Accrual method of accounting.

If you use an accrual method of accounting, you can claim the credit only in the year in which you accrue the tax. You are using an accrual method of accounting if you report income when you earn it, rather than when you receive it, and you deduct your expenses when you incur them, rather than when you pay them.

Foreign taxes generally accrue when all the events have taken place that fix the amount 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 the amount of foreign tax due is finally determined. However, if you choose to pay the tax liability you are contesting, you can take a credit for the amount you pay before a final determination of foreign tax liability is made. Once your liability is determined, the foreign tax credit is allowable for the year to which the foreign tax relates. If the amount of foreign taxes taken as a credit differs from the final foreign tax liability, you may have to adjust the credit, as discussed later under Foreign Tax Redetermination.

You may have to post a bond.

If you claim a credit for taxes accrued but not paid, you may have to post an income tax bond to guarantee your payment of any tax due in the event the amount of foreign tax paid differs from the amount claimed.

The IRS can request this bond at any time without regard to the Time Limit on Tax Assessment, discussed later under Carryback and Carryover.

Cash method of accounting.

If you use the cash method of accounting, you can choose to take the credit either in the year you pay the tax or in the year you accrue it. You are using the cash method of accounting if you report income in the year you actually or constructively receive it, and deduct expenses in the year you pay them.

Choosing to take credit in the year taxes accrue.

Even if you use the cash method of accounting, you can choose to take a credit for foreign taxes in the year they accrue. You make the choice by checking the box in Part II of Form 1116. Once you make that choice, you must follow it in all later years and take a credit for foreign taxes in the year they accrue.

In addition, the choice to take the credit when foreign taxes accrue applies to all foreign taxes qualified for the credit. You cannot take a credit for some foreign taxes when paid and take a credit for others when accrued.

If you make the choice to take the credit when foreign taxes accrue and pay them in a later year, you cannot claim a deduction for any part of the previously accrued taxes.

Credit based on taxes paid in earlier year.

If, in earlier years, you took the credit based on taxes paid, and this year you choose to take the credit based on taxes accrued, you may be able to take the credit this year for taxes from more than one year.

Translating foreign currency into U.S. dollars.

If you receive all or part of your income or pay some or all of your expenses in foreign currency, you must translate the foreign currency into U.S. dollars. How you do this depends on your functional currency. Your functional currency generally is the U.S. dollar unless you are required to use the currency of a foreign country.

You must make all federal income tax determinations in your functional currency. The U.S. dollar is the functional currency for all taxpayers except some qualified business units. A qualified business unit is a separate and clearly identified unit of a trade or business that maintains separate books and records. Unless you are self-employed, your functional currency is the U.S. dollar.

Even if you are self-employed and have a qualified business unit, your functional currency is the dollar if any of the following apply.

If your functional currency is the U.S. dollar, you must immediately translate into dollars all items of income, expense, etc., that you receive, pay, or accrue in a foreign currency and that will affect computation of your income tax. If there is more than one exchange rate, use the one that most properly reflects your income. You can generally get exchange rates from banks and U.S. Embassies.

If your functional currency is not the U.S. dollar, make all income tax determinations in your functional currency. At the end of the year, translate the results, such as income or loss, into U.S. dollars to report on your income tax return.

For more information, write to:

Rate of exchange for foreign taxes paid.

Use the rate of exchange in effect on the date you paid the foreign taxes to the foreign country unless you meet the exception discussed next. If your tax was withheld in foreign currency, you use the rate of exchange in effect for the date on which the tax was withheld. If you make foreign estimated tax payments, you use the rate of exchange in effect for the date on which you made the estimated tax payment.

Exception.

If you claim the credit for foreign taxes on an accrual basis, you must generally use the average exchange rate for the tax year to which the taxes relate. This rule applies to accrued taxes relating to tax years beginning after 1997 and only under the following conditions.

For all other foreign taxes, you should use the exchange rate in effect on the date you paid them.

Tax years beginning before 1998.

For tax years beginning before 1998, a redetermination of your U.S. tax liability is required if:

See Rate of exchange for foreign taxes paid, earlier, under Foreign Currency and Exchange Rates.

When redetermination of tax is not required.

A redetermination is not required if the change is due solely to an exchange rate fluctuation and the change in foreign tax liability for the tax year is less than the smaller of:

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

Tax years beginning after 1997.

For tax years beginning after 1997, a redetermination of your U.S. tax liability is required if:

If (2) above applies to you, you will not be allowed a credit for the unpaid taxes until you pay them. When you pay the accrued taxes, you must translate them into U.S. dollars using the exchange rate as of the date they were paid. The foreign tax credit is allowed for the year to which the foreign tax relates. See Rate of exchange for foreign taxes paid, earlier, under Foreign Currency and Exchange Rates.

Notice to the Internal Revenue Service (IRS) of redetermination.

You must file Form 1040X, Amended U.S. Individual Income Tax Return, and a revised Form 1116 for the tax year affected by the redetermination. The IRS will redetermine your U.S. tax liability for the year or years affected.

If you pay less foreign tax than you originally claimed a credit for, you must file Form 1040X and a revised Form 1116 within 180 days after the redetermination occurred. There is no limit on the time the IRS has to redetermine and assess the correct U.S. tax due. If you pay more foreign tax than you originally claimed a credit for, you have 10 years to file a claim for refund of U.S. taxes. See Time Limit on Refund Claims, later.

Failure-to-notify penalty.

If you fail to notify the IRS of a foreign tax redetermination and cannot show reasonable cause for the failure, you may have to pay a penalty.

For each month, or part of a month, that the failure continues, you pay a penalty of 5% of the tax due resulting from a redetermination of your U.S. tax. This penalty cannot be more than 25% of the tax due.

Foreign tax refund.

If you receive a foreign tax refund without interest from the foreign government, you will not have to pay interest on the amount of tax due resulting from the adjustment to your U.S. tax for the time before the date of the refund.

However, if you receive a foreign tax refund with interest, you must pay interest to the IRS up to the amount of the interest paid to you by the foreign government. The interest you must pay cannot be more than the interest you would have had to pay on taxes that were unpaid for any other reason for the same period.

Foreign tax imposed on foreign refund.

If your foreign tax refund is taxed by the foreign country, you cannot take a separate credit or deduction for this additional foreign tax. However, when you refigure the foreign tax credit taken for the original foreign tax, reduce the amount of the refund by the foreign tax paid on the refund.

