Foreign Tax Credit Compliance Tips
Foreign Source Qualified Dividends and Gains
If you have received foreign sourced qualified dividends and/or capital gains (including long-term capital gains, unrecaptured section 1250 gain, and/or section 1231 gains) that are taxed in the U.S. at a reduced tax rate, you must adjust the foreign source income that you report on Form 1116, Foreign Tax Credit (Individual, Estate, or Trust), line 1a.
How do I make the adjustment?
- Form 1116 Instructions - See the detailed instructions for “Foreign Qualified Dividends and Capital Gains (Losses)”.
- Generally, if the foreign source income was taxed at the 0% rate, then you must exclude the income from your foreign source income (Form 1116 line 1a).
- Generally, if the foreign sourced income was taxed at the 15% rate, then you must multiply that foreign sourced income by 0.3788 and include only that amount in your foreign source income on Form 1116, line 1a.
- Generally, if the foreign source income was taxed at the 20% rate, then you must multiply that foreign source income by 0.5051 and include only that amount in your foreign source income on Form 1116, line 1a.
- See Publication 514, Foreign Tax Credit for Individuals, for more information on the rate differential adjustment.
I received a Schedule K-1 that reports qualified dividends and/or capital gains and foreign source income. What amount do I include on Form 1116, line 1a as foreign source income?
- The flow through entity should provide details of any qualified dividends and/or capital gains that have been included on the Foreign Transactions reporting line (the 2015 Partnership Schedule K-1 line 16 or the 2015 S Corporation Schedule K-1 line 14) as income to be sourced at the partner level or foreign income already sourced at the partnership level.
- If Schedule K-1 reports qualified dividends and/or capital gains and foreign source income, but does not provide the necessary detail to determine the amount of the qualified dividends and/or capital gains that is foreign source income, you should contact the partnership or S corporation for the necessary details.
- Any foreign source qualified dividends and/or capital gains reported on Schedule K-1 will require the adjustments discussed above in "How do I make the adjustment?."
Interest Expense Apportioned
You must apportion interest expense between the U.S. and foreign source income using an asset method. See Publication 514, Foreign Tax Credit for Individuals, for more information on the asset methods.
Am I required to apportion interest expense even if I borrow the money in the U.S.?
Yes. Money is fungible - it can be borrowed anywhere, and it can be spent or invested anywhere and for any purpose. For this reason, you are required to apportion all interest expense between the U.S. and foreign source income.
What types of interest expense am I required to apportion?
All interest expense must be apportioned between both the U.S. and foreign source income. This includes home mortgage interest, business interest, investment interest expense, passive activity interest, and partnership interest.
Is there a de minimis exception to the interest apportionment rules?
Yes. If you are a U.S. citizen, resident alien, or domestic estate, and your gross foreign source income (including any income excluded on Form 2555 or Form 2555-EZ) does not exceed $5,000, you can allocate all of your interest expense to U.S. source income.
Where do I report the apportioned interest expense?
Interest expense that has been apportioned to foreign source income is reported on Form 1116, lines 4a and 4b.
My Schedule K-1 reports interest expense. How do I apportion that?
- You must apportion the interest expense that has been reported on Schedule K-1, line 16G (the 2015 partnership Form 1065)) and line 14G (the 2015 S corporation Form 1120-S).
- See Publication 514 for the general rules on apportioning interest expense that has been reported to you on Schedule K-1.
Do I need to apportion charitable contributions against foreign source income?
- Maybe. Charitable contributions generally DO NOT reduce your foreign source income.
- However, if you make a charitable contribution to a charity organized in Mexico, Canada, or Israel, then you must apportion the contribution against your foreign source income, based on gross income.
- See Publication 514 for rules on apportioning expenses against foreign source income.
Foreign Tax Withheld and Income Tax Treaties
The amount of foreign tax that qualifies as a credit is not necessarily the amount of tax withheld by the foreign country. If you are entitled to a reduced rate of foreign tax based on an income tax treaty between the United States and a foreign country, only that reduced tax qualifies for the credit. Include on Form 1116 Part II ONLY the amount of creditable taxes. Amounts for which you are not legally liable (such as taxes in excess of the treaty rate) should be excluded from the amount reported in Part II.
Foreign Tax Redetermination
If a foreign tax redetermination occurs, you must also redetermine your U.S. tax liability in most situations. You must file a Form 1040X (Form 1120X for corporations). Failure to notify the IRS of a foreign tax redetermination can result in a failure to notify penalty.
Tools and Links
For more information on claiming a foreign tax credit, the following information is available:
International Information on Help with Tax Questions on irs.gov
Form 1116 Foreign Tax Credit
Form 1118 Foreign Tax Credit - Corporations
Foreign Tax Credit