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 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.

A net capital loss from sources in the United States is not taken into account in determining your net loss from sources in the United States to the extent that the net capital loss reduced capital gains from sources outside the United States as discussed earlier under U.S. capital loss adjustment.

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 $80,000. You also have itemized deductions of $6,100 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 $6,100 in itemized deductions to the foreign source income. You figure the ratable part of the $6,100 that is for foreign source income, based on gross income, as follows:

$100,000 (Foreign gross income) $110,000 (Total gross income)

×

$6,100

=

$5,545

Therefore, your overall foreign loss for the year is $8,545, figured as follows:

Foreign gross income				$100,000
Less:   Foreign earned income   exclusion		$80,000
Allowable definitely related   expenses ($20,000/   100,000 × $115,000)		23,000
Ratable part of itemized   deductions		5,545		108,545
Overall foreign loss				$  8,545

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 smallest 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 2001 and 2002, 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 2001, 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 $4,400, 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 2001, you deducted your share of the partnership loss from Country X from your U.S. source income.

During 2002, 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 $8,000, after deducting the foreign earned income exclusion and the definitely related allowable expenses. This is 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 2002, 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:

A.	Determination of 2001 Overall Foreign Loss
1)	Partnership loss from Country X			$4,400
2)	Add: Part of itemized deductions allocable to gross income from Country X

$100,000 $120,000

×

$5,000

=

$4,167

3)	Overall foreign loss for 2001			$8,567
B.	Amount of Recapture for 2002
1)	Balance in general limitation category foreign loss account			$8,567
2)	Foreign source net income	$8,000
	Less: Itemized deductions  allocable to foreign source  net income ($100,000 /  $120,000 × $6,000)	5,000		$3,000
3)	50% of taxable income subject to recapture			$1,500
4)	Taxable income in general limitation category after allocation of foreign losses - General limitation income	$8,000
	Less: Itemized deductions  allocable to that income  ($100,000 / $120,000  × $6,000)	5,000
	General limitation taxable income less allocated foreign losses ($3,000 - 0)			$3,000
5)	Recapture for 2002 (smallest of (1), (3), or (4))			$1,500

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. 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 must 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. Generally, you are considered to recognize foreign source taxable income in the same separate limit category as the overall foreign loss to the extent of the lesser of:

1. The fair market value of the property that is more than your adjusted basis in the property, or
2. The remaining amount of the overall foreign loss not recaptured in prior years or in the current year as described earlier under Recapture provision and Recapturing more overall foreign loss than required.

This rule applies to a disposition whether or not you actually recognized gain on the disposition and irrespective of the source (U.S. or foreign) of any gain recognized on the disposition. The foreign source taxable income that you are considered to recognize is generally subject to recapture as U.S. source income in an amount equal to the lesser of:

1. Your foreign source taxable income in the same separate limit category as the overall foreign loss, or
2. 100% of your total foreign source taxable income for the year.

If you actually recognized foreign source gain in the same separate limit category as the overall foreign loss on a disposition of property described earlier, you must reduce the foreign source taxable income in that separate limit category by the amount of gain you are required to recapture. If you recognized foreign source gain in a different separate limit category than the overall foreign loss on a disposition of property described earlier, you are required to reduce your foreign source taxable income in that separate limit category for gain that is considered foreign source taxable income in the overall foreign loss category and subject to recapture. If you did not otherwise recognize gain on a disposition of property described earlier, you must include in your U.S. source income the foreign source taxable income you are required to recognize and recapture.

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 (for example, as ordinary income or capital gain) 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 must 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, Denmark, Finland, France, Germany, Ireland, Israel, Luxembourg, Mexico, the Netherlands, New Zealand, Portugal, Slovenia, 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 Section
P.O. Box 920
Bensalem, PA 19020-8518.

You can also contact the United States Tax Attaché 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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