Under Internal Revenue Code (IRC) Sec. 901 arises the Foreign Tax Credit.
The Foreign Tax Credit is claimed using the IRS 2 page Form 1116, Foreign Tax Credit.
Form 1116 page 1 at the top is used to choose the appropriate category of income as described below, Part I-Taxable Income or Loss From Sources Outside the United States- is used to separate by country received the associated category income and associated direct and indirect expenses.
Form 1116 bottom of page 2 Part II-Foreign Taxes Paid or Accrued- is used to elect either the Taxes Paid or Accrued Method and then to list out the applicable foreign taxes eligible for the Foreign Tax Credit.
Form 1116 page 2 Part III-Figuring the Credit- is used to adjust the taxes Paid or Accrued for the loss carry back and loss carry forward of foreign taxes, adjust the taxes Paid or Accrued for the reduction or scale down in foreign taxes as a result of the Foreign Earned Income Exclusion and then to calculate the limiting factor, which if lower will override the actual scaled down taxes Paid or Accrued.
Form 1116 page 2 Part IV- Summary of Credits from Separate- Parts III-
Complete Part IV only if you must complete more than one Form 1116 because you have more than one of the categories of income listed above Part I.
Foreign Currency Conversion
On Form 1116 report all amounts in U.S. dollars except where specified otherwise in Part II. If you have to convert from foreign currency, attach a detailed explanation of how you figured the conversion rate with Form 1116.
If you take a credit for taxes paid on Form 1116, the conversion rate is the rate of exchange in effect on the day you paid the foreign taxes (or on the day the tax was withheld). If you receive a refund of foreign taxes paid, the conversion rate is the rate in effect when you paid the taxes, not when you receive the refund.
If you choose on Form 1116 to account for foreign income taxes on an accrual basis, you must generally use the average exchange rate for the tax year to which the taxes relate.
Categories of Income
Use a separate Form 1116 to figure the credit for each category of foreign source income listed above Part I of Form 1116:
a. Passive Category Income
Passive category income on Form 1116 consists of passive income and specified passive category income.
Passive category income does not include gain from the sale of inventory or property held primarily for sale to customers in the ordinary course of your trade or business; gain from commodities hedging transactions; and active business gains or losses of producers, processors, merchants, or handlers of commodities. It may also not include dividends, interest, rents, or royalties received from a controlled foreign corporation (CFC) in which you are a U.S. shareholder who owns 10% or more of the total voting power of all classes of the corporation’s stock.
Passive income generally includes dividends, interest, royalties, rents, annuities, excess of gains over losses from the sale of property that produces such income or of non-income-producing investment property, and excess of gains over losses from foreign currency or commodities transactions. Capital gains not related to the active conduct of a trade or business are also generally passive income.
b. General Category Income
General category income on Form 1116 is income that is not passive category income. General category income may include:
- Wages, salary, and overseas allowances of an individual as an employee.
- Income earned in the active conduct of a trade or business.
- Gains from the sale of inventory or depreciable property used in a trade or business.
Financial services income.- In general, financial services income on Form 1116 is treated as general category income if it is derived by a financial services entity. You are a financial services entity if you are predominantly engaged in the active conduct of a banking, insurance, financing, or similar business for any tax year. Financial services income of a financial services entity generally includes income derived in the active conduct of a banking, financing, insurance, or similar business. Financial services income of a financial services entity also includes passive income and certain incidental income.