Citizen of U.S. possession.

If you are a citizen of a U.S. possession (except Puerto Rico), not otherwise a citizen of the United States, and not a resident of the United States, you cannot take a foreign tax credit.

Foreign country.

A foreign country includes any foreign state and its political subdivisions. Income, war profits, and excess profits taxes paid or accrued to a foreign city or province qualify for the foreign tax credit.

U.S. possessions.

For foreign tax credit purposes, all qualified taxes paid to U.S. possessions are considered foreign taxes. For this purpose, U.S. possessions include Puerto Rico, Guam, the Northern Mariana Islands, and American Samoa.

When the term “foreign country” is used in this publication, it includes U.S. possessions unless otherwise stated.

Joint return.

If you file a joint return, you can claim the credit based on the total foreign income taxes paid or accrued by you and your spouse.

Partner or S corporation shareholder.

If you are a member of a partnership, or a shareholder in an S corporation, you can claim the credit based on your proportionate share of the foreign income taxes paid or accrued by the partnership or the S corporation. These amounts will be shown on the Schedule K–1 you receive from the partnership or S corporation. However, if you are a shareholder in an S corporation that in turn owns stock in a foreign corporation, you cannot claim a credit for your share of foreign taxes paid by the foreign corporation.

Beneficiary.

If you are a beneficiary of an estate or trust, you may be able to claim the credit based on your proportionate share of foreign income taxes paid or accrued by the estate or trust. This amount will be shown on the Schedule K–1 you receive from the estate or trust. However, you must show that the tax was imposed on income of the estate and not on income received by the decedent.

Mutual fund shareholder.

If you are a shareholder of a mutual fund, you may be able to claim the credit based on your share of foreign income taxes paid by the fund if it chooses to pass the credit on to its shareholders. You should receive from the mutual fund a Form 1099–DIV, or similar statement, showing the foreign country or U.S. possession, your share of the foreign income, and your share of the foreign taxes paid. If you do not receive this information, you will need to contact the fund.

Controlled foreign corporation shareholder.

If you are a shareholder of a controlled foreign corporation and choose to be taxed at corporate rates on the amount you must include in gross income from that corporation, you can claim the credit based on your share of foreign taxes paid or accrued by the controlled foreign corporation. If you make this election, you must claim the credits by filing Form 1118, Foreign Tax Credit—Corporations.

Controlled foreign corporation.

A controlled foreign corporation is a foreign corporation in which U.S. shareholders own more than 50% of the voting power or value of the stock. You are considered a U.S. shareholder if you own, directly and indirectly, 10% or more of the total voting power of all classes of the foreign corporation's stock. See Internal Revenue Code sections 951(b) and 958(b) for more information.

Foreign tax refund.

You cannot take a foreign tax credit for income taxes paid to a foreign country if it is reasonably certain the amount would be refunded, credited, rebated, abated, or forgiven if you made a claim.

For example, the United States has tax treaties with many countries allowing U.S. citizens and residents reductions in the rates of tax of those foreign countries. However, some treaty countries require U.S. citizens and residents to pay the tax figured without regard to the lower treaty rates and then claim a refund for the amount by which the tax actually paid is more than the amount of tax figured using the lower treaty rate. The qualified foreign tax is the amount figured using the lower treaty rate and not the amount actually paid, since the excess tax is refundable.

Subsidy received.

Tax payments a foreign country returns to you in the form of a subsidy do not qualify for the foreign tax credit. This rule applies even if the subsidy is given to a person related to you, or persons who participated with you in a transaction or a related transaction. A subsidy can be provided by any means but must be determined, directly or indirectly, in relation to the amount of tax, or to the base used to figure the tax.

The term “subsidy” includes any type of benefit. Some ways of providing a subsidy are refunds, credits, deductions, payments, or discharges of obligations.

Shareholder receiving refund for corporate tax in integrated system.

Under some foreign tax laws and treaties, a shareholder is considered to have paid part of the tax that is imposed on the corporation. You may be able to claim a refund of these taxes from the foreign government. You must include the refund (including any amount withheld) in your income in the year received. Any tax withheld from the refund is a qualified foreign tax.

Specific economic benefit.

Generally, you get a specific economic benefit if you receive, or are considered to receive, an economic benefit from the foreign country imposing the levy, and:

You are considered to receive a specific economic benefit if you have a business transaction with a person who receives a specific economic benefit from the foreign country and, under the terms and conditions of the transaction, you receive directly or indirectly some part of the benefit.

However, see the exception discussed later under Pension, unemployment, and disability fund payments.

Economic benefits.

Economic benefits include the following.

.

Generally, the right or privilege merely to engage in business is not an economic benefit.

Dual-capacity taxpayers.

If you are subject to a foreign country's levy and you also receive a specific economic benefit from that foreign country, you are a “dual-capacity taxpayer.” As a dual-capacity taxpayer, you cannot claim a credit for any part of the foreign levy, unless you establish that the amount paid under a distinct element of the foreign levy is a tax, rather than a compulsory payment for a direct or indirect specific economic benefit.

For more information on how to establish amounts paid under separate elements of a levy, write to:

Pension, unemployment, and disability fund payments.

A foreign tax imposed on an individual to pay for retirement, old-age, death, survivor, unemployment, illness, or disability benefits, or for similar purposes, is not payment for a specific economic benefit if the amount of the tax does not depend on the age, life expectancy, or similar characteristics of that individual.

No deduction or credit is allowed, however, for social security taxes paid or accrued to a foreign country with which the United States has a social security agreement. For more information about these agreements, see Publication 54.

Soak-up taxes.

A foreign tax is not predominantly an income tax and does not qualify for credit to the extent it is a soak-up tax. A tax is a soak-up tax to the extent that liability for it depends on the availability of a credit for it against income tax imposed by another country. This rule applies only if and to the extent that the foreign tax would not be imposed if the credit were not available.

Taxes not based on income.

Foreign taxes based on gross receipts or the number of units produced, rather than on realized net income, do not qualify unless they are imposed in lieu of an income tax, as discussed next. Taxes based on assets, such as property taxes, do not qualify for the credit.

Penalties and interest.

Amounts paid to a foreign government to satisfy a liability for interest, fines, penalties, or any similar obligation are not taxes and do not qualify for the credit.

