Form 1118: Foreign Tax Credit—Corporations (2012)
What the Form Is For
Form 1118 is the document corporations use to claim credit for income taxes they've paid to foreign countries or U.S. possessions. Think of it as preventing double taxation—when your corporation earns income abroad and pays taxes on it to that foreign government, Form 1118 helps ensure you don't pay full U.S. taxes on the same income again. Instead of being taxed twice on the same dollar, you get a credit against your U.S. tax liability for the foreign taxes already paid.
The form applies to domestic corporations that operate internationally and foreign corporations doing business in the United States. It covers various types of foreign taxes including income taxes, war profits taxes, and excess profits taxes paid to foreign countries. The credit is subject to specific limitations—you can't claim more credit than your U.S. tax liability on the foreign income, and different categories of income (passive income, general business income, etc.) must be calculated separately.
Form 1118 is notably complex because it requires separate calculations for different ""baskets"" or categories of income. For instance, passive investment income gets treated differently than active business income, and income from countries under U.S. sanctions requires its own separate form. The form also handles ""deemed paid"" credits, which apply when your corporation receives dividends from foreign subsidiaries—you get credit not just for taxes withheld on the dividend itself, but also for a proportionate share of the foreign taxes the subsidiary paid on its underlying earnings.
When You'd Use It (Including Late and Amended Filings)
You must file Form 1118 with your corporate tax return (Form 1120 or other applicable corporate return) for any year you elect to take the foreign tax credit. This election is made annually, meaning you choose each year whether to take a credit or a deduction for your foreign taxes paid. Once you elect the credit for a given year, you cannot deduct those foreign taxes instead.
The good news is that the law provides flexibility for changing your mind. You can make or change your election to claim the foreign tax credit at any time within a special 10-year period described in Internal Revenue Code section 6511(d)(3), or longer if you've extended the period by agreement with the IRS. This extended timeline recognizes that international tax situations can be complicated and may require adjustments years after the original return was filed.
Amended returns become necessary when certain events occur after your initial filing. If you claimed credit for foreign taxes you accrued but those taxes turn out to be a different amount when actually paid, you must file an amended return with a revised Form 1118. Similarly, if you claimed accrued taxes that go unpaid for more than two years after the end of the tax year, or if you receive a refund of foreign taxes you previously claimed, you're required to redetermine your U.S. tax liability and file amendments for all affected years.
The deadlines for these amended returns depend on when the foreign tax adjustment occurs. For redeterminations resulting in U.S. tax deficiencies that happened in the three tax years immediately before your first tax year beginning on or after November 7, 2007, amended returns were due no later than the due date (with extensions) of your return for your second tax year beginning on or after that date. For adjustments occurring in later tax years, amended returns are due by the return due date (including extensions) for the year in which the redetermination occurs. Missing these deadlines can trigger penalties under section 6689 of the tax code.
Key Rules You Need to Know
Several fundamental rules govern how Form 1118 works. First, you must use a consistent accounting method—either cash or accrual—throughout any given tax year. You cannot mix methods. If you claim credit for accrued taxes, you must show both the accrual date and the payment date (if paid). Once you elect to use the accrual method for claiming foreign tax credits, that election generally applies to all future years.
Second, you can only claim credit for foreign taxes you legally owe. If you're eligible for a refund or reduction from the foreign country but don't pursue it, the IRS won't allow a credit for that excess amount. This rule prevents corporations from artificially inflating their foreign tax credits by accepting higher foreign tax bills than legally required.
Third, separate limitations apply to different categories of income. The two main categories are passive income (generally investment income like dividends, interest, and royalties) and general category income (typically active business income). Special rules called ""look-through"" provisions can reassign certain dividends and interest from controlled foreign corporations to other categories based on the underlying type of income that generated those amounts. Income from countries under U.S. sanctions (as of 2012, this included Cuba, Iran, North Korea, Sudan, and Syria) requires a completely separate Form 1118 for each sanctioned country, and no credit is allowed for taxes paid to those countries.
