How To Figure the Credit

As already indicated, you can claim a foreign tax credit only for foreign taxes on income, war profits, or excess profits, or taxes in lieu of those taxes. In addition, there is a limit on the amount of the credit that you can claim. You figure this limit and your credit on Form 1116. Your credit is the amount of foreign tax you paid or accrued or, if smaller, the limit.

If you have foreign taxes available for credit but you cannot use them because of the limit, you may be able to carry them back to the 2 previous tax years and forward to the next 5 tax years. See Carryback and Carryover, later.

Also, certain tax treaties have special rules that you must consider when figuring your foreign tax credit. See Tax Treaties, later.

Exemption from foreign tax credit limit. You will not be subject to this limit and will be able to claim the credit without using Form 1116 if the following requirements are met.

1. 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.
2. Your qualified foreign taxes for the tax year are not more than $300 ($600 if filing a joint return).
3. 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).
4. 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 not from the other requirements described in this publication. For example, the election does not exempt you from the requirement that the foreign tax be a nonrefundable income tax.

Limit on the Credit

Your foreign tax credit cannot be more than your total U.S. tax liability (line 40, Form 1040) multiplied by a fraction. The numerator of the fraction is your taxable income from sources outside the United States. The denominator is your total taxable income from U.S. and foreign sources.

To determine the limit, you must separate your foreign source income into categories, as discussed under Separate Limit Income. The limit treats all foreign income and expenses in each separate category as a single unit and limits the credit to the U.S. income tax on the taxable income in that category from all sources outside the United States.

Separate Limit Income

You must figure the limit on a separate Form 1116 for each of the following categories of income:

1. Passive income,
2. High withholding tax interest,
3. Financial services income,
4. Shipping income,
5. Certain dividends from a domestic international sales corporation (DISC) or former DISC,
6. Certain distributions from a foreign sales corporation (FSC) or former FSC,
7. Any lump sum distributions from employer benefit plans for which the special averaging treatment is used to determine your tax,
8. Section 901(j) income,
9. Income re-sourced by treaty, and
10. 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. 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 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.

Partnership distributive share. In general, a partner's distributive share of partnership income is treated as separate limit income if it is from the separate limit income of the partnership. However, if the partner owns less than a 10% interest in the partnership, the income is generally treated as passive income. For more information, see section 1.904-5(h) of the regulations.

Passive Income

Except as described earlier under Income from controlled foreign corporations and Partnership distributive share, passive income generally includes dividends, interest, rents, royalties, and annuities. It also includes net gain from the sale of non-income-producing investment property or property that generates passive income. Net gain from commodities transactions is included, except for hedging and active business gains or losses of producers, processors, merchants, or handlers of commodities. Passive income also includes amounts you must include as foreign personal holding company income under section 551(a) or 951(a) of the Internal Revenue Code and amounts includible under section 1293 of the Internal Revenue Code (relating to certain passive foreign investment companies).

If you receive foreign source distributions from a mutual fund 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 from unrelated persons.
• Any income that is defined in another separate limit category.

Export financing interest. This is interest derived from financing the sale or other disposition of property for use outside the United States if:

1. The property is manufactured or produced in the United States, and
2. 50% or less of the value of the property is due to imports into the United States.

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 section 1.904-4(c) of the regulations for more information.

High Withholding Tax Interest

High withholding tax interest is interest (except export financing interest) that is subject to a foreign 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 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 withholding or gross-basis tax of at least 5%.

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.

DISC Dividends

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.

FSC Distributions

These are:

1. Distributions from a foreign sales corporation (FSC) or former FSC out of earnings and profits attributable to foreign trade income, or
2. Interest and carrying charges incurred by an FSC or former FSC from a transaction that results in foreign trade 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.

The special averaging treatment for LSDs is elected by filing Form 4972, Tax on Lump-Sum Distributions.

Follow the Form 1116 instructions and complete the worksheet in those instructions to determine your foreign tax credit on the LSD.

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 Foreign Taxes for Which You Cannot Take a Credit, earlier.

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 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 as well as wages, salaries, and overseas allowances of an individual as an employee.

