As a general rule, you must choose to take either a credit or a deduction for all qualified foreign taxes.

If you choose to take a credit for qualified foreign taxes, you must take the credit for all of them. You cannot deduct any of them. Conversely, if you choose to deduct qualified foreign taxes, you must deduct all of them. You cannot take a credit for any of them.

See What Foreign Taxes Qualify for the Credit, later, for the meaning of qualified foreign taxes.

There are exceptions to this general rule, which are described next.

You can make or change your choice to claim a deduction or credit at any time during the period within 10 years from the regular due date for filing the return for the tax year for which you make the claim. You make or change your choice on your tax return (or on an amended return) for the year your choice is to be effective.

You can claim the credit for a qualified foreign tax in the tax year in which you pay it or accrue it, depending on your method of accounting. “Tax year” refers to the tax year for which your U.S. return is filed, not the tax year for which your foreign return is filed.

U.S. income tax is imposed on income expressed in U.S. dollars, while the foreign tax is imposed on income expressed in foreign currency. Therefore, the tax credit is affected when the foreign currency depreciates or appreciates in value in terms of U.S. dollars.

Translating foreign currency into U.S. dollars.   If you receive all or part of your income or pay some or all of your expenses in foreign currency, you must translate the foreign currency into U.S. dollars. How you do this depends on your functional currency. Your functional currency generally is the U.S. dollar unless you are required to use the currency of a foreign country.

  You must make all federal income tax determinations in your functional currency. The U.S. dollar is the functional currency for all taxpayers except some qualified business units. A qualified business unit is a separate and clearly identified unit of a trade or business that maintains separate books and records. Unless you are self-employed, your functional currency is the U.S. dollar.

  Even if you are self-employed and have a qualified business unit, your functional currency is the U.S. dollar if any of the following apply.

• You conduct the business primarily in dollars.

• The principal place of business is located in the United States.

• You choose to or are required to use the dollar as your functional currency.

• The business books and records are not kept in the currency of the economic environment in which a significant part of the business activities is conducted.

  If your functional currency is the U.S. dollar, you must immediately translate into dollars all items of income, expense, etc., that you receive, pay, or accrue in a foreign currency and that will affect computation of your income tax. If there is more than one exchange rate, use the one that most properly reflects your income. You can generally get exchange rates from banks and U.S. Embassies.

  If your functional currency is not the U.S. dollar, make all income tax determinations in your functional currency. At the end of the year, translate the results, such as income or loss, into U.S. dollars to report on your income tax return.

  

For more information, write to:

Internal Revenue Service
International Section
P.O. Box 920
Bensalem, PA 19020–8518.

A foreign tax redetermination is any change in your foreign tax liability that may affect your U.S. foreign tax credit claimed.

The time of the credit remains the year to which the foreign taxes paid or accrued relate, even if the change in foreign tax liability occurs in a later year.

If a foreign tax redetermination occurs, a redetermination of your U.S. tax liability is required in the following situations.

If you are a U.S. citizen, you are taxed by the United States on your worldwide income wherever you live. You are normally entitled to take a credit for foreign taxes you pay or accrue.

If you are a resident alien of the United States, you can take a credit for foreign taxes subject to the same general rules as U.S. citizens. If you are a bona fide resident of Puerto Rico for the entire tax year, you also come under the same rules.

Usually, you can take a credit only for those foreign taxes imposed on income you actually or constructively received while you had resident alien status.

For information on alien status, see Publication 519.

If you are a nonresident alien, you generally cannot take the credit. However, you may be able to take the credit if:

For information on alien status and effectively connected income, see Publication 519.

You can claim a credit only for foreign taxes that are imposed on you by a foreign country or U.S. possession. For example, a tax that is deducted from your wages is considered to be imposed on you. You cannot shift the right to claim the credit by contract or other means.

Generally, you can claim the credit only if you paid or accrued the foreign tax to a foreign country or U.S. possession. However, the paragraphs that follow describe some instances in which you can claim the credit even if you did not directly pay or accrue the tax yourself.

The amount of foreign tax that qualifies is not necessarily the amount of tax withheld by the foreign country. Only the legal and actual foreign tax liability that you paid or accrued during the year qualifies for the credit.

