us internal revenue service: p514--1997

8/14/2019 US Internal Revenue Service: p514--1997

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ContentsIntroduction ........................................ 1

What Is the Foreign Tax Credit? ...... 2

Who Can Take the Credit? ................ 4

What Foreign Taxes Qualify for theCredit? .......................................... 4

How To Figure the Credit .................. 7

Carryback and Carryover .................. 14

International Boycott ......................... 17

How To Claim the Credit ................... 17

Simple Example .................................. 18

Comprehensive Example .................. 18

How To Get More Information .......... 22

Index .................................................... 29

Important Change

for 1997Holding period with respect to foreigndividends. You cannot claim a foreign taxcredit for withholding tax paid on foreignsource dividends if you have not held thestock from the foreign corporation for at least16 days. See Withholding Taxes Imposed onCertain Dividends.

Important RemindersChange of address. If your addresschanges from the address shown on your last

return, use Form 8822, Change of Address,to notify the Internal Revenue Service.

Simpler Form 1116 filing if you have onlypassive income. If your only foreign incomeis passive income and the total of all yourforeign taxes shown on Form 1099DIV,1099INT, and similar statements is not morethan $200 ($400 if married filing jointly), youmay not need to show separately on Form1116, Foreign Tax Credit (Individual, Estate,Trust, or Nonresident Alien Individual), theforeign income and taxes from each country.You may be able to report only the total for-eign income and taxes. This simpler methodof filling out Form 1116 may help you if, forexample, your only foreign income is frommutual funds. See the Form 1116 instructions

for more information.

IntroductionIf you have paid or accrued foreign taxes toa foreign country on foreign sourced incomeand are subject to U.S. tax on the same in-come, you may be able to take either a creditor an itemized deduction for those taxes.Taken as a deduction, foreign income taxesreduce your U.S. taxable income. Taken asa credit, foreign income taxes reduce yourU.S. tax liability.

In most cases, it is to your advantage totake foreign income taxes as a tax credit. The

Departmentof theTreasury

InternalRevenueService

Publica tion 514Cat. No. 15018A

Foreign TaxCredit forIndividuals

For use in preparing

1997 Returns

Get f orms and other informat ion faster and easier by:COMPUTER

World Wide Web www.irs.ustreas.gov FTP ftp.irs.ustreas.gov IRIS at FedWorld (703) 321-8020

FAX From your FAX machine, dial (703) 368-9694See How To Get More Information in this publication.


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major scope of this publication is the foreigntax credit.

The publication discusses:

Who can take the credit,

What foreign taxes qualify for the credit,and

How to figure the credit.

The amount of foreign tax credit you cantake in a tax year is limited. The publicationtells you how to carry back or carry over theunused foreign taxes to other tax years.

You claim the credit by filing Form 1116,Foreign Tax Credit, with your U.S income taxreturn. Two examples with filled-in Forms1116 are provided at the end of the publica-tion.

Useful ItemsYou may want to see:

Publication

54 Tax Guide for U.S. Citizens andResident Aliens Abroad

519 U.S. Tax Guide for Aliens

570 Tax Guide for Individuals With In-come From U.S. Possessions

Form (and Instruction)

1116 Foreign Tax Credit

See How To Get More Information nearthe end of this publication for informationabout getting these publications and forms.

What Is theForeign Tax Credit?The foreign tax credit is intended to relieveU.S. taxpayers of the double tax burden whentheir foreign source income is taxed both bythe United States and the foreign countryfrom which the income comes. Generally, ifthe foreign tax rate is higher than the U.S.rate, there will be no U.S. tax on the foreignincome. If the foreign tax rate is lower thanthe U.S. rate, U.S. tax on the foreign incomewill be limited to the difference between therates. Because the foreign tax credit appliesonly with respect to foreign source income, itcannot reduce U.S. taxes on U.S. source in-come.

Choice To Take

Credit or DeductionYou can choose each tax year to take theamount of any qualified foreign taxes paid oraccrued during the year as a foreign tax creditor as an i temized deduction. You can changeyour choice for each year's taxes.

To choose the foreign tax credit, you mustcomplete Form 1116 and attach it to your U.S.tax return. To choose to claim the taxes asan itemized deduction, use Schedule A,Itemized Deductions (Form 1040).

TIP

Figure your tax both ways claimingthe credit and claiming the deduction.Then fill out your return the way that

benefits you most. See Why Choose theCredit, later.

Choice Applies to AllQualified Foreign TaxesAs a general rule, you must choose to takeeither a credit or a deduction for all qualifiedforeign taxes. There are exceptions to thisgeneral rule, which are described under For-eign taxes not allowed as a credit, next.

Under the general rule, if you choose totake a credit for foreign taxes, you must takethe credit for all qualified foreign taxes. Youcannot deduct any of them. Conversely, if youchoose to deduct qualified foreign taxes, you

must deduct all of them. You cannot take acredit for any of them.

See What Foreign Taxes Qualify for theCredit, later, for the meaning of qualified for-eign taxes.

CAUTION

!You cannot take a credit or a de-duction for foreign taxes paid on in-come you exclude under the foreign

earned income exclusion or the foreignhousing exclusion.

Foreign taxes not allowed as a credit.Even if you claim a credit for other foreigntaxes, you can deduct any foreign tax that isnot allowed as a credit because:

1) You participated in or cooperated withan international boycott (discussed laterunder International Boycott),

2) You paid the tax to one of certain coun-tries for which a credit is not allowedbecause these countries provide supportfor acts of international terrorism, or be-cause the United States does not havediplomatic relations with them or recog-nize their governments, or

3) You paid withholding tax on dividendsfrom foreign corporations whose stockyou did not hold for the required periodof time.

For more information on items (2) and (3),

see the discussion later under Foreign Taxesfor Which You Cannot Take a Credit.

Foreign taxes other than income taxes.The deduction for foreign taxes other thanforeign income taxes is not related to the for-eign tax credit. You may be able to deductforeign taxes for which you cannot take thecredit, such as real and personal propertytaxes, even though you claim the foreign taxcredit for foreign income taxes.

Generally, you can deduct these othertaxes only if they are expenses incurred in atrade or business or in the production of in-come. However, you can deduct foreign realproperty taxes that are not expenses incurredin your trade or business as an itemized de-

duction on Schedule A (Form 1040).

Carrybacks and carryovers. There is a limiton the credit you can claim in a tax year. Ifyour qualified foreign taxes exceed the creditlimit, you can carry over or carry back theexcess to another tax year. If you deductqualified foreign taxes in a tax year, youcannot use a carryback or carryover in thatyear. That is because you cannot take botha deduction and a credit for qualified foreigntaxes in the same tax year.

For more information on the limit, see Howto Figure the Credit, later. For more informa-tion on carrybacks and carryovers, seeCarryback and Carryover, later.

Making or Changing Your ChoiceYou can make or change your choice to claima deduction or credit at any time during theperiod within 10 yearsfrom the due date forfiling the return for the tax year for which youmake the claim. You make or change yourchoice on your tax return (or on an amendedreturn) for the year your choice is to be ef-fective.

Example. You paid foreign taxes for thelast 13 years and chose to deduct them on

your U.S. income tax returns. You were timelyin both filing and paying your U.S. tax liability.In February 1997 you file an amended returnfor tax year 1986 choosing to take a credit foryour 1986 foreign taxes because you nowrealize that the credit is more advantageousthan the deduction for that year. Becauseyour return for 1986 was not due until April15, 1987, this choice is timely (within 10years) and you are able to take a credit for the1986 foreign taxes against your 1986 U.S. taxliability.

Because there is a limit on the credit foryour 1986 foreign tax, you have unused 1986foreign taxes. Ordinarily, you first carry backunused foreign taxes and claim them as acredit in the 2 preceding tax years. If you areunable to claim all of them in those 2 years,

you carry them forward to the 5 years follow-ing the year in which they arose.

Because you originally did not choose totake a credit for your foreign taxes and thetime (10 years) for changing the choice for1984 and 1985 has passed, you cannot carrythe unused 1986 foreign taxes back as creditsagainst your U.S. income tax for tax years1984 and 1985.

However, because 10 years have notpassed since the due date for your 1987through 1991 income tax returns, you can stillchoose to carry forward any unused 1986foreign taxes. You must reduce the unused1986 foreign taxes that you carry forward bythe amount that would have been allowed asa carryback if you had timely carried back the

foreign tax to tax years 1984 and 1985.

Why Choose the CreditAlthough no one rule covers all situations, itis generally better to take a credit for qualifiedforeign taxes than to deduct them as anitemized deduction. This is because:

1) A credit reduces your actual U.S. incometax on a dollar-for-dollar basis, while adeduction reduces only your incomesubject to tax.

2) You can choose to take the foreign taxcredit even if you do not itemize yourdeductions. You then are allowed thestandard deduction in addition to thecredit.

3) If you choose to take a credit for theforeign taxes paid, and the taxes paidexceed the credit limit for the tax year,you can carry over or carry back the ex-cess to another tax year. (See Limit onthe Credit, discussed later under HowTo Figure the Credit.)