Allocation of Foreign Taxes

If you paid or accrued foreign income tax for a tax year on income in more than one separate limit income category, allocate the tax to the income category to which the tax specifically relates. If the tax is not specifically related to any one category, you must allocate the tax to each category of income.

You do this by multiplying the foreign income tax related to more than one category by a fraction. The numerator of the fraction is the net income in a separate category. The denominator is the total net foreign income.

You figure net income by deducting from the gross income in each category and from the total foreign income any expenses, losses, and other deductions definitely related to them under the laws of the foreign country or U.S. possession. If the expenses, losses, and other deductions are not definitely related to a category of income under foreign law, they are apportioned under the principles of the foreign law. If the foreign law does not provide for apportionment, use the principles covered in the U.S. Internal Revenue Code.

Table 4. Source of Income

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.

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:

The net wages are $75,759 ($80,000 - $4,241).

You figure the expenses allocable to interest (passive income) as follows:

The net interest is $2,841 ($3,000 - $159).

Then, to figure the foreign tax on the wages, you multiply the total foreign income tax by the following fraction:

You figure the foreign tax on the interest income as follows.

Foreign Taxes From a Partnership or an S Corporation

If foreign taxes were paid or accrued on your behalf by a partnership or an S corporation, you will figure your credit using certain information from the Schedule K-1 you received from the partnership or S corporation. If you received a 2000 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 37 of Form 1040. Then for each category of income, you must figure your taxable income from sources outside the United States.

Foreign earned income. For this computation, taxable income does not include any income that is exempt from tax under the foreign earned income exclusion or the foreign housing exclusion. These exclusions from income are discussed in detail in Publication 54.

Determining Source of Income

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 4.

Sales or exchanges of certain personal property. 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 10, 1999, 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 section 1.865-1T(f)(2) of the regulations. For stock losses, see section 1.865-2(e) of the regulations.

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 section 1.863-3 of the Regulations.

Intangibles. Income from the sale of intangible property (such as a patent, copyright, trademark, or goodwill) that is contingent on the productivity, use, or disposition of the property is sourced in the country where the property is used. 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 10, 1999, 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 section 1.865-1T(f)(2) of the regulations.

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:

1. The income from the sale is from the business operations located outside the United States, and
2. 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 10, 1999, 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 section 1.865-1T(f)(2) of the regulations. For stock losses, see section 1.865-2(e) of the regulations.

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.

Determining Taxable Income From Sources Outside the United States

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:

1. As a result of, or incident to, an activity from which that income is derived, or
2. In connection with property from which that income is derived.

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:

1. More than one separate limit category, or
2. 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:

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. 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 or the tax book value.

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 section 1.861-9T(e) of the regulations.

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 interest. You also have a bank loan in the amount of $40,000. The proceeds from the bank loan were divided equally between your business and your investment portfolio. Your gross income from your business is $50,000. Your investment portfolio generated $4,000 in U.S. source income and $6,000 in foreign source passive income. All of your debts bear interest at the annual rate of 10%.

The interest expense for your business is $2,000. It is apportioned on the basis of the business assets. All of your business assets generate U.S. source income; therefore, they are U.S. assets. This $2,000 is interest expense allocable to U.S. source income.

The interest expense for your investments is also $2,000. It is apportioned on the basis of investment assets. $800 ($40,000/ $100,000 x $2,000) of your investment interest is apportioned to U.S. source income and $1,200 ($60,000 / $100,000 x $2,000) is apportioned to foreign source passive income.

Your home mortgage interest expense is $12,000. It is apportioned on the basis of all your gross income. Your gross income consists of $60,000, $54,000 of which is U.S. source income and $6,000 of which is foreign source passive income. Thus, $1,200 ($6,000 / $60,000 x $12,000) of the home mortgage interest is apportioned to foreign source passive income.

State income taxes. State income taxes (and certain taxes measured by taxable income) are definitely related and allocable to the gross income on which the taxes are imposed. If state income tax is imposed in part on foreign source income, the part of your state tax imposed on the foreign source income is definitely related and allocable to foreign source income.

Foreign income not exempt from state tax. If the state does not specifically exempt foreign income from tax, the following rules apply.