Fourth, the credit cannot exceed a specific limitation calculated on the form. The basic limitation formula is: your U.S. tax liability multiplied by a fraction where the numerator is your foreign source taxable income in that category and the denominator is your total taxable income from all sources. This ensures the credit only offsets the U.S. tax on foreign income, not U.S. source income.
If your foreign taxes paid exceed the limitation for a given year, you're not out of luck—you can carry the excess back one year or forward ten years (five years for older credits) to offset taxes in the same category. The carryback and carryforward rules ensure that temporary mismatches between when foreign and U.S. taxes spike don't permanently cost you the benefit of your foreign tax credits.
Step-by-Step Process (High Level)
The form consists of multiple schedules that work together to calculate your final credit. Start with Schedule A, where you report your gross income from foreign sources in the applicable category. You'll list income by country using two-letter country codes, breaking it down into specific types: dividends (with separate reporting for certain deemed dividends and the associated ""gross-up"" for taxes paid by foreign corporations), interest, rents and royalties, service income, and other income. You'll also report deductions that are definitely allocable to that foreign income.
Next, move to Schedule B, Part I, where you report the actual foreign taxes paid or accrued. For taxes you paid directly, you'll show withholding taxes on different types of income and other foreign taxes. For taxes ""deemed paid"" through ownership of foreign corporations, those amounts come from Schedules C, D, and E, which calculate the taxes your foreign subsidiaries paid that are attributable to dividends or other inclusions you received from them.
Schedules C through E handle the intricate deemed paid credit calculations. Schedule C covers taxes deemed paid by your first-tier foreign subsidiaries. Schedule D covers second- and third-tier subsidiaries. Schedule E extends the calculation to fourth-, fifth-, and sixth-tier subsidiaries for controlled foreign corporations. These schedules use formulas that allocate a proportionate share of the subsidiary's foreign taxes to the dividend or income inclusion, based on ratios of distributions to earnings and profits pools.
Schedule H is where you apportion deductions that can't be definitely allocated to a specific source of income—things like interest expense, research and development costs, and general corporate overhead. These deductions must be allocated between U.S. and foreign source income, and among different categories of foreign income, using specific methods prescribed in the regulations.
After completing all the schedules, Schedule B, Part II brings everything together. You'll total your foreign taxes (paid, accrued, and deemed paid), make any required reductions (reported on Schedule G for things like international boycott participation or certain disallowed taxes), and apply any carryovers from prior years (tracked on Schedule K). Then you'll calculate your limitation by dividing your foreign source taxable income (from Schedule A, as adjusted by Schedule J if needed) by your total taxable income, and multiply that fraction by your total U.S. tax liability. Your allowable credit is the smaller of your total foreign taxes or the limitation amount.
Finally, Schedule B, Part III summarizes your separate credits from each income category, and the total flows to your corporate tax return to offset your U.S. tax liability.
Common Mistakes and How to Avoid Them
One frequent error is inconsistent use of accounting methods. Corporations sometimes claim credits on a cash basis one year and accrual basis the next, or mix both methods within the same year. To avoid this, establish a consistent policy and document it clearly. Remember that once you elect to use the accrual method for foreign tax credits, you're generally locked into that method for future years.
Another common mistake is claiming credit for taxes you don't legally owe. This can happen when a foreign country offers refunds, rebates, or procedures to reduce taxes, but the corporation doesn't pursue them. Perhaps you received a tax assessment abroad that seems too high, but you didn't appeal it or request a correction. The IRS won't allow credit for amounts you could have gotten back. Always exercise available remedies to minimize your foreign tax liability to the legally correct amount, and document your efforts.
Failing to file separate forms for each income category trips up many taxpayers. The rules require a complete Form 1118 for passive income, another for general category income, and additional separate forms for sanctioned country income or treaty-resourced income. Mixing categories on a single form invalidates your calculations. Create a checklist identifying which categories apply to your corporation and prepare a complete package for each.
