2007
Income categories eliminated. The following categories of income have been eliminated for purposes of computing the foreign tax credit limit. Income that previously fell in these categories is either passive category income or general category income.
- High withholding tax interest.
- Financial services income.
- Shipping income.
- Dividends from a domestic international sales corporation (DISC) or former DISC.
- Certain distributions from a foreign sales corporation (FSC) or former FSC.
High withholding tax interest and shipping income are passive category income or general category income depending on the circumstances. Financial services income is general category income if you are predominantly engaged in the active conduct of a banking, insurance, financing or similar business. Dividends from a DISC or former DISC, and certain distributions from a former FSC, are passive category income. See Separate Limit Income under How To Figure the Credit.
Carryforward and carryback of unused foreign taxes. Special rules apply to carrybacks of unused foreign taxes to 2006 and carryforwards of unused foreign taxes to 2007 and later years. See Special rules for carryforwards and carrybacks of pre-2007 and post-2006 unused foreign taxes under Carryback and Carryover.
Recharacterization of overall domestic loss. If you have an overall domestic loss for any tax year beginning after 2006, you must recharacterize a portion of your U.S. source taxable income in succeeding years as foreign source taxable income for purposes of the foreign tax credit. In a tax year you choose to claim the foreign tax credit, the overall domestic loss is the domestic loss for that tax year to the extent it offsets foreign source taxable income for that tax year or for any preceding tax year (in which you chose to claim the foreign tax credit) because of a carryback. If you do not choose to claim the foreign tax credit for a tax year, the overall domestic loss is the domestic loss for that tax year to the extent it offsets foreign source taxable income for any preceding tax year (in which you chose to claim the foreign tax credit) because of a carryback. A domestic loss is the amount by which the U.S. source gross income for the tax year is exceeded by the sum of the deductions properly allocated or apportioned to the income (determined without regard to any carryback from a subsequent tax year). For more information, see Internal Revenue Code section 904(g).
Country-by-country reporting no longer required of mutual fund or other regulated investment company (RIC) shareholders. If you claim a foreign tax credit in 2007 or later years on your share of the foreign taxes paid by a mutual fund or other RIC, you no longer have to report the income or taxes paid on a country-by-country basis on Form 1116. See the Instructions for Form 1116, line g.
Foreign tax redetermination. There are new rules for notifying the IRS of a foreign tax redetermination, which is a change in your foreign tax liability that may affect your foreign tax credit. See Foreign Tax Redetermination.
Ordering rules for adjustments to taxable income or loss. The ordering rules for allocating foreign losses and U.S. losses among the separate income categories have changed. See Allocation of Foreign and U.S. Losses.
Reminders
Change of address. If your address changes from the address shown on your last return, use Form 8822, Change of Address, to notify the Internal Revenue Service.
Introduction
If you paid or accrued foreign taxes to a foreign country on foreign source income and are subject to U.S. tax on the same income, you may be able to take either a credit or an itemized deduction for those taxes. Taken as a deduction, foreign income taxes reduce your U.S. taxable income. Taken as a credit, foreign income taxes reduce your U.S. tax liability.
In most cases, it is to your advantage to take foreign income taxes as a tax credit. The major scope of this publication is the foreign tax credit.
The publication discusses:
- How to choose to take the credit or the deduction,
- Who can take the credit,
- What foreign taxes qualify for the credit,
- How to figure the credit, and
- How to carry over unused foreign taxes to other tax years.
Unless you choose not to be subject to the foreign tax credit limit, you claim the credit by filing Form 1116 with your U.S. income tax return. Two examples with filled-in Forms 1116 are provided at the end of this publication.
Useful Items - You may want to see:
Publication
- 54 Tax Guide for U.S. Citizens and Resident Aliens Abroad
- 519 U.S. Tax Guide for Aliens
- 570 Tax Guide for Individuals With Income From U.S. Possessions
Form (and Instruction)
- 1116
Foreign Tax Credit
See How To Get Tax Help near the end of this publication for information about getting these publications and this form.
Choosing To Take Credit or Deduction
You can choose each tax year to take the amount of any qualified foreign taxes paid or accrued during the year as a foreign tax credit or as an itemized deduction. You can change your choice for each year's taxes.
To choose the foreign tax credit, you generally must complete Form 1116 and attach it to your U.S. tax return. However, you may qualify for the exception that allows you to claim the foreign tax credit without using Form 1116. See How To Figure the Credit, later. To choose to claim the taxes as an itemized deduction, use Schedule A (Form 1040), Itemized Deductions.
Figure your tax both ways—claiming the credit and claiming the deduction. Then fill out your return the way that benefits you most. See Why Choose the Credit, later.Choice Applies to All Qualified Foreign Taxes
As a general rule, you must choose to take either a credit or a deduction for all qualified foreign taxes.
If you choose to take a credit for qualified foreign taxes, you must take the credit for all of them. You cannot deduct any of them. Conversely, if you choose to deduct qualified foreign taxes, you must deduct all of them. You cannot take a credit for any of them.
See What Foreign Taxes Qualify for the Credit, later, for the meaning of qualified foreign taxes.
There are exceptions to this general rule, which are described next.
Exceptions for foreign taxes not allowed as a credit
Even if you claim a credit for other foreign taxes, you can deduct any foreign tax that is not allowed as a credit if:
- You paid the tax to a country for which a credit is not allowed because it provides support for acts of international terrorism, or because the United States does not have diplomatic relations with it or recognize its government,
- You paid withholding tax on dividends from foreign corporations whose stock you did not hold for the required period of time,
- You paid withholding tax on income or gain (other than dividends) from property you did not hold for the required period of time,
- You paid withholding tax on income or gain to the extent you had to make related payments on positions in similar or related property,
- You participated in or cooperated with an international boycott, or
- You paid taxes in connection with the purchase or sale of oil or gas.
Foreign taxes that are not income taxes
Generally, only foreign income taxes qualify for the foreign tax credit. Other taxes, such as foreign real and personal property taxes, do not qualify. But you may be able to deduct these other taxes even if you claim the foreign tax credit for foreign income taxes. You generally can deduct these other taxes only if they are expenses incurred in a trade or business or in the production of income. However, you can deduct foreign real property taxes that are not trade or business expenses as an itemized deduction on Schedule A (Form 1040).
Carrybacks and carryovers
There is a limit on the credit you can claim in a tax year. If your qualified foreign taxes exceed the credit limit, you may be able to carry over or carry back the excess to another tax year. If you deduct qualified foreign taxes in a tax year, you cannot use a carryback or carryover in that year. That is because you cannot take both a deduction and a credit for qualified foreign taxes in the same tax year. For more information on the limit, see How To Figure the Credit, later. For more information on carrybacks and carryovers, see Carryback and Carryover, later.
Making or Changing Your Choice
You can make or change your choice to claim a deduction or credit at any time during the period within 10 years from the regular due date for filing the return for the tax year for which you make the claim. You make or change your choice on your tax return (or on an amended return) for the year your choice is to be effective.
Example —
You paid foreign taxes for the last 13 years and chose to deduct them on your U.S. income tax returns. You were timely in both filing your returns and paying your U.S. tax liability. In February 2007, you file an amended return for tax year 1996 choosing to take a credit for your 1996 foreign taxes because you now realize that the credit is more advantageous than the deduction for that year. Because the regular due date of your 1996 return was April 15, 1997, this choice is timely (within 10 years).
Because there is a limit on the credit for your 1996 foreign tax, you have unused 1996 foreign taxes. Ordinarily, you first carry back unused foreign taxes arising in 1996 to, and claim them as a credit in, the 2 preceding tax years. If you are unable to claim all of them in those 2 years, you carry them forward to the 5 years following the year in which they arose.
Because you originally chose to deduct your foreign taxes and the 10-year period for changing the choice for 1994 and 1995 has passed, you cannot carry the unused 1996 foreign taxes back to tax years 1994 and 1995.