Example 1. For 1997, you and yourspouse have adjusted gross income of$50,000, including $20,000 of dividend in-come from foreign sources. You file a jointreturn and can claim two $2,650 exemptions.You had to pay $2,000 in foreign incometaxes on the dividend income from foreignsources. If you take the foreign taxes as an

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itemized deduction, your total itemized de-ductions are $9,000. Your taxable incomethen is $35,700 and your tax is $5,359.

If you take the credit instead, your item-ized deductions are only $7,000. Your taxableincome then is $37,700, and your tax beforethe credit is $5,659. After the credit, however,your tax is only $3,659. Therefore, you havean additional tax benefit of $1,700 ($5,359 $3,659) by taking the credit.

Example 2. In 1997 you receive invest-ment income of $5,000 from a foreign coun-

try, which imposes a tax of $3,500 on thatincome. You report on your U.S. return thisincome as well as $34,000 of income fromU.S. sources. You are single, entitled to one$2,650 exemption, and have other itemizeddeductions of $4,400. If you deduct the for-eign tax on your U.S. return, your taxable in-come is $28,450 ($5,000 + $34,000 $2,650 $4,400 $3,500) and your overall tax bill is$4,769.

If you take the credit instead (you can takea credit of only $737 because of limits dis-cussed later), your taxable income is $31,950($5,000 + $34,000 $2,650 $4,400) andyour tax before the credit is $5,749. Your taxafter the credit is $5,012 ($5,749$737),which is $243 more than if you deduct the

foreign tax.If you choose the credit, you will haveunused foreign taxes of $2,763 ($3,500 $737). When deciding whether to take thecredit or the deduction this year, you will needto consider whether you can benefit from acarryback or carryover of that unused foreigntax.

Credit for TaxesPaid or AccruedYou can claim the credit for a qualified foreigntax in the tax year in which you pay it accrueit. The tax year referred to is the tax year forwhich your U.S. return is filed.

When accrued. If you use an accrualmethod of accounting, you can claim thecredit only in the year in which you accrue thetax. You are using an accrual method of ac-counting if you report income when you earnit, rather than when you receive it, and youdeduct your expenses when you incur them,rather than when you pay them.

Foreign taxes generally accrue when allthe events have taken place that fix theamount of the tax and your liability to pay it.If you are contesting your foreign tax liability,you cannot accrue it and take a credit until theamount of foreign tax due is finally deter-mined. However, if you choose to pay the taxliability you are contesting, you can take creditbefore a final determination of foreign tax li-

ability is made. Once determined, the foreigntax credit is allowable for the year to which theforeign tax relates. If the amount of foreigntaxes taken as a credit differs from the finalforeign tax liability, you must make an ad-

justment to the credit, as discussed later un-der Foreign Tax Redeterminations.

When paid. If you use the cash method ofaccounting, you can choose to take the crediteither in the year you pay the tax or in theyear you accrue it. You are using the cashmethod of accounting if you report income inthe year you actually or constructively receiveit, and deduct expenses in the year you paythem.

Choosing to accrue taxes. Even if you usethe cash method of accounting, you canchoose to take a credit for foreign taxes in theyear they accrue. You make the choice bychecking the box in Part II of Form 1116.Once you make that choice, you must followit in all later years and take a credit for foreigntaxes in the year they accrue.

In addition, the choice to accrue foreigntaxes applies to allforeign taxes qualified forthe credit. You cannot take a credit for someforeign taxes when paid and take a credit forothers when accrued.

If you make the choice to accrue foreigntaxes and pay them in a later year, you can-not claim a deduction for any part of the pre-viously accrued taxes.

Cash method used in earlier year. If, inearlier years, you took the credit based ontaxes paid, and this year you choose to takethe credit based on taxes accrued, you maybe able to take the credit this year for taxesfrom more than one year.

Example. Last year you used the cashmethod of crediting foreign taxes. This yearyou chose to use the accrual method. Duringthe year you paid foreign income taxes owedfor last year. You also accrued foreign incometaxes that you did not pay by the end of the

year. You can base the credit on your returnfor this year on both last year's taxes that youpaid and this year's taxes that you accrued.

You may have to post a bond. If youclaim a credit for taxes accrued but not paid,you may have to post an income tax bondto guarantee your payment of any tax due inthe event the amount of foreign tax paid dif-fers from the amount claimed.

This bond can be requested at any timewithout regard to the Time Limit on Tax As-sessment, discussed later.

Foreign Tax RedeterminationsA foreign tax redetermination is any changein your foreign tax liability that may affect yourU.S. foreign tax credit claimed. This may oc-cur if the amount of foreign taxes you accruedin one year is different from the amount youlater pay for that year. It also may occur if youpay additional taxes for that year or receivea refund of taxes paid in that year.

In any case, the foreign tax you can takeas a credit is the amount you actually paid tothe foreign country. The time of the credit re-mains the year to which the foreign taxes paidor accrued relate, even if the change in for-eign tax liability occurs in a later year.

Currency fluctuation. Accrued but unpaidtaxes must be translated into U.S. dollars atthe prevailing exchange rate on the last dayof the year. Foreign taxes paid must be

translated into U.S. dollars at the prevailingexchange rate on the date you pay the tax.See Translating foreign currency into U.S.dollars, later under Foreign Currency andExchange Rates.

You must make an adjustment to accruedforeign taxes if you find that the amount ac-crued differs from the amount later paid be-cause of fluctuations in the dollar value of theforeign currency between the date of accrualand the date of payment. But see When re-determination of tax is not required, below.

Notice to the Internal Revenue Service ofchange in tax. You must file Form 1040X,Amended U.S. Individual Income Tax Return,

and Form 1116 for the year to which a foreigntax relates if in a later year you:

1) Must pay additional foreign taxes,

2) Receive a foreign tax refund, or

3) Have a change to the foreign tax ac-crued because of exchange rate fluctu-ations.

The IRS will redetermine your U.S. tax liabilityfor the year or years affected. If you pay lesstax than you originally claimed credit for, thereis no limit on the time the IRS has to rede-termine and assess the correct U.S. tax due.If you pay more tax than you originallyclaimed a credit for, see Time Limit on RefundClaims, later.

When redetermination of tax not re-quired. A redetermination of your U.S. tax isnot required if the change is due solely to anexchange rate fluctuation and the change inforeign tax liability for the tax year is less thanthe smallerof:

1) $10,000, or

2) 2% of the total dollar amount of the for-eign tax initially accrued for that foreigncountry.

In this case, you must adjust your U.S. tax inthe tax year in which the accrued foreigntaxes are paid.

Failure-to-notify penalty. If you fail tonotify the Service of a foreign tax change andcannot show reasonable cause for the failure,you may have to pay a penalty.

For each month, or part of a month, thatthe failure continues, you pay a penalty of 5%of the tax due resulting from a redetermi-nation of your U.S. tax. This penalty cannotbe more than 25% of the tax due.

Foreign tax refund. If you receive a foreigntax refund without interest from the foreigngovernment, you will not have to pay in-tereston the amount of tax due resulting from

the adjustment to your U.S. tax for the timebefore the date of the refund.

However, if you receive a foreign tax re-fund with interest, you must pay interest tothe Internal Revenue Service up to theamount of the interest paid to you by the for-eign government. The interest you must paycannot be more than the interest you wouldhave had to pay on taxes that were unpaid forany other reason for the same period.

Foreign tax imposed on foreign refund.If you receive a foreign tax refund that istaxed by the foreign country, you cannot takea separate credit or deduction for this addi-tional foreign tax. However, when you refigurethe credit taken for the original tax, reduce therefund by the foreign tax paid on it.

Example. You paid a foreign income taxof $3,000 in 1995, and received a foreign taxrefund of $500 in 1997 on which a foreign taxof $100 was imposed. Because you can re-duce your refund by the foreign tax imposedon it, you must make an adjustment of only$400 to the credit you took against your 1995U.S. income tax.

Time Limit on Refund ClaimsYou have 10 years to file a claim for refundof U.S. tax if you find that you paid or accrueda larger foreign tax than you claimed a creditfor. The 10-year period begins the day afterthe regular due date for filing the return for the

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year in which the taxes were actually paid oraccrued.

You have 10 years to file your claim re-gardless of whether you claim the credit ontaxes paid or taxes accrued. The 10-yearperiod applies to claims for refund or creditbased on:

1) Fixing math errors in figuring qualifiedforeign taxes,

2) Reporting qualified foreign taxes not ori-ginally reported on the return, or

3) Any other change in the size of the credit(including one caused by correcting theforeign tax credit limit).

The special 10-year period also applies tomaking or changing your choice of whetherto claim a deduction or credit for foreigntaxes. See Making or Changing Your Choice,discussed earlier under Choice To TakeCredit or Deduction.

Who Can Takethe Credit?If you have paid foreign income tax and are

subject to U.S. tax on foreign source income,you may be able to take a foreign tax credit.

U.S. CitizensIf you are a U.S. citizen, you are taxed by theUnited States on your worldwide incomewherever you live. You are normally entitledto take a credit for foreign taxes you pay oraccrue.

Citizen of U.S. possession. If you are acitizen of a U.S. possession (except PuertoRico), not otherwise a citizen of the UnitedStates, and are not a resident of the UnitedStates, you cannot take a foreign tax credit.

