By Anthony Diosdi
An individual claiming a foreign tax credit must attach Internal Revenue Service (“IRS”) Form 1116, Foreign Tax Credit to his or her tax return. See Treas. Reg. Section 1.905-2(a)(1). This article will go line-by-line through the Form 1116. This article is based on the instructions provided by the Internal Revenue Service (“IRS”) for the Form 1116. The Form 1116 is designed to calculate foreign tax credits for individual taxpayers. Before any taxpayer attempts to complete the Form 1116, he or she should understand some basic rules regarding claiming foreign tax credits. First, U.S. taxpayers are generally subject to U.S. tax on their worldwide income, but may be provided a tax credit for foreign income taxes paid or accrued. The main purpose of the foreign tax credit is to mitigate the double taxation of foreign source income that might occur if such income is taxed by both the United States and a foreign country.
A U.S. taxpayer may receive a “direct” foreign tax credit for foreign taxes that the taxpayer itself pays. However, when a taxpayer receives subpart F or global intangible low-taxed income (“GILTI”) income, the taxpayer may potentially not be eligible to claim a foreign tax credit for foreign taxes paid unless an election is made under Section 962 of the Internal Revenue Code. Determining whether foreign taxes are creditable against U.S. income is complicated. If you are unsure if a foreign tax qualifies for a tax credit, you should consult with a qualified international tax professional.
Categories of Income
The foreign tax credit is generally limited to a taxpayer’s U.S. tax liability on its foreign- source taxable income (computed under U.S. tax accounting principles). This limitation is computed by multiplying a taxpayer’s total U.S. tax liability (prior to the foreign tax credit) in that year by the ratio of the taxpayer’s foreign source taxable income in that year to the taxpayer’s worldwide taxable income in that year. Under current law, the limitation is applied separately to Section 951A or GILTI income, foreign branch income, passive income, (passive income includes income that would be foreign personal holdings company income under Section 954(c) of the Internal Revenue Code (e.g., dividends, interest, royalties, and other types of passive income), general income, Section 901(j) income (income from sanctioned countries), certain income re-sourced by treaty (certain U.S. tax treaties provide a “resourcing” rule, under which a U.S. taxpayer may treat as foreign source any income that the other contracting state may tax under the treaty), and lump sum distributions (distributions from a pension plan).
In order to determine foreign source taxable income in each category or basket for purposes of calculating the foreign tax credit, a taxpayer must first identify the foreign source income to be reported on the Form 1116. A separate Form 1116 must be prepared for each category of foreign source income. The taxpayer must check the applicable box on the Form 1116 for the foreign source income being disclosed.
Line i. Foreign Country or U.S. Possession
Generally, if the taxpayer received income from, or paid taxes to, more than one foreign country or U.S. possession, the taxpayer must report information on a country-by-country basis on the line.
Line h.
Line h requires the taxpayer to state the name of the country he or she is a resident.
Part I. Taxable Income or Loss from Sources Outside the United States
Line 1a. Foreign Gross Income
For line 1a, the taxpayer must state income that is taxable by the United States and is from sources within the country entered on line i. The taxpayer must list the foreign source income even if it is not taxable by that foreign country.
Line 1b.
For line 1b, the taxpayer must check the box on line 1b if all of the following apply: 1) the income on line 1a is compensation for services he or she performed as an employee; 2) the taxpayer’s total employee compensation from both U.S. and foreign sources was $250,000 or more. In addition, attach to Form 1116 a statement that contains the following: 1) the specific fringe benefit for which the alternative is used; 2) for each such item, the alternative basis of allocation of source used; 3) for each such item, a computation showing how the alternative allocation was computed; 3) a comparison of the dollar amount of the compensation sourced within and without the United States under both the alternative basis and the time or geographical basis for determining the source.
Line 2.
For line 2, the taxpayer should enter his or her deductions that definitely relate to the gross income from foreign sources shown on line 1a. For example, if the taxpayer is an employee reporting foreign earned income on line 1a, the taxpayer should include on line 2 expenses such as those incurred to move to a new principal place of work outside the United States or supplies the taxpayer bought for his or her job outside the United States.
Lines 3a. and 3b.
For lines 3a and 3b, the taxpayer should enter any deductions (other than interest expense) that: 1) are not shown on line 2 and are not related to the taxpayer’s U.S. source income.
Line 3a.
For line 3a, the taxpayer should enter following itemized deductions (from Schedule A (Form 1040) on line 3a: 1) medical expenses; 2) general sales taxes; 3) real estate taxes for your home. If the taxpayer does not itemize deductions, the taxpayer should enter his or her standard deduction on line 3a.
Line 3b.
For line 3b, the taxpayer should enter any other deductions that do not definitely relate to any specific type of income stated on his or her tax return.
Line 3c.