Because the 10-year periods have not passed for your 1997 through 2001 income tax returns, you can still choose to carry forward any unused 1996 foreign taxes. However, you must reduce the unused 1996 foreign taxes that you carry forward by the amount that would have been allowed as a carryback if you had timely carried back the foreign tax to tax years 1994 and 1995.
Why Choose the Credit?
The foreign tax credit is intended to relieve you of the double tax burden when your foreign source income is taxed by both the United States and the foreign country. Generally, if the foreign tax rate is higher than the U.S. rate, there will be no U.S. tax on the foreign income. If the foreign tax rate is lower than the U.S. rate, U.S. tax on the foreign income will be limited to the difference between the rates. The foreign tax credit can only reduce U.S. taxes on foreign source income; it cannot reduce U.S. taxes on U.S. source income.
Although no one rule covers all situations, it is generally better to take a credit for qualified foreign taxes than to deduct them as an itemized deduction. This is because:
- A credit reduces your actual U.S. income tax on a dollar-for-dollar basis, while a deduction reduces only your income subject to tax,
- You can choose to take the foreign tax credit even if you do not itemize your deductions. You then are allowed the standard deduction in addition to the credit, and
- If you choose to take the foreign tax credit, and the taxes paid or accrued exceed the credit limit for the tax year, you may be able to carry over or carry back the excess to another tax year. (See Limit on the Credit under How To Figure the Credit, later.)
Example —
For 2007, you and your spouse have adjusted gross income of $80,000, including $20,000 of dividend income from foreign sources. None of the dividends are qualified dividends. You file a joint return and can claim two $3,400 exemptions. You had to pay $2,000 in foreign income taxes on the dividend income. If you take the foreign taxes as an itemized deduction, your total itemized deductions are $15,000. Your taxable income then is $58,200 and your tax is $7,951.
If you take the credit instead, your itemized deductions are only $13,000. Your taxable income then is $60,200 and your tax before the credit is $8,251. After the credit, however, your tax is only $6,251. Therefore, your tax is $1,700 lower ($7,951 - $6,251) by taking the credit.
Example —
In 2007, you receive investment income of $5,000 from a foreign country, which imposes a tax of $3,500 on that income. You report on your U.S. return this income as well as $56,000 of income from U.S. sources. You are single, entitled to one $3,400 exemption, and have other itemized deductions of $5,400. If you deduct the foreign tax on your U.S. return, your taxable income is $48,700 ($5,000 + $56,000 - $3,400 - $5,400 - $3,500) and your tax is $8,605.
If you take the credit instead, your taxable income is $52,200 ($5,000 + $56,000 - $3,400 - $5,400) and your tax before the credit is $9,480. You can take a credit of only $777 because of limits discussed later. Your tax after the credit is $8,703 ($9,480 - $777), which is $98 ($8,703 - $8,605) more than if you deduct the foreign tax.
If you choose the credit, you will have unused foreign taxes of $2,723 ($3,500 - $777). When deciding whether to take the credit or the deduction this year, you will need to consider whether you can benefit from a carryback or carryover of that unused foreign tax.
Credit for Taxes Paid or Accrued
You can claim the credit for a qualified foreign tax in the tax year in which you pay it or accrue it, depending on your method of accounting. “Tax year” refers to the tax year for which your U.S. return is filed, not the tax year for which your foreign return is filed.
Accrual method of accounting
If you use an accrual method of accounting, you can claim the credit only in the year in which you accrue the tax. You are using an accrual method of accounting if you report income when you earn it, rather than when you receive it, and you deduct your expenses when you incur them, rather than when you pay them. Foreign taxes generally accrue when all the events have taken place that fix the amount of the tax and your liability to pay it.
Contesting your foreign tax liability
If you are contesting your foreign tax liability, you cannot accrue it and take a credit until the amount of foreign tax due is finally determined. However, if you choose to pay the tax liability you are contesting, you can take a credit for the amount you pay before a final determination of foreign tax liability is made. Once your liability is determined, the foreign tax credit is allowable for the year to which the foreign tax relates. If the amount of foreign taxes taken as a credit differs from the final foreign tax liability, you may have to adjust the credit, as discussed later under Foreign Tax Redetermination.
You may have to post a bond
If you claim a credit for taxes accrued but not paid, you may have to post an income tax bond to guarantee your payment of any tax due in the event the amount of foreign tax paid differs from the amount claimed. The IRS can request this bond at any time without regard to the Time Limit on Tax Assessment, discussed later under Carryback and Carryover.
Cash method of accounting
If you use the cash method of accounting, you can choose to take the credit either in the year you pay the tax or in the year you accrue it. You are using the cash method of accounting if you report income in the year you actually or constructively receive it, and deduct expenses in the year you pay them.
Choosing to take credit in the year taxes accrue
Even if you use the cash method of accounting, you can choose to take a credit for foreign taxes in the year they accrue. You make the choice by checking the box in Part II of Form 1116. Once you make that choice, you must follow it in all later years and take a credit for foreign taxes in the year they accrue. In addition, the choice to take the credit when foreign taxes accrue applies to all foreign taxes qualifying for the credit. You cannot take a credit for some foreign taxes when paid and take a credit for others when accrued. If you make the choice to take the credit when foreign taxes accrue and pay them in a later year, you cannot claim a deduction for any part of the previously accrued taxes.
Credit based on taxes paid in earlier year
If, in earlier years, you took the credit based on taxes paid, and this year you choose to take the credit based on taxes accrued, you may be able to take the credit this year for taxes from more than one year.
Example —
Last year you took the credit based on taxes paid. This year you chose to take the credit based on taxes accrued. During the year you paid foreign income taxes owed for last year. You also accrued foreign income taxes for this year that you did not pay by the end of the year. You can base the credit on your return for this year on both last year's taxes that you paid and this year's taxes that you accrued.
Foreign Currency and Exchange Rates
U.S. income tax is imposed on income expressed in U.S. dollars, while the foreign tax is imposed on income expressed in foreign currency. Therefore, fluctuations in the value of the foreign currency relative to the U.S. dollar will affect the foreign tax credit.
Translating foreign currency into U.S. dollars. If you receive all or part of your income or pay some or all of your expenses in foreign currency, you must translate the foreign currency into U.S. dollars. How you do this depends on your functional currency. Your functional currency generally is the U.S. dollar unless you are required to use the currency of a foreign country. You must make all federal income tax determinations in your functional currency. The U.S. dollar is the functional currency for all taxpayers except some qualified business units. A qualified business unit is a separate and clearly identified unit of a trade or business that maintains separate books and records. Unless you are self-employed, your functional currency is the U.S. dollar. Even if you are self-employed and have a qualified business unit, your functional currency is the U.S. dollar if any of the following apply.- You conduct the business primarily in dollars.
- The principal place of business is located in the United States.
- You choose to or are required to use the dollar as your functional currency.
- The business books and records are not kept in the currency of the economic environment in which a significant part of the business activities is conducted.
Internal Revenue Service
International Section
P.O. Box 920
Bensalem, PA 19020-8518.
Rate of exchange for foreign taxes paid
Use the rate of exchange in effect on the date you paid the foreign taxes to the foreign country unless you meet the exception discussed next. If your tax was withheld in foreign currency, you use the rate of exchange in effect for the date on which the tax was withheld. If you make foreign estimated tax payments, you use the rate of exchange in effect for the date on which you made the estimated tax payment.
Exception
If you claim the credit for foreign taxes on an accrual basis, you must generally use the average exchange rate for the tax year to which the taxes relate. This rule applies to accrued taxes relating to tax years beginning after 1997 and only under the following conditions.
- The foreign taxes are paid on or after the first day of the tax year to which they relate.
- The foreign taxes are paid not later than 2 years after the close of the tax year to which they relate.