Excluded income. You cannot take a creditfor foreign income taxes you pay or accrueon income that you exclude from gross in-come under the foreign earned income orforeign housing exclusion. See the discussionof Taxes on excluded income, later, underReduction in Total Foreign Taxes Availablefor Credit. These exclusions are discussed indetail in Publication 54.

Resident of American Samoa. If you are abona fide resident of American Samoa andexclude income from sources in AmericanSamoa, Guam, or the Northern Mariana Is-lands, you cannot take a credit for the taxesyou pay or accrue on the excluded income.For more information on this exclusion, see

Publication 570.

Resident AliensIf you are a resident alien of the UnitedStates, you can take a credit for foreign taxessubject to the same general rules as U.S.citizens. If you are a bona fide resident ofPuerto Rico for the entire tax year, you alsocome under the same rules.

Usually, you can take a credit only forthose foreign taxes imposed on your foreignsource income. You must have actually orconstructively received the income while youhad resident alien status.

If you exclude income under the foreignearned income exclusion or the foreign

housing exclusion, you cannot take a foreigntax credit for foreign income taxes paid oraccrued on the excluded income. See thediscussion of Taxes on excluded income,later, under Reduction in Total Foreign TaxesAvailable for Credit. For information on alienstatus, see Publication 519.

Nonresident AliensAs a nonresident alien, you can claim a creditfor taxes paid or accrued to a foreign countryor possession of the United States only onforeign source or possession source incomethat is effectively connected with a trade orbusiness in the United States. For informationon alien status and effectively connected in-come, see Publication 519.

Who Paid or Accruedthe Foreign Tax?Generally, you can claim the credit only if youpaid or accrued the foreign tax. However, theparagraphs that follow describe some in-stances in which you can claim the crediteven if you did not directly pay or accrue thetax yourself.

Joint return. If you file a joint return, you canclaim the credit based on the total of any for-eign income tax paid or accrued by you andyour spouse.

Partner or S corporation shareholder. Ifyou are a member of a partnership, or ashareholder in an S corporation, you canclaim the credit based on your proportionateshare of the foreign income taxes paid or ac-crued by the partnership or the S corporation.These amounts will be shown on the Sched-ule K1 you receive from the partnership orS corporation. However, if you are a share-holder in an S corporation that in turn ownsstock in a foreign corporation, you cannotclaim a credit for your share of foreign taxes

paid by the foreign corporation.

Beneficiary. If you are a beneficiary of anestate or trust, you may be able to claim thecredit based on your proportionate share offoreign income taxes paid or accrued by theestate or trust. This amount will be shown onthe Schedule K1 you receive from the estateor trust. However, you must show that the taxwas imposed on income of the estate and noton income received by the decedent.

Investment company shareholder. If youare a shareholder of a regulated investmentcompany (mutual fund) or a foreign invest-ment company, you may be able to claim thecredit based on your share of foreign incometaxes paid by the company if it chooses topass the credit on to its shareholders. Youshould receive from the mutual fund a Form1099DIV, or similar statement, showing theforeign country or U.S. possession, yourshare of the income from that country, andyour share of the foreign taxes paid to thatcountry. If you do not receive this information,you will need to contact the company.

Controlled foreign corporation share-holder. If you are at least a 10% shareholderof a controlled foreign corporation and chooseto be taxed at corporate rates on the amountyou must include in gross income from thatcorporation, you can claim the credit basedon your share of foreign taxes paid or accrued

by the controlled foreign corporation. If youmake this election, you must claim the creditsby filing Form 1118, Foreign TaxCreditCorporations.

Controlled foreign corporation. A con-trolled foreign corporation is a foreign corpo-ration in which U.S. shareholders own morethan 50% of the voting power or value of thestock. You are considered a U.S. shareholderif you own 10% or more of the total votingpower of all classes of the foreign corpo-ration's stock.

What Foreign TaxesQualify for the Credit?Generally, only income, war profits, and ex-cess profits taxes (income taxes) paid or ac-crued during the tax year to a foreign country(defined later) or a U.S. possession qualify forthe foreign tax credit. However, under certainconditions a tax paid or accrued to a foreigncountry or U.S. possession in lieu of a tax onincome, war profits, or excess profits willqualify. (See Taxes in Lieu of Income Taxes,later.)

Whether an amount imposed by a foreigncountry (foreign charge or levy) qualifies forcredit depends on the characteristics of thecharge involved.

As a general rule, to qualify for the credit,the foreign tax must have been imposed onyou and you must have paid or accrued theforeign tax. You cannot shift the right to claimthe credit by contract or other means unlessspecifically provided by foreign law. A qual-ified tax that is deducted from wages is con-sidered to be imposed upon the recipient ofthe wages.

Amount of foreign tax that qualifies. Theamount of qualified foreign tax that you canuse each year for credit purposes or as a

deduction is not necessarily the amount of taxwithheld by the foreign country. The amountof qualified foreign tax, for credit or deductionpurposes, is only the amount of foreign in-come tax that is the legal and actual tax li-ability that you paid or accrued during theyear.

Foreign tax refund. You cannot take aforeign tax credit or deduction for incometaxes paid to a foreign country to the extentit is reasonably certain the amount would berefunded, credited, rebated, abated, or for-given if you made a claim.

For example, the United States has taxtreaties or conventions with many countriesallowing U.S. citizens and residents re-ductions in the rates of tax of those foreigncountries. However, some treaty countriesrequire U.S. citizens and residents to pay thetax figured without regard to the lower treatyrates and then claim a refund for the amountby which the tax actually paid is more than theamount of tax figured using the lower treatyrate. For credit or deduction purposes, thetaxpayer's qualified foreign tax is the amountfigured using the lower treaty rate and not theamount actually paid, since the taxpayer canclaim a refund for the excess tax paid.

Subsidy received. If a foreign countryreturns your foreign tax payments to you inthe form of a subsidy, you cannot claim thesepayments as taxes qualified for the foreign taxcredit. A subsidy can be provided by anymeans but must be determined, directly or

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indirectly, in relation to the amount of tax, orto the base used to figure the tax.

The term subsidy includes any type ofbenefit. Some ways of providing a subsidy arerefunds, credits, deductions, payments ordischarges of obligations. The credit is alsonot allowed if the subsidy is given to a personrelated to you, or persons who participated ina transaction, or a related transaction, withyou.

Shareholder receiving refund for cor-porate tax in integrated system. Undersome foreign tax laws and treaties, a share-holder is considered to have paid part of thetax that is imposed on the corporation. Youmay be able to claim a refund of these taxesfrom the foreign government. You must in-clude the refund (including any amount with-held) in your income in the year received. Anytax withheld from the refund is a qualifiedforeign tax.

Example. You are a shareholder of a U.K.corporation. You receive a $100 refund of thetax paid to the United Kingdom by the corpo-ration on the earnings distributed to you as adividend. The U.K. government imposes a15% withholding tax ($15) on the refund youreceived. You receive a check for $85. Youinclude $100 in your income. The $15 of tax

withheld is a qualified foreign tax.

Foreign country. A foreign country includesany foreign state or political subdivisionthereof. Income, war profits, and excess pro-fits taxes paid or accrued to a foreign city orprovince qualify for the U.S. foreign tax credit.

A foreign country also includes the conti-nental shelfof a foreign country if the countryhas exclusive rights under international lawover the exploration and exploitation of na-tural resources there, and exercises taxing

jurisdiction over that exploration and exploi-tation. This rule for continental shelf areas islimited to activities involving natural re-sources.

U.S. possessions. For foreign tax creditpurposes, all qualified taxes paid to pos-sessions of the United States are consideredforeign taxes. For this purpose, U.S. pos-sessions include Puerto Rico, Guam, theNorthern Mariana Islands, and American Sa-moa.

When the term foreign country is usedin this publication, it includes U.S. pos-sessions unless otherwise stated.

Penalties and interest. Amounts paid to aforeign government to satisfy a liability for in-terest, fines, penalties, or any similar obli-gation are not taxes and do not qualify forcredit.

Tax Must BeBased on IncomeTo qualify for credit, the foreign levy must bean income tax (or a tax in lieu of income tax).Simply because the levy is called an incometax by the foreign taxing authority does notmake it an income tax for this purpose.

Income tax. A foreign levy is an income taxonly if it meets both of these tests:

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

2) The predominant character of the tax isthat of an income tax in the U.S. sense.

A foreign levy may meet these requirementseven if the foreign tax law differs from U.S. taxlaw. The foreign law may include in incomeitems that the United States does not include,or it may allow certain exclusions or de-ductions that are not allowed under the U.S.income tax law.

Specific economic benefit. Generally, youget a specific economic benefit if you receive,

or are considered to receive, an economicbenefit from the foreign country imposing thelevy, and

1) If there is a generally imposed incometax, the economic benefit is not availableon substantially the same terms to allpersons subject to the income tax, or

2) If there is no generally imposed incometax, the economic benefit is not madeavailable on substantially the sameterms to the population of the foreigncountry in general.

However, see the exception discussed laterunder Pension, unemployment, and disabilityfund payments.