For line 3c, the taxpayer should add lines 3a and 3b.
Lines 3d. and 3e.
For lines 3d and 3e, the taxpayer must list all gross income from foreign and all sources. For lines 3d and 3e, gross income means the total of the taxpayer’s gross receipts (reduced by cost of goods sold), total capital and ordinary gains (before subtracting any losses) and all other income (before subtracting any deductions).
Line 3d.
For line 3d, the taxpayer must enter his or her gross foreign source income from the category the checked above. The taxpayer will be required to include any foreign earned income he or she has excluded on Form 2555 as a result of an election under Section 911 of the Internal Revenue Code.
Line 3e.
For line 3e, the taxpayer must enter his or her gross income from all sources and all categories, both U.S. and foreign. As with line 3d, the taxpayer should include any foreign earned income that has been excluded on Form 2555.
Line 3f.
For line 3f, the taxpayer should divide line 3d by line 3e and round off the result to at least four decimal places.
Line 3g.
For line 3g, the taxpayer should multiply line 3c by line 3f.
Line 4.
For lines 4a and 4b, the taxpayer must enter his or her pro rata share of interest expense.
Line 4a.
For line 4a, if a taxpayer’s foreign source income (including income stated on Form 2555) does not exceed $5,000, the taxpayer can allocate all of his or her interest expense to U.S. source income. Otherwise, the taxpayer can apportion deductible home mortgage interest expenses by using a gross income method. A worksheet discussed in the instructions to Form 1116 provides clarification as to how to apportion home mortgage interest. According to the worksheet, home mortgage interest is allocated as follows:
1. Enter gross foreign source income of the type
Shown on Form 1116 (Do not include income excluded on Form 2555) 1. __________
2. Enter gross income from all sources (Do not include income excluded
on Form 2555) 2.___________
3. Divide line 1 by line 2 and enter the result as a decimal
(rounded to at least four places) 3.___________
4. Enter deductible home mortgage interest (from line 8e of
Schedule A (Form 1040)) 4.___________
5. Multiply line 4 by line 3. Enter the result here and on the
appropriate Form 1116, line 4a 5.___________
A separate worksheet should be completed for each country with foreign source income.
Line 4b.
For line 4b, the taxpayer must enter his or her interest expense. This includes investment interest, interest incurred in a trade or business, and passive activity interest. If the taxpayer’s gross foreign source income does not exceed $5,000, the taxpayer can allocate all of his or her interest expense to U.S. source income. Otherwise, each type of interest expense is apportioned separately using an “asset method.”
The IRS’s instructions to Form 1116 provide an example as to how to allocate interest expense using the “asset method.” For example, You have investment interest expense of $2,000. Your assets of $100,000 consist of stock generating U.S. source income (adjusted basis, $40,000) and stock generating foreign source income (adjusted basis, $60,000). You apportion 40% ($40,000/$100,000) of $2,000, or $800 of your investment interest, to U.S. source income and 60% ($60,000/$100,000) of $2,000, or $1,200, to foreign source income. In this example, you will enter the $1,200 apportioned to foreign source income on line 4b. You will not enter the $800 apportioned to U.S. source income on any of Part I of Form 1116.
Line 5.
For line 5, the taxpayer must list any capital losses from foreign sources.
Line 6.
For line 6, the taxpayer must add lines 2, 3g, 4a, and 5.
Line 7.
For line 7, the taxpayer must subtract line 6 from line 1a. The taxpayer must state the result on line 7 and line 15, page two of Form 1116.
Part II Foreign Taxes Paid or Accrued
Generally, the taxpayer must enter in Part II the amount of foreign taxes, in both the foreign currency denominations and as converted into U.S. dollars, that relate to the category of income checked above in Part I. Taxes are related to the income if the income is included in the foreign tax base on which the tax is imposed. If the foreign tax you paid or accrued relates to more than one category of income, apportion the tax among the categories. The apportionment is based on the ratio of net foreign taxable income in each category to the total net income subject to the foreign tax.
The taxpayer must also enter in Part II the foreign taxes that were previously suspended under Section 909 and that are allowed because the related income is taken into account in the present year. Under Internal Revenue Code Section 909, where there is a “foreign tax credit splitting event” with respect to foreign income tax paid or accrued by the taxpayer, the foreign tax is not taken into account for U.S. tax purposes before the tax year in which the related income is taken into account by the taxpayer. The definition of “foreign tax credit splitting event” is broad and could reach a variety of situations such as disregarded payments, transfer pricing adjustments, contributions of property resulting in a shift of deductions and timing differences under U.S. and foreign law. In the case of a suspended tax under Section 909, enter “909 taxes” in column (l) instead of the date paid or accrued.
Part III Figuring the Foreign Tax Credit
Line 9.