Election to use exchange rate on date paid
If you have accrued foreign taxes that you are otherwise required to convert using the average exchange rate, you may elect to use the exchange rate in effect on the date the foreign taxes are paid if the taxes are denominated in a foreign currency. You may make the election for all nonfunctional currency foreign income taxes or only those nonfunctional currency foreign income taxes that are attributable to qualified business units with a U.S. dollar functional currency. Once made, the election applies to the tax year for which made and all subsequent tax years unless revoked with the consent of the IRS. The election is available for tax years beginning after 2004. It must be made by the due date (including extensions) for filing the tax return for the first tax year to which the election applies. Make the election by attaching a statement to the applicable tax return. The statement should identify whether the election is made for all foreign taxes or only for foreign taxes attributable to qualified business units with a U.S. dollar functional currency.
Foreign Tax Redetermination
A foreign tax redetermination is any change in your foreign tax liability that may affect your U.S. foreign tax credit claimed.
The time of the credit remains the year to which the foreign taxes paid or accrued relate, even if the change in foreign tax liability occurs in a later year.
If a foreign tax redetermination occurs, a redetermination of your U.S. tax liability is required in the following situations.
Tax years beginning before 1998
For tax years beginning before 1998, a redetermination of your U.S. tax liability is required if:
- You must pay additional foreign taxes,
- You receive a refund of foreign taxes paid, or
- There is a change in the dollar amount of your foreign tax credit because of differences in the exchange rate at the time the foreign taxes were accrued and the time they were paid.
When redetermination of tax is not required
A redetermination is not required if the change is due solely to an exchange rate fluctuation and the change in foreign tax liability for the tax year is less than the smaller of:
- $10,000, or
- 2% of the total dollar amount of the foreign tax initially accrued for that foreign country.
Tax years beginning after 1997
For tax years beginning after 1997, a redetermination of your U.S. tax liability is required if any of the following conditions apply.
- The accrued taxes when paid differ from the amounts claimed as a credit.
- The accrued taxes you claimed as a credit in one tax year are not paid within 2 years after the end of that tax year. If this applies to you, you must reduce the credit previously claimed by the amount of the unpaid taxes. You will not be allowed a credit for the unpaid taxes until you pay them. When you pay the accrued taxes, you must translate them into U.S. dollars using the exchange rate as of the date they were paid. The foreign tax credit is allowed for the year to which the foreign tax relates. See Rate of exchange for foreign taxes paid, earlier, under Foreign Currency and Exchange Rates.
- The foreign taxes you paid are refunded in whole or in part.
- For taxes taken into account when accrued but translated into dollars on the date of payment, the dollar value of the accrued tax differs from the dollar value of the tax paid because of fluctuations in the exchange rate between the date of accrual and the date of payment. However, no redetermination is required if the change in foreign tax liability for each foreign country is less than the smaller of:
- $10,000, or
- 2% of the total dollar amount of the foreign tax initially accrued for that foreign country for the U.S. tax year.
Notice to the Internal Revenue Service (IRS) of Redetermination
The notification requirements discussed here apply to foreign tax redeterminations occurring in:
- 2008 and later tax years.
- 2005, 2006, and 2007 if:
- The redetermination reduced the amount of foreign taxes you paid or accrued for any tax year, and
- As of November 7, 2007, you had not notified the IRS of the redetermination.
If you are required to notify the IRS about a redetermination of your U.S. tax liability for each tax year affected by the redetermination, you generally must file Form 1040X, Amended U.S. Individual Income Tax Return, with a revised Form 1116 and a statement that contains information sufficient for the IRS to redetermine your U.S. tax liability for the year or years affected. See Contents of statement later.
You are not required to attach Form 1116 for a tax year affected by a redetermination if:
- The amount of your creditable taxes paid or accrued during the tax year is not more than $300 ($600 if married filing a joint return) as a result of the foreign tax redetermination, and
- You meet the requirements listed under Exemption from foreign tax credit limit under How To Figure the Credit, later.
There are other exceptions to this requirement. They are discussed later under Due date of notification to IRS.
Contents of statement
The statement must include all of the following.
- Your name, address, and taxpayer identification number.
- The tax year or years that are affected by the foreign tax redetermination.
- The date or dates the foreign taxes were accrued, if applicable.
- The date or dates the foreign taxes were paid.
- The amount of foreign taxes paid or accrued on each date (in foreign currency) and the exchange rate used to translate each amount.
- Information sufficient to determine any interest due from or owing to you, including the amount of any interest paid to you by the foreign government and the dates received.
Due date of notification to IRS
If you pay less foreign tax than you originally claimed a credit for, you must file a notification by the due date (with extensions) of your original return for your tax year in which the foreign tax redetermination occurred. There is no limit on the time the IRS has to redetermine and assess the correct U.S. tax due. If you pay more foreign tax than you originally claimed a credit for, you have 10 years to file a claim for refund of U.S. taxes. See Time Limit on Refund Claims, later. Exceptions to this due date are explained in the next three paragraphs.
Redeterminations occurring in 2005, 2006, and 2007
If the redetermination occurred in 2005, 2006, or 2007, you must file the notification by the due date (including extensions) of your 2009 Form 1040 or Form 1040NR. Multiple redeterminations of U.S. tax liability for same tax year. Where more than one foreign tax redetermination requires a redetermination of U.S. tax liability for the same tax year and those redeterminations occur in the same tax year or within two consecutive tax years, you can file for that tax year one notification (Form 1040X with a Form 1116 and the required statement) that reflects all those tax redeterminations. If you choose to file one notification, the due date for that notification is the due date of the original return (with extensions) for the year in which the first foreign tax redetermination that reduced your foreign tax liability occurred. However, foreign tax redeterminations with respect to the tax year for which a redetermination of U.S. tax liability is required may occur after the due date for providing that notification. In this situation, you may have to file more than one Form 1040X for that tax year. Additional U.S. tax due eliminated by foreign tax credit carryback or carryover. If a foreign tax redetermination requires a redetermination of U.S. tax liability that would otherwise result in an additional amount of U.S. tax due, but the additional tax is eliminated by a carryback or carryover of an unused foreign tax, you do not have to amend your tax return for the year affected by the redetermination. Instead, you can notify the IRS by attaching a statement to the original return for the tax year in which the foreign tax redetermination occurred. You must file the statement by the due date (with extensions) of that return. The statement must show the amount of the unused foreign taxes paid or accrued and a detailed schedule showing the computation of the carryback or carryover (including the amounts carried back or over to the year for which a redetermination on U.S. tax liability is required). Failure-to-notify penalty. If you fail to notify the IRS of a foreign tax redetermination and cannot show reasonable cause for the failure, you may have to pay a penalty. For each month, or part of a month, that the failure continues, you pay a penalty of 5% of the tax due resulting from a redetermination of your U.S. tax. This penalty cannot be more than 25% of the tax due.
Foreign tax refund
If you receive a foreign tax refund without interest from the foreign government, you will not have to pay interest on the amount of tax due resulting from the adjustment to your U.S. tax for the time before the date of the refund. However, if you receive a foreign tax refund with interest, you must pay interest to the IRS up to the amount of the interest paid to you by the foreign government. The interest you must pay cannot be more than the interest you would have had to pay on taxes that were unpaid for any other reason for the same period. Interest also is owed from the time you receive a refund until you pay the additional tax due.
Foreign tax imposed on foreign refund
If your foreign tax refund is taxed by the foreign country, you cannot take a separate credit or deduction for this additional foreign tax. However, when you refigure the foreign tax credit taken for the original foreign tax, reduce the amount of the refund by the foreign tax paid on the refund.
Example —
You paid a foreign income tax of $3,000 in 2005, and received a foreign tax refund of $500 in 2007 on which a foreign tax of $100 was imposed. When you refigure your credit for 2005, you must reduce the $3,000 you paid by $400.