Inadequate documentation causes problems during IRS examinations. While you don't submit receipts or foreign tax returns with Form 1118, you must produce them on request. Maintain organized files with foreign tax returns, payment receipts, withholding statements, and worksheets showing how you translated foreign currency amounts. Document exchange rates used and their source. If the IRS requests substantiation and you cannot provide it, your credits may be disallowed entirely.
Missing the required disclosures for treaty-based positions is another pitfall. If you're relying on a tax treaty to override U.S. tax law provisions—for example, re-sourcing U.S. income as foreign source under a treaty—you must file Form 8833 disclosing this position. Failure to disclose can result in a $10,000 penalty per failure.
Finally, many corporations miss the requirement to file amended returns when foreign tax redeterminations occur. If your foreign taxes paid differ from what you accrued, or if you receive a refund, or if accrued taxes remain unpaid beyond the two-year grace period, you must amend all affected years. Set up systems to track when foreign taxes are actually paid and reconcile them to your accrued amounts. Build in calendar reminders to catch situations where accrued taxes remain unpaid as the two-year window approaches.
What Happens After You File
Filing Form 1118 doesn't end the process—it begins a period during which the IRS may review and request additional information. Although you don't attach supporting documentation to the form itself, you must maintain complete records and be prepared to produce them on request. The IRS has authority to ask for proof of foreign taxes paid or accrued at any time during the statute of limitations period.
If you claimed credit for taxes you accrued but haven't yet paid, the IRS may require you to post a bond on Form 1117 (Income Tax Surety Bond) before allowing the credit. This protects the government if those taxes ultimately aren't paid or are paid in a different amount than claimed.
When foreign tax redeterminations occur—meaning the foreign taxes you ultimately pay differ from what you originally claimed—you must file amended returns for all affected years. You'll submit a revised Form 1118 along with detailed information including the dates taxes were accrued and paid, amounts in foreign currency, exchange rates used, and explanations of the changes. For taxes deemed paid through foreign subsidiaries, you must show how the adjustment affects earnings and profits pools and foreign tax pools.
The IRS will compute interest on any underpayment or overpayment that results from foreign tax adjustments. If you end up owing more U.S. tax because your foreign taxes were less than claimed, you'll owe interest from the original due date of the return. Conversely, if you're due a refund because your foreign taxes were higher than claimed, the IRS pays you interest on the overpayment.
Failure to comply with the reporting requirements for foreign tax redeterminations triggers penalties under section 6689. The penalty applies if you don't file required amended returns within the specified deadlines or don't provide the detailed information the regulations require. These penalties are in addition to any interest on underpayments.
If you carried excess foreign tax credits back to a prior year, that earlier year's return is amended, potentially generating a refund. If you're carrying credits forward, you must track them on Schedule K (Foreign Tax Carryover Reconciliation Schedule) and report them in future years when they can be used. Credits that remain unused after the carryforward period (generally ten years) expire and provide no future benefit.
Frequently Asked Questions
Can I switch between taking a credit and taking a deduction for my foreign taxes from year to year?
Yes, the election to claim a foreign tax credit or deduction is made annually, so you can make a different choice each year. However, within any single tax year, you must be consistent—you cannot take a credit for some foreign taxes and a deduction for others in the same year. Consider each year's circumstances, such as whether you have enough U.S. tax liability to use the credits, and whether you expect to carry excess credits to other years. You can even change your election retroactively within the special 10-year period mentioned earlier, giving you flexibility as your tax situation becomes clearer with hindsight.
What if my foreign subsidiary paid taxes in multiple countries—how does the deemed paid credit work?
When your controlled foreign corporation earns income and pays taxes in various countries, those taxes and earnings are tracked in separate pools by country and by income category. When the subsidiary pays you a dividend, you calculate the deemed paid credit using a formula that multiplies the subsidiary's foreign tax pool by a fraction: the dividend amount divided by the subsidiary's total earnings and profits. If the subsidiary received dividends from its own lower-tier subsidiaries, you also get credit for a proportionate share of those lower-tier taxes through a similar calculation cascading down the corporate chain. The key is maintaining accurate pools of post-1986 undistributed earnings and foreign taxes in the subsidiary's functional currency, then translating to U.S. dollars at the appropriate exchange rates.