For line 9, the taxpayer must enter the total foreign taxes paid or accrued for the category of income stated in Part 1.
Line 10.
For line 10, the taxpayer should state the amount of any unused foreign taxes in the separate category from another tax year that are eligible to be carried forward to or back to the present year. Generally, a taxpayer can carry back one year and then forward 10 years any foreign tax you paid or accrued to any foreign country or U.S. possession on income in a separate category that is more than the limitation. First, the taxpayer should apply the excess to the earliest year to which it may be carried. Then, the taxpayer applies it to the next earliest year, and so on.
However, no foreign tax carryovers are allowed for foreign taxes paid or accrued on Section 951A category income. If the taxpayer has Section 951A or GILTI income, the taxpayer should leave line 10 of Form 1116 blank.
In addition, any unused foreign taxes in the pre-2018 separate category for general income carried forward generally are allowed to a taxpayer’s post-2017 separate category for general income. Alternatively, the taxpayer can allocate those foreign taxes to the post-2017 separate category for foreign branch category income to the extent the unused foreign taxes would have been allocated to the taxpayer’s post-2017 separate category for foreign branch category income, and would have been unused foreign taxes with respect to that separate category, if that separate category had applied in the year or years the unused foreign taxes arose.
Line 11.
For line 11, the taxpayer must add lines 9 and 10.
Line 12.
For line 12, the taxpayer should enter any reductions to foreign taxes. Reductions to foreign taxes include the following:
Taxes on income excluded on Form 2555.
The taxpayer should reduce or exclude from foreign source income as a result of a Section 911 exclusion. If only part of the taxpayer’s foreign source income is excluded, he or she must determine the amount of tax allocable to the excluded income. To do so, the taxpayer should multiply the foreign source taxes paid or accrued on foreign income received or accrued during the tax year by the following fraction.
Numerator: Foreign earned income and housing amounts the taxpayer excluded for the tax year minus otherwise deductible expenses (not including the foreign housing deduction) allocable to that income.
Denominator: The taxpayer’s total foreign earned income received or accrued during the tax year minus deductible expenses (including the foreign housing deduction) allocable to that income. However, if the foreign jurisdiction charges tax on foreign earned income and other income and the taxes cannot be segregated, the denominator is the total amount of income subject to foreign tax minus deductible expenses allocable to that income.
Taxes on income from Puerto Rico exempt from U.S. tax. A reduction applies if the taxpayer has income from Puerto Rican sources that is not taxable on his or her U.S. federal income tax return.
Taxes on income from American Samoa excluded on Form 4563. If the taxpayer is a bona fide resident of American Samoa, he or she must reduce taxes paid or accrued by any taxes attributable to income sources in American Samoa excluded on Form 4563.
Taxes on combined foreign oil and gas income. A reduction on taxes paid or accrued by a portion of taxes imposed on combined foreign oil and gas income should be listed. The amount of the reduction is the amount by which the taxpayer’s foreign oil and gas taxes exceed the amount of his or her combined foreign oil and gas income for the year multiplied by a fraction equal to the pre-credit U.S. tax liability (for example, the total of Form 1040 or Form 1040-SR, line 16 and Schedule 2 (Form 1040), Part 1, line 2) divided by the taxpayer’s worldwide taxable income.
Taxes on foreign mineral income. The taxpayer should reduce taxes paid or accrued on mineral income from a foreign country or U.S. possession if he or she took a deduction for percentage depletion under Section 613 for any part of the mineral income.
Reduction for failure to file Form 5471 or Form 8866. If a taxpayer does not timely file Form 5471 or Form 8865 by the due date, the IRS may require the taxpayer to reduce his or her foreign tax credits by 10 percent. This adjustment entered on line 12.
Line 13.
For line 13, the taxpayer must enter any taxes reclassified under high tax kickout. The high-tax kickout rule applies when the effective tax rate for foreign source income allocated to the passive basket exceeds the greatest U.S. tax rate. Under the high-tax kickout rule, the high-taxed income is removed from the passive basket and reallocated to the general income category. The first and most significant impact of the high-tax kickout rule is to prevent cross-crediting within the passive income basket. Second, the high-tax kickout prevents the manipulation of expenses allocation rules of shifting taxes from limitation categories with excess credits to categories with excess limitations.
For example, assume a CFC with excess credits in the general limitation category can engage in simultaneous loans, one as borrower and the other as lender, to create equal amounts of interest income and expenses; the interest income may be entirely passive limitation income, but the corresponding interest expense is apportioned to reduce taxable income in all limitation categories (as well as U.S. source income). The tax effect of this transaction (which is a “wash,” from an economic perspective) is that high foreign taxes actually paid on general limitation income are attributed to income in the passive limitation category and thus may offset residual U.S. tax on other low-taxed passive income. The high-tax kickout, together with the “netting” rule of Treasury Regulation Section 1.904-5(c)(2) (which allocates related person interest expenses of a CFC directly against passive income of the CFC), inhibits this manipulation of the expense allocation rules.