Economic benefits. Economic benefitsinclude:

Goods,

Services,

Fees or other payments,

Rights to use, acquire, or extract re-sources, patents, or other property theforeign country owes or controls, and

Discharges of contractual obligations.

.Generally, the right or privilege merely to

engage in business is not an economic ben-efit.

You are considered to receive an eco-

nomic benefit if you have a business trans-action with a person who receives a specificeconomic benefit from the foreign countryand, under the terms and conditions of thetransaction, you receive directly or indirectlysome part of the benefit.

Dual-capacity taxpayers. If you aresubject to a foreign country's levy and youalso receive a specific economic benefit fromthat foreign country, you are a dual-capacitytaxpayer. As a dual-capacity taxpayer, youcannot claim a credit for any part of the for-eign levy, unless you establish that theamount paid under a distinct element of theforeign levy is a tax, rather than a compulsorypayment for a direct or indirect specific eco-nomic benefit.

For more information on how to es-tablish amounts paid under separateelements of a levy, write to:

Internal Revenue ServiceAssistant Commissioner (International)Attention: CP:IN:D:CS950 L'Enfant Plaza South, S.W.Washington, D.C. 20024

Pension, unemployment, and disabilityfund payments. A foreign tax imposed onan individual to pay for retirement, old-age,death, survivor, unemployment, illness, ordisability benefits, or for similar purposes, isnot payment for a specific economic benefitif the amount of the tax does not depend on

the age, life expectancy, or similar character-istics of that individual.

No deduction or credit is allowed, how-ever, for social security taxes paid or ac-crued to a foreign country with which theUnited States has a social security agree-ment. For more information about theseagreements, see Publication 54 or Publication519.

Soak-up taxes. A foreign tax is not pre-dominantly an income tax and does notqualify for credit to the extent it is a soak-uptax. A tax is a soak-up tax to the extent thatliability for it depends on the availability of acredit for it against income tax imposed byanother country. This rule applies only if andto the extent that the foreign tax would notbe imposed if the credit were not available.

Taxes based on income. Foreign taxes onwages, dividends, interest, and royaltiesgenerally qualify for the credit. Furthermore,foreign taxes on income can qualify eventhough they are not imposed under an incometax law.

Taxes not based on income. Foreign taxesbased on gross receipts, rather than on real-ized net income, do not qualify unless theyare imposed in lieu of an income tax, as dis-cussed next. Taxes based on assets, suchas property taxes, do not qualify for the credit.

Taxes in Lieuof Income TaxesA tax paid or accrued to a foreign countryqualifies for the credit if it is imposed in lieuof an income tax otherwise generally im-posed. A foreign levy is a tax in lieu of anincome tax only if:

1) It is not payment for a specific economicbenefit as discussed earlier, and

2) It meets the substitution requirements;

that is, the tax is imposed in place of,and not in addition to, an income taxotherwise generally imposed. See alsothe earlier discussion of soak-up taxes.

Since a tax in lieu of an income tax doesnot have to be based on realized net income,a foreign tax imposed on gross income, grossreceipts or sales, or the number of unitsproduced or exported can qualify for thecredit.

Reduction in TotalForeign TaxesAvailable for CreditYou must reduce your total foreign taxes thatare available for the credit under the followingcircumstances.

Taxes on excluded income. You must re-duce your foreign taxes available for thecredit by the amount of those taxes paid oraccrued on income that is excluded from U.S.income under the foreign earned income ex-clusion or the foreign housing exclusion. SeePublication 54 for more information on theforeign earned income and housing exclu-sions.

Wages completely excluded. If yourwages are completely excluded, you cannottake a credit for any of the foreign taxes paidor accrued on these wages.

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Wages partly excluded. If only part ofyour wages is excluded, you cannot take acredit for the foreign income taxes allocableto the excluded part. You find the amountallocable to your excluded wages by multi-plying the foreign tax paid or accrued on for-eign earned income received or accrued dur-ing the tax year by a fraction.

The numeratorof the fraction is your ex-cluded foreign earned income for the tax yearminus otherwise deductible expenses directlyrelated and properly apportioned to that in-come (not including the foreign housing de-duction).

The denominator is your total foreignearned income received or accrued during thetax year minus all deductible expensesallocable to that income (including the foreignhousing deduction). If the foreign law taxesforeign earned income and some other in-come (for example, earned income from U.S.sources or a type of income not subject toU.S. tax), and the taxes on the other incomecannot be segregated, the denominator of thefraction is the total amount of income subjectto the foreign tax minus deductible expensesallocable to that income.

Example. You are a U.S. citizen and acash basis taxpayer, employed by CompanyX and living in Country A. Your records showthe following:

Because you can exclude part of yourwages, you cannot claim a credit for part ofthe foreign taxes. To find that part, do thefollowing.

First, find the amount of business ex-penses allocable to excluded wages andtherefore not deductible. To do this, multiply

the otherwise deductible expenses by a frac-tion. That fraction is the excluded wages overyour foreign earned income.

$20,000 $77,225

$120,000= $12,871

Next, find the numerator of the fraction bywhich you will multiply the foreign taxes paid.To do this, subtract business expensesallocable to excluded wages ($12,871) fromexcluded wages ($77,225). The result is$64,354.

Then, find the denominator of the fractionby subtracting all your deductible expensesfrom all your foreign earned income($120,000 $20,000 = $100,000).

Finally, multiply the foreign tax you paid

by the resulting fraction.

$30,000 $64,354

$100,000= $19,306

The amount of Country A tax you cannot takea credit for is $19,306.

Taxes on foreign mineral income. Youmust reduce any taxes paid or accrued to aforeign country or possession on mineral in-come from that country or possession if youwere allowed a deduction for percentage de-pletion for any part of the mineral income.

Taxes from international boycott oper-ations. In general, if you participate in orcooperate with an international boycott, yourforeign taxes resulting from the boycott activ-ity will reduce the total taxes available forcredit. For more information, see the dis-cussion later under International Boycott.

Taxes of persons controlling foreign cor-porations. If you are an officer, director or5% or more shareholder of a foreign corpo-ration, you may be required to file an annualinformation return on Form 5471, InformationReturn of U.S. Persons With Respect ToCertain Foreign Corporations.

Penalty for not filing. If you fail to file thereturn by the due date, you must reduce by10% all foreign taxes that may be used for theforeign tax credit. You then subtract from this10% reduction any dollar penalty for failure tofurnish this information. Generally, the dollarpenalty is $1,000 for each failure. Additionalpenalties apply if the failure continues for 90days or more.

Foreign Taxes for WhichYou Cannot Take a CreditYou cannot claim a foreign tax credit for for-

eign income taxes paid or accrued under thefollowing circumstances. However, you canclaim a deduction for these taxes. See ChoiceTo Take Credit or Deduction, earlier.

Taxes Imposed By CertainForeign CountriesYou cannot claim a foreign tax credit for in-come taxes paid or accrued to any country ifthe income giving rise to the tax is for a period(the sanction period) during which:

1) The Secretary of State has designatedthe country as one that repeatedly pro-vides support for acts of internationalterrorism,

2) The United States has severed or doesnot conduct diplomatic relations with thecountry, or

3) The United States does not recognizethe country's government, unless thatgovernment is eligible to purchase de-fense articles or services under the ArmsExport Control Act.

Table 1 lists countries that meet this de-scription for 1997.

Table 1. Countries That Do NotQualify for a ForeignTax Credit in 1997

CubaIran

IraqLibya

North KoreaSudan

Syria

Income that is paid through one or moreentities is treated as coming from a foreigncountry listed in Table 1 if the original sourceof the income is from one of the listed coun-tries.

Limit on credit. In figuring the foreign taxcredit limit, discussed later, income for thesanction period of a country listed in Table 1is treated as a separate category of foreignincome. This will prevent the foreign taxes forthe sanction period of these countries frombeing used as a credit against the U.S. tax.

Example. You lived and worked in Libyauntil August, when you were transferred toItaly. You paid taxes to each country on theincome earned in that country. You cannotclaim a foreign tax credit for the foreign taxespaid on the income earned in Libya. Whenfiguring your foreign tax credit limit, you musttreat the income earned in Libya as a sepa-rate category of foreign income. You cannottake a credit for taxes paid on the incomeearned in Libya, but that income is taxable inthe United States.

Figuring the credit when a sanction ends.Table 2lists the countries for which sanctionshave been lifted. For any of these countries,you can claim a foreign tax credit for the taxespaid or accrued to that country on the incomefor the period that begins after the end of thesanctioned period.

Example. The sanctions against CountryX were lifted on July 31. On August 19, youreceive a distribution from a mutual fund ofCountry X income. The fund paid Country Xincome tax for you on the distribution. Be-cause the distribution was made after thesanction was lifted, you may include the for-eign tax paid on the distribution to computeyour foreign tax credit.

Amounts for the nonsanctioned period.If during your tax year a sanction period endsand you are not able to determine the actualincome and taxes for the nonsanctioned pe-riod, you can allocate amounts to that period.Multiply the income or taxes for the year bythe following fraction to determine theamounts allocated to the nonsanctioned pe-riod.

