Form 1116 Foreign Tax Credit Calculations

Form 1116 Instructions for Foreign Tax Credits: When a US Person individual earns foreign income abroad and pays foreign tax on that income, they may be able to claim a Foreign Tax Credit on IRS Form 1116 (Entities use Form 1118). Depending on the total amount of income the Taxpayer earns, along with the total foreign taxes paid and overall US tax liability, there are usually three (3) possible tax outcomes:

• Sufficient Foreign Tax Credits to offset all US Tax
• Some Foreign Tax Credit to offset some US Tax
• No US Tax liability sufficient to apply the Foreign Tax Credit.

A Romp Through Form 1116 Foreign Tax Credits

Any unused portion of the Foreign Tax Credits can usually be carry-forwarded to future years — in which the US Taxpayer has other foreign income to apply the credits to. Unfortunately, the foreign tax credits are not usually “dollar-for-dollar.” In addition, not all foreign taxes apply towards foreign tax credits. If you use commercial software such as TurboTax, the program will usually do much of the work for you — but not always, and it is important to have a baseline idea of how it works. Let’s take a (short) romp through Form 1116.

Which Foreign Taxes are Not Eligible for a Credit?

Not all foreign income qualifies for Form 1116 Foreign Tax Credits.

• • You can’t take a credit for the following foreign taxes.

    • Taxes paid to a foreign country that you don’t legally owe, including amounts eligible for refund by the foreign country. If you don’t exercise your available remedies to reduce the amount of foreign tax to what you legally owe, a credit for the excess amount isn’t allowed. The amount of tax actually withheld by a foreign country isn’t necessarily 100% creditable. See Regulations section 1.901-2(e)(2)(i).

    • Taxes imposed by and paid to certain foreign countries. 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 doesn’t have or doesn’t conduct diplomatic relations, or countries whose governments aren’t recognized by the United States and aren’t otherwise eligible to purchase defense articles or services under the Arms Export Control Act. Pub. 514 contains a list of these countries.

    • Foreign taxes withheld on a dividend from a corporation, if you haven’t held the stock for at least 16 days within the 31-day period that begins 15 days before the ex-dividend date. This required holding period is greater for preferred-stock dividends attributable to periods totaling more than 366 days. See section 901(k)(3) or Pub. 514.

    • Foreign taxes withheld on a dividend to the extent that you have to make related payments on positions in substantially similar or related property. Example. You receive a dividend subject to foreign withholding tax. You are obligated to pay someone else an amount equal to all these dividends you receive. You can’t claim a foreign tax credit for the withholding tax on these dividends.

    • Foreign taxes withheld on income or gain (other than dividends) from property if you haven’t held the property for at least 16 days within the 31-day period that begins 15 days before the date on which the right to receive the payment arises. See section 901(l) or Pub. 514.

    • Foreign taxes withheld on income or gain (other than dividends) from property to the extent you have to make related payments on positions in substantially similar or related property.

    • Payments of foreign tax that are returned to you in the form of a subsidy.

    • Taxes paid or accrued to a foreign country in connection with the purchase or sale of oil or gas extracted in that country if you don’t have an economic interest in the oil or gas, and the purchase price or sales price is different from the fair market value of the oil or gas at the time of the purchase or sale.

    • Foreign taxes paid or accrued on income for which you are claiming an exclusion on Form 8873, Extraterritorial Income Exclusion. However, see section 943(d) for an exception for certain withholding taxes.

    • The disqualified portion of any foreign tax paid or accrued in connection with a covered asset acquisition. Covered asset acquisitions include certain acquisitions that result in a stepped-up basis for U.S. tax purposes. 

Category of Income for Form 1116

There are various types of income which may qualify for a Form 1116 Foreign Tax Credit, including:

• • • Section 951A Category Income: GILTI

    • Foreign Branch Category Income

    • Passive Category Income

    • General Category Income

    • Section 901(j) Income

    • Certain Income Re-Sourced By Treaty

    • Lump-Sum Distributions

Each category of income should have its own Form 1116, which are then summarized in Part IV on the bottom of the Form 1116.

Country(s) of the Foreign Income for Form 1116

For each specific category of foreign income, the 1116 should identify which country(s) the income was generated in

*HTKO (High Tax Kick Out) will also appear as a country, but it refers to certain income which transmutes in general category income due to the high-tax rate.

Deductions and Losses on Form 1116

When a person has certain deductions and losses, this will serve to reduce the foreign income — which will in turn reduce the foreign tax credit.        

Expenses

Certain expenses are deducted from the gross income in order to determine the net amount that is available to obtain the foreign tax credit — to avoid any double-dipping.  For example, if a person earns $90,000 in gross foreign income, the following expenses have to be considered:

• • • Expenses related to the income

    • Itemized deductions (excluding Home mortgage interest)

    • Home mortgage interest

    • Other interest expenses

Once the total amount of deductions losses are calculated, they are subtracted from the gross income and category of income for the particular source of income income the 1116 applies to — and then that is the amount of income that was used to determine how much of the foreign tax credit may apply to.

Calculating the Credit

Once the total amount of income is determined, next taxpayer must figure to credit using the following steps.

• • • What is the total amount of foreign taxes paid for the particular category of income;

    • Is there any carry-back or carryover foreign tax credit;

    • Ad 1 and 2 together

    • Subtract any reduction for taxes (such is the foreign earned income exclusion)

    • Determine what portion qualifies for reclassification under the High Tax Kickout

    • Determine what portion of taxes are applicable towards the foreign tax credit

    • Insert the amount of taxable income from the first page

    • Determine if any adjustments necessary in the total US tax liability

    • Performed a vital calculation to determine how much credit can be used.

Golding & Golding: About our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure. 

Contact our firm for assistance.