Generally, only income, war profits, and excess profits taxes (income taxes) qualify for the foreign tax credit. Foreign taxes on wages, dividends, interest, and royalties generally qualify for the credit. Furthermore, foreign taxes on income can qualify even though they are not imposed under an income tax law if the tax is in lieu of an income, war profits, or excess profits tax. See Taxes in Lieu of Income Taxes, later.

Income Tax

Simply because the levy is called an income tax by the foreign taxing authority does not make it an income tax for this purpose. A foreign levy is an income tax only if it meets both of the following tests.

1. It is a tax; that is, you have to pay it and you get no specific economic benefit (discussed below) from paying it.

2. The predominant character of the tax is that of an income tax in the U.S. sense.

A foreign levy may meet these requirements even if the foreign tax law differs from U.S. tax law. The foreign law may include in income items that U.S. law does not include, or it may allow certain exclusions or deductions that U.S. law does not allow.

Specific economic benefit.   Generally, you get a specific economic benefit if you receive, or are considered to receive, an economic benefit from the foreign country imposing the levy, and:

1. If there is a generally imposed income tax, the economic benefit is not available on substantially the same terms to all persons subject to the income tax, or

2. If there is no generally imposed income tax, the economic benefit is not available on substantially the same terms to the population of the foreign country in general.

  You are considered to receive a specific economic benefit if you have a business transaction with a person who receives a specific economic benefit from the foreign country and, under the terms and conditions of the transaction, you receive directly or indirectly all or part of the benefit.

  However, see the exception discussed later under Pension, unemployment, and disability fund payments.

Economic benefits.   Economic benefits include the following.

• Goods.

• Services.

• Fees or other payments.

• Rights to use, acquire, or extract resources, patents, or other property the foreign country owns or controls.

• Discharges of contractual obligations.

.

  Generally, the right or privilege merely to engage in business is not an economic benefit.

Dual-capacity taxpayers.   If you are subject to a foreign country's levy and you also receive a specific economic benefit from that foreign country, you are a “dual-capacity taxpayer.” As a dual-capacity taxpayer, you cannot claim a credit for any part of the foreign levy, unless you establish that the amount paid under a distinct element of the foreign levy is a tax, rather than a compulsory payment for a direct or indirect specific economic benefit.

  

For more information on how to establish amounts paid under separate elements of a levy, write to:

Internal Revenue Service
International Section
P.O. Box 920
Bensalem, PA 19020-8518.

Pension, unemployment, and disability fund payments.   A foreign tax imposed on an individual to pay for retirement, old-age, death, survivor, unemployment, illness, or disability benefits, or for similar purposes, is not payment for a specific economic benefit if the amount of the tax does not depend on the age, life expectancy, or similar characteristics of that individual.

   No deduction or credit is allowed, however, for social security taxes paid or accrued to a foreign country with which the United States has a social security agreement. For more information about these agreements, see Publication 54.

Soak-up taxes.   A foreign tax is not predominantly an income tax and does not qualify for credit to the extent it is a soak-up tax. A tax is a soak-up tax to the extent that liability for it depends on the availability of a credit for it against income tax imposed by another country. This rule applies only if and to the extent that the foreign tax would not be imposed if the credit were not available.

Taxes not based on income.   Foreign taxes based on gross receipts or the number of units produced, rather than on realized net income, do not qualify unless they are imposed in lieu of an income tax, as discussed next. Taxes based on assets, such as property taxes, do not qualify for the credit.

Penalties and interest.   Amounts paid to a foreign government to satisfy a liability for interest, fines, penalties, or any similar obligation are not taxes and do not qualify for the credit.

You may not take a credit for foreign taxes paid or accrued on income excluded from U.S. gross income.

You cannot claim a foreign tax credit for foreign income taxes paid or accrued under the following circumstances. However, you can claim an itemized deduction for these taxes. See Choosing To Take Credit or Deduction, earlier.

You must reduce foreign taxes paid or accrued on foreign oil related income to the extent that the tax imposed by the foreign country on such income is considered to be materially greater than the tax imposed by that country on income other than foreign oil related income or foreign oil and gas extraction income (discussed later). See Regulations section 1.907(b)-1. The amount of tax not allowed as a credit under this rule is allowed as a business expense deduction.