Wages completely excluded.

If your wages are completely excluded, you cannot take a credit for any of the foreign taxes paid or accrued on these wages.

Wages partly excluded.

If only part of your wages is excluded, you cannot take a credit for the foreign income taxes allocable to the excluded part. You find the amount allocable to your excluded wages by multiplying the foreign tax paid or accrued on foreign earned income received or accrued during the tax year by a fraction.

The numerator of the fraction is your foreign earned income and housing amounts excluded under the foreign earned income and housing exclusions for the tax year minus otherwise deductible expenses definitely related and properly apportioned to that income. Deductible expenses do not include the foreign housing deduction.

The denominator is your total foreign earned income received or accrued during the tax year minus all deductible expenses allocable to that income (including the foreign housing deduction). If the foreign law taxes foreign earned income and some other income (for example, earned income from U.S. sources or a type of income not subject to U.S. tax), and the taxes on the other income cannot be segregated, the denominator of the fraction is the total amount of income subject to the foreign tax minus deductible expenses allocable to that income.

Waiver of denial of the credit.

A waiver can be granted to a sanctioned country if the President of the United States determines that granting the waiver is in the national interest of the United States and will expand trade and investment opportunities for U.S. companies in the sanctioned country. The President must report to Congress his intentions to grant the waiver and his reasons for granting the waiver not less than 30 days before the date on which the waiver is granted.

Limit on credit.

In figuring the foreign tax credit limit, discussed later, income from a sanctioned country is a separate category of foreign income. You must fill out a separate Form 1116 for this income. This will prevent you from claiming a credit for foreign taxes paid or accrued to the sanctioned country.

Figuring the credit when a sanction ends.

Table 1 (below) lists the countries for which sanctions have been lifted. For any of these countries, you can claim a foreign tax credit for the taxes paid or accrued to that country on the income for the period that begins after the end of the sanction period.

Amounts for the nonsanctioned period.

If a sanction period ends during your tax year and you are not able to determine the actual income and taxes for the nonsanctioned period, you can allocate amounts to that period based on the number of days in the period that fall in your tax year. Multiply the income or taxes for the year by the following fraction to determine the amounts allocable to the nonsanctioned period.

Further information.

The rules for figuring the foreign tax credit after a country's sanction period ends are more fully explained in Revenue Ruling 92–62, Cumulative Bulletin 1992–2, page 193. This Cumulative Bulletin can be found in many libraries and IRS offices.

Withholding tax.

For this purpose, withholding tax includes any tax determined on a gross basis. It does not include any tax which is in the nature of a prepayment of a tax imposed on a net basis.

Ex-dividend date.

The ex-dividend date is the first date on which, if the stock were sold, the dividend would be payable to the seller rather than the buyer.

Exception.

If you are a securities dealer who actively conducts business in a foreign country, you may be able to claim a foreign tax credit for qualified taxes paid on dividends regardless of how long you held the stock. See section 901(k)(4) of the Internal Revenue Code for more information.

List of boycotting countries.

A list of the countries which may require participation in or cooperation with an international boycott is published by the Department of the Treasury each calendar quarter. As of the date this publication was printed, the following countries are listed.

For information concerning changes to the list, write to:

Determinations of whether the boycott rule applies.

You may request a determination from the Internal Revenue Service as to whether a particular operation constitutes participation in or cooperation with an international boycott. The procedures for obtaining a determination from the Service are outlined in Revenue Procedure 77–9 in Cumulative Bulletin 1977–1. You can buy the Cumulative Bulletin from the Government Printing Office. Copies are also available in most IRS offices and you are welcome to read them there.

Public inspection.

A determination and any related background file is open to public inspection. However, your identity and certain other information will remain confidential.

Reporting requirements.

You must file a report with the IRS if you or any of the following persons have operations in or related to a boycotting country or with the government, a company, or national of a boycotting country.

Form 5713 required.

If you have to file a report, you must use Form 5713, International Boycott Report, and attach all supporting schedules.

You must file the form in duplicate when your tax return is due, including extensions. Send one copy to the Internal Revenue Service Center, Philadelphia, PA 19255. Attach the other copy to your income tax return that you file with your usual Internal Revenue Service Center. Your reports submitted as part of the tax return are confidential.

Penalty for failure to file.

If you willfully fail to make a report, in addition to other penalties, you may be fined $25,000 or imprisoned for no more than one year, or both.

U.S. persons controlling foreign corporations.

If you had control of a foreign corporation for an uninterrupted period of at least 30 days during the annual accounting period of that corporation, you may have to file an annual information return on Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations. Under this rule, you generally had control of a foreign corporation if at any time during the corporation's tax year you owned:

U.S. persons controlling foreign partnerships.

If you had control of a foreign partnership at any time during the partnership's tax year, you may have to file an annual information return on Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships. Under this rule, you generally had control of the partnership if you owned more than 50% of the capital or profits or interest, or an interest to which 50% of the deductions or losses were allocated.

You also may have to file Form 8865 if at any time during the tax year of the partnership, you owned a 10% or greater interest in the partnership while the partnership was controlled by U.S. persons owning at least a 10% interest. See the Instructions for Form 8865 for more information.

Penalty for not filing Form 5471 or Form 8865.

Generally, there is a dollar penalty of $10,000 for each annual accounting period for which you fail to furnish information. Additional penalties apply if the failure continues for more than 90 days after the day on which notice of the failure to furnish the information is mailed.

If you fail to file either Form 5471 or Form 8865 when due, you may also be required to reduce by 10% all foreign taxes that may be used for the foreign tax credit. This 10% reduction shall not exceed the greater of $10,000 or the income of the foreign corporation or foreign partnership for the accounting period for which the failure occurs. This foreign tax credit penalty is also reduced by the amount of the dollar penalty imposed.

Exemption from foreign tax credit limit.

You will not be subject to this limit and will be able to claim the credit without using Form 1116 if the following requirements are met.

If you make this election, you cannot carry back or carry over any unused foreign tax to or from this tax year.

This election exempts you only from the limit figured on Form 1116 and not from the other requirements described in this publication. For example, the election does not exempt you from the requirement that the foreign tax be a nonrefundable income tax.

Income from controlled foreign corporations.