What exchange rate should I use when converting foreign taxes to U.S. dollars?
For foreign taxes paid on a cash basis, use the exchange rate on the date of payment. For taxes claimed on the accrual basis, generally use an average exchange rate for the tax year to which the taxes relate. However, there are important exceptions: if you pay accrued taxes more than two years after the close of the tax year they relate to, or if you pay them in a year before they relate to, you must use the exchange rate on the date of payment. Additionally, for tax years beginning after December 31, 2004, you can elect to use the payment date exchange rate for all your foreign income taxes (or just for those attributable to subsidiaries with U.S. dollar functional currencies). This election, once made by attaching a statement to Form 1118, applies to all subsequent years and can only be revoked with IRS consent.
What happens if I discover I paid foreign taxes that weren't legally required—can I still claim the credit?
No. The IRS only allows credits for foreign taxes you legally owe. If the foreign country's tax was imposed by mistake, or if you're eligible for a refund or reduction but haven't pursued it, you cannot claim credit for that excess amount. This means you should actively monitor foreign tax assessments and exercise any available remedies—filing foreign amended returns, requesting competent authority assistance under tax treaties, or pursuing foreign refund procedures. If you already claimed credit for such taxes and later receive a refund from the foreign country, you must amend your U.S. return to reduce your foreign tax credit accordingly and pay back any excess U.S. tax benefit you received.
Are there any foreign taxes that can never qualify for the credit even if I legally paid them?
Yes, several categories of foreign taxes are specifically excluded from the credit. Taxes paid to countries the U.S. has sanctioned under section 901(j)—which as of 2012 included Cuba, Iran, North Korea, Sudan, and Syria—don't qualify (though you still must calculate a separate limitation for income from those countries). Taxes reduced under section 901(e) for mineral income and taxes on foreign oil and gas extraction income subject to special limitations don't fully qualify. Certain taxes paid if you participated in an international boycott are denied under section 908. Taxes on dividends or property gains where you didn't meet minimum holding periods or had obligations to make related payments may be disqualified under sections 901(k) and (l). Starting with covered asset acquisitions after December 31, 2010, section 901(m) disqualifies a portion of taxes on income from relevant foreign assets. These disqualified amounts are reported on Schedule G.
If my foreign tax credit exceeds the limitation, how long can I carry the excess to other years?
Unused foreign tax credits can generally be carried back one year and forward ten years (though the carryforward was limited to five years for excess credits carried to years ending before October 23, 2004). The excess must be applied to the earliest possible year first, then to the next earliest, and so on. Importantly, you can only carry credits to years where you also elected to take the credit rather than a deduction for foreign taxes. The credit must stay within its income category—passive category credit carryovers can only offset future passive category income; general category carryovers only offset general category income. Special rules apply for pre-2007 carryovers because the category definitions changed in 2007, generally allowing you to allocate old passive category carryovers to the new passive category and other old category carryovers to the new general category. Schedule K tracks these carryovers from year to year.
Do I need to attach proof of foreign taxes paid when I file Form 1118?
No, you don't attach receipts, foreign tax returns, or other documentation to Form 1118 when you file it. However, you absolutely must maintain these records and be able to produce them if the IRS requests them during an examination. Keep foreign tax returns, proof of payment (such as wire transfer records or bank statements showing payments to foreign tax authorities), withholding statements (like Forms 1042-S or their foreign equivalents), and worksheets showing your calculations and currency translations. Also maintain documentation of exchange rates used and their sources. If the IRS asks for substantiation and you cannot provide adequate proof, your foreign tax credits may be disallowed, resulting in additional U.S. tax, interest, and potentially penalties. Think of it as ""trust but verify""—the IRS trusts your Form 1118 calculations initially but reserves the right to verify them later.
Sources: All information in this summary comes from official IRS publications:
