Passive income generally includes dividends, interest, royalties, rents, annuities, gain from the sale of property that produces such income or of non-income-producing investment property, and gains from foreign currency or commodities transactions. Capital gains not related to the active conduct of a trade or business are also generally passive income.

Passive income does not include high withholding tax interest, export financing interest, active business rents and royalties, or high-taxed income (see High-Taxed Income on page 4).

Passive income also does not include gain from the sale of inventory or property held primarily for sale to customers in the ordinary course of your trade or business; gain from commodities hedging transactions; and active business gains or losses of producers, processors, merchants, or handlers of commodities. It may also not include dividends, interest, rents, or royalties received from a controlled foreign corporation (CFC) in which you are a U.S. shareholder who owns 10% or more of the total voting power of all classes of the corporation's stock.

In general, high withholding tax interest is foreign interest that is subject to a foreign withholding or other gross-basis tax of 5% or more.

Financial services income generally includes income derived by a financial services entity predominantly engaged in the active conduct of a banking, financing, insurance, or similar business. Financial services income of a financial services entity also includes passive income and certain incidental income; however, no part of the passive income that is financial services income is treated as high-taxed income (see High-Taxed Income on page 4).

If you qualify as a financial services entity because you treat certain items of income as active financing income under Regulations section 1.904-4(e)(2)(i)(Y), you must show the type and amount of each item on an attachment to Form 1116.

Shipping income generally includes 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 and ocean activities. Treat income that is both shipping income and financial services income as financial services income.

This category includes dividends from a DISC (domestic international sales corporation) or former DISC to the extent these dividends are treated as foreign sourced. See section 992(a).

This category includes distributions from a FSC (foreign sales corporation) or former FSC out of earnings and profits attributable to “foreign trade income.” Foreign trade income is the gross income of a FSC attributable to foreign trading gross receipts.

You can take a foreign tax credit for taxes you paid or accrued on a foreign source lump-sum distribution from a pension plan. Special formulas may be used to figure a separate tax on a qualified lump-sum distribution for the year in which the distribution is received. See Pub. 575 for more information.

If you are able to elect, and do elect, to figure your U.S. tax on a lump-sum distribution using Form 4972, Tax on Lump-Sum Distributions, a separate foreign tax credit limitation applies. Use a separate Form 1116. On this separate Form 1116, check box g above Part I. Skip Part I. Complete Part II showing only foreign taxes that are attributable to the lump-sum distribution. Then, complete the Worksheet for Lump-Sum Distributions, on page 4, to figure the amounts to enter in Part III.

No credit is allowed for foreign taxes imposed by and paid or accrued to certain sanctioned countries. However, income derived from each such country is subject to a separate foreign tax credit limitation. Therefore, you must use a separate Form 1116 for income derived from each such country.

These countries are those designated by the Secretary of State as countries that repeatedly provide support for acts of international terrorism, countries with which the United States does not have diplomatic relations, or countries whose governments are not recognized by the United States. Pub. 514 contains a list of these countries.

If you paid taxes to a country that ceased to be a sanctioned country during the tax year, see Pub. 514 for details on how to figure the foreign tax credit for the period that begins after the end of the sanctions.

Presidential waiver.   For periods beginning on or after February 1, 2001, the President of the United States has the authority to waive the denial of the credit with respect to a sanctioned country if (a) it is in the national interest of the United States and will expand trade and investment opportunities for U.S. companies in such sanctioned country, and (b) the President reports to the Congress, not less than 30 days before the waiver is granted, the intention to grant such a waiver and the reason for such waiver.

  

Since no credit is allowed for taxes paid to sanctioned countries, you would generally complete Form 1116 for this category only through line 16.

If a sourcing rule in an applicable income tax treaty treats any of the specific types of income described below as foreign source, and you elect to apply the treaty, the income will be treated as foreign source.

General limitation income is income that does not fall into one of the above categories. Common examples include:

In some cases, passive income and taxes must be treated as general limitation income and taxes. Generally, passive income and taxes must be placed in the general limitation income category if the foreign taxes you paid on the income (after allocation of expenses) exceed the highest U.S. tax that can be imposed on the income. However, no part of the passive income that is financial services income is treated as high-taxed income. See Regulations section 1.904-4(c) for more information.

