51415018AForeign Tax
Credit for
IndividualsWhat's New for 20051Reminders1Introduction2Choosing To Take Credit or Deduction2Why Choose the Credit?3Who Can Take the Credit?5What Foreign Taxes Qualify for the Credit?5Foreign Taxes for Which You Cannot Take a Credit6How To Figure the Credit9Carryback and Carryover19How To Claim the Credit22Simple Example22Comprehensive Example23How To Get Tax Help31Index35What's New for 2005Rate of exchange for foreign taxes.
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 taxes
relate. However in tax years beginning in 2005 and later years, you can elect to use the exchange rate in effect on the date the taxes are paid if the
foreign tax liability is denominated in a nonfunctional currency. See Foreign Currency and Exchange Rates.
Source of compensation for labor or personal services.
In tax years beginning after July 13, 2005, new rules apply in determining the source of compensation for labor or personal services performed as
an employee. If you file your tax returns on a calendar year basis, the new rules apply to your returns for 2006 and later years.
Under the new rules, compensation (other than fringe benefits) is sourced on a time basis. Fringe benefits (such as housing and education are
sourced on a geographical basis. For more information, see Regulations section 1.861-4.
RemindersChange 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.
Photographs of missing children.
The Internal Revenue Service is a proud partner with the National Center for Missing and Exploited Children. Photographs of missing children
selected by the Center may appear in this publication on pages that would otherwise be blank. You can help bring these children home by looking at the
photographs and calling 1-800-THE-LOST (1-800-843-5678) if you recognize a child.
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.
Comments and suggestions.Comments on publicationSuggestions for publication
We welcome your comments about this publication and your suggestions for future editions.
You can write to us at the following address:
Internal Revenue Service
Individual Forms and Publications Branch
SE:W:CAR:MP:T:I
1111 Constitution Ave. NW, IR-6406
Washington, DC 20224
We respond to many letters by telephone. Therefore, it would be helpful if you would include your daytime phone number, including the area code, in
your correspondence.
You can email us at
*taxforms@irs.gov. (The asterisk must be included in the
address.) Please put Publications Comment on the subject line. Although we cannot respond individually to each email, we do appreciate your
feedback and will consider your comments as we revise our tax products.
Tax questions.
If you have a tax question, visit
www.irs.gov or call 1-800-829-1040. We cannot answer tax questions at either
of the addresses listed above.
Ordering forms and publications.
Visit
www.irs.gov/formspubs to download forms and publications, call 1-800-829-3676, or write to the National Distribution Center at the
address shown under How To Get Tax Help in the back of this publication.
Publication54Tax Guide for U.S. Citizens and Resident Aliens Abroad519U.S. Tax Guide for Aliens570Tax Guide for Individuals With Income From U.S. PossessionsForm (and Instruction)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 TaxesChoice to take credit or deduction:Choice applied 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.
For more information on these items, see Taxes for Which You Can Only Take an Itemized Deduction later under Foreign Taxes for
Which You Cannot Take a Credit.
Foreign taxes that are not income taxes.Deduction for 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.Carryback and carryover:Unused foreign tax credits, carryback or carryover
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 ChoiceChoice to take credit or deduction:Changing your choiceMaking 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 2005, you file an amended return for tax year 1994 choosing to take a credit for your 1994 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 1994 return
was April 17 (April 15 was a Saturday in 1995), 1995, this choice is timely (within 10 years).
Because there is a limit on the credit for your 1994 foreign tax, you have unused 1994 foreign taxes. Ordinarily, you first carry back unused
foreign taxes arising in 1994 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 1992 and 1993 has passed, you cannot
carry the unused 1994 foreign taxes back to tax years 1992 and 1993.
Because the 10-year periods have not passed for your 1995 through 1999 income tax returns, you can still choose to carry forward any unused 1994
foreign taxes. However, you must reduce the unused 1994 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 1992 and 1993.
You cannot take a credit or a deduction for foreign taxes paid on income you exclude under the foreign earned income exclusion or the foreign
housing exclusion.