Under Internal Revenue Code Section 904(f)(5), a separate limitation loss (i.e., an excess of deductions allocated to foreign source income in a separate limitation category over the income in that category) is reallocated to other separate limitation categories in proportion to the income in those categories. When income is generated in the loss category in a subsequent year, that income is reallocated to the categories previously reduced by the loss in order to recapture the loss.
Similarly, an overall foreign loss reduces taxable U.S. source income in the year generated and thus the U.S. tax on U.S. source income earned in that year. Section 904(f) recaptures the loss, however, by re-sourcing foreign source income earned in a later year as domestic source. Re-sourcing applies to an amount of foreign source income equal to the amount of the overall foreign loss, but the amount re-sourced in any single year is limited to 50 percent of the entities’ or individual’s foreign source income in that year.
The effect of the re-sourcing is to reduce the foreign tax credit limitation in the subsequent year(s); the amount of U.S. tax may be increased by a corresponding amount, in which case the rule effectively recaptures the prior reduction in U.S. tax on U.S. source income that resulted from the foreign source loss. This rule is intended to prevent U.S. entities and individuals from deriving a “double benefit,” i.e., a deduction to reduce U.S. tax on U.S. source income and the ability to claim a foreign tax credit in a later income year.
Line 14.
For line 14, the taxpayer must combine lines 11, 12, and 13.
Line 15.
The amount on line 15 is the taxpayer’s taxable income (or loss), before adjustments, from sources outside the United States. If the amount on line 15 is zero or a loss, the taxpayer generally has no foreign tax credit for the category of income checked above Part 1 of this Form 1116.
Line 16.
For line 16, the taxpayer is required to increase or decrease the amount on line 15 by the following adjustments.
Line 17.
For line 17, the taxpayer must combine the amounts on lines 15 and 16.
Line 18.
If the taxpayer has qualified dividends or capital gains, he or she may be required to make adjustments to those qualified dividends and gains before you take those amounts into account on line 18.
Line 19.
For line 19, the taxpayer must divide line 17 by line 18. If line 17 is more than line 18, enter “1.”
Line 20.
For line 20, enter the total of Form 1040 or Form 1040-SR, line 16, and Schedule 2, line 2. If the taxpayer is a nonresident, enter the total of Form 1040-NR, line 16 and Schedule 2 (Form 1040) line 2. If the taxpayer is an estate or trust, enter the amount from Form 1041, Schedule G, line 1a; or the total of Form 990-T, Part II, lines 2, 3, 4, and 6. If the taxpayer is a foreign estate or trust, it should enter the amount from Form 1040-NR, line 16. If the taxpayer is filing Form 1116 for a lump sum distribution, a special worksheet will need to be completed.
Line 21.
For line 21, the taxpayer must multiply line 20 by line 22.
Line 22.
For line 22, the taxpayer must enter the amount of any increase to his or her limitation as determined under the excess limitation rules of Section 960(c). Section 960(c) limits the foreign taxes deemed paid with respect to Section 956 investments in United States property. Under Sections 951 and 956, a CFC’s investment in United States property may be subpart F income to the U.S. parent. Where the U.S. parent is treated under Section 960 as having paid its pro rata share of foreign taxes paid by the CF on the earnings invested in U.S. property. Under Internal Revenue Code Section 960(c), for acquisitions of U.S. property, the amount of foreign taxes deemed paid as a result of Section 956 inclusions is limited to the lesser of 1) the foreign taxes deemed paid with respect to the U.S. shareholder’s Section 956 exclusion or 2) the hypothetical amount of foreign taxes deemed as computed under the provision (the “hypothetical credit”). The hypothetical credit is the amount of foreign taxes that would have been deemed paid if an amount equal to the Section 956 inclusion had been distributed through a chain of ownership that begins with the CFC that holds an investment in U.S. property and ends with the U.S. shareholder.
Line 23.
For line 23, the taxpayer must add lines 21 and 22.
Line 24.
For line 24, the taxpayer must enter the smaller of line 14 or 23. This is the maximum foreign tax credit.
Part IV. Summary of Credits from Separate Parts III
Taxpayers must complete lines 25 through 31 in Part IV only if they have completed more than one Form 1116 because they will have more than one of the categories of income listed in Part I.
Conclusion
Calculating foreign tax credits and completing a Form 1116 can be complicated. If you are uncertain how to properly compute a foreign tax credit or complete a Form 1116, you should contact a qualified international tax professional.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic and international tax attorney, Anthony Diosdi provides international tax advice to closely held entities and publicly traded corporations. Anthony Diosdi also has substantial experience in matters involving cross-border estate planning. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.