Certain income received or accrued by you as a 10%-or-more U.S. shareholder in a controlled foreign corporation (CFC) is treated as income in one of the separate limitation categories listed under Categories of Income starting on page 3. For example, Subpart F inclusions, dividends, interest, rents, and royalties from a CFC are treated as separate limitation income to the extent they are attributable to separate limitation income of the CFC. See Regulations section 1.904-5 for more information.

If you received a 2006 Schedule K-1 from a partnership or S corporation that includes foreign tax information, use the rules below to report that information on Form 1116.

General Information for Partners and S Corporation Shareholders

Less-than-10% limited partners and certain less-than-10% S corporation shareholders.   If you are a limited partner or an S corporation shareholder who does not actively participate in the management of the S corporation and you own a less-than-10% interest (by value) in the partnership or S corporation, you generally may assign exclusively to the passive income category your distributive share of foreign source income and deductions from that partnership or S corporation. See Regulations section 1.904-5(h)(2) for more details and exceptions.

  

This rule takes precedence over the income category rules outlined in the instructions that follow for line 16, codes C and D-F, (or line 14, codes C and D-F) of the Schedule K-1, and the apportionment of deductions rules outlined in the instructions on page 5 for line 16, codes H and I-K, (or line 14 codes H and I-K) of the Schedule K-1.

Reporting amounts on Form 1116.   Include amounts reported to you on Schedule K-1 with any other amounts reportable on Form 1116 using:

• A separate Form 1116 for each category of income.

• A separate column in Part I and a separate line in Part II for each country or possession.

Explanation of Certain Line Items on Schedule K-1

In each instance that follows, the first line reference is to the Schedule K-1 for Form 1065 and the second line reference is to the Schedule K-1 for Form 1120S. (The Schedule K-1 for Form 1065-B includes all foreign tax information in an attachment for box 9.)

Line 16, code B, or line 14, code B—Gross income from all sources.   Combine your distributive share of “gross income from all sources” with all of your other gross income and enter the total on line 3e. “Gross income from all sources” is a constant amount (that is, you will enter the same amount on line 3e of all Forms 1116 that you file).

Line 16, code C, or line 14, code C—Gross income sourced at partner or shareholder level.   This line includes income from the sale of eligible personal property (most personal property other than inventory, depreciable property, and certain intangible property). See Pub. 514 for details.

  

Although all income reported to you on this line of the Schedule K-1 has been apportioned to separate categories of income, you must nevertheless first determine (using the rules below) whether the income on this line is U.S. source income or foreign source income. Then, enter only foreign source income in Part I of each of the applicable Forms 1116 (that is, those Forms 1116 for each category of income you received from the partnership or S corporation).

  Use the following rules to source the income reported to you on this line of the Schedule K-1. If you are a U.S. resident (as defined below), the income is U.S. source income. If you are a nonresident (as defined below), the income is foreign source income.

U.S. resident.   A U.S. resident is a U.S. citizen or resident alien who does not have a tax home in a foreign country or a nonresident alien who has a tax home in the United States.

Tax home.   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 not be treated as nonresidents for a sale of eligible personal property unless a foreign tax of 10% or more was paid or accrued on the gain on the sale (or, in the case of a loss sale, a foreign tax of 10% or more would have been paid had the sale resulted in a gain).

Note.

To help you with these rules, the partnership or S corporation has specifically identified the following.

• Gains on the sale of eligible personal property for which a foreign tax of 10% or more was paid or accrued.

• Losses on the sale of eligible personal property for which a foreign tax of 10% or more would have been paid had the sale resulted in a gain.

  Include foreign source income in Part I of the applicable Form 1116 (that is, the Form 1116 for each category of income provided to you for this line of the Schedule K-1). Do not include in Part I of Form 1116 income that you determined (using the above rules) to be U.S. source income.

  

If the partnership or S corporation has specifically identified any capital gains or losses or unrecaptured section 1250 gain on this line (Schedule K-1, line 16, code C, or line 14, code C) and you have determined that those gains or losses are foreign source, see Foreign Qualified Dividends and Capital Gains (Losses) starting on this page before entering an amount in Part I of
Form 1116.