1. If the total income taxed by the state is greater than the amount of U.S. source income for federal tax purposes, then the state tax is allocable to both U.S. source and foreign source income.
2. If the total income taxed by the state is less than or equal to the U.S. source income for federal tax purposes, none of the state tax is allocable to foreign source income.

Foreign income exempt from state tax. If state law specifically exempts foreign income from tax, the state taxes are allocable to the U.S. source income.

Example. Your total income for federal tax purposes, before deducting state tax, is $100,000. Of this amount, $25,000 is foreign source income and $75,000 is U.S. source income. Your total income for state tax purposes is $90,000, on which you pay state income tax of $6,000. The state does not specifically exempt foreign source income from tax. The total state income of $90,000 is greater than the U.S. source income for federal tax purposes. Therefore, the $6,000 is definitely related and allocable to both U.S. and foreign source income.

Assuming that $15,000 ($90,000 - $75,000) is the foreign source income taxed by the state, $1,000 of state income tax is apportioned to foreign source income, figured as follows:

Deductions not definitely related. You must apportion to your foreign income in each separate limit category a fraction of your other deductions that are not definitely related to a specific class of gross income. If you itemize, these deductions are medical expenses, charitable contributions, and real estate taxes for your home. If you do not itemize, this is your standard deduction. You should also apportion any other deductions that are not definitely related to a specific class of income, including deductions shown on Form 1040, lines 23-31a.

The numerator of the fraction is your gross foreign income in the separate limit category, and the denominator is your total gross income from all sources. For this purpose, gross income includes income that is excluded under the foreign earned income provisions.

Itemized deduction limit. For 2000, you may have to reduce your itemized deductions on Schedule A (Form 1040) if your adjusted gross income is more than $128,950 ($64,475 if married filing separately). This reduction does not apply to medical and dental expenses, casualty and theft losses, gambling losses, and investment interest.

You figure the reduction by using the Itemized Deductions Worksheet in the instructions for Schedule A (Form 1040). Line 3 of the worksheet shows the total itemized deductions subject to the reduction. Line 9 shows the amount of the reduction.

To determine your taxable income from sources outside the United States, you must first divide the reduction (line 9 of the worksheet) by the itemized deductions subject to the reduction (line 3 of the worksheet). This is your reduction percentage. Then, multiply each itemized deduction subject to the reduction by your reduction percentage. Subtract the result from the itemized deduction to determine the amount you can allocate to income from sources outside the United States.

Example. You are single and have an adjusted gross income of $150,000. This is the amount on line 5 of the worksheet. Your itemized deductions subject to the reduction total $20,000. This is the amount on line 3 of the worksheet. Reduce your adjusted gross income (line 5) by $128,950. Enter the result ($21,050) on line 7. The amount on line 8 is $632 ($21,050 x 3%). This amount is also entered on line 9.

You have a charitable contribution deduction of $12,000 shown on Schedule A (Form 1040) that is subject to the reduction. Your reduction percentage is 3.1% (632 / $20,000). You must reduce your $12,000 deduction by $372 (3.1% x $12,000). The reduced deduction, $11,628 ($12,000 - $372), is used to determine your taxable income from sources outside the United States.

Treatment of personal exemptions. Do not take the deduction for personal exemptions, including exemptions for dependents, in figuring taxable income from sources outside the United States.

Capital Gains and Losses

If you have any capital gains or losses, you may have to make certain adjustments when figuring your foreign source taxable income and your foreign tax credit.

If you file a Schedule D (Form 1040), Capital Gains and Losses, and both lines 16 and 17 of that schedule are gains, you must adjust the amount you enter on line 17 of Form 1116. You must also make this adjustment if you received capital gain distributions and you figured your tax using the Capital Gain Tax Worksheet (found in the Form 1040 instructions). Complete the Worksheet for Line 17, found in the Form 1116 instructions, to figure this amount.

If you have any foreign source capital gain or loss, you must adjust the amount of capital gain or capital loss you enter on line 1 or 5 of Form 1116. This adjustment is discussed next.