As a U.S. shareholder, certain income that you receive or accrue from a controlled foreign corporation (CFC) is treated as separate limit income. You are considered a U.S. shareholder in a CFC if you own 10% or more of the total voting power of all classes of the corporation's stock.

Subpart F inclusions, interest, rents, and royalties from a CFC are generally treated as separate limit income if they are attributable to the separate limit income of the CFC. A dividend paid or accrued out of the earnings and profits of a CFC is treated as separate limit income in the same proportion that the part of earnings and profits attributable to income in the separate category bears to the total earnings and profits of the CFC.

Partnership distributive share.

In general, a partner's distributive share of partnership income is treated as separate limit income if it is from the separate limit income of the partnership. However, if the partner owns less than a 10% interest in the partnership, the income is generally treated as passive income. For more information, see section 1.904–5(h) of the Regulations.

What is not passive income.

Passive income does not include any of the following.

Export financing interest.

This is interest derived from financing the sale or other disposition of property for use outside the United States if:

High-taxed income.

This is passive income subject to foreign taxes that are higher than the highest U.S. tax rate that can be imposed on the income. The high-taxed income and the taxes imposed on it are moved from the passive income category into the general limitation income category. See section 1.904–4(c) of the Regulations for more information.

Sales or exchanges of certain personal property.

Generally, if personal property is sold by a U.S. resident, the gain or loss from the sale is treated as U.S. source. If personal property is sold by a nonresident, the gain or loss is treated as foreign source.

This rule does not apply to the sale of inventory, intangible property, or depreciable property, or property sold through a foreign office or fixed place of business. The rules for these types of property are discussed later.

U.S. resident.

The term “U.S. resident,” for this purpose, means a U.S. citizen or resident alien who does not have a tax home in a foreign country. The term also includes a nonresident alien who has a tax home in the United States. Generally, your tax home is the general area of your main place of business, employment, or post of duty, regardless of where you maintain your family home. Your tax home is the place where you are permanently or indefinitely engaged to work as an employee or self-employed individual. If you do not have a regular or main place of business because of the nature of your work, then your tax home is the place where you regularly live. If you do not fit either of these categories, you are considered an itinerant and your tax home is wherever you work.

Nonresident.

A nonresident is any person who is not a U.S. resident.

U.S. citizens and resident aliens with a foreign tax home will be treated as nonresidents for a sale of personal property only if an income tax of at least 10% of the gain on the sale is paid to a foreign country.

This rule also applies to losses recognized after January 7, 2002, if the foreign country would have imposed a 10% or higher tax had the sale resulted in a gain. You can choose to apply this rule to losses recognized in tax years beginning after 1986. For details about making this choice, see section 1.865–1(f)(2) of the Regulations. For stock losses, see section 1.865–2(e) of the Regulations.

Inventory.

Income from the sale of inventory that you purchased is sourced where the property is sold. Generally, this is where title to the property passes to the buyer.

Income from the sale of inventory that you produced in the United States and sold outside the United States (or vice versa) is sourced based on an allocation. For information on making the allocation, see section 1.863–3 of the Regulations.

Intangibles.

Intangibles include patents, copyrights, trademarks, and goodwill. The gain from the sale of amortizable or depreciable intangible property, up to the previously allowable amortization or depreciation deductions, is sourced in the same way as the original deductions were sourced. This is the same as the source rule for gain from the sale of depreciable property. See Depreciable property, below, for details on how to apply this rule.

Gain in excess of the amortization or depreciation deduction is sourced in the country where the property is used if the income from the sale is contingent on the productivity, use, or disposition of that property. If the income is not contingent on the productivity, use, or disposition of the property, the income is sourced according to the seller's tax home as discussed earlier. Payments for goodwill are sourced in the country where the goodwill was generated if the payments are not contingent on the productivity, use, or disposition of the property.

Depreciable property.

The gain from the sale of depreciable personal property, up to the amount of the previously allowable depreciation, is sourced in the same way as the original deductions were sourced. Thus, to the extent the previous deductions for depreciation were allocable to U.S. source income, the gain is U.S. source. To the extent the depreciation deductions were allocable to foreign sources, the gain is foreign source income. Gain in excess of the depreciation deductions is sourced the same as inventory.

If personal property is used predominantly in the United States, treat the gain from the sale, up to the amount of the allowable depreciation deductions, entirely as U.S. source income.

If the property is used predominantly outside the United States, treat the gain, up to the amount of the depreciation deductions, entirely as foreign source income.

A loss recognized after January 7, 2002, is sourced in the same way as the depreciation deductions were sourced. However, if the property was used predominantly outside the United States, the entire loss reduces foreign source income. You can choose to apply this rule to losses recognized in tax years beginning after 1986. For details about making this choice, see section 1.865–1(f)(2) of the Regulations.

Depreciation includes amortization and any other allowable deduction for a capital expense that is treated as a deductible expense.

Sales through foreign office or fixed place of business.

Income earned by U.S. residents from the sale of personal property through an office or other fixed place of business outside the United States is generally treated as foreign source if:

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

This rule also applies to losses recognized after January 7, 2002, if the foreign country would have imposed a 10% or higher tax had the sale resulted in a gain. You can choose to apply this rule to losses recognized in tax years beginning after 1986. For details about making this choice, see section 1.865–1(f)(2) of the Regulations. For stock losses, see section 1.865–2(e) of the Regulations.

This rule does not apply to income sourced under the rules for inventory property, depreciable personal property, intangible property (when payments in consideration for the sale are contingent on the productivity, use, or disposition of the property), or goodwill.

Definitely related.

A deduction is definitely related to a specific class of gross income if it is incurred either:

Classes of gross income.

You must determine which of the following classes of gross income your deductions are definitely related to.

Exempt income.

When you allocate deductions that are definitely related to one or more classes of gross income, you take exempt income into account for the allocation. However, do not take exempt income into account to apportion deductions that are not definitely related to a separate limit category.

Interest expense and state income taxes.

You must allocate and apportion your interest expense and state income taxes under the special rules discussed later under Interest expense and State income taxes.

Class of gross income that includes more than one separate limit category.

If the class of gross income to which a deduction definitely relates includes either:

you must apportion the definitely related deductions within that class of gross income.

To apportion, you can use any method that reflects a reasonable relationship between the deduction and the income in each separate limit category. One acceptable method for many individuals is based on a comparison of the gross income in a class of income to the gross income in a separate limit income category.