Why Choose the Credit?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 1.
For 2005, 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 $3,200 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 $12,000. Your taxable income then is
$61,600 and your tax is $8,736.
If you take the credit instead, your itemized deductions are only $10,000. Your taxable income then is $63,600 and your tax before the credit is
$9,236. After the credit, however, your tax is only $7,236. Therefore, your tax is $1,500 lower ($8,736 − $7,236) by taking the credit.
Example 2.
In 2005, 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 $3,200 exemption, and have other itemized
deductions of $5,400. If you deduct the foreign tax on your U.S. return, your taxable income is $48,900 ($5,000 + $56,000 − $3,200 −
$5,400 − $3,500) and your tax is $8,896.
If you take the credit instead, your taxable income is $52,400 ($5,000 + $56,000 − $3,200 − $5,400) and your tax before the credit is
$9,771. You can take a credit of only $801 because of limits discussed later. Your tax after the credit is $8,970 ($9,771 − $801), which is 74
($8,970 − $8,896) more than if you deduct the foreign tax.
If you choose the credit, you will have unused foreign taxes of $2,699 ($3,500 − $801). 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 AccruedCredit for taxes paid or accruedTaxes: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.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.Bond, income taxIncome tax 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.
Accrual foreign taxes, adjustments
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 RatesExchange ratesForeign 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, the tax credit is affected when the foreign currency depreciates or appreciates in value in terms of U.S. dollars.
Translating foreign currency into U.S. dollars.Translating foreign currencyForeign income, translatingFunctional currency
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.
Qualified business unitA 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.
If your functional currency is the U.S. dollar, you must immediately translate into dollars all items of income, expense, etc., that you receive,
pay, or accrue in a foreign currency and that will affect computation of your income tax. If there is more than one exchange rate, use the one that
most properly reflects your income. You can generally get exchange rates from banks and U.S. Embassies.
If your functional currency is not the U.S. dollar, make all income tax determinations in your functional currency. At the end of the year,
translate the results, such as income or loss, into U.S. dollars to report on your income tax return.
For more information, write to:
Internal Revenue Service
International Section
P.O. Box 920
Bensalem, PA 19020-8518.
Rate of exchange for foreign taxes paid.Rate of exchange
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.
For all other foreign taxes, you should use the exchange rate in effect on the date you paid them.
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 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 RedeterminationForeign tax(es):RedeterminationRedetermination of foreign tax
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.
See Rate of exchange for foreign taxes paid, earlier, under Foreign Currency and Exchange Rates.
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.
In this case, you must adjust your U.S. tax in the tax year in which the accrued foreign taxes are paid.
Tax years beginning after 1997.
For tax years beginning after 1997, a redetermination of your U.S. tax liability is required if:
The accrued taxes when paid differ from the amount you 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, or
The foreign taxes you paid are refunded in whole or in part.
If (2) above applies to you, 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.
Notice to the Internal Revenue Service (IRS) of redetermination.Notice to the IRS of change in tax
You must file Form 1040X, Amended U.S. Individual Income Tax Return, and a revised Form 1116 for the tax year affected by the redetermination. The
IRS will redetermine your U.S. tax liability for the year or years affected.
If you pay less foreign tax than you originally claimed a credit for, you must file Form 1040X and a revised Form 1116 within 180 days after the
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.
Failure-to-notify penalty.Penalties:Penalties:Failure to notify, foreign tax change
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.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.
Foreign tax imposed on foreign refund.Foreign tax(es):RefundForeign tax(es):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 2003, and received a foreign tax refund of $500 in 2005 on which a foreign tax of $100 was imposed. When
you refigure your credit for 2003, you must reduce the $3,000 you paid by $400.
Time Limit on Refund ClaimsRefund claims, time limitTime limit:Refund claimsWhen refunds can be claimed
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?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. CitizensU.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 AliensResident 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 AliensNonresident 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?Foreign tax(es):Qualifying for 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).