Time Limit on Refund Claims
You have 10 years to file a claim for refund of U.S. tax if you find that you paid or accrued a larger foreign tax than you claimed a credit for. The 10-year period begins the day after the regular due date for filing the return for the year in which the taxes were actually paid or accrued.
You have 10 years to file your claim regardless of whether you claim the credit for taxes paid or taxes accrued. The 10-year period applies to claims for refund or credit based on:
- Fixing math errors in figuring qualified foreign taxes,
- Reporting qualified foreign taxes not originally reported on the return, or
- Any other change in the size of the credit (including one caused by correcting the foreign tax credit limit).
The special 10-year period also applies to making or changing your choice of whether to claim a deduction or credit for foreign taxes. See Making or Changing Your Choice discussed earlier under Choosing To Take Credit or Deduction.
Who Can Take the Credit?
U.S. citizens, resident aliens, and nonresident aliens who paid foreign income tax and are subject to U.S. tax on foreign source income may be able to take a foreign tax credit.
U.S. Citizens
If you are a U.S. citizen, you are taxed by the United States on your worldwide income wherever you live. You are normally entitled to take a credit for foreign taxes you pay or accrue.
Resident Aliens
If you are a resident alien of the United States, you can take a credit for foreign taxes subject to the same general rules as U.S. citizens. If you are a bona fide resident of Puerto Rico for the entire tax year, you also come under the same rules.
Usually, you can take a credit only for those foreign taxes imposed on income you actually or constructively received while you had resident alien status.
For information on alien status, see Publication 519.
Nonresident Aliens
If you are a nonresident alien, you generally cannot take the credit. However, you may be able to take the credit if:
- You were a bona fide resident of Puerto Rico during your entire tax year, or
- You pay or accrue tax to a foreign country or U.S. possession on income from foreign sources that is effectively connected with a trade or business in the United States. But if you must pay tax to a foreign country or U.S. possession on income from U.S. sources only because you are a citizen or a resident of that country or U.S. possession, do not use that tax in figuring the amount of your credit.
For information on alien status and effectively connected income, see Publication 519.
What Foreign Taxes Qualify for the Credit?
Generally, the following four tests must be met for any foreign tax to qualify for the credit.
- The tax must be imposed on you.
- You must have paid or accrued the tax.
- The tax must be the legal and actual foreign tax liability.
- The tax must be an income tax (or a tax in lieu of an income tax).
Tax Must Be Imposed on You
You can claim a credit only for foreign taxes that are imposed on you by a foreign country or U.S. possession. For example, a tax that is deducted from your wages is considered to be imposed on you. You cannot shift the right to claim the credit by contract or other means.
Foreign country
A foreign country includes any foreign state and its political subdivisions. Income, war profits, and excess profits taxes paid or accrued to a foreign city or province qualify for the foreign tax credit. U.S. possessions. For foreign tax credit purposes, all qualified taxes paid to U.S. possessions are considered foreign taxes. For this purpose, U.S. possessions include Puerto Rico, Guam, the Northern Mariana Islands, and American Samoa. When the term “foreign country” is used in this publication, it includes U.S. possessions unless otherwise stated.
You Must Have Paid or Accrued the Tax
Generally, you can claim the credit only if you paid or accrued the foreign tax to a foreign country or U.S. possession. However, the paragraphs that follow describe some instances in which you can claim the credit even if you did not directly pay or accrue the tax yourself.
Joint return
If you file a joint return, you can claim the credit based on the total foreign income taxes paid or accrued by you and your spouse.
Partner or S corporation shareholder
If you are a member of a partnership, or a shareholder in an S corporation, you can claim the credit based on your proportionate share of the foreign income taxes paid or accrued by the partnership or the S corporation. These amounts will be shown on the Schedule K-1 you receive from the partnership or S corporation. However, if you are a shareholder in an S corporation that in turn owns stock in a foreign corporation, you cannot claim a credit for your share of foreign taxes paid by the foreign corporation.
Beneficiary
If you are a beneficiary of an estate or trust, you may be able to claim the credit based on your proportionate share of foreign income taxes paid or accrued by the estate or trust. This amount will be shown on the Schedule K-1 you receive from the estate or trust. However, you must show that the tax was imposed on income of the estate and not on income received by the decedent.
Mutual fund shareholder
If you are a shareholder of a mutual fund or other regulated investment company (RIC), you may be able to claim the credit based on your share of foreign income taxes paid by the fund if it chooses to pass the credit on to its shareholders. You should receive from the mutual fund or other RIC a Form 1099-DIV, or similar statement, showing your share of the foreign income, and your share of the foreign taxes paid. If you do not receive this information, you will need to contact the fund.
Controlled foreign corporation shareholder
If you are a shareholder of a controlled foreign corporation and choose to be taxed at corporate rates on the amount you must include in gross income from that corporation, you can claim the credit based on your share of foreign taxes paid or accrued by the controlled foreign corporation. If you make this election, you must claim the credit by filing Form 1118, Foreign Tax Credit—Corporations.
Controlled foreign corporation
A controlled foreign corporation is a foreign corporation in which U.S. shareholders own more than 50% of the voting power or value of the stock. You are considered a U.S. shareholder if you own, directly or indirectly, 10% or more of the total voting power of all classes of the foreign corporation's stock. See Internal Revenue Code sections 951(b) and 958(b) for more information.
Tax Must Be the Legal and Actual Foreign Tax Liability
The amount of foreign tax that qualifies is not necessarily the amount of tax withheld by the foreign country. Only the legal and actual foreign tax liability that you paid or accrued during the year qualifies for the credit.
Foreign tax refund
You cannot take a foreign tax credit for income taxes paid to a foreign country if it is reasonably certain the amount would be refunded, credited, rebated, abated, or forgiven if you made a claim. For example, the United States has tax treaties with many countries allowing U.S. citizens and residents reductions in the rates of tax of those foreign countries. However, some treaty countries require U.S. citizens and residents to pay the tax figured without regard to the lower treaty rates and then claim a refund for the amount by which the tax actually paid is more than the amount of tax figured using the lower treaty rate. The qualified foreign tax is the amount figured using the lower treaty rate and not the amount actually paid, because the excess tax is refundable.
Subsidy received
Tax payments a foreign country returns to you in the form of a subsidy do not qualify for the foreign tax credit. This rule applies even if the subsidy is given to a person related to you, or persons who participated with you in a transaction or a related transaction. A subsidy can be provided by any means but must be determined, directly or indirectly, in relation to the amount of tax, or to the base used to figure the tax. The term “subsidy” includes any type of benefit. Some ways of providing a subsidy are refunds, credits, deductions, payments, or discharges of obligations.
Shareholder receiving refund for corporate tax in integrated system
Under some foreign tax laws and treaties, a shareholder is considered to have paid part of the tax that is imposed on the corporation. You may be able to claim a refund of these taxes from the foreign government. You must include the refund (including any amount withheld) in your income in the year received. Any tax withheld from the refund is a qualified foreign tax.
Example —
You are a shareholder of a French corporation. You receive a $100 refund of the tax paid to France by the corporation on the earnings distributed to you as a dividend. The French government imposes a 15% withholding tax ($15) on the refund you received. You receive a check for $85. You include $100 in your income. The $15 of tax withheld is a qualified foreign tax.
Tax Must Be an Income Tax (or Tax in Lieu of Income Tax)
Generally, only income, war profits, and excess profits taxes (income taxes) qualify for the foreign tax credit. Foreign taxes on wages, dividends, interest, and royalties generally qualify for the credit. Furthermore, foreign taxes on income can qualify even though they are not imposed under an income tax law if the tax is in lieu of an income, war profits, or excess profits tax. See Taxes in Lieu of Income Taxes, later.
Income Tax
Simply because the levy is called an income tax by the foreign taxing authority does not make it an income tax for this purpose. A foreign levy is an income tax only if it meets both of the following tests.
- It is a tax; that is, you have to pay it and you get no specific economic benefit (discussed below) from paying it.