Use the following formula to figure the amount of the definitely related deduction apportioned to the income in the separate limit category:

Do not take exempt income into account when you apportion the deduction. However, income excluded under the foreign earned income or foreign housing exclusion is not considered exempt. You must, therefore, apportion deductions to that income.

Interest expense.

Generally, you apportion your interest expense on the basis of your assets. However, certain special rules apply. If you have gross foreign source income (including income that is excluded under the foreign earned income exclusion) of $5,000 or less, your interest expense can be allocated entirely to U.S. source income.

Business interest.

Apportion interest incurred in a trade or business using the asset method based on your business assets.

Under the asset method, you apportion the interest expense to your separate limit categories based on the value of the assets that produced the income. You can value assets at fair market value or the tax book value.

Investment interest.

Apportion this interest on the basis of your investment assets.

Passive activity interest.

Apportion interest incurred in a passive activity on the basis of your passive activity assets.

Partnership interest.

General partners and limited partners with partnership interests of 10% or more must classify their distributive shares of partnership interest expense under the three categories listed above. They must apportion the interest expense according to the rules for those categories by taking into account their distributive share of partnership gross income or pro rata share of partnership assets. For special rules that may apply, see section 1.861–9T(e) of the Regulations.

Home mortgage interest.

This is your deductible home mortgage interest from Schedule A (Form 1040). Apportion it under a gross income method, taking into account all income (including business, passive activity, and investment income), but excluding income that is exempt under the foreign earned income exclusion. The gross income method is based on a comparison of the gross income in a separate limit category with total gross income.

The Instructions for Form 1116 have a worksheet for apportioning your deductible home mortgage interest expense.

For this purpose, however, any qualified residence that is rented is considered a business asset for the period in which it is rented. You therefore apportion this interest under the rules for passive activity or business interest.

State income taxes.

State income taxes (and certain taxes measured by taxable income) are definitely related and allocable to the gross income on which the taxes are imposed. If state income tax is imposed in part on foreign source income, the part of your state tax imposed on the foreign source income is definitely related and allocable to foreign source income.

Foreign income not exempt from state tax.

If the state does not specifically exempt foreign income from tax, the following rules apply.

Foreign income exempt from state tax.

If state law specifically exempts foreign income from tax, the state taxes are allocable to the U.S. source income.

Deductions not definitely related.

You must apportion to your foreign income in each separate limit category a fraction of your other deductions that are not definitely related to a specific class of gross income. If you itemize, these deductions are medical expenses, charitable contributions, and real estate taxes for your home. If you do not itemize, this is your standard deduction. You should also apportion any other deductions that are not definitely related to a specific class of income, including deductions shown on Form 1040, lines 23–33a.

The numerator of the fraction is your gross foreign income in the separate limit category, and the denominator is your total gross income from all sources. For this purpose, gross income includes income that is excluded under the foreign earned income provisions.

Itemized deduction limit.

For 2002, you may have to reduce your itemized deductions on Schedule A (Form 1040) if your adjusted gross income is more than $137,300 ($68,650 if married filing separately). This reduction does not apply to medical and dental expenses, casualty and theft losses (other than losses of employee property), gambling losses, and investment interest.

You figure the reduction by using the Itemized Deductions Worksheet in the instructions for Schedule A ( Form 1040). Line 3 of the worksheet shows the total itemized deductions subject to the reduction. Line 9 shows the amount of the reduction.

To determine your taxable income from sources outside the United States, you must first divide the reduction ( line 9 of the worksheet) by the itemized deductions subject to the reduction ( line 3 of the worksheet). This is your reduction percentage. Then, multiply each itemized deduction subject to the reduction by your reduction percentage. Subtract the result from the itemized deduction to determine the amount you can allocate to income from sources outside the United States.

Treatment of personal exemptions.

Do not take the deduction for personal exemptions, including exemptions for dependents, in figuring taxable income from sources outside the United States.

Lines 1 and 5.

If you have foreign source capital gains or losses, you may be required to make certain adjustments to those foreign source capital gains or losses before you take them into account on line 1 or line 5 of Form 1116. You may use the instructions in this publication to determine the adjustments you must make. You may use the instructions under Foreign Capital Gains and Losses in the instructions for Form 1116 instead of the instructions in this publication if either:

If you choose not to use the instructions in this publication or in the instructions to Form 1116, see section 904(b)(2) of the Internal Revenue Code and the related regulations to determine the adjustments you must make.

If you choose to use the instructions in this publication, see Adjustments to Foreign Source Capital Gains and Losses below to determine the adjustments you must make.

Line 17 (Form 1116).

If you have U.S. or foreign source capital gains, you may be required to adjust the amount you enter on line 17 of Form 1116. Use the instructions for line 17 in the Instructions for Form 1116 to determine whether you are required to make an adjustment and to determine the amount of the adjustment.

U.S. capital loss adjustment.

You must adjust the amount of your foreign source capital gains to the extent that your foreign source net capital gain exceeds the amount of your worldwide net capital gain (the “U.S. capital loss adjustment”).

Your “foreign source net capital gain” is the amount of your foreign source capital gains in excess of your foreign source capital losses. If your foreign source capital gains do not exceed your foreign source capital losses, you do not have a foreign source net capital gain and you do not need to make the U.S. capital loss adjustment.

Your “worldwide net capital gain” is the amount of your worldwide (U.S. and foreign) capital gains in excess of your worldwide (U.S. and foreign) capital losses. If your worldwide capital losses equal or exceed your worldwide capital gains, your “worldwide net capital gain” is zero.

Your U.S. capital loss adjustment is the amount of your foreign source net capital gain in excess of your worldwide net capital gain. (If the amount of your foreign source net capital gain does not exceed the amount of your worldwide net capital gain, you do not have a U.S. capital loss adjustment.) If you have a U.S. capital loss adjustment, you must reduce your foreign source capital gains by the amount of the U.S. capital loss adjustment. The method you use to reduce your foreign source capital gains will differ depending on whether or not you qualify for the rate differential adjustment exception.

Rate differential adjustment exception.