Certain foreign taxes do not qualify for the credit even if the four tests are met. See Foreign Taxes for Which You Cannot Take a
Credit, later.
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.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.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.Joint return:Credit based on foreign tax of both spousesMarried couples: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.PartnerS 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
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.Mutual fund shareholderShareholderMutual fund distributions
If you are a shareholder of a mutual fund, 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 a Form 1099-DIV, or similar statement, showing the foreign
country or U.S. possession, 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.
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 credits 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.
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.Subsidy
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 TaxLevyIncome 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.Economic benefits
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.
You are considered to receive a specific economic benefit if you have a business transaction with a person who receives a specific economic benefit
from the foreign country and, under the terms and conditions of the transaction, you receive directly or indirectly all or part of the benefit.
However, see the exception discussed later under Pension, unemployment, and disability fund payments.
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.
.
Generally, the right or privilege merely to engage in business is not an economic benefit.
Dual-capacity taxpayers.Dual-capacity taxpayers
If you are subject to a foreign country's levy and you also receive a specific economic benefit from that foreign country, you are a
dual-capacity taxpayer. As a dual-capacity taxpayer, you cannot claim a credit for any part of the foreign levy, unless you establish that the
amount paid under a distinct element of the foreign levy is a tax, rather than a compulsory payment for a direct or indirect specific economic
benefit.
For more information on how to establish amounts paid under separate elements of a levy, write to:
Internal Revenue Service
International Section
P.O. Box 920
Bensalem, PA 19020-8518.
Pension, unemployment, and disability fund payments.Pension, employment, 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.
Social security taxesNo 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.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.PenaltiesInterest
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 TaxesTaxes: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 CreditForeign tax(es):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 of U.S. persons controlling foreign corporations or partnerships, and
Taxes on foreign oil and gas extraction income.
Taxes on Excluded IncomeExcluded income:Taxes on
You cannot take a credit for foreign taxes paid or accrued on income excluded from U.S. gross income.
Foreign Earned Income and Housing ExclusionsExcluded income:Foreign earnedTaxes:Excluded income
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.Wages
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$120,000Unreimbursed business travel expenses 20,000Income tax paid to Country A 30,000Exclusion of foreign earned
income and housing allowance87,225
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 ExclusionPossession exclusionAmerican Samoa, resident of
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 ExclusionExtraterritorial incomeForm:8873
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 DeductionItemized 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)Sanctioned countriesSection 901(j) sanctioned 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 2005. Income taxes paid or accrued to these countries in 2005 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 2005 on which you paid tax of $4,500. Sanctions against Country X
ended on July 11, 2005. 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, 2005, 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.
<ROM>Table 1.</ROM> Countries Removed From the Sanctioned List or Granted Presidential WaiverSanctioned PeriodCountryStarting DateEnding DateIraqFebruary 1, 1991June 27, 2004LibyaJanuary 1,1987December 9, 2004*VietnamJanuary 1, 1987July 21, 1995*Presidential waiver granted for qualified income taxes arising after December
9, 2004.
Taxes Imposed on Certain DividendsDividends:Taxes onTaxes:On 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 1.
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 2.
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)Taxes:Withheld on income or gain
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 GasPurchase or sale of oil or gas, taxes in connection with
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 IncomeForeign oil related income, taxes onOil related income, foreign
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 IncomeForeign mineral income, taxes onMineral income, foreign,
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 OperationsInternational boycott
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.
Boycotting 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 each calendar quarter. As of December 2004, the following countries are listed.
Bahrain.
Kuwait.
Lebanon.
Libya.
Oman.
Qatar.
Saudi Arabia.
Syria.
United Arab Emirates.
Republic of Yemen.
For information concerning changes to the list, write to:
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.Reporting requirements (international boycott)
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 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,
Form:5713and attach all supporting schedules.
You must file the form in duplicate when your tax return is due, including extensions. Send one copy to the Internal Revenue Service Center,
Philadelphia, PA 19255. Attach the other copy to your income tax return that you file with your usual Internal Revenue Service Center. Your reports
submitted as part of the tax return are confidential.