You must reduce any taxes paid or accrued to a foreign country or possession on mineral income from that country or possession if you were allowed a deduction for percentage depletion for any part of the mineral income.

If you participate in or cooperate with an international boycott during the tax year, your foreign taxes resulting from boycott activities will reduce the total taxes available for credit. See the instructions for line 12 in the Form 1116 instructions to figure this reduction.

This rule generally does not apply to employees with wages who are working and living in boycotting countries, or to retirees with pensions who are living in these countries.

List of boycotting countries.   A list of the countries which may require participation in or cooperation with an international boycott is published by the Department of the Treasury each calendar quarter. As of the date this publication was printed, the following countries are listed.

• Bahrain.

• Kuwait.

• Lebanon.

• Libya.

• Oman.

• Qatar.

• Saudi Arabia.

• Syria.

• United Arab Emirates.

• Republic of Yemen.

  

For information concerning changes to the list, write to:

Internal Revenue Service
International Section
P.O. Box 920
Bensalem, PA 19020–8518

You must reduce your foreign taxes by a portion of any foreign taxes imposed on foreign oil and gas extraction income. The amount of the reduction is the amount by which your foreign oil and gas extraction taxes exceed the amount of your foreign oil and gas extraction income multiplied by a fraction equal to your pre-credit U.S. tax liability (Form 1040, line 43) divided by your worldwide income. You may be entitled to carry over to other years taxes reduced under this rule. See Internal Revenue Code section 907(f).

If you had control of a foreign corporation or a foreign partnership for the annual accounting period of that corporation or partnership that ended with or within your tax year, you may have to file an annual information return. If you do not file the required information return, you may have to reduce the foreign taxes that may be used for the foreign tax credit. See Penalty for not filing Form 5471 or Form 8865, later.

Your foreign tax credit cannot be more than your total U.S. tax liability (line 43 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.

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

In figuring your separate limits, you must combine the income (and losses) in each category from all foreign sources, and then apply the limit.

Lump-Sum Distribution

If you receive a foreign source lump-sum distribution (LSD) from a retirement plan, and you figure the tax on it using the special averaging treatment for LSDs, you must make a special computation. Follow the Form 1116 instructions and complete the worksheet in those instructions to determine your foreign tax credit on the LSD.

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

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.

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 2004 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.

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 40 of Form 1040. Then for each category of income, you must figure your taxable income from sources outside the United States.

If you have any qualified dividends, you may be required to make adjustments to the amount of those qualified dividends before you take them into account on line 1 or line 17 of Form 1116. See Foreign Qualified Dividends and Capital Gains (Losses) in the Form 1116 instructions to determine the adjustments you may be required to make before taking foreign qualified dividends into account on line 1 of Form 1116. See the instructions for Line 17 in the Form 1116 instructions to determine the adjustments you may be required to make before taking U.S. or foreign qualified dividends into account on line 17 of Form 1116.

If you have capital gains (including any capital gain distributions) or capital losses, you may have to make certain adjustments to those gains or losses before taking them into account on line 1 (gains), line 5 (losses), or line 17 (taxable income before subtracting exemptions) of Form 1116.

You must allocate foreign losses for any taxable year and U.S. losses for any taxable year (to the extent such losses do not exceed the separate limitation incomes for such year) among incomes on a proportionate basis.

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.

Note.

The amount of your taxable income (or loss) in a separate category is determined after any adjustments you make to your foreign source qualified dividends or your foreign source capital gains (losses). See Qualified Dividends and Adjustments to Foreign Source Capital Gains and Losses earlier under Capital Gains and Losses.

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. For this purpose, the amount of your U.S. source income is your taxable income from U.S. sources increased by the amount of capital losses from U.S. sources that reduced foreign source capital gains as part of a U.S. capital loss adjustment. See U.S. capital loss adjustment earlier under Adjustments to Foreign Source Capital Gains and Losses. 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).

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, Switzerland, and the United Kingdom. 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 also contact the United States Tax Attaché at the U.S. Embassies in Berlin, London, and Paris, 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).

When you carry back an unused foreign tax, IRS is given additional time to assess any tax resulting from the carryback. An assessment can be made up to the end of one year after the expiration of the statutory period for an assessment relating to the year in which the carryback originated.