You qualify for the rate differential exception if:

If you qualify for the rate differential adjustment exception, you must apportion the U.S. capital loss adjustment among your separate categories that have a net capital gain. A separate category has a net capital gain if the amount of foreign source capital gains in the separate category exceeds the amount of foreign source capital losses in the separate category. You must apportion the U.S. capital loss adjustment pro rata based on the amount of net capital gain in each separate category.

Rate differential adjustment exception not met.

If you do not qualify for the rate differential adjustment exception, you must apportion the U.S. capital loss adjustment among each capital gain rate group in each separate category (a “separate category capital gain rate group”) that has a net capital gain. You must apportion the U.S. capital loss adjustment pro rata based on the amount of your net capital gain in each separate category capital gain rate group.

The “capital gain rate groups” are the short-term capital gain rate group, the 28% capital gain rate group, the 25% capital gain rate group, and the 20% capital gain rate group. A capital gain or loss is in the 28% capital gain rate group if the gain or loss is entered on lines 8 through 14 of column (g) of your Schedule D (Form 1040) (lines 6 through 11 of column (g) of Schedule D (Form 1041)). A capital gain is in the 25% capital gain rate group if it is included in the amount shown on line 13 of the Unrecaptured Section 1250 Gain Worksheet you completed for your Schedule D. A capital gain or loss is in the 20% capital gain rate group if it is a long-term capital gain or loss that is not in the 28% or 25% capital gain rate group.

You have a net capital gain in a separate category capital gain rate group if the amount of your foreign source capital gains in that separate category capital gain rate group exceeds the amount of your foreign source capital losses in that separate category capital gain rate group. If the amount of your foreign source capital losses in the separate category capital gain rate group exceeds the amount of your foreign source capital gains in the separate category capital gain rate group, you have a net capital loss in the separate category capital gain rate group.

Capital gain rate differential adjustment.

After you have made your U.S. capital loss adjustment, if any, you are generally required to make additional adjustments (capital gain rate differential adjustments) to your foreign source capital gains and losses. However, you do not need to make the capital gain rate differential adjustments if you qualified for the rate differential adjustment exception above under U.S. capital loss adjustment.

If you did not qualify for the rate differential adjustment exception, you are required to make a capital gain rate differential adjustment for each separate category capital gain rate group that has a net capital gain or loss. See U.S. capital loss adjustment, earlier, for instructions on how to determine whether you have a net capital gain or loss in a separate category capital gain rate group and to determine the amount of any U.S. capital loss adjustment you must make before you make your capital gain rate differential adjustments.

How to make the adjustment.

How you make the capital gain rate differential adjustment depends on whether you have a net capital gain or net capital loss in a separate category capital gain rate group.

Net capital gain in a separate category capital gain rate group.

If you have a net capital gain in a separate category capital gain rate group, you make the capital gain rate differential adjustment by doing the following.

Include the results on line 1 of the applicable Form 1116.

No adjustment is required if you have a net capital gain in a short-term capital gain rate group. Include the amount of net capital gain in any separate category short-term capital gain rate group on line 1 of the applicable Form 1116 without adjustment.

Net capital loss in a separate category capital gain rate group.

If you have a net capital loss in a separate category capital gain rate group, you must do the following.

How to determine the capital gain rate group of the capital gain offset by the net capital loss.

Use the following ordering rules to determine the capital gain rate group of the capital gain offset by the net capital loss.

Determinations under the following ordering rules are made after you have taken into account any U.S. capital loss adjustment. However, determinations under the following ordering rules do not take into account any capital gain rate differential adjustments that you made to any net capital gain in a separate category capital gain rate group.

Step 1.

Net capital losses from each separate category capital gain rate group are netted against net capital gains in the same capital gain rate group in other separate categories. This is done ratably to the extent that net capital gains or losses in a particular capital gain rate group occur in two or more separate categories.

Step 2.

U.S. source capital losses are netted against U.S. source capital gains in the same capital gain rate group.

Step 3.

Net capital losses from each separate category capital gain rate group in excess of the amount netted against foreign source net capital gains in Step 1 are netted against your remaining foreign source net capital gains and your U.S. source net capital gains as follows.

The net capital losses in any separate category capital gain rate group are treated as coming pro rata from each separate category that contains a net capital loss in that capital gain rate group to the extent netted against:

Capital gain rate differential adjustment for net capital loss.

After you have determined the capital gain rate group of the capital gain offset by the net capital loss, you make the capital gain rate differential adjustment by doing the following.

Include the results on line 5 of the applicable Form 1116.

How to allocate.

You must allocate foreign losses among the separate limit income categories in the same proportion as each category's income bears to total foreign income.

Loss more than foreign income.

If you have a loss remaining after reducing the income in other separate limit categories, use the remaining loss to reduce U.S. source income. When you use a foreign loss to offset U.S. source income, you must recapture the loss as explained later under Recapture of Foreign Losses.

Recharacterization of subsequent income in a loss category.

If you use a loss in one separate limit category (category A) to reduce the amount of income in another category or categories (category B and/or category C) and, in a later year you have income in category A, you must, in that later year, recharacterize some or all of the income from category A as income from category B and/or category C.

Do not recharacterize the tax.

U.S. losses.

Allocate any net loss from sources in the United States among the different categories of foreign income after:

A net capital loss from sources in the United States is not taken into account in determining your net loss from sources in the United States to the extent that the net capital loss reduced capital gains from sources outside the United States as discussed earlier under U.S. capital loss adjustment.

Overall foreign loss.

An overall foreign loss is the amount by which your gross income from foreign sources for a tax year is exceeded by the sum of your expenses, losses, or other deductions that you allocated and apportioned to foreign income under the rules explained earlier under Determining Taxable Income From Sources Outside the United States. But see Losses not considered, later, for exceptions.

Losses not considered.

You do not consider the following in figuring an overall foreign loss in a given year.

Recapture provision.

If you have an overall foreign loss for any tax year and use the loss to offset U.S. source income, part of your foreign source taxable income (in the same separate limit category as the loss) for each succeeding year is treated as U.S. source taxable income. The part that is treated as U.S. source taxable income is the smallest of:

The amount of the recapture is shown on line 15, Form 1116.

Recapturing more overall foreign loss than required.

If you want to make an election or change a prior election to recapture a greater part of the balance of an overall foreign loss account than is required (as discussed earlier), you must attach a statement to your Form 1116. If you change a prior year's election, you should file Form 1040X.

The statement you attach to Form 1116 must show:

Deduction for foreign taxes.