Number ofnonsanctioneddays in year

Number ofdays in year

Example. You are a calendar year filerand received $20,000 of income from CountryX in 1997 on which you paid tax of $4,500.Sanctions against Country X were lifted onJuly 11, 1997. You are unable to determinehow much of the income or tax is for thenonsanctioned period. Because your tax yearstarts on January 1, and the Country Xsanction was lifted on July 11, 1997, 173 daysof your tax year are in the nonsanctionedperiod. You would compute the income for thenonsanctioned period as follows:

$20,000 = $9,479173 days

365 days

You would compute the tax for the nonsanc-tioned period as follows:

$4,500 = $2,133173 days

365 days

To figure your foreign tax credit, you woulduse $9,479 as the income from Country X and$2,133 as the tax.

Further information. The rules for figur-ing the foreign tax credit after a country'ssanction period ends are more fully explainedin Revenue Ruling 9262, 19922 Cumula-tive Bulletin, page 193. This ruling can befound in many libraries and IRS offices.

Foreign earned income received ............. $120,000

Unreimbursed business travel expenses . 20,000

Income tax paid to Country A .................. 30,000

Exclusion of foreign earned income andhousing allowance ................................... 77,225

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Table 2. Countries Removed From the Sanctioned List

CountrySanction Period

Starting Date Ending Date

Afghanistan

Albania

Angola

Cambodia

South Africa

Vietnam

Peoples DemocraticRepublic of Yemen

January 1, 1987

January 1, 1988

August 4, 1994

March 15, 1991

June 18, 1993

August 4, 1994

July 10, 1991

July 21, 1995

May 22, 1990

January 1, 1987

January 1, 1987

January 1, 1987

January 1, 1987

January 1, 1987

Complete Part lll of Form 1116 to figurethe limit on your credit. The maximum amountof your credit will be shown on line 20.

Separate Limit IncomeYou must figure the limit on a separate Form1116 for each of the following categories ofincome:

1) Passive income,

2) High withholding tax interest,

3) Financial services income,

4) Shipping income,

5) Certain dividends from a domestic inter-national sales corporation (DISC) or for-mer DISC,

6) Certain distributions from a foreign salescorporation (FSC) or former FSC,

7) Any lump-sum distributions from em-ployer benefit plans for which the specialaveraging treatment is used to determineyour tax, and

8) All other income not included in theabove categories (general limitationincome).

In figuring your separate limits, you mustcombine the income (and losses) in eachcategory from all foreign sources, and thenapply the limit.

Income from controlled foreign corpo-rations. As a U.S. shareholder, certain in-come that you receive or accrue from a con-trolled foreign corporation (CFC) is treated asseparate limit income. You are considered aU.S. shareholder in a CFC if you own 10%or more of the total voting power of all classesof the corporation's stock.

Subpart F inclusions, interest, rents, androyalties from a CFC are generally treated asseparate limit income to the extent that they

are attributable to the separate limit incomeof the CFC. A dividend paid or accrued outof the earnings and profits of a CFC is treatedas separate limit income in the same propor-tion that the part of earnings and profits at-tributable to income in the separate categorybears to the total earnings and profits of theCFC.

Partnership distributive share. In general,a partner's distributive share of partnershipincome is treated as separate limit income tothe extent it is from the separate limit incomeof the partnership. However, if the partnerowns less than a 10% interest in the partner-ship, the income is generally treated as pas-sive income.

Passive IncomePassive income generally includes dividends,interest, rents, royalties, and annuities. It alsoincludes gains from the sale of non-income-producing investment property or propertythat generates passive income. Gains fromcommodities transactions are included, ex-cept for hedging and active business gainsor losses of producers, processors, mer-chants, or handlers of commodities. Passiveincome also includes amounts you must in-clude as foreign personal holding companyincome under section 551(a) or 951(a) of theInternal Revenue Codes and amountsincludible under section 1293 of the Internal

Taxes Imposed on CertainDividends

You cannot claim a foreign tax credit forwithholding tax on dividends paid or accruedafter September 4, 1997, if the dividends are:

1) On stock you held for less than 16 daysduring the holding period described be-low, or

2) For a period or periods totaling morethan 366 days on preferred stock youheld for less than 46 days during theholding period described below.

Regardless of your holding period, you cannotclaim the credit to the extent you have anobligation under a short sale or otherwise, tomake payments related to the dividend forpositions in substantially similar or relatedproperty.

Withholding tax. For this purpose, withhold-ing tax includes any tax determined on agross basis. It does not include any tax whichis in the nature of a prepayment of a tax im-

posed on a net basis.

Holding period. To claim the credit for taxeson dividends, you must satisfy the holdingperiod. You must hold the stock for at least16 days within the 30-day period that begins15 days before the ex-dividend date (the dateyou are entitled to the stock dividend). For apreferred stock dividend, if the dividend is fora period or periods totaling more than 366days, you must hold the preferred stock forat least 46 days within the 90-day period thatbegins 45 days before you are entitled to thepreferred stock dividend. If the dividend is notfor more than 366 days, the general 16 dayrule, described above applies to the preferredstock. When figuring the holding period, do

not count the day you acquired the stock orany days in which you are protected from riskof loss (but do count the day you sold thestock).

Example 1. You bought common stockfrom a foreign corporation on November 3.You sold the stock on November 19. You re-ceived a dividend on this stock, because youowned it on the ex-dividend date of November5. To claim the credit, you must have held thestock for at least 16 days within the 30-dayperiod that began on October 21 (15 daysbefore the ex-dividend date). Since you heldthe stock for 16 days, from November 4 untilNovember 19, you are entitled to the credit.

Example 2. The facts are the same as inexample 1 except that you sold the stock onNovember 14. You held the stock for only 11days. You are not entitled to the credit.

Exception. If you are a securities dealer,actively conducting business in a foreigncountry, you may be able to claim a foreigntax credit for qualified taxes paid on dividendsregardless of your holding period. See section901(k)(4) of the Internal Revenue Code forinformation.

How To Figurethe CreditAs already indicated, you can claim a foreigntax credit only for foreign taxes on income,war profits, or excess profits, or taxes in lieuof those taxes. In addition, there is a limit onthe amount of the credit that you can claim.You figure this limit and your credit on Form1116. Your credit is the amount of foreign taxyou paid or accrued or, if smaller, the limit.

If you have foreign taxes available forcredit but you cannot use them because of

the limit, you may be able to carry them backto the 2 previous tax years and forward to thenext 5 tax years.

Also, certain tax treaties have specialrules that you must consider when figuringyour foreign tax credit. See Tax Treaties,later.

Limit on the CreditYour foreign tax credit cannot be more thanyour total U.S. tax multiplied by a fraction. Thenumerator (top part) of the fraction is yourtaxable income from sources outside theUnited States. The denominator (bottom part)is your total taxable income from all domesticand foreign sources.

To determine the limit, you must separateyour foreign source income into categories,as discussed under Separate Limit Income.The limit treats all foreign income and ex-penses in each separate category as a singleunit and limits the credit to the U.S. incometax on the taxable income in that categoryfrom all sources outside the United States.

In determining your taxable income fromsources outside the United States, incomefrom the countries listed in Table 1, earlier, istreated as a separate category. You cannotclaim a credit for the taxes on that income.However, that income is taxable in the UnitedStates. Therefore, you must include it in totaltaxable income from all domestic and foreignsources.

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Revenue Code (relating to certain passiveforeign investment companies).

If you receive foreign source distributionsfrom a mutual fund that elects to passthrough to you the foreign tax credit, the in-come is generally considered passive. Themutual fund will need to provide you with thisinformation.

What is not passive income. Passive in-come does not include gains from the saleof inventory property or property held mainly

for sale to customers in the ordinary courseof your trade or business. Passive incomealso does not include export financing inter-est, high-taxed income, active business rentsand royalties from unrelated persons, or anyincome that is defined in another separatelimit category.

Export financing interest. This is inter-est derived from financing the sale or otherdisposition of property for use outside theUnited States if:

1) The property is manufactured orproduced in the United States, and

2) 50% or less of the value of the propertyis due to imports to the United States.

High-taxed income. This is passive in-come subject to foreign taxes that are higherthan the highest U.S. tax rate that can beimposed on the income. The high-taxed in-come and the taxes imposed on it are movedfrom the passive income category into thegeneral limitation income category.

High Withholding Tax InterestHigh withholding tax interest is interest (ex-cept export financing interest) that is subjectto a foreign withholding tax or other tax de-termined on a gross basis of at least 5%. Ifinterest is not high withholding tax interestbecause it is export financing interest, it isusually general limitation income. However,if it is received by a financial services entity,

it is financial services income.

Financial Services IncomeFinancial services income generally is incomereceived or accrued by a financial servicesentity. This is an entity predominately en-gaged in the active conduct of a banking, fi-nancing, insurance, or similar business. Ifyou qualify as a financial services entity, fi-nancial services income includes income fromthe active conduct of such business, passiveincome, certain incidental income, and exportfinancing interest which is subject to a foreignwithholding or gross-basis tax of at least 5%.Financial services income does not includeany export financing interest or high with-

holding tax interest (except, as noted above,when the export financing interest is subjectto a high withholding tax and is received bya financial services entity).

Effective on August 5, 1997, financialservices income includes high-taxed income,discussed earlier.

