Foreign Tax Credit Compliance Tips

 

Foreign Source Qualified Dividends and Gains

If you receive foreign source 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 is taxed at the 0% rate, then you must exclude the income from your foreign source income (Form 1116, line 1a).
  • Generally, if the foreign source income is taxed at the 15% rate, then you must multiply that foreign sourced income by 0.4054 and include only that amount in your foreign source income on Form 1116, line 1a.
  • Generally, if the foreign source income is taxed at the 20% rate, then you must multiply that foreign source income by 0.5405 and include only that amount in your foreign source income on Form 1116, line 1a.
  • Generally, if the foreign source income is taxed at the 25% rate, then you must multiply that foreign source income by 0.6757 and include only that amount in your foreign source income on Form 1116, line 1a.
  • Generally, if the foreign source income is taxed at the 28% rate, then you must multiply that foreign source income by 0.7568 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 for the applicable year. Note: The above rate differential factors are taken from the 2021 Publication 514.

I received a Schedule K-1, along with Schedule K-3, that reports qualified dividends and/or long-term capital gains and foreign source income.  What amount do I include on Form 1116, line 1a as foreign source income?

  • The partnership or S corporation should provide details of any qualified dividends and/or long-term capital gains that have been included.  Beginning in 2021, foreign transactions are reported on Schedule K-3. Boxes on line 16 of Schedule K-1 (2021 Form 1065) and line 14 of Schedule K-1 (2021 Form 1120-S). will be checked if Schedule K-3 is attached to your Schedule K-1.  Qualified dividends are reported in Part II line 8 and long-term capital gains are reported in Part II line 12 as income to be sourced at the partner level or foreign income already sourced at the partnership level.
  • Any foreign source qualified dividends and/or long-term capital gains reported on Schedule K-3 will require the adjustments discussed above in "How do I make the adjustment?"

Interest Expense Apportioned

  • You must apportion interest expense between U.S. and foreign source income, unless the de minimis exception applies. See Is there a de minimis exception to the interest apportionment rules below.  In most cases, you apportion your interest expense on the basis of your assets. using an asset method. However, certain special rules may apply, See Publication 514, Foreign Tax Credit for Individuals, for more information on the allocation and apportionment of interest expense.

Am I required to apportion interest expense even if I borrow the money in the U.S.?

  • Yes. Money is fungible. Money can be borrowed anywhere, and it can be spent or invested anywhere for any purpose. For this reason, you are required to apportion all interest expense between U.S. and foreign source income.

What types of interest expense am I required to apportion?

  • All interest expense must be apportioned between both 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 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.

Charitable Contributions

Do I need to apportion charitable contributions to 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, you must apportion the contribution  to your foreign source income, based on gross income. See Publication 526, Charitable Contributions.
  • See Publication 514 for rules on apportioning expenses  to 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 a  foreign country. If you are entitled to a reduced rate of foreign tax based on an income tax treaty between  two countries, only the lower rate qualifies for the credit.  Only include the amount of creditable taxes on Form 1116 Part II.  Amounts for which you are not legally liable (including taxes in excess of the treaty rate) should be excluded from the amount reported in Part II.

Foreign Tax Redetermination

A foreign tax redetermination is any change in your foreign tax liability that may affect your U.S. foreign tax credit claimed. If this occurs, you must redetermine your U.S. tax liability in most situations. Generally, you must file Form 1040-X, Amended U.S. Individual Income Tax Return, with a revised Form 1116 along with proper documentation. Failure to notify the IRS of a foreign tax redetermination can result in a failure to notify penalty. See Publication 514, Foreign Tax Credit for Individuals, for required documentation.

Tools and Links

For more information on claiming a foreign tax credit, the following information is available:

 

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