You must recapture part (or all, if applicable) of an overall foreign loss in tax years in which you deduct, rather than credit, your foreign taxes. You recapture the lesser of:

Dispositions.

If you dispose of appreciated trade or business property used predominantly outside the United States, and that property generates foreign source taxable income of the same separate limit category that resulted in an overall foreign loss, the disposition is subject to the recapture rules. Generally, you are considered to recognize foreign source taxable income in the same separate limit category as the overall foreign loss to the extent of the lesser of:

This rule applies to a disposition whether or not you actually recognized gain on the disposition and irrespective of the source (U.S. or foreign) of any gain recognized on the disposition.

The foreign source taxable income that you are considered to recognize is generally subject to recapture as U.S. source income in an amount equal to the lesser of:

If you actually recognized foreign source gain in the same separate limit category as the overall foreign loss on a disposition of property described earlier, you must reduce the foreign source taxable income in that separate limit category by the amount of gain you are required to recapture. If you recognized foreign source gain in a different separate limit category than the overall foreign loss on a disposition of property described earlier, you are required to reduce your foreign source taxable income in that separate limit category for gain that is considered foreign source taxable income in the overall foreign loss category and subject to recapture. If you did not otherwise recognize gain on a disposition of property described earlier, you must include in your U.S. source income the foreign source taxable income you are required to recognize and recapture.

Predominant use outside United States.

Property is used predominantly outside the United States if it was located outside the United States more than 50% of the time during the 3-year period ending on the date of disposition. If you used the property fewer than 3 years, count the use during the period it was used in a trade or business.

Disposition defined.

A disposition includes the following transactions.

The character of the income (for example, as ordinary income or capital gain) recognized solely because of the disposition rules is the same as if you had sold or exchanged the property.

However, a disposition does not include:

Basis adjustment.

If gain is recognized on a disposition solely because of an overall foreign loss account balance at the time of the disposition, the recipient of the property must increase its basis by the amount of gain deemed recognized. If the property was transferred by gift, its basis in the hands of the donor immediately prior to the gift is increased by the amount of gain deemed recognized.

Report required.

You may have to report certain information with your return if you claim a foreign tax credit under a treaty provision. For example, if a treaty provision allows you to take a foreign tax credit for a specific tax that is not allowed by the Internal Revenue Code, you must report this information with your return. To report the necessary information, use Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b).

If you do not report this information, you may have to pay a penalty of $1,000.

You do not have to file Form 8833 if you are claiming the additional foreign tax credit (discussed previously).

Effect of bankruptcy or insolvency.

If your debts are canceled because of bankruptcy or insolvency, you may have to reduce your unused foreign tax carryovers to or from the tax year of the debt cancellation by 33⅓ cents for each $1 of canceled debt that you exclude from your gross income. Your bankruptcy estate may have to make this reduction if it has acquired your unused foreign tax carryovers. Also, you may not be allowed to carry back any unused foreign tax to a year before the year in which the bankruptcy case began. For more information, see Reduction of Tax Attributes in Publication 908, Bankruptcy Tax Guide.

Unused taxes carried to deduction year.

If you carry unused foreign taxes to a year in which you chose to deduct qualified foreign taxes, you must compute a foreign tax credit limit for the deduction year as if you had chosen to credit foreign taxes for that year. If the credit computation results in an excess limit (as defined earlier) for the deduction year, you must treat the unused foreign taxes carried to the deduction year as absorbed in that year. You cannot actually deduct or claim a credit for the unused foreign taxes carried to the deduction year. But, this treatment reduces the amount of unused foreign taxes that you can carry to another year.

Because you cannot deduct or claim a credit for unused foreign taxes treated as absorbed in a deduction year, you will get no tax benefit for them unless you file an amended return to reverse your choice from deducting the taxes to claiming the credit. You have 10 years from the due date of the return for the deduction year to make this change. See Making or Changing Your Choice, under Choosing To Take Credit or Deduction, earlier.

Continuous use of joint return.

If you and your spouse file a joint return for the current tax year, and file joint returns for each of the other tax years involved in figuring the carryback or carryover of unused foreign tax to the current tax year, you figure the joint carryback or carryover to the current tax year using the joint unused foreign tax and the joint excess limits.

Joint and separate returns in different years.

If you and your spouse file a joint return for the current tax year, but file separate returns for all the other tax years involved in figuring the carryback or carryover of the unused foreign tax to the current tax year, your separate carrybacks or carryovers will be a joint carryback or carryover to the current tax year.

In other cases in which you and your spouse file joint returns for some years and separate returns for other years, you must make the allocation described in Allocations Between Husband and Wife.

Method of allocation.

For a tax year in which you must allocate the unused foreign tax or the excess limit for your separate income categories between you and your spouse, you must take the following steps.

Allocation of the carryback and carryover.

The mechanics of the carryback and carryover, when allocations between husband and wife are needed, are illustrated by the following example.

Exceptions.

If you meet the requirements discussed under Exemption from foreign tax limit, earlier, and choose to be exempt from the foreign tax credit limit, do not file Form 1116. Instead, enter your foreign taxes directly on line 45 of Form 1040.

If you are a shareholder of a controlled foreign corporation and chose to be taxed at corporate rates on the amount you must include in gross income from that corporation, use Form 1118 to claim the credit. See Controlled foreign corporation shareholder under You Must Have Paid or Accrued the Tax, earlier.

Income from United States.

Robert received wages of $2,400 for services performed during the one week in the United States. He also received dividend income of $3,000 from sources within the United States.

Income from Country X.

Robert received the following income from Country X during the year and paid tax on the income to Country X on December 31. The conversion rate throughout the year was 2 pesos to each U.S. dollar (2:1).

Foreign earned income.

Robert is a bona fide resident of Country X and figures his allowable exclusion of foreign earned income on Form 2555, Foreign Earned Income (not illustrated). He excludes $80,000 of the wages earned in Country X.

Itemized deductions.

Robert was entitled to the following itemized deductions.

Employee business expenses.

Robert paid $3,400 of unreimbursed business expenses, of which $1,000 were definitely related to the wages earned in the United States and $2,400 were definitely related to wages earned in Country X.