- The predominant character of the tax is that of an income tax in the U.S. sense.
A foreign levy may meet these requirements even if the foreign tax law differs from U.S. tax law. The foreign law may include in income items that U.S. law does not include, or it may allow certain exclusions or deductions that U.S. law does not allow.
Specific economic benefit
Generally, you get a specific economic benefit if you receive, or are considered to receive, an economic benefit from the foreign country imposing the levy, and:
- If there is a generally imposed income tax, the economic benefit is not available on substantially the same terms to all persons subject to the income tax, or
- If there is no generally imposed income tax, the economic benefit is not available on substantially the same terms to the population of the foreign country in general.
Economic benefits
Economic benefits include the following.
- Goods.
- Services.
- Fees or other payments.
- Rights to use, acquire, or extract resources, patents, or other property the foreign country owns or controls.
- Discharges of contractual obligations.
Internal Revenue Service
International Section
P.O. Box 920
Bensalem, PA 19020-8518.
Pension, unemployment, and disability fund payments
A foreign tax imposed on an individual to pay for retirement, old-age, death, survivor, unemployment, illness, or disability benefits, or for similar purposes, is not payment for a specific economic benefit if the amount of the tax does not depend on the age, life expectancy, or similar characteristics of that individual. No deduction or credit is allowed, however, for social security taxes paid or accrued to a foreign country with which the United States has a social security agreement. For more information about these agreements, see Publication 54.
Soak-up taxes. A foreign tax is not predominantly an income tax and does not qualify for credit to the extent it is a soak-up tax. A tax is a soak-up tax to the extent that liability for it depends on the availability of a credit for it against income tax imposed by another country. This rule applies only if and to the extent that the foreign tax would not be imposed if the credit were not available.
Penalties and interest
Amounts paid to a foreign government to satisfy a liability for interest, fines, penalties, or any similar obligation are not taxes and do not qualify for the credit.
Taxes not based on income
Foreign taxes based on gross receipts or the number of units produced, rather than on realized net income, do not qualify unless they are imposed in lieu of an income tax, as discussed next. Taxes based on assets, such as property taxes, do not qualify for the credit.
Taxes in Lieu of Income Taxes
A tax paid or accrued to a foreign country qualifies for the credit if it is imposed in lieu of an income tax otherwise generally imposed. A foreign levy is a tax in lieu of an income tax only if:
- It is not payment for a specific economic benefit as discussed earlier, and
- The tax is imposed in place of, and not in addition to, an income tax otherwise generally imposed.
A tax in lieu of an income tax does not have to be based on realized net income. A foreign tax imposed on gross income, gross receipts or sales, or the number of units produced or exported can qualify for the credit.
A soak-up tax (discussed earlier) generally does not qualify as a tax in lieu of an income tax. However, if the foreign country imposes a soak-up tax in lieu of an income tax, the amount that does not qualify for foreign tax credit is the lesser of the following amounts.
- The soak-up tax.
- The foreign tax you paid that is more than the amount you would have paid if you had been subject to the generally imposed income tax.
Foreign Taxes for Which You Cannot Take a Credit
This part discusses the foreign taxes for which you cannot take a credit. These are:
- Taxes on excluded income,
- Taxes for which you can only take an itemized deduction,
- Taxes on foreign oil related income,
- Taxes on foreign mineral income,
- Taxes from international boycott operations,
- Taxes on foreign oil and gas extraction income, and
- Taxes of U.S. persons controlling foreign corporations and partnerships.
Taxes on Excluded Income
You cannot take a credit for foreign taxes paid or accrued on income excluded from U.S. gross income.
Foreign Earned Income and Housing Exclusions
You must reduce your foreign taxes available for the credit by the amount of those taxes paid or accrued on income that is excluded from U.S. income under the foreign earned income exclusion or the foreign housing exclusion. See Publication 54 for more information on the foreign earned income and housing exclusions.
Wages completely excluded
If your wages are completely excluded, you cannot take a credit for any of the foreign taxes paid or accrued on these wages.
Wages partly excluded
If only part of your wages is excluded, you cannot take a credit for the foreign income taxes allocable to the excluded part. You find the amount allocable to your excluded wages by multiplying the foreign tax paid or accrued on foreign earned income received or accrued during the tax year by a fraction. The numerator of the fraction is your foreign earned income and housing amounts excluded under the foreign earned income and housing exclusions for the tax year minus otherwise deductible expenses definitely related and properly apportioned to that income. Deductible expenses do not include the foreign housing deduction. The denominator is your total foreign earned income received or accrued during the tax year minus all deductible expenses allocable to that income (including the foreign housing deduction). If the foreign law taxes foreign earned income and some other income (for example, earned income from U.S. sources or a type of income not subject to U.S. tax), and the taxes on the other income cannot be segregated, the denominator of the fraction is the total amount of income subject to the foreign tax minus deductible expenses allocable to that income.
Example —
You are a U.S. citizen and a cash basis taxpayer, employed by Company X and living in Country A. Your records show the following:
| Foreign earned income received | $120,000 |
| Unreimbursed business travel expenses | 20,000 |
| Income tax paid to Country A | 30,000 |
| Exclusion of foreign earned income and housing allowance | 87,225 |
Because you can exclude part of your wages, you cannot claim a credit for part of the foreign taxes. To find that part, do the following.
First, find the amount of business expenses allocable to excluded wages and therefore not deductible. To do this, multiply the otherwise deductible expenses by a fraction. That fraction is the excluded wages over your foreign earned income.
| $20,000 | × | $87,225 $120,000 | = | $14,538 | |
Next, find the numerator of the fraction by which you will multiply the foreign taxes paid. To do this, subtract business expenses allocable to excluded wages ($14,538) from excluded wages ($87,225). The result is $72,687.
Then, find the denominator of the fraction by subtracting all your deductible expenses from all your foreign earned income ($120,000 - $20,000 = $100,000).
Finally, multiply the foreign tax you paid by the resulting fraction.
| $30,000 | × | $72,687 $100,000 | = | $21,806 |
The amount of Country A tax you cannot take a credit for is $21,806.
Taxes on Income From Puerto Rico Exempt From U.S. Tax
If you have income from Puerto Rican sources that is not taxable, you must reduce your foreign taxes paid or accrued by the taxes allocable to the exempt income. For information on figuring the reduction, see Publication 570.
Possession Exclusion
If you are a bona fide resident of American Samoa and exclude income from sources in American Samoa, you cannot take a credit for the taxes you pay or accrue on the excluded income. For more information on this exclusion, see Publication 570.
Extraterritorial Income Exclusion
You cannot take a credit for taxes you pay on qualifying foreign trade income excluded on Form 8873, Extraterritorial Income Exclusion. However, see Internal Revenue Code section 943(d) for an exception for certain withholding taxes.
Taxes for Which You Can Only Take an Itemized Deduction
You cannot claim a foreign tax credit for foreign income taxes paid or accrued under the following circumstances. However, you can claim an itemized deduction for these taxes. See Choosing To Take Credit or Deduction, earlier.
Taxes Imposed By Sanctioned Countries (Section 901(j) Income)
You cannot claim a foreign tax credit for income taxes paid or accrued to any country if the income giving rise to the tax is for a period (the sanction period) during which:
- The Secretary of State has designated the country as one that repeatedly provides support for acts of international terrorism,
- The United States has severed or does not conduct diplomatic relations with the country, or
- The United States does not recognize the country's government, unless that government is eligible to purchase defense articles or services under the Arms Export Control Act.
The following countries meet this description for 2007. Income taxes paid or accrued to these countries in 2007 do not qualify for the credit.
- Cuba.
- Iran.
- Libya (but see Note below).
- North Korea.
- Sudan.
- Syria.
Income that is paid through one or more entities is treated as coming from a foreign country listed above if the original source of the income is from one of the listed countries.