Shipping IncomeThis is income derived from, or in connectionwith, the use (or hiring or leasing for use) ofany aircraft or vessel in foreign commerce orincome derived from space or ocean activ-ities. It also includes income from the sale orother disposition of these aircraft or vessels.Shipping income that is also financial services

income is treated as financial services in-come.

DISC DividendsThis dividend income generally consists ofdividends from an interest charge domesticinternational sales corporation (DISC) or for-mer DISC that are treated as foreign sourceincome.

FSC Distributions

These are:

1) Distributions from a foreign sales corpo-ration (FSC) or former FSC out ofearnings and profits attributable to for-eign trade income, or

2) Interest and carrying charges incurredby an FSC or former FSC from a trans-action that results in foreign trade in-come.

Lump-Sum DistributionIf you receive a foreign-source lump-sumdistribution (LSD) from a retirement plan, andyou figure the tax on it using the special av-eraging treatment for LSDs, you must make

a special computation.

TIP

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

Follow the Form 1116 instructions andcomplete the worksheet in those instructionsto determine your foreign tax credit on theLSD.

General Limitation IncomeThis is income from sources outside theUnited States that does not fall into one of theother separate limit categories. It generallyincludes active business income as well aswages, salaries, and overseas allowances of

an individual as an employee.

Allocation of Foreign TaxesIf you have paid or accrued foreign incometax for a tax year on income in more than oneseparate limit income category, but the tax isnot specifically related to any one category,you must allocate the tax to each categoryof income.

You do this by multiplying the foreign in-come tax related to more than one categoryby a fraction. The numerator of the fraction isthe net income in a separate category. Thedenominator is the total net foreign income.

You figure net income by deducting fromthe gross income in each category and from

the total foreign income any expenses,losses, and other deductions definitely relatedto them under the laws of the foreign countryor U.S. possession. If the expenses, losses,and other deductions are not definitely relatedto a category of income under foreign law,they are apportioned under the principles ofthe foreign law. If the foreign law does notrelate the expenses to a particular categoryof income and does not provide for appor-tionment, use the principles covered in theU.S. Internal Revenue Code.

Example. You paid foreign income taxesof $3,200 to Country A on wages of $80,000and interest income of $3,000. These werethe only items of income on your foreign re-

turn. You also have deductions of $4,400 that,under foreign law, are not definitely related toeither the wages or interest income.

Because the foreign tax is not specificallyfor either item of income, you must allocatethe tax between the wages and the interestunder the tax laws of Country A. For purposesof this example, assume that the laws ofCountry A do this in a manner similar to theU.S. Internal Revenue Code. First figure thenet income in each category by allocatingthose expenses that are not definitely relatedto either category of income. You figure theexpenses allocable to wages (general limita-tion income) as follows:

$4,400$80,000 (wages)

$83,000 (total income)= $4,241

The net wages are $75,759 ($80,000 $4,241).

You figure the expenses allocable to in-terest (passive income) as follows:

$4,400$3,000 (interest)

$83,000 (total income)= $159

The net interest is $2,841 ($3,000 $159).Then, to figure the foreign tax on the

wages, you multiply the total foreign incometax by the following fraction:

$3,200$75,759 (net wages)

$78,600 (total net income)= $3,084

You figure the foreign tax on the interestincome as follows:

$3,200$2,841 (net interest)

$78,600 (total net income)= $116

Foreign Taxes From aPartnershipIf you are a partner in a partnership that hasforeign income and the partnership paid oraccrued foreign income tax, you will figure

your credit using certain information from theSchedule K1 you received from the partner-ship. To figure your credit, you will need torefer to lines 17a through 17g on the Sched-ule K1. Line 17e is the foreign tax that waspaid or accrued on your behalf by the part-nership.

S corporation. If you own stock in an Scorporation and receive a Schedule K1(Form 1120S), you will find this informationabout foreign taxes on lines 15a through 15g.

Figuring the LimitFor each category of income, you must figure:

1) Your taxable income from sources out-side the United States, and

2) Your total taxable income from allsources.

You must do this before you can determinethe limit on your credit.

Taxable income. Your taxable income isgross income less any deductions that apply.

For this computation, do not include inyour gross income any earned income that isexempt from tax under the foreign earned in-come exclusion or the foreign housing exclu-sion. These exclusions from income are dis-cussed in detail in Publication 54.

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Table 3. Source of Income

Item of Income Factor Determining Source

Salaries, wages, other compensationBusiness income:

Personal servicesSale of inventory purchased

Interest

Dividends

RentsRoyalties:

Natural resourcesPatents, copyrights, etc.

Sale of real property

Sale of personal property

Pensions

Where services performedWhere sold

Residence of payer

Whether a U.S. or foreign corporation1

Location of propertyWhere property is used

Sellers tax home (but see the discussionunder Capital Gains and Losses, later,for exceptions)

Where services were performed that earnedthe pension

1Exceptions include:a) Dividends paid by a U.S. Corporation are foreign source if the corporation elects the Puerto Rico

economic activity credit or possessions tax credit.b) Part of a dividend paid by a foreign corporation is U.S. source if at least 25% of the corporations grossincome is effectively connected with a U.S. trade or business for the 3 tax years before the year in whichthe dividends are paid.

Location of property

Location of property

Where services performed

Sale of inventory produced Allocation

Sale of natural resources Allocation

you must apportionthe definitely related de-ductions within that class of gross income.

To apportion, you can use any methodthat reflects a reasonable relationship be-tween the deduction and the income in eachseparate limit category. One acceptablemethod for many individuals is based on acomparison of the gross income in a class ofincome to the gross income in a separate limitincome category.

Use the following formula to figure theamount of the definitely related deductionapportioned to the income in the separatelimit category:

deductionGross income in separate limit category

Total gross income in the class

Do not take exempt income into accountwhen you apportion the deduction. However,income excluded under the foreign earnedincome or foreign housing exclusion is notconsidered exempt. You must, therefore,apportion deductions to that income.

Interest expense. Generally, you apportionyour interest expense on the basis of yourassets. However, certain special rules apply.If you have gross foreign source income (in-cluding income that is excluded under the

foreign earned income exclusion ) of $5,000or less, your interest expense can be appor-tioned entirely to domestic source income.

Business interest. Apportion interest in-curred in a trade or business using the assetmethod based on your business assets.

Under the asset method, you apportionthe interest expense to your separate limitcategories based on the value of the assetsthat produced the income. You can value as-sets at fair market value or the tax book value.

Investment interest. Apportion this in-terest on the basis of your investment assets.

Passive activity interest. Apportion in-terest incurred in a passive activity on thebasis of your passive activity assets.

Home mortgage interest. This is your

deductible home mortgage interest fromSchedule A (Form 1040). Apportion it undera gross income method, taking into accountall income (including business, passive activ-ity, and investment income), but excludingincome that is exempt under the foreignearned income exclusion. The gross incomemethod is based on a comparison of thegross income in a separate limit category withtotal gross income.

The Instructions for Form 1116 have aworksheet for apportioning your deductiblehome mortgage interest expense.

For this purpose, however, any qualifiedresidence that is rented is considered a busi-ness asset for the period in which it is rented.You therefore apportion this interest under therules for passive activity or trade or businessinterest.

Example. You are engaged in a businessthat you operate as a sole proprietorship.Your business generates only U.S. sourceincome. Your investment portfolio consists ofseveral less than 10% stock investments. Youhave stocks with an adjusted basis of$100,000. Some of your stocks (with an ad-

justed basis of $40,000) generate U.S. sourceincome; your other stocks (with an adjustedbasis of $60,000) generate foreign passiveincome. You own your main home, which issubject to a mortgage of $120,000. Intereston this loan is home mortgage interest. Youalso have a bank loan in the amount of

Self-employed. If you are self-employed,the type of business or profession you are indetermines what you must include in grossincome. If you are in a manufacturing, selling,or mining business, gross income is grossprofit (gross receipts less cost of goods sold).If you are in a business of providing services,then gross income is gross receipts.

Determiningthe Source of IncomeBefore you can figure your taxable income ineach category from sources outside theUnited States, you must first determinewhether your gross income in each categoryis from U.S. sources or foreign sources.Some of the general rules for figuring thesource of income are outlined in Table 3.

Determining Taxable IncomeFrom Sources Outside the UnitedStatesTo figure your taxable income in each cate-gory from sources outside the United States,you first allocate to specific classes (kinds)of gross income the expenses, losses, andother deductions (including the deduction forforeign housing costs) that are definitely re-latedto that income.

Definitely related. A deduction is definitelyrelated to a specific class of gross income ifit is incurred either:

1) As a result of, or incident to, an activityfrom which that income is derived, or

2) In connection with property from whichthat income is derived.

Classes of gross income. You must deter-mine which of the following classes of grossincome your deductions are definitely relatedto:

1) Compensation for services, includingwages, salaries, fees, and commissions,

2) Gross income from business,

3) Gains from dealings in property,

4) Interest,

5) Rents,

6) Royalties,

7) Dividends,

8) Alimony and separate maintenance,

9) Annuities,

10) Pensions,

11) Income from life insurance and endow-ment contracts,

12) Income from cancelled debts,

13) Your share of partnership gross income,

14) Income in respect of a decedent, and

15) Income from an estate or trust.