Penalty for failure to file.Penalties:Failure to file Form 5713
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 IncomeForeign oil and gas extraction income, taxes on
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 PartnershipsForeign corporation–U.S. shareholders, filing requirementsForeign partnerships–U.S. partners, filing requirementForm:54718865
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.
U.S. persons controlling foreign partnerships.
If you are a U.S. citizen or resident who had control of a foreign partnership at any time during the partnership's tax year, you may have to file
an annual information return on Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships. Under this rule, you generally had
control of the partnership if you owned more than 50% of the capital or profits or interest, or an interest to which 50% of the deductions or losses
were allocated.
You also may have to file Form 8865 if at any time during the tax year of the partnership, you owned a 10% or greater interest in the partnership
while the partnership was controlled by U.S. persons owning at least a 10% interest. See the Instructions for Form 8865 for more information.
Penalty for not filing Form 5471 or Form 8865.Penalties:Failure to file Form 5471, 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 CreditCredit:How to figure
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.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 income. Passive income is defined later under Separate Limit Income.
However, for purposes of this rule, high taxed income and export financing interest are also passive income. Passive income also includes income
that would be passive except that it is also described in another income category.
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.
If you make this election, you cannot carry back or carry over any unused foreign tax to or from this tax year.
This election exempts you only from the limit figured on Form 1116 and not from the other requirements described in this publication. For example,
the election does not exempt you from the requirements discussed earlier under What Foreign Taxes Qualify for the Credit.
Limit on the CreditCredit:Limit onLimit on credit
Your foreign tax credit cannot be more than your total U.S. tax liability (line 44 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 IncomeSeparate limit income:
You must figure the limit on a separate Form 1116 for each of the following categories of income.
Passive income.
High withholding tax interest.
Financial services income.
Shipping income.
Certain dividends from a domestic international sales corporation (DISC) or former DISC.
Certain distributions from a foreign sales corporation (FSC) or former FSC.
Any lump sum distributions from employer benefit plans for which the special averaging treatment is used to determine your tax.
Section 901(j) income.
Income re-sourced by treaty.
General limitation income. This is all other income not included in the above categories.
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.Controlled foreign corporation shareholder
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.Partner
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 IncomePassive incomeSeparate limit income:Separate limit 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).
Mutual fund distributions
If you receive foreign source distributions from a mutual fund that elects to pass through to you the foreign tax credit, the income is generally
considered passive. The mutual fund will need to provide you with a written 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.
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 value of the property is due to imports into the United States.
High-taxed income.High-taxed income
This is passive income subject to foreign taxes that are higher than the highest U.S. tax rate that can be imposed on the income. The high-taxed
income and the taxes imposed on it are moved from the passive income category into the general limitation income category. See Regulations section
1.904-4(c) for more information.
High withholding tax interest is interest (except export financing interest) that is subject to a foreign or U.S. possession withholding tax or
other tax determined on a gross basis of at least 5%. If interest is not high withholding tax interest because it is export financing interest, it is
usually general limitation income. However, if it is received by a financial services entity, it is financial services income.
Financial Services IncomeDistributions:FSCFinancial services incomeSeparate limit income:Financial services income
Financial services income generally is income received or accrued by a financial services entity. This is an entity predominantly engaged in the
active conduct of a banking, financing, insurance, or similar business. If you qualify as a financial services entity, financial services income
includes income from the active conduct of that business, passive income, high-taxed income, certain incidental income, and export financing interest
which is subject to a foreign or U.S. possession withholding tax or gross-basis tax of at least 5%.
Shipping IncomeShipping incomeSeparate limit income:Shipping income
This is income derived from, or in connection with, the use (or hiring or leasing for use) of any aircraft or vessel in foreign commerce or income
derived from space or ocean activities. It also includes income from the sale or other disposition of these aircraft or vessels. Shipping income that
is also financial services income is treated as financial services income.