Robert must prorate the business expenses related to the wages earned in Country X between the wages he includes on his U.S. tax return and the amount he excludes as foreign earned income. He cannot deduct the part of the expenses related to the income that he excludes. He figures his allowable expenses (related to the wages earned in Country X) as follows:

His employee business expense deduction is $872. This is the difference between his business expenses of $1,480 ($480 + $1,000 from U.S. business trip) and the 2%-of-ad- justed-gross-income limit ($608).

Form 1116—General limitation income.

On this Form 1116, Robert figures his taxable income from Country X for income in the general limitation income category only. He does not include his passive income of interest and dividends.

Line 1.

Robert enters the wages earned in Country X of $20,000 on line 1.

Line 2.

The unreimbursed employee business expenses related to these foreign source wages included in income are $480, as shown earlier. Robert must determine which part of the 2%-of-adjusted-gross-income limit ($608) is allocable to these employee business expenses. He figures this as follows:

The denominator ($1,480) is the total allowable unreimbursed business expenses ($1,000 + $480). The amount of deductible expenses definitely related to $20,000 of taxable foreign wages is $283 ($480 - $197). He enters $283 on line 2. He attaches this explanation to his Form 1116 that he files with his tax return.

Line 3a–g.

Robert enters $1,400 on line 3a. This is the sum of his real estate tax ($940) and charitable contributions ($460), which are itemized deductions not definitely related to income from any source. Robert must prorate these itemized deductions by using the ratio of gross income from Country X in the general limitation category (line 3d) to his gross income from all sources (line 3e). For this purpose, gross income from Country X and gross income from all sources include the $80,000 of wages that qualify for the foreign earned income exclusion. He figures the ratable part of deductions, $1,268, as follows and enters it on line 3g.

Line 4a.

Robert apportions his qualified home mortgage interest, $2,900, to general limitation income as follows:

Robert enters this amount, $1,908 on line 4a.

Line 6.

Robert adds the amounts on lines 2, 3g, and 4a, and enters that total ($3,459) on line 6.

Line 7.

He subtracts the amount on line 6 from the amount on line 1 to arrive at foreign source taxable income of $16,541 in this category. Robert enters this amount on line 7.

Form 1116—Passive income.

On this Form 1116, Robert determines the taxable income from Country X for passive interest and dividend income.

Line 1.

He adds the $1,000 interest income and the $4,000 dividend income ($5,000) from Country X and enters the total ($5,000) on line 1.

Line 3a–g.

Robert figures the part of his itemized deductions (real estate tax and charitable contributions) allocable to passive income as follows and enters the amount on line 3g.

Line 4a.

Robert apportions the qualified home mortgage interest to passive income as follows:

He enters this amount, $477, on line 4a.

Line 6.

Robert adds the amounts on lines 3g and 4a and enters that total ($540) on line 6.

Line 7.

He subtracts the amount on line 6 from the amount on line 1 to arrive at foreign source taxable income of $4,460 in this category. Robert enters this amount on line 7.

Form 1116—General limitation income.

On this Form 1116, Robert enters the amount of foreign taxes paid (withheld at source), in foreign currency and in U.S. dollars, on the wages from Country X.

Form 1116—Passive income.

On this Form 1116, Robert enters the amount of foreign taxes paid, in foreign currency and in U.S. dollars, on the interest and dividend income.

Form 1116—General limitation income.

On this Form 1116, Robert figures the amount of foreign tax credit allowable for the foreign taxes paid on his wages from Country X.

Line 10.

He has a carryover of $200 for unused foreign taxes paid in 2001 and enters that amount on line 10. He attaches a schedule showing how he figured his $200 carryover to 2002 after carrying back the unused $350 tax paid in 2001 to the 2 preceding tax years. (This schedule is shown in Table 4.) The unused foreign tax in 2001 and the excess limits in 1999 and 2000 are in the general limitation income category. The unused foreign tax of $200 is carried over to the general limitation income category in 2002.

Line 12.

On line 12, Robert must reduce the total foreign taxes paid by the amount related to the wages he excludes as foreign earned income. To do this, he multiplies the $27,400 foreign tax he paid on his foreign wages by a fraction. The numerator of the fraction is his foreign earned income exclusion ($80,000) minus a proportionate part of his definitely related business expenses ($2,400 - $480 = $1,920). The denominator of the fraction is his total foreign wages ($100,000) minus his total definitely related business expenses ($2,400).

He enters the result, $21,920, on line 12.

Line 13.

His total foreign taxes available for credit are $5,680 ($200 carryover from 2001 + $5,480 paid in 2002 ($27,400 - $21,920)).

Line 20.

By completing the rest of Part III, Robert finds that his limit is $1,989.

Line 21.

The foreign tax credit on the general limitation income is the lesser of the foreign tax available for credit, $5,680, or the limit, $1,989

Form 1116—Passive income.

Robert now figures the foreign tax credit allowable for the foreign taxes he paid on his interest and dividend income from Country X.

By completing Part III of Form 1116, he finds that the limit on his credit is $536.

The foreign tax credit is the lesser of the foreign tax paid, $500, or the limit, $536.

General limitation income.

Robert has 2002 unused foreign taxes of $3,491 ($5,480 - $1,989) and $200 of 2001 unused foreign taxes available as a carryover to 2003 and later years. (The foreign taxes related to his foreign earned income exclusion are not available for carryover.) He cannot carry back any part of the 2002 unused taxes to 2000 or 2001 as shown in Table 4.

Passive income.

Since the tax Robert paid on his interest and dividend income is less than the amount for which he could have claimed a credit in 2002 under the limit for this separate income category, he has no unused tax and therefore no carryback or carryover to other tax years.

Contacting your Taxpayer Advocate.

If you have attempted to deal with an IRS problem unsuccessfully, you should contact your Taxpayer Advocate.

The Taxpayer Advocate represents your interests and concerns within the IRS by protecting your rights and resolving problems that have not been fixed through normal channels. While Taxpayer Advocates cannot change the tax law or make a technical tax decision, they can clear up problems that resulted from previous contacts and ensure that your case is given a complete and impartial review.

To contact your Taxpayer Advocate:

For more information, see Publication 1546, The Taxpayer Advocate Service of the IRS.

Free tax services.

To find out what services are available, get Publication 910, Guide to Free Tax Services. It contains a list of free tax publications and an index of tax topics. It also describes other free tax information services, including tax education and assistance programs and a list of TeleTax topics.