Exempt income. When you allocate de-ductions that are definitely related to one ormore classes of gross income, you take ex-empt income into account for the allocation.However, do not take exempt income into

account to apportion deductions that are notdefinitely related to a separate limit category.

Interest expense and state incometaxes. You must allocate and apportion yourinterest expense and state income taxes un-der the special rules discussed later underInterest expenseand State income taxes.

Class of gross income that includesmore than one separate limit category. Ifthe class of gross income to which a de-duction definitely relates includes either:

1) More than one separate limit category,or

2) At least one separate limit category andU.S. source income,

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$40,000. The proceeds were divided equallybetween your business and your investmentportfolio. Your gross income from your busi-ness is $50,000. Your investment portfoliogenerated $4,000 in U.S. source income and$6,000 in foreign source passive income. Allof your debts bear interest at the annual rateof 10%.

The interest expense for your business is$2,000. It is apportioned on the basis of thebusiness assets. All of your business assetsgenerate U.S. source income; therefore, theyare U.S. assets. The $2,000 in interest ex-pense on the business loan is allocable toU.S. source income.

The interest expense for your investmentsis also $2,000. It is apportioned on the basisof investment assets. Your assets consist ofstock (adjusted basis, $40,000) generatingU.S. source income and stock (adjusted ba-sis, $60,000) generating foreign source pas-sive income. For purposes of figuring the limiton the foreign tax credit, 40%($40,000/$100,000) or $800 (40% of $2,000)of your investment interest is apportioned toU.S. source income and 60%($60,000/$100,000) or $1,200 (60% of$2,000) is apportioned to foreign passive in-come.

Your home mortgage interest expense is

$12,000. It is apportioned on the basis of allyour gross income. Your gross income con-sists of $60,000, $54,000 of which is U.S.source income and $6,000 of which is foreignsource passive income. Thus, $1,200($6,000/$60,000 $12,000) of the homemortgage interest is apportioned to foreignsource passive income.

State income taxes. State income taxes(and certain taxes measured by taxable in-come) are definitely related and allocable tothe gross income on which the taxes are im-posed. If you pay this kind of state tax and itis imposed in part on foreign source income,the part of your state tax imposed on the for-eign source income is definitely related and

allocable to foreign source income.Foreign income not exempt from state

tax. If the state does not specifically exemptforeign income from tax, the following aretrue:

1) If the total income taxed by the state isgreater thanthe amount of U.S. sourceincome for federal tax purposes, then thestate tax is allocable to both U.S. sourceand foreign source income.

2) If the total income taxed by the state isless than or equal tothe U.S. sourceincome for federal tax purposes, noneof the state tax is allocable to foreignsource income.

Foreign income exempt from state tax.If state law specifically exempts foreign in-come from tax, the state taxes are definitelyallocable to the U.S. source income.

Example. Your total income for federaltax purposes, before deducting state tax, is$100,000. Of this amount, $25,000 is foreignsource income and $75,000 is U.S. sourceincome. Your total income for state tax pur-poses is $90,000, on which you pay state in-come tax of $6,000. The state does not spe-cifically exempt foreign source income fromtax. The total state income of $90,000 isgreater than the U.S. source income for fed-eral tax purposes. Therefore, the $6,000 is

definitely related and allocable to gross in-come that includes foreign source income.

Assuming that $15,000 ($90,000 $75,000) is the foreign source income taxedby the state, $1,000 of state income tax isallocated to foreign source income, figuredas follows:

$6,000$15,000

$90,000= $1,000

Deductions not definitely related. Youmust apportion to your foreign income in eachseparate limit category a fraction of yourother expenses that are not definitely relatedto a specific class of gross income. If youitemize, these deductions are medical ex-penses, charitable contributions, and real es-tate taxes for your home. If you do not item-ize, this is your standard deduction. Inaddition to those amounts, you should takeinto account any other deductions that are notdefinitely related to a specific class of income,including amounts shown on Form 1040, lines2330a.

The numerator of the fraction is yourgross foreign income in the separate limitcategory, and the denominator is your totalgross income from all sources. For this pur-

pose, gross income includes income that isexcluded under the foreign earned incomeprovisions.

Itemized deduction limit. For 1997, youmay have to reduce your itemized deductionsif your adjusted gross income is more than$121,200 ($60,600 if married filing sepa-rately). This reduction does not apply tomedical and dental expenses, casualty andtheft losses, gambling losses, and investmentinterest.

You figure the reduction by using theItemized Deduction Worksheet in the in-structions for Schedule A (Form 1040). Line3 of the worksheet shows the total itemizeddeductions subject to the reduction. Line 9

shows the amount of the reduction.To determine your taxable income from

sources outside the United States, you mustfirst divide the reduction (line 9 of the work-sheet) by the deductions subject to the re-duction (line 3 of the worksheet). This is yourreduction percentage. Then, multiply the de-duction shown on Schedule A (Form 1040)by your reduction percentage. Subtract theresult from the deduction shown on ScheduleA to determine the amount you can allocateto income from sources outside the UnitedStates.

Example. You are single and have anadjusted gross income of $150,000. This isthe amount on line 5 of the worksheet. Youritemized deductions other than medical anddental expenses, casualty and theft losses,gambling losses, and investment interest total$20,000. This is the amount on line 3 of theworksheet. Reduce your adjusted gross in-come (line 5) by $121,200. Enter the result($28,800) on line 7. The amount on line 8 is$864 ($28,800 3%). This amount is alsoentered on line 9.

You have a charitable contribution de-duction of $12,000 shown on Schedule A(Form 1040) that is subject to the reduction.Your reduction percentage is 4.3%($864/$20,000). You must reduce your$12,000 deduction by $516 (4.3% $12,000).The reduced deduction, $11,484 ($12,000 $516), is used to determine your taxable in-

come from sources outside the United States.

Treatment of personal exemptions. Do nottake the deduction for personal exemptions,including exemptions for dependents, in fig-uring taxable income from sources outsidethe United States.

Taxable income from all sources. You alsofigure your total taxable income from allsources without regard to personal ex-

emptions, including exemptions for depen-dents. You get this figure from line 36, Form1040.

U.S. tax liability. You figure your U.S. taxliability on your taxable income, figured bytaking into account the deduction for personalexemptions and exemptions for dependents.You use the amount on line 39, Form 1040,less any amounts on lines 40, 41, 42, andany mortgage interest credit and District ofColumbia first-time homebuyer credit on line44 of Form 1040.

Example of Figuring the LimitChris Smith is single, under 65, and has been

a bona fide resident of Country A for 5 years.Chris earned a salary of $85,000 in CountryA. He also had interest income of $5,000 frominvestments in that country on which he paidan investment counseling fee of $700. Chrispaid income tax to Country A on theseamounts. In addition, he received $5,000dividend income from sources in the UnitedStates. Chris contributed $500 to his churchand other charitable organizations in theUnited States. He paid $1,500 real estatetaxes on his residence in Country A, anddeductible interest of $2,500 on his mortgagein Country A.

Chris' income subject to U.S. tax is thetotal received from all sources. However, fromthe $85,000 salary received in Country A, heexcludes $70,000 under the foreign earnedincome exclusion. His adjusted gross incomeis $25,000. Chris' salary is in the generallimitation income category. His interest in-come is in the passive income category.Therefore, he needs to figure two limits. Thelimits on Chris' salary and interest income are$1,529 and $548, respectively, as shown inTable 4.

Capital Gains and LossesIf you show a capital gain on both lines 16and 17 of Schedule D (Form 1040), you mustadjust the denominator of your limiting frac-tion. Complete the Worksheet for Line 17,found in the Form 1116 instructions, to figureyour adjusted denominator.

If you have any foreign source capital gainor loss, you must adjust the denominator ofyour limiting fraction. See Adjustment forForeign Source Capital Gains and Losseslater.

Foreign source capital gain. Your taxableincome from foreign sources in a separatelimit category (the numerator of the limitingfraction) includes gains from the sale or ex-change of capital assets up to the amount offoreign source capital gain net income.Your taxable income from all sources (thedenominator of the fraction) includes gainsfrom the sale or exchange of capital assetsup to the amount of capital gain net income.

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Table 4. Chris Smith Example

Chris computes his Form 1040 U.S. tax liability as follows.A.

B.

C.D.

E.

F.