This dividend income generally consists of dividends from an interest charge domestic international sales corporation (DISC) or former DISC that
are treated as foreign source income.
Distributions from a foreign sales corporation (FSC) or former FSC out of earnings and profits attributable to foreign trade income,
or
Interest and carrying charges incurred by an FSC or former FSC from a transaction that results in foreign trade income.
Lump-Sum DistributionDistributions:Lump-sumLump-sum distributionsSeparate limit income: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.
Section 901(j) IncomeSection 901(j) incomeSeparate limit income: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.
Income Re-Sourced By TreatyIncome re-sourced by treaty, separate limitSeparate limit income: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(g)(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.
General Limitation IncomeGeneral limitation income, separate limitSeparate limit income:General limitation income
This is income from sources outside the United States that does not fall into one of the other separate limit categories. It generally includes
active business income that does not fall into one of the other separate categories. It also includes wages, salaries, and overseas allowances of an
individual as an employee.
Allocation of Foreign TaxesAllocation:Foreign taxesForeign tax(es):Allocation to income categories
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 limitation income) as follows.
$80,000 (wages) $83,000 (total income)×$4,400=$4,241The net wages are $75,759 ($80,000 − $4,241).
You figure the expenses allocable to interest (passive income) as follows.
$3,000 (interest) $83,000 (total income)×$4,400=$159The 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 CorporationPartnerS corporation shareholder
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 2005 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 (minus any amount of Form 8914, line 2). Then for each category of income, you
must figure your taxable income from sources outside the United States.
Determining Source of IncomeSource of income, rules for determining
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.
Income from sources in 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.
Sales or exchanges of certain personal property.Personal property, sales or exchanges of
Generally, if personal property is sold by a U.S. resident, the gain or loss from the sale is treated as U.S. source. If personal property is sold
by a nonresident, the gain or loss is treated as foreign source.
This rule does not apply to the sale of inventory, intangible property, or depreciable property, or property sold through a foreign office or fixed
place of business. The rules for these types of property are discussed later.
U.S. resident.
The term U.S. resident, for this purpose, means a U.S. citizen or resident alien who does not have a tax home in a foreign country. The term
also includes a nonresident alien who has a tax home in the United States. Generally, your tax home is the general area of your main place of
business, employment, or post of duty, regardless of where you maintain your family home. Your tax home is the place where you are permanently or
indefinitely engaged to work as an employee or self-employed individual. If you do not have a regular or main place of business because of the nature
of your work, then your tax home is the place where you regularly live. If you do not fit either of these categories, you are considered an itinerant
and your tax home is wherever you work.
Nonresident.
A nonresident is any person who is not a U.S. resident.
U.S. citizens and resident aliens with a foreign tax home will be treated as nonresidents for a sale of personal property only if an income tax of
at least 10% of the gain on the sale is paid to a foreign country.
This rule also applies to losses recognized after January 7, 2002, if the foreign country would have imposed a 10% or higher tax had the sale
resulted in a gain. You can choose to apply this rule to losses recognized in tax years beginning after 1986. For details about making this choice,
see Regulations section 1.865-1(f)(2). For stock losses, see Regulations section 1.865-2(e).
Inventory.
Income from the sale of inventory that you purchased is sourced where the property is sold. Generally, this is where title to the property passes
to the buyer.
Income from the sale of inventory that you produced in the United States and sold outside the United States (or vice versa) is sourced based on an
allocation. For information on making the allocation, see Regulations section 1.863-3.
Intangibles.
Intangibles include patents, copyrights, trademarks, and goodwill. The gain from the sale of amortizable or depreciable intangible property, up to
the previously allowable amortization or depreciation deductions, is sourced in the same way as the original deductions were sourced. This is the same
as the source rule for gain from the sale of depreciable property. See Depreciable property, next, for details on how to apply this rule.