If you have an unused foreign tax that you are carrying back to the first or the second preceding tax year, you should file Form 1040X for each earlier tax year to which you are carrying the unused foreign tax, and attach a revised Form 1116.

In a given year, you must either claim a credit for all foreign taxes that qualify for the credit or claim a deduction for all of them. This rule is applied with the carryback and carryover procedure, as follows.

For a tax year in which you and your spouse file a joint return, you must figure the unused foreign tax or excess limit in each separate limit category on the basis of your combined income, deductions, taxes, and credits.

For a tax year in which you and your spouse file separate returns, you figure the unused foreign tax or excess limit by using only your own separate income, deductions, taxes, and credits. However, if you file a joint return for any other year involved in figuring a carryback or carryover of unused foreign tax to the current tax year, you will need to make an allocation, as explained under Allocations Between Husband and Wife, later.

You must file a Form 1116 with your U.S. income tax return, Form 1040. You must file a separate Form 1116 for each of the following categories of income for which you claim a foreign tax credit.

A Form 1116 consists of four parts as explained next.

The receipt or return you keep as proof should be either the original, a duplicate original, a duly certified or authenticated copy, or a sworn copy. If the receipt or return is in a foreign language, you also should have a certified translation of it. Revenue Ruling 67-308 in Cumulative Bulletin 1967-2 discusses in detail the requirements of the certified translation. You can buy the Cumulative Bulletin from the Government Printing Office. Issues of the Cumulative Bulletin are also available in most IRS offices and you are welcome to read them there.

In addition to your regular income tax, you may be liable for the alternative minimum tax. A foreign tax credit may be allowed in figuring this tax. See the instructions for Form 6251, Alternative Minimum Tax—Individuals, for a discussion of the alternative minimum tax foreign tax credit.

Betsy enters the name of the foreign country in column A and shows on line 1 the amount of income ($620) and type of income (dividends) she received from XYZ. None of the dividends are qualified dividends. Next, since Betsy does not itemize her deductions, she puts her standard deduction ($4,850) on line 3a and completes 3b and 3c. Her gross foreign source income (line 3d) is $620 and gross income from all sources (line 3e) is $21,620. She enters $139 on line 6. Line 7 is $481, the difference between lines 1 and 6.

Betsy checks the “Paid” box and enters $93 on line A, columns (t) and (x), and on line 8.

Since the income was reported to Betsy in U.S. dollars on Form 1099-DIV, she does not have to convert the amount shown into foreign currency. She enters “1099 taxes” on line A, column (o).

Betsy figures her credit as shown on the completed form. The computation shows that she may take only $49 of the amount paid to Country Z as a credit against her U.S. income tax. The remaining $44 is available for a carryback and/or carryover.

Because this is the only Form 1116 that Betsy must complete, she does not need to fill in lines 22 through 30 of Part IV

Robert must use two Forms 1116 to figure his allowable foreign tax credit. On one Form 1116, he will mark the block to the left of General limitation income, and figure his foreign tax credit on the wages of $20,000 (Country X wages minus excluded wages). On the other Form 1116, he will mark the block to the left of Passive income, and figure his foreign tax credit on his interest income of $1,000 and dividend income of $4,000.

Under the later discussions for each part on the Form 1116, Robert's computations are explained for each Form 1116 that must be completed. Both Forms 1116 are illustrated near the end of this publication.

Before making any entries on Form 1116, Robert must figure his taxable income on Form 1040.

His taxable income is $22,128 figured as follows:

On each Form 1116, Robert enters $25,228 (his taxable income before the personal exemption) on line 17 of Part III.

In figuring the limit on both Forms 1116, Robert must separately determine his taxable income from Country X (Form 1116, line 7).

Robert uses Part II, Form 1116, to report the foreign tax paid or accrued on income from foreign sources.

Robert figures the amount of foreign tax credit in Part III on each Form 1116.

Robert summarizes his foreign tax credits for the two types of income on Part IV of one Form 1116. He uses the Part IV of Form 1116—General limitation income.

Robert leaves line 32 blank because he did not participate in or cooperate with an international boycott during the tax year. The allowable foreign tax credit is $2,442 ($500 + $1,942), shown on line 33. He also enters this amount on Form 1040, line 46.

Robert now determines if he has any unused foreign taxes that can be used as a carryback or carryover to other tax years.