Income Subject to U.S. Tax1)2)3)4)5)6)

Salary (Country A)Less: Foreign earned income exclusionSalary includible in U.S. federal tax returnInterest (Country A)Dividends (United States)Adjusted gross income

Less: Itemized DeductionsContributions (United States)Taxes on residence (Country A)

Home mortgage interest (Country A)Investment counselling fee (Country A) ($700 - 500, 2% of AGI)Total itemized deductions

Taxable Income Before Personal ExemptionLess: Personal Exemption

Taxable Income

U.S. Tax Liability from Tax Table under Single Column

$85,00070,000

$15,0005,0005,000

$25,000

$ 5001,500

2,500200

4,700

$20,3002,650

$17,650

$2,651

1)2)

3)4)5)

Chris computes his Form 1116 taxable general limitation income from Country A as follows.G. Computation of Taxable Income from Country A (General Limitation Income)

1)

2)

3)4)

5)

6)

7)8)

General limitation income from Country A includible in U.S. federalincome tax return (Line A(3)) $15,000Home mortgage interest apportioned to general limitationincome (Line B(3))

$2,500 $15,000$25,000

1,500

Total itemized deductions (Line B(5)) $4,700Less: Home mortgage interest, plus itemizeddeductions definitely related to specific incomeitems (Lines B(3) and (4)) 2,700

Itemized deductions to be apportioned $2,000

Ratable part of $2,000 applicable to general limitation income

$2,000 $85,000 (Lines A(2) and G(1))$95,000 (Lines A(2) and A(6))

1,789

Total deductions that apply to general limitation income 3,289Taxable income in general limitation income category $11,711

Chris computes his Form 1116 taxable passive income from Country A as follows. (Aseparate Form 1116 is needed for each category of income.)H. Computation of Taxable Income from Country A (Passive Income)

1)

2)3)

4)5)

6)

7)

8)9)

Passive income from Country A includible in U.S. federal income taxreturn (Line A(4))Expenses definitely related to passive income (Line B(4))Home mortgage interest apportioned to passive income(Line B(3))

$2,500 $ 5,000$25,000

Total itemized deductions (Line B(5))Less: Home mortgage interest, plus itemizeddeductions definitely related to specific incomeitems (Lines B(3) and (4))Itemized deductions to be apportioned

Ratable part of $2,000 applicable to income category

$2,000 $5,000 (Line A(4))

$95,000 (Lines A(2) and A(6))Total deductions that apply to passive incomeTaxable income in passive income category

$5,000$200

500

$4,700

2,700$2,000

105

805$4,195

Chris computes his credit limit for each category of income. (See discussion of thiscalculation earlier under Limit on the Credit.)I.

J.

K.

Computation of Taxable Income from All Sources for Purposes of theForeign Tax CreditTaxable income from all sources (Line C)Computation of the Limit on Foreign Tax Credit Allowable (GeneralLimitation Income)$11,711 (Line G(8))$20,300 (Line I)

$2,651 (Line F)

Computation of the Limit on Foreign Tax Credit Allowable (PassiveIncome)$4,195 (Line H(9))$20,300 (Line I)

$2,651 (Line F)

$20,300

$ 1,529

548$

Foreign source capital gain net income.Foreign source capital gain net income for aseparate limit category is the lesser of:

1) Capital gain net income from foreignsources in the separate limit category,or

2) Capital gain net income from all sourcesin that category.

Capital gain net income. This is the ex-cess of your gains from sales or exchanges

of capital assets over your losses from salesor exchanges of capital assets. This includesnet section 1231 gain.

Capital asset. Generally, everything youown and use for personal purposes or in-vestment is a capital asset. Some examplesare: stocks or bonds held in your personalaccount, a home owned and occupied by youand your family, household furnishings, a carused for pleasure or commuting, coin orstamp collections, gems and jewelry, andgold, silver, or any other metal.

Net section 1231 gain. Section 1231property includes property used in a trade orbusiness and held more than one year. It alsoincludes any capital asset held in connectionwith a trade or business or a transaction en-tered into for profit that is subjected to an in-

voluntary conversion, if held for more thanone year. You combine all gains and lossesfrom the sales and dispositions of section1231 property for the tax year. If your section1231 gains exceed your section 1231 losses,you have a net section 1231 gain. For moreinformation on these gains, see Publication544, Sales and Other Dispositions of Assets.

Example. You are a U.S. citizen and livein Country X. You had a $10,000 long-termcapital gain and a $2,000 long-term capitalloss from sales of foreign corporate stockthrough Country X's stock exchange. This isincome in the passive category. You also hada $6,000 long-term capital loss from U.S.sources. Your foreign source capital gain net

income is $2,000, the lesser of (1) or (2):

When figuring the limit in your passive incomecategory, the amount to include in the nu-merator of the limiting fraction is $2,000. Theamount to include in the denominator is also$2,000, capital gain net income from allsources. However, these amounts will haveto be adjusted. See Adjustment for ForeignSource Capital Gains and Losseslater.

Foreign source capital loss. Your taxableincome from foreign sources in a separatelimit category (the numerator of the limitingfraction) is reduced by any net capital lossfrom foreign sources in that category, to theextent taken into account in figuring yourcapital gain net income. For this purpose,your net capital loss is the total of your lossesfrom the sale or exchange of capital assetsand any capital loss carryover less your cap-

1) Capital gain net income from foreign sources:

Long-term capital gainCountry X $10,000

Long-term capital lossCountry X (2,000)

Capital gain net income from foreign

sources (passive income category) $8,000

2) Capital gain net income from all sources:

Long-term capital gainCountry X $10,000

Long-term capital lossCountry X (2,000)

Long-term capital lossU.S. (6,000)

Capital gain net income from all sources $2,000

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ital loss deduction limit for the tax year. Gen-erally your capital loss deduction limit is$3,000 ($1,500 if married filing separately).

When figuring net capital loss, includegains and losses that are not from the saleor exchange of capital assets but that aretreated as capital gains and losses, such asnet section 1231 gains.

Sales or exchanges of certain personalproperty. Generally, if personal property issold by a U.S. resident, the income from thesale is treated as U.S. sourced. If sold by anonresident, the income is treated as foreignsourced.

U.S. resident. The term U.S. resident,for this purpose, means a U.S. citizen or res-ident alien who does not have a tax home ina foreign country. The term also includes anonresident alien who has a tax home in theUnited States. Generally, your tax home is thegeneral area of your main place of business,employment, or post of duty, regardless ofwhere you maintain your family home. Yourtax home is the place where you are perma-nently or indefinitely engaged to work as anemployee or self-employed individual. If youdo not have a regular or main place of busi-ness because of the nature of your work, then

your tax home is the place where you regu-larly live. If you do not fit either of these cat-egories, you are considered an itinerant andyour tax home is wherever you work.

Nonresident. A nonresident is any per-son other than a U.S. resident.

U.S. citizens and resident aliens will notbe treated as nonresidents for a sale of per-sonal property unless an income tax of atleast 10% of the gain on the sale is paid to aforeign country.

Inventory. Income from the sale of in-ventory that you purchased is sourced wherethe property is sold. Generally, this is wheretitle to the property passes to the buyer.

Income from the sale of inventory that youproduced in the United States and sold out-

side the United States (or vice versa) issourced based on an allocation. For informa-tion on making the allocation, see section1.8633 of the Income Tax Regulations.

Intangibles. Income from the sale of in-tangible property (such as a patent, copyright,trademark, or goodwill) that is contingent onthe productivity, use, or disposition of theproperty is sourced in the country where theproperty is used. Payments for goodwill aresourced in the country where the goodwillwas generated.

Depreciable property. The gain from thesale of depreciable personal property, up tothe amount of the previously allowable de-preciation, is sourced in the same way as theoriginal deductions were sourced. Thus, tothe extent the previous deductions for depre-

ciation were allocable to U.S. source income,the gain is U.S. source. To the extent thedepreciation deductions were allocable toforeign sources, the gain is foreign sourceincome. Gain in excess of the depreciationdeductions is sourced the same as inventory.

If personal property is used predomi-nantly in the United States, treat the gainfrom the sale, up to the amount of the allow-able depreciation deductions, entirely as U.S.source income.

If the property is used predominantlyoutside the United States, treat the gain, up

to the amount of the depreciation deductions,entirely as foreign source income.

Depreciation includes amortization andany other allowable deduction that treats acapital expenditure as a deductible expense.

Sales through foreign office or fixedplace of business. Income earned by U.S.residents from the sale of personal propertythrough an office or other fixed place of busi-ness outside the United States is generallytreated as foreign source if:

1) The income from the sale is from thebusiness operations located outside theUnited States, and

2) At least 10% of the income is paid as taxto the foreign country.

If less than 10% is paid as tax, the income isU.S. source.

This rule does not apply to incomesourced under the rules for inventory prop-erty, depreciable personal property, intangibleproperty (when payments in consideration forthe sale are contingent on the productivity,use, or disposition of the property), or good-will.

Adjustment for Foreign SourceCapital Gains and LossesIf you had a foreign source capital gain orloss, you must adjust the numerator of thelimiting fraction. The Form 1116 instructionscontain worksheets for figuring the adjust-ments.

CAUTION

!If you show a foreign or domesticsource capital gain on both lines 16and 17 of Schedule D (Form 1040),

you must adjust the denominator of your lim-iting fraction. Complete the Worksheet forLine 17 found in the Form 1116 instructionsto figure your adjusted denominator.

Foreign Schedule D. If you had a foreignsource capital gain or loss, you must com-plete a separate Schedule D using only yourforeign source capital gains and losses. Onthis foreign Schedule D, complete Parts I,II, and III.

If Part lll, line 17, is a gain, complete PartlV (through line 50) of that Schedule D. Alsocomplete Worksheet A (Capital Gains) in theinstructions for Form 1116.

If Part lll, line 17, is a loss, you can us

us internal revenue service: p514--1997

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