Gain in excess of the amortization or depreciation deduction is sourced in the country where the property is used if the income from the sale is
contingent on the productivity, use, or disposition of that property. If the income is not contingent on the productivity, use, or disposition of the
property, the income is sourced according to the seller's tax home as discussed earlier. Payments for goodwill are sourced in the country where the
goodwill was generated if the payments are not contingent on the productivity, use, or disposition of the property.
Depreciable property.
The gain from the sale of depreciable personal property, up to the amount of the previously allowable depreciation, is sourced in the same way as
the original deductions were sourced. Thus, to the extent the previous deductions for depreciation were allocable to U.S. source income, the gain is
U.S. source. To the extent the depreciation deductions were allocable to foreign sources, the gain is foreign source income. Gain in excess of the
depreciation deductions is sourced the same as inventory.
If personal property is used predominantly in the United States, treat the gain from the sale, up to the amount of the allowable depreciation
deductions, entirely as U.S. source income.
If the property is used predominantly outside the United States, treat the gain, up to the amount of the depreciation deductions, entirely as
foreign source income.
A loss recognized after January 7, 2002, is sourced in the same way as the depreciation deductions were sourced. However, if the property was used
predominantly outside the United States, the entire loss reduces foreign source income. You can choose to apply this rule to losses recognized in tax
years beginning after 1986. For details about making this choice, see Regulations section 1.865-1(f)(2).
Depreciation includes amortization and any other allowable deduction for a capital expense that is treated as a deductible expense.
Sales through foreign office or fixed place of business.
Income earned by U.S. residents from the sale of personal property through an office or other fixed place of business outside the United States is
generally treated as foreign source if:
The income from the sale is from the business operations located outside the United States, and
At least 10% of the income is paid as tax to the foreign country.
If less than 10% is paid as tax, the income is U.S. source.
This rule also applies to losses recognized after January 7, 2002, if the foreign country would have imposed a 10% or higher tax had the sale
resulted in a gain. You can choose to apply this rule to losses recognized in tax years beginning after 1986. For details about making this choice,
see Regulations section 1.865-1(f)(2). For stock losses, see Regulations section 1.865-2(e).
This rule does not apply to income sourced under the rules for inventory property, depreciable personal property, intangible property (when
payments in consideration for the sale are contingent on the productivity, use, or disposition of the property), or goodwill.
<ROM>Table 2.</ROM> Source of IncomeItem of IncomeFactor Determining SourceSalaries, wages, other compensationWhere services performedBusiness income: Personal servicesWhere services performed Sale of inventory—purchasedWhere sold Sale of inventory—producedAllocationInterestResidence of payerDividendsWhether a U.S. or foreign corporation*RentsLocation of propertyRoyalties: Natural resourcesLocation of property Patent, copyrights, etc.Where property is usedSale of real propertyLocation of propertySale of personal propertySeller's tax home (but see Sales or exchanges of certain personal property, later, for
exceptions)PensionsWhere services were performed that earned the pensionSale of natural resourcesAllocation based on fair market value of product at export terminal. For more information, see Regulations section
1.863-1(b).
*Exceptions include:
a) Dividends paid by a U.S. corporation are foreign source if the corporation elects the Puerto Rico economic activity credit or possessions
tax credit.
b) Part of a dividend paid by a foreign corporation is U.S. source if at least 25% of the corporation's gross income is effectively connected
with a U.S. trade or business for the 3 tax years before the year in which the dividends are declared.
Determining Taxable Income From Sources Outside the United StatesTaxable income from sources outside the U.S., determination of
To figure your taxable income in each category from sources outside the United States, you first allocate to specific classes (kinds) of gross
income the expenses, losses, and other deductions (including the deduction for foreign housing costs) that are definitely related to that income.
Definitely related.
A deduction is definitely related to a specific class of gross income if it is incurred either:
As a result of, or incident to, an activity from which that income is derived, or
In connection with property from which that income is derived.
Classes of gross income.Classes of gross income
You must determine which of the following classes of gross income your deductions are definitely related to.
Compensation for services, including wages, salaries, fees, and commissions.
Gross income from business.
Gains from dealings in property.