Adjustment for Foreign Source Capital Gains and Losses

You must adjust your foreign source capital gains to reflect U.S. capital gains tax rates. You do this by completing Worksheet A in the instructions for Form 1116. Also, your foreign source capital gain net income included in the amount on line 1 of Form 1116 cannot exceed your worldwide capital gain net income.

You must adjust your foreign source net capital loss (to the extent taken into account in determining worldwide capital gain net income) based on the U.S. tax rate applicable to the worldwide capital gain the loss offsets. You can use Worksheet B in the Form 1116 instructions to make this required adjustment.

A "foreign Schedule D" is used to make these adjustments to your foreign source capital gains and losses.

However, a "foreign Capital Gain Tax Worksheet" is used to make adjustments to your foreign source capital gain distributions if you figured your tax using the Capital Gain Tax Worksheet, instead of Schedule D.

You must complete the "foreign Schedule D" or the "foreign Capital Gain Tax Worksheet" before completing Worksheet A or B.

Foreign Schedule D. If you had a foreign source capital gain (and line 17 of the Schedule D you file with your U.S. tax return shows zero or a positive number) or a foreign source capital loss, you must complete a separate Schedule D using only your foreign source capital gains and losses. On this "foreign Schedule D," complete Parts I, II, and III.

If Part lll, line 17, is a gain, complete Part lV (through line 50) of that Schedule D. Also complete the Worksheet for Line 17 and Worksheet A (Capital Gains) in the instructions for Form 1116.

If Part lll, line 17, is a loss, you can use Worksheet B (Capital Losses) in the instructions for Form 1116 to make the adjustment.

Use your foreign Schedule D only to compute the adjusted amounts. Do not file it with your return.

Foreign Capital Gain Tax Worksheet. If you figured your tax using the Capital Gain Tax Worksheet and some or all of your capital gain distributions were foreign source, you must complete a separate Capital Gain Tax Worksheet using only foreign capital gain distributions. See the Instructions for Form 1116 for special instructions for completing this foreign Capital Gain Tax Worksheet and Worksheet A.

Use your foreign Capital Gain Tax Worksheet only to compute the adjusted amounts. Do not file it with your return.

More than one category. If you have foreign source capital gains or losses from more than one separate limit income category, complete a separate foreign Schedule D for each category. Then, depending on whether the category has a gain or a loss on line 17, use whichever of the following procedures applies.

Loss categories. For each category for which line 17 of the foreign Schedule D shows a loss, you must adjust the amount of your foreign loss (to the extent taken into account in determining your worldwide capital gain net income) based on the tax rate applicable to the worldwide gain the loss offsets. You can use Worksheet B (Capital Losses) in the Form 1116 instructions to make this required adjustment. To do so, add together the net losses (from line 17 of your foreign Schedules D) of all the separate limitation categories that have losses on line 17 of the foreign Schedule D. Enter the total of all the net losses, to the extent taken into account in determining your worldwide capital gain net income, on line 1 of Worksheet B. Complete Worksheet B. Use only one Worksheet B for all of your loss categories. Your adjusted net capital loss appears on line 16 of Worksheet B. Then take the following steps.

1. Add together the net losses (from line 17 of your foreign Schedules D) of all of your loss categories.
2. For each loss category, divide the loss from line 17 of that category's foreign Schedule D by the amount in step 1.
3. For each loss category, multiply the amount from step 2 by your adjusted net loss (line 16 of Worksheet B). This is your adjusted net loss amount for that loss category that you include on line 5 of that category's Form 1116. The amount on line 5 of that category's Form 1116 cannot include more capital loss than the adjusted net loss amount for that category.

Gain categories. If you have foreign source capital gains from more than one separate limitation income category, take the following steps.

1. For each separate limitation income category that has a gain (or zero) on line 17 of its foreign Schedule D, complete Worksheet A in the Form 1116 instructions. Complete a separate Worksheet A for each gain category.
2. Total your adjusted foreign capital gains from line 12 of each Worksheet A. From this total subtract the total of all of your adjusted foreign source capital losses in all loss categories (which appears on line 16 of Worksheet B , as discussed under Loss categories earlier).
3. Compare the amount from step 2 to the amount on line 12 of the Worksheet for Line 17 in the Form 1116 instructions. (The foreign capital gain net income taken into account for purposes of the foreign tax credit cannot exceed your worldwide capital gain net income.)

If the amount on line 12 of the Worksheet for Line 17 is equal to or greater than the amount in step 2, no further adjustment is necessary. For each category, include the amount determined in step 1 as capital gain on line 1, Form 1116, or the amount determined under Loss categories as capital loss on line 5, Form 1116. The amount of capital gain included on line 1 of a category's Form 1116 cannot exceed the amount determined under step 1.

See Allocation of Foreign Losses and Recapture of Foreign Losses, later.

If the amount on line 12 of the Worksheet for Line 17 is less than the amount from step 2, you must allocate the difference to your gain categories. You reduce the gain for each category by an amount figured by multiplying the difference by the adjusted gain in a particular category divided by the total of all adjusted capital gains from all gain categories (not your net gain from step 2, which has been reduced by losses).

Examples. The following examples show how to make the required adjustments if you have foreign source capital gains and losses in more than one separate limitation income category.

Example 1. Your total adjusted foreign capital gain is $25,000 (determined by adding the adjusted capital gains from line 12 of your Worksheets A for each of your gain categories). All categories have gains on line 16 and line 17 of their foreign Schedules D. $5,000 is from the general limitation category. The amount on line 12 of the Worksheet for Line 17 (your adjusted worldwide net capital gain) is $22,580. Since that amount is less than the amount from step 2, you must allocate the difference, $2,420 ($25,000 - $22,580) to each of the categories. You must reduce the gain in the general limitation category by $484 ($5,000/$25,000 x $2,420). On the Form 1116 that you complete for the general limitation category, you would include $4,516 ($5,000 - $484) of your capital gain on line 1. If you had $10,000 of ordinary income (such as wages) in the general limitation category, the total amount on line 1 of that category's Form 1116 would be $14,516 ($4,516 of capital gain + $10,000 of ordinary income).

Example 2. Your total foreign loss is $5,000. It consists of a passive category loss of $2,000 and a general limitation category loss of $3,000 (as shown on line 17 of your foreign Schedules D for those categories). Assume your adjusted net capital loss (from line 16 of Worksheet B) is $2,222. For the passive category, the amount of capital loss to include on line 5 of Form 1116 is $889 ($2,000/$5,000 x $2,222).

Example 3. You have a net gain on line 17 of the Schedule D you are filing with your Form 1040. You have net foreign source capital gains in your passive separate limit category and your general limitation category (from line 17 of the foreign Schedules D for those categories). You have a net foreign source capital loss in your shipping separate limit category (shown on line 17 of your foreign Schedule D for that category).

You complete Worksheet A in the Form 1116 instructions separately for the passive and general limitation categories. The amount on line 12 of Worksheet A is $2,000 for the passive category and $3,000 for the general limitation category. Therefore, your total adjusted foreign capital gain is $5,000 ($2,000 + $3,000).

You complete Worksheet B for the shipping category, and the amount on line 16 of that worksheet is $1,000. Because the shipping category is your only loss category, all of the $1,000 adjusted foreign capital loss belongs in that category. The excess of your adjusted gains over your adjusted losses (your net adjusted capital gain) is $4,000 ($5,000 - $1,000).

Assume $1,500 appears on line 12 of the Worksheet for Line 17 in the Form 1116 instructions. This amount is less than your foreign net adjusted capital gain. The excess of your net adjusted capital gain over the amount from the Worksheet for Line 17 (your worldwide net adjusted capital gain) is $2,500 ($4,000 - $1,500). Because your foreign capital gain cannot exceed your worldwide capital gain in the foreign tax credit calculation (reflected on the Form 1116), you must allocate this $2,500 excess, as a reduction, between your foreign net capital gain categories based on the portion of your total foreign adjusted capital gain that is attributable to each category. On line 1 of your passive category Form 1116, you include $1,000 ($2,000 - ($2,500 x $2,000/$5,000)).

On line 1 of your general limitation category Form 1116, you include $1,500 ($3,000 - ($2,500 x $3,000/$5,000)).

For the shipping category, the $1,000 adjusted capital loss should be included on line 5 of the Form 1116.

Example 4. The facts are the same as in Example 3, except that line 12 of the Worksheet for Line 17 shows $6,000. This amount is more than your $4,000 foreign net adjusted capital gain, so no further adjustment is necessary. Include the $2,000, $3,000, and $1,000 amounts on the Forms 1116 for the appropriate categories.

Example 5. You have net capital losses of $3,000 in the passive separate limit category and $4,000 in the general limitation category (from line 17 of the foreign Schedules D for those categories).

You have a net capital gain of $2,000 in the shipping category (from line 17 of the foreign Schedule D for that category).

Your total foreign source capital loss is $7,000 ($3,000 + $4,000). All $7,000 is taken into account in determining worldwide capital gain net income for the year, so all $7,000 must be adjusted. You include all $7,000 on line 1 of Worksheet B in the Form 1116 instructions. Assume $4,500 is the amount on line 16 of Worksheet B. The amount to include on line 5 of your passive category Form 1116 is $1,929 ($4,500 x $3,000/$7,000). The amount to include on line 5 of your general limitation category Form 1116 is $2,571 ($4,500 x $4,000/$7,000). Complete Worksheet A in the Form 1116 instructions for your shipping category, to determine the amount of capital gain to include on line 1 of your shipping category Form 1116.

Allocation of Foreign Losses

If you have a foreign loss when figuring your taxable income in a separate limit income category, and you have income in one or more of the other separate categories, you must first reduce the income in these other categories by the loss before reducing income from U.S. sources.

Example. You have $10,000 of income in the passive income category and incur a loss of $5,000 in the general limitation income category. You must use the $5,000 loss to offset $5,000 of the income in the passive category.

How to allocate. You must allocate foreign losses among the separate limit income categories in the same proportion as each category's income bears to total foreign income.

Example. You have a $2,000 loss in the general limitation income category, $3,000 of passive income, and $2,000 in distributions from a FSC. You must allocate the $2,000 loss to the income in the other separate categories. 60% ($3,000/$5,000) of the $2,000 loss (or $1,200) reduces passive income and 40% ($2,000/$5,000) or $800 reduces FSC distributions.

Loss more than foreign income. If you have a loss remaining after reducing the income in other separate limit categories, use the remaining loss to reduce U.S. source income. When you use a foreign loss to offset U.S. source income, you must recapture the loss as explained later under Recapture of Foreign Losses.

Recharacterization of subsequent income in a loss category. If you use a loss in one separate limit category (category A) to reduce the amount of income in another category or categories (category B and/or category C) and, in a later year you have income in category A, you must, in that later year, recharacterize some or all of the income from category A as income from category B and/or category C.

Do not recharacterize the tax.

Example. The facts are the same as in the previous example. However, in the next year you have $4,000 of passive income, $1,000 in FSC distributions, and $5,000 of general limitation income. Since $1,200 of the general limitation loss was used to reduce your passive income in the previous year, $1,200 of the current year's general limitation income of $5,000 must be recharacterized as passive income. This makes the current year's total of passive income $5,200 ($4,000 + $1,200). Similarly, $800 of the general limitation income must be recharacterized as FSC distributions, making the current year's total of FSC distributions $1,800 ($1,000 + $800). The total income in the general limitation category is $3,000 ($5,000 - $1,200 - $800).

U.S. losses. Allocate any net loss from sources in the United States among the different categories of foreign income after:

1. Allocating all foreign losses as described earlier,
2. Recapturing any prior year overall foreign loss as described below, and
3. Recharacterizing foreign source income as described above.

Recapture of Foreign Losses

If you have only losses in your separate limit categories, or if you have a loss remaining after allocating your foreign losses to other separate categories, you have an overall foreign loss. If you use this loss to offset U.S. source income (resulting in a reduction of your U.S. tax liability), you must recapture your loss in each succeeding year in which you have taxable income from foreign sources in the same separate limit category. You must recapture the overall loss regardless of whether you chose to claim the foreign tax credit for the loss year.