Line 16, codes D, E, and F, or line 14, codes D, E, and F—Foreign gross income sourced at partnership or S corporation level.   Income reported on this line has already been sourced for you by the partnership or S corporation. The partnership or S corporation has reported this income to you by country and by category of income. Include these amounts in Part I of each of the applicable Forms 1116 (that is, those Forms 1116 for each category of income you received).

You should disregard any information shown on your Schedule K-1 pertaining to gross income attributable to a foreign branch. It is intended only for corporate partners preparing Form 1118.

Line 16, code G, or line 14, code G—Interest expense.   See the instructions for line 4b on page 14 to allocate and apportion the interest expense shown on this line of Schedule K-1. In applying those instructions, take into account your distributive share of the partnership's or S corporation's gross income (for purposes of the $5,000 threshold) or your pro rata share of the partnership's or S corporation's assets. However, if you were a limited partner or an S corporation shareholder who did not actively participate in the management of the S corporation and your interest in the partnership or S corporation was less than 10%, see the next paragraph. Include interest expense that you allocate to foreign source income on line 4b of the applicable Form 1116. Do not enter in Part I of Form 1116 any interest expense that you allocate to U.S. source income.

Less-than-10% limited partners and certain less-than-10% S corporation shareholders.   If you are a limited partner or an S corporation shareholder (who does not actively participate in the management of the S corporation) and you own (directly or indirectly) a less-than-10% interest (by income) in the partnership or S corporation, you may generally allocate your distributive share of interest expense from that partnership or S corporation to foreign or U.S. source income based on your distributive share of the gross foreign or U.S. source income of that partnership or S corporation. The interest expense you allocate to foreign source income generally may be apportioned exclusively to the passive income category. However, see Temporary Regulations section 1.861-9T(e)(4) for exceptions.

Line 16, code H, or line 14, code H—Other expenses.   This line includes expenses (other than interest expense) of the partnership or S corporation that must be allocated and apportioned at the partner or shareholder level (for example, research and experimental expenses).

  Combine your distributive share of these expenses with all of your other like expenses, if any, and then allocate and apportion them using the applicable rules (for example, for research and experimental expenses, the rules under Regulations section 1.861-17(f)).

  Include expenses that you allocate to foreign source income on line 2 of the applicable Form 1116. Expenses that you allocate to U.S. source income should not be entered on any line of Part I of Form 1116.

Line 16, codes I, J, and K, or line 14, codes I, J, and K—Deductions allocated and apportioned at partnership or S corporation level to foreign source income.   The partnership or S corporation has already allocated these expenses to foreign source income and has reported them to you by country and by category of income. Include these amounts on line 2 of each of the applicable Forms 1116 (that is, those Forms 1116 for each category of income you received).

  

You should disregard any information shown on your Schedule K-1 pertaining to definitely allocable deductions attributable to a foreign branch. It is intended only for corporate partners preparing Form 1118.

Line 16, codes L and M, or line 14, codes L and M—Total foreign taxes.   The partnership or S corporation has already allocated and apportioned total foreign taxes for you and has reported them to you by country and by category of income. Include these amounts in Part II of each of the applicable Forms 1116 (that is, those Forms 1116 for each category of income you received).

Line 16, code N, or line 14, code N—Reduction in taxes available for credit.   The partnership or S corporation has already apportioned the reduction in taxes available for credit and has reported it to you by country and by category of income. Include these amounts on line 12 of each of the applicable Forms 1116 (that is, those Forms 1116 for each category of income you received).

If you completed the Qualified Dividends and Capital Gain Tax Worksheet in your tax return instructions and you do not have to file Schedule D, you may have to adjust the amount of your foreign source qualified dividends and capital gain distributions.

How to make adjustments.   To adjust your foreign source qualified dividends or capital gain distributions, multiply your foreign source qualified dividends or capital gain distributions in each separate category by 0.4286. Include the results on line 1a of the applicable Form 1116.

  

Do not adjust the amount of any foreign source qualified dividends or capital gain distributions that you elected to include on Form 4952, line 4g.

If you completed the Qualified Dividends Tax Worksheet in the Instructions for Form 1041, you must adjust the amount of your foreign source qualified dividends if: