Credit Limitations

Taxes Eligible for a Credit

Domestic corporations. Generally, a domestic corporation can claim a foreign tax credit (subject to the limitation of section 904) for the following taxes:

• Income, war profits, and excess profits taxes (defined in Regulations section 1.901-2(a) paid or accrued during the tax year to any foreign country or U.S. possession;
• Taxes deemed paid under sections 902 and 960; and
• Taxes paid in lieu of income taxes as described in section 903 and Regulations section 1.903-1.

Some foreign taxes that are otherwise eligible for the foreign tax credit must be reduced. These reductions are reported on Schedule G.

Note: A corporation may not claim a foreign tax credit for foreign taxes paid to a foreign country that the corporation does not legally owe, including amounts eligible for refund by the foreign country. If the corporation does not exercise its available remedies to reduce the amount of foreign tax to what it legally owes, a credit is not allowed for the excess amount.

Foreign corporations. Foreign corporations are allowed (under section 906) a foreign tax credit for income, war profits, and excess profits taxes paid or accrued (or deemed paid under section 902) to any foreign country or U.S. possession for income effectively connected with the conduct of a trade or business within the United States. The credit is not applicable, however, if a foreign country or U.S. possession imposes the tax on income from U.S. sources solely because the foreign corporation was created or organized under the law of the foreign country or U.S. possession or is domiciled there for tax purposes.

The credit cannot be taken against any tax imposed on income not effectively connected with a U.S. business.

In computing the foreign tax credit limitation, the foreign corporation's taxable income includes only the taxable income that is effectively connected with the conduct of a trade or business within the United States.

A foreign corporation claiming a foreign tax credit will be treated as a domestic corporation for tax deemed paid (section 902(a)) and dividend gross-up (section 78).

Definition of foreign corporation for purposes of the deemed paid credit. In computing the deemed paid credit on Schedules C, D, and E, the term foreign corporation includes:

• A DISC or former DISC, but only for dividends from the DISC or former DISC that are treated as income from sources outside the United States and
• A contiguous country life insurance branch that has made an election to be treated as a foreign corporation under section 814(g).

Credit or Deduction

A corporation may choose to take either a credit or a deduction for eligible foreign taxes paid or accrued. The choice is made annually. Generally, if a corporation elects the benefits of the foreign tax credit for any tax year, no portion of the foreign taxes will be allowed as a deduction in that year or any subsequent tax year.

Exceptions. However, a corporation that elects the credit for eligible foreign taxes may be allowed a deduction for certain taxes for which a credit was not allowed. These include:

• Taxes for which the credit was denied because of the boycott provisions of section 908.
• Certain taxes on foreign oil related income under section 907(b).
• Certain taxes on the purchase or sale of oil or gas (section 901(f)).
• Certain taxes used to provide subsidies (section 901(i)).
• Taxes paid to certain foreign countries for which a credit was denied under section 901(j).
• Taxes paid on dividends if the minimum holding period is not met with respect to the underlying stock, or if the corporation is obligated to make related payments with respect to positions in similar or related property (section 901(k)).

No Credit or Deduction

No foreign tax credit (or deduction) is allowed for certain taxes including:

• Taxes on mineral income that were reduced under section 901(e).
• Certain taxes paid on distributions from possessions corporations (section 901(g)).
• Taxes attributable to foreign trade income (other than section 923(a)(2) non-exempt income) distributed to a shareholder of a FSC (section 901(h)).
• Taxes of a FSC on foreign trade income (section 906(b)(5)).
• Taxes on foreign oil and gas extraction income that were reduced under section 907(a).
• Taxes paid or accrued to a foreign country or U.S. possession on taxable income that is taken into account in computing the possessions corporation tax credit (section 936(c)).
• Taxes attributable to income excluded under section 814(a) (relating to contiguous country branches of domestic life insurance companies).
• Taxes paid or accrued to a foreign country or U.S. possession with respect to income excluded from gross income on Form 8873, Extraterritorial Income Exclusion. However, see section 943(d) for an exception for certain withholding taxes.

Carryback and Carryforward of Excess Foreign Taxes

If the allowable foreign taxes paid, accrued, or deemed paid in a tax year in a separate category exceeds the foreign tax credit limitation for the tax year for that separate category, the excess may be carried back 2 years and then forward 5 years to offset taxes imposed on income in the same separate category. The excess is applied first to the earliest of the 7 years to which it may be carried, then to the next earliest year, etc. The corporation cannot carry a credit to a tax year for which it claimed a deduction, rather than a credit, for foreign taxes paid or accrued. Furthermore, the corporation must reduce the amount of any carryback or carryforward by the amount it would have used if it had chosen to claim a credit rather than a deduction in that tax year. See section 904(c) and Regulations section 1.904-2 for more details.

How to claim the excess credit. If the corporation is carrying back the excess credit to an earlier year, file an amended tax return with a revised Form 1118. Attach the statement described in Regulations section 1.904-2(f) for each tax year to which the corporation is carrying back or carrying forward the excess credit.

Special rules apply to:

• The carryback and carryover of foreign taxes paid or accrued on foreign oil and gas extractions or related taxes (see section 907(f)) and
• An excess foreign tax credit carried to a tax year beginning after September 30, 1993, if an excess limitation account was established under section 960(b)(2).

Treaty-Based Return Positions

Corporations that adopt a return position that any U.S. treaty overrides or modifies any provision of the Internal Revenue Code, and causes (or potentially causes) a reduction of any tax incurred at any time, generally must disclose this position. Complete Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or Section 7701(b), and attach it to Form 1118. See section 6114 and Regulations section 301.6114-1 for details.

Failure to make such a report may result in a $10,000 penalty.

Proof of Credits

Form 1118 must be carefully filled in with all the information called for and with the calculations of credits indicated.

Important: Documentation (e.g., receipts of payments or a foreign tax return for accrued taxes) is not required to be attached to Form 1118. However, proof must be presented upon request by the IRS to substantiate the credit. See Regulations section 1.905-2.

If the corporation claims a foreign tax credit for tax accrued but not paid, the IRS may require a bond to be furnished on Form 1117, Income Tax Surety Bond, before the credit is allowed. See Regulations section 1.905-2(c).

Foreign Tax Credit Redeterminations

The corporation's foreign tax credit must be redetermined if:

• Accrued foreign taxes when paid differ from the amounts claimed as credits;
• Accrued foreign taxes that relate to tax years beginning after 1997 are not paid within 2 years after the close of the tax year to which they relate; or
• Any foreign tax paid is fully or partially refunded.

Reporting Requirements

If any of the above occurs, the corporation generally must redetermine its U.S. tax liability. To do this, the corporation must:

• File an amended return and Form 1118 with the Service Center where it filed the tax return on which it claimed the affected foreign tax credit and
• Provide identifying information such as the corporation's name, address, employer identification number (EIN), and the tax year or years that are affected by the redetermination.

Additional information required. If the redetermination was because of one of the following, the corporation must provide the additional information as indicated.

• Refund of foreign taxes paid -
  1. The date or dates on which the foreign taxes were paid;
  2. The amount of foreign taxes paid on each date (in foreign currency);
  3. The exchange rate on each date the foreign taxes were paid; and
  4. The amount of foreign taxes refunded (in foreign currency).
• Foreign taxes that when paid differ from the accrued amounts claimed as credits for a year beginning before 1998 -
  1. The date on which the foreign taxes were accrued;
  2. The dates on which the foreign taxes were paid;
  3. The exchange rate for each date the foreign taxes were accrued and paid; and
  4. The amount of foreign taxes accrued or paid on each such date (in foreign currency).
• Foreign taxes that when paid differ from accrued amounts claimed as credits for a tax year beginning after 1997 because the corporation paid more or less foreign tax than was originally accrued or failed to pay accrued taxes within 2 years -
  1. The date on which the foreign taxes were accrued;
  2. The dates on which the foreign taxes were paid;
  3. The average exchange rate for the year for which the foreign taxes were accrued;
  4. For taxes paid more than 2 years after the year to which they relate, the exchange rate at the time of payment; and
  5. The amount of tax accrued or paid for each such date, and the amount of accrued tax that was not paid within 2 years (in foreign currency).
• Foreign taxes deemed paid under section 902 or 960 - If the corporation is required to make a redetermination under Temporary Regulations section 1.905-3T(d)(4), include the following basic information as an attachment to the tax return for the year for which the redetermination applies:
  1. The dates and amounts of any dividend distributions or other inclusions from E&P for the affected year or years;
  2. The amount of E&P from which such dividends were paid for the affected year or years; and
  3. The information described above for foreign taxes paid or accrued, as applicable.

If foreign taxes deemed paid under sections 902 or 960 are adjusted and the corporation is not required to redetermine its U.S. tax liability, adjust the appropriate pools of foreign taxes and E&P using the rules outlined in Temporary Regulations section 1.905-3T(d)(2)(ii).

If an adjustment to the appropriate pools of foreign taxes and E&P is required, attach a notice of the adjustment to the tax return for the tax year during which the foreign tax adjustment occurs. Provide the following information:

• The corporation's name and EIN;
• The foreign corporation's name, address, and EIN (if any);
• The amount of any refunds of foreign taxes and the exchange rate originally used to translate the refunded foreign taxes;
• The amounts of unrefunded foreign taxes when paid and when accrued in foreign currency, the exchange rates applicable to the unrefunded foreign taxes, and the dollar amounts of unrefunded foreign taxes paid and accrued; and
• The current balances of the pools of E&P and foreign taxes before and after the foreign tax adjustment.

If an adjustment relates to a foreign tax overaccrual of 2% or more, identify each such adjustment and include a complete factual description justifying the reasons for the overaccrual (Temporary Regulations section 1.905-3T(d)(2)(iii)).