Interest.
Rents.
Royalties.
Dividends.
Alimony and separate maintenance.
Annuities.
Pensions.
Income from life insurance and endowment contracts.
Income from cancelled debts.
Your share of partnership gross income.
Income in respect of a decedent.
Income from an estate or trust.
Exempt income.
When you allocate deductions that are definitely related to one or more classes of gross income, you take exempt income into account for the
allocation. However, do not take exempt income into account to apportion deductions that are not definitely related to a separate limit category.
Interest expense and state income taxes.
You must allocate and apportion your interest expense and state income taxes under the special rules discussed later under Interest expense
and State income taxes.
Class of gross income that includes more than one separate limit category.
If the class of gross income to which a deduction definitely relates includes either:
More than one separate limit category, or
At least one separate limit category and U.S. source income,
you must apportion the definitely related deductions within that class of gross income.
To apportion, you can use any method that reflects a reasonable relationship between the deduction and the income in each separate limit category.
One acceptable method for many individuals is based on a comparison of the gross income in a class of income to the gross income in a separate limit
income category.
Use the following formula to figure the amount of the definitely related deduction apportioned to the income in the separate limit category:
Gross income in separate limit category Total gross income in the class×deduction
Do not take exempt income into account when you apportion the deduction. However, income excluded under the foreign earned income or foreign
housing exclusion is not considered exempt. You must, therefore, apportion deductions to that income.
Interest expense.Interest expense, apportioning
Generally, you apportion your interest expense on the basis of your assets. However, certain special rules apply. If you have gross foreign source
income (including income that is excluded under the foreign earned income exclusion) of $5,000 or less, your interest expense can be allocated
entirely to U.S. source income.
Business interest.
Apportion interest incurred in a trade or business using the asset method based on your business assets.
Under the asset method, you apportion the interest expense to your separate limit categories based on the value of the assets that produced the
income. You can value assets at fair market value, the tax book value, or the alternative book value. For more information about the asset method, see
Temporary Regulations section 1.861-9T(g).
If you use the tax book value method, you can elect to change to the fair market value method at any time without IRS approval. If you elect to use
the fair market value method, you must continue to use that method unless you have IRS approval to change methods. However, you may be able to change
from the fair market value method to the alternative tax book value method by attaching a statement to your timely filed Form 1116. For details, see
Revenue Procedure 2005-28 on page 1093 of Internal Revenue Bulletin 2005-21at
www.irs.gov/pub/irs-irbs/irb05-21.pdf.
Investment interest.
Apportion this interest on the basis of your investment assets.
Passive activity interest.
Apportion interest incurred in a passive activity on the basis of your passive activity assets.
Partnership interest.
General partners and limited partners with partnership interests of 10% or more must classify their distributive shares of partnership interest
expense under the three categories listed above. They must apportion the interest expense according to the rules for those categories by taking into
account their distributive share of partnership gross income or pro rata share of partnership assets. For special rules that may apply, see
Regulations section 1.861-9T(e).
Home mortgage interest.
This is your deductible home mortgage interest from Schedule A (Form 1040). Apportion it under a gross income method, taking into account all
income (including business, passive activity, and investment income), but excluding income that is exempt under the foreign earned income exclusion.
The gross income method is based on a comparison of the gross income in a separate limit category with total gross income.
The Instructions for Form 1116 have a worksheet for apportioning your deductible home mortgage interest expense.
For this purpose, however, any qualified residence that is rented is considered a business asset for the period in which it is rented. You
therefore apportion this interest under the rules for passive activity or business interest.
Example.
You are operating a business as a sole proprietorship. Your business generates only U.S. source income. Your investment portfolio consists of
several less-than-10% stock investments. You have stocks with an adjusted basis of $100,000. Some of your stocks (with an adjusted basis of $40,000)
generate U.S. source income. Your other stocks (with an adjusted basis of $60,000) generate foreign passive income. You own your main home, which is
subject to a mortgage of $120,000. Interest on this loan is home mortgage