Waiver of denial of the credit
A waiver can be granted to a sanctioned country if the President of the United States determines that granting the waiver is in the national interest of the United States and will expand trade and investment opportunities for U.S. companies in the sanctioned country. The President must report to Congress his intentions to grant the waiver and his reasons for granting the waiver not less than 30 days before the date on which the waiver is granted.
Note.
Effective December 10, 2004, the President granted a waiver to Libya. Income taxes arising on or after this date qualify for the credit if they meet the other requirements in this publication.
Limit on credit
In figuring the foreign tax credit limit, discussed later, income from a sanctioned country is a separate category of foreign income unless a Presidential waiver is granted. You must fill out a separate Form 1116 for this income. This will prevent you from claiming a credit for foreign taxes paid or accrued to the sanctioned country.
Example —
You lived and worked in Syria until August, when you were transferred to Italy. You paid taxes to each country on the income earned in that country. You cannot claim a foreign tax credit for the foreign taxes paid on the income earned in Syria. Because the income earned in Syria is a separate category of foreign income, you must fill out a separate Form 1116 for that income. You cannot take a credit for taxes paid on the income earned in Syria, but that income is taxable in the United States.
Figuring the credit when a sanction ends
Table 1 lists the countries for which sanctions have ended or for which a Presidential waiver has been granted. For any of these countries, you can claim a foreign tax credit for the taxes paid or accrued to that country on the income for the period that begins after the end of the sanction period or the date the Presidential waiver was granted.
Example —
The sanctions against Country X ended on July 31. On August 19, you receive a distribution from a mutual fund of Country X income. The fund paid Country X income tax for you on the distribution. Because the distribution was made after the sanction ended, you may include the foreign tax paid on the distribution to compute your foreign tax credit.
Amounts for the nonsanctioned period
If a sanction period ends (or a Presidential waiver is granted) during your tax year and you are not able to determine the actual income and taxes for that period, you can allocate amounts to that period based on the number of days in the period that fall in your tax year. Multiply the income or taxes for the year by the following fraction to determine the amounts allocable to that period.
| Number of nonsanctioned days in year Number of days in year |
Example —
You are a calendar year filer and received $20,000 of income from Country X in 2007 on which you paid tax of $4,500. Sanctions against Country X ended on July 11, 2007. You are unable to determine how much of the income or tax is for the nonsanctioned period. Because your tax year starts on January 1, and the Country X sanction ended on July 11, 2007, 173 days of your tax year are in the nonsanctioned period. You would compute the income for the nonsanctioned period as follows:
| 173 365 | × | $20,000 | = | $9,479 | |
You would figure the tax for the nonsanctioned period as follows:
| 173 365 | × | $4,500 | = | $2,133 | |
To figure your foreign tax credit, you would use $9,479 as the income from Country X and $2,133 as the tax.
Further information
The rules for figuring the foreign tax credit after a country's sanction period ends are more fully explained in Revenue Ruling 92-62, Cumulative Bulletin 1992-2, page 193. This Cumulative Bulletin can be found in many libraries and IRS offices.
Table 1. Countries Removed From the Sanction List or Granted Presidential Waiver
| Sanction Period | ||
| Country | Starting Date | Ending Date |
| Iraq | February 1, 1991 | June 27, 2004 |
| Libya | January 1,1987 | December 9, 2004* |
| *Presidential waiver granted for qualified income taxes arising after December 9, 2004. | ||
Taxes Imposed on Certain Dividends
You cannot claim a foreign tax credit for withholding tax (defined later) on dividends paid or accrued if either of the following applies to the dividends.
- The dividends are on stock you held for less than 16 days during the 31-day period that begins 15 days before the ex-dividend date (defined later).
- The dividends are for a period or periods totaling more than 366 days on preferred stock you held for less than 46 days during the 91-day period that begins 45 days before the ex-dividend date. If the dividend is not for more than 366 days, rule (1) applies to the preferred stock.
When figuring how long you held the stock, count the day you sold it, but do not count the day you acquired it or any days on which you were protected from risk or loss.
Regardless of how long you held the stock, you cannot claim the credit to the extent you have an obligation under a short sale or otherwise to make payments related to the dividend for positions in substantially similar or related property.
Withholding tax
For this purpose, withholding tax includes any tax determined on a gross basis. It does not include any tax which is in the nature of a prepayment of a tax imposed on a net basis. Ex-dividend date. The ex-dividend date is the first date following the declaration of a dividend on which the purchaser of a stock is not entitled to receive the next dividend payment.
Example —
You bought common stock from a foreign corporation on November 3. You sold the stock on November 19. You received a dividend on this stock because you owned it on the ex-dividend date of November 5. To claim the credit, you must have held the stock for at least 16 days within the 31-day period that began on October 21 (15 days before the ex-dividend date). Because you held the stock for 16 days, from November 4 until November 19, you are entitled to the credit.
Example —
The facts are the same as in Example 1 except that you sold the stock on November 14. You held the stock for only 11 days. You are not entitled to the credit.
Exception
If you are a securities dealer who actively conducts business in a foreign country, you may be able to claim a foreign tax credit for qualified taxes paid on dividends regardless of how long you held the stock or whether you were obligated to make payments for positions in substantially similar or related property. See section 901(k)(4) of the Internal Revenue Code for more information.
Taxes Withheld on Income or Gain (Other Than Dividends)
For income or gain (other than dividends) paid or accrued on property, you cannot claim a foreign tax credit for withholding tax (defined later):
- If you have not held the property for at least 16 days during the 31-day period that begins 15 days before the date on which the right to receive the payment arises, or
- To the extent you have to make related payments on positions in substantially similar or related property.
When figuring how long you held the property, count the day you sold it, but do not count the day you acquired it or any days on which you were protected from risk or loss.
Withholding tax
For this purpose, withholding tax includes any tax determined on a gross basis. It does not include any tax which is in the nature of a prepayment of a tax imposed on a net basis.
Exception for dealers
If you are a dealer in property who actively conducts business in a foreign country, you may be able to claim a foreign tax credit for qualified taxes withheld on income or gain from that property regardless of how long you held it or whether you have to make related payments on position in similar or related property. See section 901(I)(2) of the Internal Revenue Code for more information.
Taxes in Connection With the Purchase or Sale of Oil or Gas
You cannot claim a foreign tax credit for taxes paid or accrued to a foreign country in connection with the purchase or sale of oil or gas extracted in that country if you do not have an economic interest in the oil or gas, and the purchase price or sales price is different from the fair market value of the oil or gas at the time of purchase or sale.
Taxes on Foreign Oil Related Income
You must reduce foreign taxes paid or accrued on foreign oil related income to the extent that the tax imposed by the foreign country on such income is considered to be materially greater than the tax imposed by that country on income other than foreign oil related income or foreign oil and gas extraction income (discussed later). See Regulations section 1.907(b)-1. The amount of tax not allowed as a credit under this rule is allowed as a business expense deduction.
Taxes on Foreign Mineral Income
You must reduce any taxes paid or accrued to a foreign country or possession on mineral income from that country or possession if you were allowed a deduction for percentage depletion for any part of the mineral income.
Taxes From International Boycott Operations
If you participate in or cooperate with an international boycott during the tax year, your foreign taxes resulting from boycott activities will reduce the total taxes available for credit. See the instructions for line 12 in the Form 1116 instructions to figure this reduction.
This rule generally does not apply to employees with wages who are working and living in boycotting countries, or to retirees with pensions who are living in these countries.
List of boycotting countries
A list of the countries which may require participation in or cooperation with an international boycott is published by the Department of the Treasury. As of December 2007, the following countries are listed.
- Kuwait.
- Lebanon.
- Libya.
- Qatar.
- Saudi Arabia.
- Syria.
- United Arab Emirates.
- Republic of Yemen.
