A Separate Basket Limitations for Foreign Tax Credits Overview

The Separate Basket Limitations for Foreign Tax Credits

Foreign tax credits are very important for US taxpayers who have a US tax liability but they have already paid foreign taxes on their income. In a common situation, a US taxpayer may have generated capital gains or dividends from abroad. They have already paid tax in that foreign country but now they also have to include the foreign income on the US tax return — because the US follows a worldwide income model which then requires taxpayers to report income earned across the globe on their US tax return. There have been some recent updates and modifications to the foreign tax credit laws, but let’s walk through the basics of the separate basket limitations.

What are Separate Basket Limitations?

When a person is dealing with foreign tax credits, the category of income will dictate how it is categorized for US tax purposes. This in turn will impact the different baskets of foreign tax credits available to the taxpayer. For example, if a person has general category foreign income such as working overseas, then they may have foreign tax credits available for the general category. Likewise, taxpayers, who have foreign passive income may have tax credits available for income taxes they paid overseas for income such as dividends and capital gains.

General Category

The majority of the time, general category income is income that was generated through foreign employment or other income earned through a trade or business. For example, a taxpayer may work in a foreign country and earn $300,000 a year and they paid $120,000 in foreign tax on that income. The taxpayer can then apply (at least a portion of) the $120,000 foreign taxes paid as a US Tax credit to reduce or eliminate taxes on that income.

As provided by the IRS:

• • • General category income is income that isn’t section 951A category income, foreign branch category income, passive category income, or income described in categories e, f, and g, discussed later. General category income may include the following.

      • • Wages, salary, and overseas allowances of an individual as an employee. •

        • Income earned in the active conduct of a trade or business.

        • Gains from the sale of inventory or depreciable property used in a trade or business.

Passive Category

The passive category of foreign income refers to passive income generated from nonemployment sources such as interest, dividends, capital gains, etc. In general, most passive income can apply their foreign tax credits, but there are some limitations and exceptions — especially in situations in which it is either associated with an active trade or business or it is considered high-taxed income.

As provided by the IRS:

Passive Category Income

• • • Passive category income consists of passive income and specified passive category income. Passive category income doesn’t 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 CFC in which you are a U.S. shareholder who owns 10% or more of the total voting power or the total value of all classes of the corporation’s stock.

    • Passive income generally includes dividends, interest, royalties, rents, annuities, excess of gains over losses from the sale of property that produces such income or of non-income-producing investment property, and excess of gains over losses 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 doesn’t include export financing interest, active business rents and royalties, or high-taxed income.

    • High-taxed income is income 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. Passive income also doesn’t include financial services income derived by a financial services entity.

High-Taxed Income 

In the United States, most passive types of income are taxed at a reduced tax rate of either 15 or 20%. With foreign tax credits, the IRS is always concerned that the taxpayer may (improperly) use excessive foreign tax credits to offset US tax on other non-foreign income, which is strictly prohibited. Thus, in a situation in which a taxpayer paid a very high tax on passive income, they are not allowed to use the foreign tax credits for passive invome but instead, it is re-categorized as HTKO (High-Tax Kick Out) – kicked out into the general income category.

As provided by the IRS:

HTKO

• • • If you have passive income that is high-taxed income, use a separate column in Part I. Enter “HTKO” on line i of Forms 1116 for passive category income and the other category of income to which such passive category income is reclassified. If you had a foreign tax credit splitting event in a previous year and you are taking the related income into account in 2021, enter “909 income” on line i for that income instead of the country or possession name.

    • High-taxed income.

      • On your Form 1116 for passive category income, passive income that is treated as another category of income because it is high taxed should be included on line 1a in the column for the country entered on line i. Also, enter the high-taxed income in the “HTKO” column on line 1a as a negative number.

      • On your Form 1116 for the other category of income, the high-taxed income should be entered as a positive number on line 1a in the “HTKO” column

GILTI (951A) – TCJA

GILTI refers to Global Intangible Low-Taxed Income and was introduced into the tax code as a result of the TCJA (Tax Cuts and Jobs Act). GILTI further complicates the US tax code on foreign income and operates similarly — but not identical — to Subpart F Income. It is important to note that there is a separate category of foreign tax credit for GILTI Income.

As provided by the IRS:

• • • Section 951A Category Income Section 951A category income includes any amount included in gross income under section 951A (other than passive category income). Section 951A category income is otherwise referred to as global intangible low-taxed income (GILTI) and is included by U.S. shareholders of certain CFCs. See Pub. 514 for additional details

Foreign Branch

Foreign branch income also has its own bucket of foreign tax credits. Foreign branch income can get very complicated since it also involves the complex world of qualified business units (QBU) which can span many different countries — especially depending on the business structure itself. It is important to note, that if there is foreign branch income and taxes paid on that income overseas then foreign branch category income has its own separate bucket.

As provided by the IRS:

Foreign Branch Category

• • • Income Foreign branch category income consists of the business profits of U.S. persons that are attributable to one or more qualified business units (QBUs) in one or more foreign countries. Foreign branch category income doesn’t include any passive category income. See Pub. 514 for further information.

Section 901(j) Income

Section 901 involves foreign tax credits in countries that are sanctioned — and thus credits may not be applicable. It is important to note that not all income associated with a sanctioned country may not qualify for the foreign tax credit (as provided in the example below where a person may be in a non-sanctioned country and pays a residence base tax in that non-sanctioned country but the business activities include income generated from a sanctioned country).

As provided by the IRS:

• • • No credit is allowed for foreign taxes imposed by and paid or accrued to certain sanctioned countries. However, income derived from each sanctioned country is subject to a separate foreign tax credit limitation.

    • Therefore, you must use a separate Form 1116 for income derived from each sanctioned country. Because no credit is allowed for taxes paid to sanctioned countries, you would generally complete Form 1116 for this category only through line 17. Note. A foreign tax credit may be claimed for foreign taxes paid or accrued with respect to section

    • 901(j) income if such tax is paid or accrued to a country other than a sanctioned country. For example, if a U.S. citizen resident in a non-sanctioned country pays a residence-based income tax in that country on income derived from business activities in a sanctioned country, those foreign taxes would be eligible for a foreign tax credit. In this situation, you would continue completing Form 1116, and not stop at line

      • • Sanctioned 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.

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