If the corporation fails to attach the required notice, to provide the necessary information, or to make the required adjustments, it must provide notification of the foreign tax changes under Temporary Regulations section 1.905-4T. The notification must include a complete factual description justifying the reasons for the failure to attach the required notification or make the required adjustments. The IRS may, in its discretion, make a redetermination of the corporation's U.S. tax liability and apply the interest provisions of section 6601 and the penalty provisions of section 6689.

Important: Temporary Regulations section 1.905-3T(d)(2)(ii)(A) has been suspended, as well as that portion of Regulations section 1.905-3T(d)(2)(ii)(C) that refers to Regulations section 1.905-3T(d)(2)(ii)(A). These suspensions are effective for taxes deemed paid or accrued for E&P of a foreign corporation accumulated in tax years beginning after 1986.

Until final regulations are issued under section 905(c), redeterminations otherwise subject to those regulations sections must be accounted for through adjustment to the appropriate pools of E&P and foreign taxes as described in Temporary Regulations section 1.905-3T(d)(3) and subject to the exceptions in Temporary Regulations section 1.905-3T(d)(4). See Notice 90-26, 1990-1 C.B. 336, for details.

Interest and Penalties

In most cases, interest is computed on the deficiency or overpayment that resulted from the foreign tax adjustment (sections 6601 and 6611 and the related regulations). See Temporary Regulations section 1.905-4T(c) for additional information.

If the corporation does not comply with the requirements discussed above within the time for filing specified, the penalty provisions of section 6689 (and the related regulations) will apply.

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Specific Instructions

Report all amounts in U.S. dollars unless otherwise specified. If it is necessary to convert from a foreign currency, attach a statement explaining how the conversion rate was determined.

Separate category of income boxes. The corporation must complete a separate Form 1118 for each applicable category of income. See Categories of Income beginning on page 1.

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Schedule A

Report gross income or (loss) from sources outside the United States for the applicable separate category in columns 2 through 7. Gross income equals gross receipts reduced by cost of goods sold. Report the applicable deductions to this gross income in columns 9 and 10. Be sure to include in all columns the gross income and deductions that pertain to foreign branches.

Aggregate all section 863(b) gross income and deductions and report the totals on a single line.

Column 1. Enter the two-letter codes (from the list beginning on page 10) of all foreign countries and U.S. possessions within which income is sourced and/or to which taxes were paid, accrued, or deemed paid.

For section 863(b) income, enter 863(b) instead of a two-letter code.

Column 2(a). If the corporation is a U.S. shareholder in a CFC, report all income deemed received under section 951(a)(1)(A) (before gross-up). See section 904(d)(3) and Look-Through Rules on page 2 for more information. If the corporation is a U.S. shareholder in a passive foreign investment company (PFIC) and receives distributions from stock in that PFIC, report all income deemed received (before gross-up) under section 1291.

Column 3(a). Report all other dividends (before gross-up) not included in column 2(a) from sources outside the United States for the applicable separate category. Other dividends include amounts included in gross income under section 951(a)(1)(B).

Note: All dividends from a domestic corporation are of U.S. source, including dividends from a domestic corporation which has 80% or more of its gross income from sources outside the United States.

Columns 2(b) and 3(b). Include taxes deemed paid by a domestic corporation under section 902 or section 960 on distributions by a foreign corporation in income as dividend gross-up. See Regulations section 1.960-3(b) for exceptions.

Column 4. Enter all interest received from foreign sources. See section 861(c) for the treatment of interest from a domestic corporation that meets the foreign business requirement.

Column 6. Include gross income, including compensation, commissions, fees, etc., for technical, managerial, engineering, construction, scientific, or similar services outside the United States. Be sure to include gross income from services performed through a foreign branch.

Column 7. Include all other gross income from sources outside the United States for the applicable separate category, including all other gross income of foreign branches and pass-through entities and any exchange gain or loss recognized under sections 986(c) or 987(3) on a distribution or remittance of previously taxed amounts. Attach a schedule identifying the gross income by type and by the foreign country or U.S. possession from which it was sourced.

Column 9(d). Include all other deductions definitely allocable to income from sources outside the United States (dividends, interest, etc.) for the applicable separate category. Include deductions allocable to income of foreign branches.

Include any reduction of foreign source capital gain net income. If foreign source capital gain net income from all separate categories is more than the capital gain net income reported on the corporation's tax return, enter a pro rata portion of the excess as a negative number in each separate category. See Capital Gains on page 3.

Column 10. Enter only the apportioned share from Schedule H, Part II, Column (d) that relates to gross income reported in columns 2 through 7.

Note: If the corporation qualified as a financial services entity because it treated certain amounts as active financing income that are not listed in Regulations sections 1.904-4(e)(2)(i)(A) through (X), but that are described as similar items in Regulations section 1.904-4(e)(2)(i)(Y), attach a statement to Form 1118 showing the types and amounts of the similar items.

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