Internal Revenue Service
International Section
P.O. Box 920
Bensalem, PA 19020-8518
Determinations of whether the boycott rule applies
You may request a determination from the Internal Revenue Service as to whether a particular operation constitutes participation in or cooperation with an international boycott. The procedures for obtaining a determination from the Service are outlined in Revenue Procedure 77-9 in Cumulative Bulletin 1977-1. You can buy the Cumulative Bulletin from the Government Printing Office. Copies are also available in most IRS offices and you are welcome to read them there.
Public inspection
A determination and any related background file is open to public inspection. However, your identity and certain other information will remain confidential.
Reporting requirements
You must file a report with the IRS if you or any of the following persons have operations in or related to a boycotting country or with the government, a company, or a national of a boycotting country.
- A foreign corporation in which you own 10% or more of the voting power of all voting stock but only if you own the stock of the foreign corporation directly or through foreign entities.
- A partnership in which you are a partner.
- A trust you are treated as owning.
Form 5713 required
If you have to file a report, you must use Form 5713, International Boycott Report, and attach all supporting schedules. See the Instructions for Form 5713 for information on when and where to file the form.
Penalty for failure to file
If you willfully fail to make a report, in addition to other penalties, you may be fined $25,000 or imprisoned for no more than one year, or both.
Taxes on Foreign Oil and Gas Extraction Income
You must reduce your foreign taxes by a portion of any foreign taxes imposed on foreign oil and gas extraction income. The amount of the reduction is the amount by which your foreign oil and gas extraction taxes exceed the amount of your foreign oil and gas extraction income multiplied by a fraction equal to your pre-credit U.S. tax liability (Form 1040, line 44) divided by your worldwide income. You may be entitled to carry over to other years taxes reduced under this rule. See Internal Revenue Code section 907(f).
Taxes of U.S. Persons Controlling Foreign Corporations and Partnerships
If you had control of a foreign corporation or a foreign partnership for the annual accounting period of that corporation or partnership that ended with or within your tax year, you may have to file an annual information return. If you do not file the required information return, you may have to reduce the foreign taxes that may be used for the foreign tax credit. See Penalty for not filing Form 5471 or Form 8865, later.
U.S. persons controlling foreign corporations. If you are a U.S. citizen or resident who had control of a foreign corporation for an uninterrupted period of at least 30 days during the annual accounting period of that corporation, you may have to file an annual information return on Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations. Under this rule, you generally had control of a foreign corporation if at any time during the corporation's tax year you owned:- Stock possessing more than 50% of the total combined voting power of all classes of stock entitled to vote, or
- More than 50% of the total value of shares of all classes of stock of the foreign corporation.
Penalty for not filing Form 5471 or Form 8865
Generally, there is a dollar penalty of $10,000 for each annual accounting period for which you fail to furnish information. Additional penalties apply if the failure continues for more than 90 days after the day on which notice of the failure to furnish the information is mailed. If you fail to file either Form 5471 or Form 8865 when due, you may also be required to reduce by 10% all foreign taxes that may be used for the foreign tax credit. This 10% reduction shall not exceed the greater of $10,000 or the income of the foreign corporation or foreign partnership for the accounting period for which the failure occurs. This foreign tax credit penalty is also reduced by the amount of the dollar penalty imposed.
How To Figure the Credit
As already indicated, you can claim a foreign tax credit only for foreign taxes on income, war profits, or excess profits, or taxes in lieu of those taxes. In addition, there is a limit on the amount of the credit that you can claim. You figure this limit and your credit on Form 1116. Your credit is the amount of foreign tax you paid or accrued or, if smaller, the limit.
If you have foreign taxes available for credit but you cannot use them because of the limit, you may be able to carry them back 1 tax year and forward to the next 10 tax years. See Carryback and Carryover, later.
Also, certain tax treaties have special rules that you must consider when figuring your foreign tax credit. See Tax Treaties, later.
Exemption from foreign tax credit limit
You will not be subject to this limit and will be able to claim the credit without using Form 1116 if the following requirements are met.
- Your only foreign source gross income for the tax year is passive category income. Passive category income is defined later under Separate Limit Income. However, for purposes of this rule, high taxed income and export financing interest are also passive category income.
- Your qualified foreign taxes for the tax year are not more than $300 ($600 if married filing a joint return).
- All of your gross foreign income and the foreign taxes are reported to you on a payee statement (such as a Form 1099-DIV or 1099-INT).
- You elect this procedure for the tax year.
Limit on the Credit
Your foreign tax credit cannot be more than your total U.S. tax liability (line 44 on Form 1040) multiplied by a fraction. The numerator of the fraction is your taxable income from sources outside the United States. The denominator is your total taxable income from U.S. and foreign sources.
To determine the limit, you must separate your foreign source income into categories, as discussed under Separate Limit Income. The limit treats all foreign income and expenses in each separate category as a single unit and limits the credit to the U.S. income tax on the taxable income in that category from all sources outside the United States.
Separate Limit Income
You must figure the limit on a separate Form 1116 for each of the following categories of income.
- Passive category income.
- General category income.
- Section 901(j) income.
- Certain income re-sourced by treaty.
- Any lump sum distribution from an employer benefit plan for which the special averaging treatment is used to determine your tax.
In figuring your separate limits, you must combine the income (and losses) in each category from all foreign sources, and then apply the limit.
Income from controlled foreign corporations
As a U.S. shareholder, certain income that you receive or accrue from a controlled foreign corporation (CFC) is treated as separate limit income. You are considered a U.S. shareholder in a CFC if you own 10% or more of the total voting power of all classes of the corporation's voting stock. Subpart F inclusions, interest, rents, and royalties from a CFC are generally treated as separate limit income if they are attributable to the separate limit income of the CFC. A dividend paid or accrued out of the earnings and profits of a CFC is treated as separate limit income in the same proportion that the part of earnings and profits attributable to income in the separate category bears to the total earnings and profits of the CFC. For more information, see section 904(d)(3) of the Internal Revenue Code and Regulations section 1.904-5.
Partnership distributive share
In general, a partner's distributive share of partnership income is treated as separate limit income if it is from the separate limit income of the partnership. However, if the partner owns less than a 10% interest in the partnership, the income is generally treated as passive income. For more information, see Regulations section 1.904-5(h).
Passive Category Income
Passive category income consists of passive income and specified passive category income.
Passive income
Except as described earlier under Income from controlled foreign corporations and Partnership distributive share, passive income generally includes the following.
- Dividends.
- Interest.
- Rents.
- Royalties.
- Annuities.
- Net gain from the sale of non-income-producing investment property or property that generates passive income.
- Net gain from commodities transactions, except for hedging and active business gains or losses of producers, processors, merchants, or handlers of commodities.
- Amounts you must include as foreign personal holding company income under section 551(a) or 951(a) of the Internal Revenue Code.
- Amounts includible in income under section 1293 of the Internal Revenue Code (relating to certain passive foreign investment companies).
If you receive foreign source distributions from a mutual fund or other regulated investment company that elects to pass through to you the foreign tax credit, the income is generally considered passive. The mutual fund will provide you with a Form 1099-DIV or substitute statement showing the amount of foreign taxes it elected to pass through to you.
What is not passive income
Passive income does not include any of the following.
- Gains or losses from the sale of inventory property or property held mainly for sale to customers in the ordinary course of your trade or business.
- Export financing interest.
- High-taxed income.
- Active business rents and royalties.
- Any income that is defined in another separate limit category.
Export financing interest
This is interest derived from financing the sale or other disposition of property for use outside the United States if:
- The property is manufactured, produced, grown, or extracted in the United States, and
- 50% or less of the fair market value of the property is due to imports into the United States.
Specified passive category income
Specified passive income consists of:
- Dividends from a DISC (domestic international sales corporation) or former DISC to the extent the dividends are treated as foreign source income, and
- Distributions from a former FSC (foreign sales corporation) out of earnings and profits that are attributable to:
- Foreign trade income, or
- Interest and carrying charges derived from a transaction that results in foreign trade income.