You recapture the loss by treating part of your taxable income from foreign sources in a later year as U.S. source income. In addition, if, in a later year, you sell or otherwise dispose of property used in your foreign trade or business, you may have to recognize gain and treat it as U.S. source income, even if the disposition would otherwise be nontaxable. See Dispositions, later. The amount you treat as U.S. source income reduces the foreign source income, and therefore reduces the foreign tax credit limit.

You must establish separate accounts for each type of foreign loss that you sustain. The balances in these accounts are the overall foreign loss subject to recapture. Reduce these balances at the end of each tax year by the loss that you recaptured. You must attach a statement to your Form 1116 to report the balances (if any) in your overall foreign loss accounts.

Overall foreign loss. An overall foreign loss is the amount by which your gross income from foreign sources for a tax year is exceeded by the sum of your expenses, losses, or other deductions that you allocated and apportioned to foreign income under the rules explained earlier under Determining Taxable Income From Sources Outside The United States. But see Losses not considered, later, for exceptions.

Example. You are single and have gross dividend income of $10,000 from U.S. sources. You also have a greater-than-10% interest in a foreign partnership in which you materially participate. The partnership has a loss for the year, and your distributive share of the loss is $15,000. Your share of the partnership's gross income is $100,000, and your share of its expenses is $115,000. Your only foreign source income is your share of partnership income which is in the general limitation income category. You are a bona fide resident of a foreign country and you elect to exclude your foreign earned income. You exclude the maximum $76,000. You also have itemized deductions of $4,700 that are not definitely related to any item of income.

In figuring your overall foreign loss in the general limitation category for the year, you must allocate a ratable part of the $4,700 in itemized deductions to the foreign source income. You figure the ratable part of the $4,700 that is for foreign source income, based on gross income, as follows:

Therefore, your overall foreign loss for the year is $7,873, figured as follows:

Losses not considered. You do not consider the following in figuring an overall foreign loss in a given year.

1. Net operating loss deduction.
2. Foreign expropriation loss not compensated by insurance or other reimbursement.
3. Casualty or theft loss not compensated by insurance or other reimbursement.

Recapture provision. If you have an overall foreign loss for any tax year and use the loss to offset U.S. source income, part of your foreign source taxable income (in the same separate limit category as the loss) for each succeeding year is treated as U.S. source taxable income. The part that is treated as U.S. source taxable income is the least of:

1. The balance in the applicable overall foreign loss account,
2. 50% (or a larger percentage that you can choose) of your foreign source taxable income for the succeeding tax year, or
3. The foreign source taxable income for the succeeding tax year which is in the same separate limit category as the loss after the allocation of foreign losses (discussed earlier).

Example. During 1999 and 2000, you were single and a 20% general partner in a partnership that derived its income from Country X. You also received dividend income from U.S. sources during those years.

For 1999, the partnership had a loss and your share was $20,000, consisting of $100,000 gross income less $120,000 expenses. Your net loss from the partnership was $5,200, after deducting the foreign earned income exclusion and definitely related allowable expenses.This loss is related to income in the general limitation category. Your U.S. dividend income was $20,000. Your itemized deductions totaled $5,000 and were not definitely related to any item of income. In figuring your taxable income for 1999, you deducted your share of the partnership loss from Country X from your U.S. source income.

During 2000, the partnership had net income from Country X. Your share of the net income was $40,000, consisting of $100,000 gross income less $60,000 expenses. Your net income from the partnership was $9,600, after deducting the foreign earned income exclusion and the definitely related allowable expenses. This loss is related to income in the general limitation category. You also received dividend income of $20,000 from U.S. sources. Your itemized deductions were $6,000, which are not definitely related to any item of income. You paid income taxes of $4,000 to Country X on your share of the partnership income.

When figuring your foreign tax credit for 2000, you must find the foreign source taxable income that you must treat as U.S. source income because of the foreign loss recapture provisions.

You figure the foreign taxable income that you must recapture as follows:

The amount of the recapture is shown on line 15, Form 1116.

Recapturing more overall foreign loss than required. If you want to make an election or change a prior election to recapture a greater part of the balance of an overall foreign loss account than is required (as discussed earlier), you must attach a statement to your Form 1116 making the election. If you change a prior year's election, you should file Form 1040X.

The statement you attach to Form 1116 must show:

1. The percentage and amount of your foreign taxable income that you are treating as U.S. source income, and
2. The balance (both before and after the recapture) in the overall foreign loss account that you are recapturing.

Deduction for foreign taxes. You can recapture part (or all, if applicable) of an overall foreign loss in tax years in which you deduct, rather than credit, your foreign taxes. You recapture the lesser of:

1. The balance in the applicable overall foreign loss account, or
2. The foreign source taxable income of the same separate limit category that resulted in the overall foreign loss minus the foreign taxes imposed on that income.

Dispositions. If you dispose of appreciated trade or business property used predominantly outside the United States, and that property generates foreign source taxable income of the same separate limit category that resulted in an overall foreign loss, the disposition is subject to the recapture rules. You are considered to have received and recognized foreign source taxable income in the year you dispose of the property.

The foreign source income that you are considered to have received and recognized on the property and that you must treat as U.S. source income is 100% of the lesser of:

1. The fair market value of the property that is more than your adjusted basis, or
2. The remaining amount of the overall foreign loss not treated as U.S. source income in the current year or any prior tax year.

Predominant use outside United States. Property is used predominantly outside the United States if it was located outside the United States more than 50% of the time during the 3-year period ending on the date of disposition. If you used the property fewer than 3 years, count the use during the period it was used in a trade or business.

Disposition defined. A disposition includes the following transactions.

• A sale, exchange, distribution, or gift of property.
• A transfer upon the foreclosure of a security interest (but not a mere transfer of title to a creditor or debtor upon creation or termination of a security interest).
• An involuntary conversion.
• A contribution to a partnership, trust, or corporation.
• A transfer at death.
• Any other transfer of property whether or not gain or loss is normally recognized on the transfer.

The character of the income recognized solely because of the disposition rules is the same as if you had sold or exchanged the property.

However, a disposition does not include:

• A disposition of property that is not a material factor in producing income, or
• A transaction in which gross income is not realized.

Basis adjustment. If gain is recognized on a disposition solely because of an overall foreign loss account balance at the time of the disposition, the recipient of the property can increase its basis by the amount of gain deemed recognized. If the property was transferred by gift, its basis in the hands of the donor immediately prior to the gift is increased by the amount of gain deemed recognized.

Tax Treaties

The United States is a party to tax treaties that are designed, in part, to prevent double taxation of the same income by the United States and the treaty country. Many treaties do this by allowing you to treat U.S. source income as foreign source income. Certain treaties have special rules you must consider when figuring your foreign tax credit if you are a U.S. citizen residing in the treaty country. These rules generally allow an additional credit for part of the tax imposed by the treaty partner on U.S. source income. It is separate from, and in addition to, your foreign tax credit for foreign taxes paid or accrued on foreign source income. The treaties that provide for this additional credit include those with Australia, Austria, Canada, Finland, France, Germany, Ireland, Israel, Mexico, the Netherlands, New Zealand, Portugal, South Africa, Sweden, and Switzerland. There is a worksheet at the end of this publication to help you figure the additional credit. But do not use this worksheet to figure the additional credit under the treaties with Australia and New Zealand. Also, do not use this worksheet for income that is in the "Income re-sourced by treaty" category discussed earlier under Separate Limit Income.

You can get more information, and the worksheet to figure the additional credit under the Australia and New Zealand treaties, by writing to: Internal Revenue Service International Returns Section P.O. Box 920 Bensalem, PA 19020-8518.

You can also contact the United States Revenue Service Representatives at the U.S. Embassies in Berlin, London, Mexico City, Paris, Rome, Singapore, and Tokyo, as appropriate, for assistance.

Report required. You may have to report certain information with your return if you claim a foreign tax credit under a treaty provision. For example, if a treaty provision allows you to take a foreign tax credit for a specific tax that is not allowed by the Internal Revenue Code, you must report this information with your return. To report the necessary information, use Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b).

If you do not report this information, you may have to pay a penalty of $1,000.

You do not have to file Form 8833 if you are claiming the additional foreign tax credit (discussed previously).

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