General Category Income
General category income includes income from sources outside the United States that is not passive category income or does not fall into one of the other separate limit categories discussed later. It generally includes active business income and wages, salaries, and overseas allowances of an individual as an employee. General category income includes high-taxed income that would otherwise be passive income. See High-taxed income earlier under What is not passive income.
Financial services income
In general, financial services income is treated as general category income if it is derived by a financial services entity. You are a financial services entity if you are predominantly engaged in the active conduct of a banking, insurance, financing, or similar business for any taxable year. Financial services income of a financial services entity generally includes income derived in the active conduct of a banking, financing, insurance or similar business. Financial services income of a financial services entity also includes passive income and certain incidental income. If you qualify as a financial services entity because you treat certain items of income as active financing income under Regulations section 1.904-4(e)(2)(i)(Y), you must show the type and amount of each item on an attachment to Form 1116.
Section 901(j) Income
This is income earned from activities conducted in sanctioned countries. Income derived from each sanctioned country is subject to a separate foreign tax credit limitation. Therefore, you must use a separate Form 1116 for income earned from each such country. See Taxes Imposed By Sanctioned Countries (Section 901(j) Income) under Taxes for Which You Can Only Take an Itemized Deduction, earlier.
Certain Income Re-Sourced By Treaty
If a sourcing rule in an applicable income tax treaty treats any of the income described below as foreign source, and you elect to apply the treaty, the income will be treated as foreign source.
- Certain gains (section 865(h)).
- Certain income from a U.S.-owned foreign corporation (section 904(h)(10)). See Regulations section 1.904-5(m)(7) for an example.
You must compute a separate foreign tax credit limitation for any such income for which you claim benefits under a treaty, using a separate Form 1116 for each amount of re-sourced income from a treaty country.
Lump-Sum Distribution
If you receive a foreign source lump-sum distribution (LSD) from a retirement plan, and you figure the tax on it using the special averaging treatment for LSDs, you must make a special computation. Follow the Form 1116 instructions and complete the worksheet in those instructions to determine your foreign tax credit on the LSD.
The special averaging treatment for LSDs is elected by filing Form 4972, Tax on Lump-Sum Distributions.Allocation of Foreign Taxes
If you paid or accrued foreign income tax for a tax year on income in more than one separate limit income category, allocate the tax to the income category to which the tax specifically relates. If the tax is not specifically related to any one category, you must allocate the tax to each category of income.
You do this by multiplying the foreign income tax related to more than one category by a fraction. The numerator of the fraction is the net income in a separate category. The denominator is the total net foreign income.
You figure net income by deducting from the gross income in each category and from the total foreign income any expenses, losses, and other deductions definitely related to them under the laws of the foreign country or U.S. possession. If the expenses, losses, and other deductions are not definitely related to a category of income under foreign law, they are apportioned under the principles of the foreign law. If the foreign law does not provide for apportionment, use the principles covered in the U.S. Internal Revenue Code.
Example —
You paid foreign income taxes of $3,200 to Country A on wages of $80,000 and interest income of $3,000. These were the only items of income on your foreign return. You also have deductions of $4,400 that, under foreign law, are not definitely related to either the wages or interest income. Your total net income is $78,600 ($83,000-$4,400).
Because the foreign tax is not specifically for either item of income, you must allocate the tax between the wages and the interest under the tax laws of Country A. For purposes of this example, assume that the laws of Country A do this in a manner similar to the U.S. Internal Revenue Code. First figure the net income in each category by allocating those expenses that are not definitely related to either category of income.
You figure the expenses allocable to wages (general category income) as follows.
| $80,000 (wages) $83,000 (total income) | × | $4,400 | = | $4,241 |
| The net wages are $75,759 ($80,000 - $4,241). | ||||
You figure the expenses allocable to interest (passive category income) as follows.
| $3,000 (interest) $83,000 (total income) | × | $4,400 | = | $159 |
| The net interest is $2,841 ($3,000 - $159). | ||||
Then, to figure the foreign tax on the wages, you multiply the total foreign income tax by the following fraction.
| $75,759 (net wages) $78,600 (total net income) | × | $3,200 | = | $3,084 |
You figure the foreign tax on the interest income as follows.
| $2,841 (net interest) $78,600 (total net income) | × | $3,200 | = | $116 |
Foreign Taxes From a Partnership or an S Corporation
If foreign taxes were paid or accrued on your behalf by a partnership or an S corporation, you will figure your credit using certain information from the Schedule K-1 you received from the partnership or S corporation. If you received a 2007 Schedule K-1 from a partnership or an S corporation that includes foreign tax information, see your Form 1116 instructions for how to report that information.
Figuring the Limit
Before you can determine the limit on your credit, you must first figure your total taxable income from all sources before the deduction for personal exemptions. This is the amount shown on line 41 of Form 1040. Then for each category of income, you must figure your taxable income from sources outside the United States.
Before you can figure your taxable income in each category from sources outside the United States, you must first determine whether your gross income in each category is from U.S. sources or foreign sources. Some of the general rules for figuring the source of income are outlined in Table 2.
See Determining the Source of Compensation for Labor or Personal Services and Determining the Source of Income From the Sales or Exchanges of Certain Personal Property for a more detailed discussion on determining the source of these types of income.
Determining the source of income from U.S. possessions. The rules for determining whether income is from sources in a U.S. possession are generally the same as those for determining whether income is from U.S. sources. But exceptions apply. See Publication 570 for more information.Determining the Source of Compensation for Labor or Personal Services
If you are an employee and receive compensation for labor or personal services performed both inside and outside the United States, special rules apply in determining the source of the compensation. Compensation (other than certain fringe benefits) is sourced on a time basis. Certain fringe benefits (such as housing and education) are sourced on a geographical basis.
Or, you may be permitted to use an alternative basis to determine the source of compensation. See Alternative basis later.
If you are self-employed, you determine the source of compensation for labor or personal services from self-employment on the basis that most correctly reflects the proper source of that income under the facts and circumstances of your particular case. In many cases, the facts and circumstances will call for an apportionment on a time basis as explained next.
Time basis
Use a time basis to figure your foreign source compensation (other than the fringe benefits discussed later). Do this by multiplying your total compensation (other than the fringe benefits discussed later) by the following fraction:
| Number of days you performed services in the foreign country during the year | ||
| Total number of days you performed services during the year |
Example —
Christina Brooks, a U.S. citizen, worked 240 days for a U.S. company during the tax year. She received $80,000 in compensation. None of it was for fringe benefits. Christina performed services in the United States for 60 days and performed services in the United Kingdom for 180 days. Using the time basis for determining the source of compensation, $60,000 ($80,000 × 180/240) is her foreign source income.
Example —
Rob Waters, a U.S. citizen, is employed by a U.S. corporation. His principal place of work is in the United States. His annual salary is $100,000. None of it is for fringe benefits. During the first quarter of the year he worked entirely within the United States. On April 1, Rob was transferred to Singapore for the remainder of the year. Rob is able to establish that the first quarter of the year and the last 3 quarters of the year are two separate, distinct, and continuous periods of time. Accordingly, $25,000 of Rob's annual salary is attributable to the first quarter of the year (.25 × $100,000). All of it is U.S. source income because he worked entirely within the United States during that quarter. The remaining $75,000 is attributable to the last three quarters of the year. During those quarters, he worked 150 days in Singapore and 30 days in the United States. His periodic performance of services in the United States did not result in distinct, separate, and continuous periods of time. Of his $75,000 salary, $62,500 ($75,000 × 150/180) is foreign source income for the year.
Table 2. Source of Income
| Item of Income | Factor Determining Source |
| Salaries, wages, other compensation | Where services performed |
| Business income: | |
| Personal services | Where services performed |
| Sale of inventory—purchased | Where sold |
| Sale of inventory—produced | Allocation |
| Interest |