Form 1118: Foreign Tax Credit—Corporations (2013)

What Form 1118 Is For

Form 1118 is the IRS document that corporations use to claim a foreign tax credit for income taxes paid or accrued to foreign countries or U.S. possessions. Think of it as the mechanism that prevents your corporation from being taxed twice on the same income—once by a foreign government and again by the United States.

When your corporation earns income abroad and pays taxes to another country, the U.S. tax system recognizes that you shouldn't have to pay full taxes twice. Form 1118 calculates how much credit you can claim against your U.S. tax bill based on those foreign taxes. The form is highly detailed because it must track different types of foreign income separately, calculate deemed paid credits through foreign subsidiaries, and apply various limitations to ensure the credit doesn't exceed what's appropriate under tax law.

Only corporations that elect to take the foreign tax credit (rather than a deduction for foreign taxes) must file Form 1118. The form attaches to your corporate income tax return and includes multiple schedules that break down foreign income by category, calculate taxes paid at various subsidiary levels, and apportion deductions between U.S. and foreign sources.

When You'd Use Form 1118 (Late or Amended Filing)

The election to claim the foreign tax credit can be made or changed within a special 10-year period described in section 6511(d)(3). This extended window means you have considerable flexibility to initially claim the credit or switch between taking a credit versus a deduction for foreign taxes.

You would file an amended return with a revised Form 1118 when certain triggering events occur. The most common situation is when foreign tax amounts change after you've already filed—for instance, if accrued taxes paid later differ from what you originally claimed, if you receive a refund of foreign taxes, or if you failed to pay accrued taxes within two years after the tax year they relate to. These are called "foreign tax redeterminations," and they require you to recalculate your U.S. tax liability.

If you're carrying back excess foreign tax credits to an earlier year, you'll also need to file an amended return for that prior year with a revised Form 1118 and supporting schedules. For tax years beginning after November 7, 2007, amended returns reflecting foreign tax redeterminations that result in U.S. tax deficiencies must generally be filed by the due date (including extensions) of your return for the tax year when the redetermination occurs.

When filing late or amending, you must provide specific documentation: the dates foreign taxes were accrued and paid, the amounts in foreign currency, exchange rates used for conversion, and detailed explanations of why amounts changed. The IRS needs this information to verify the legitimacy of the adjustments and properly apply interest and penalty provisions.

Key Rules or Details for 2013

The foreign tax credit operates under a fundamental limitation: you cannot get a larger credit than the U.S. tax you would owe on that same foreign income. Form 1118 calculates this limitation by multiplying your total U.S. tax liability by a fraction—your foreign source taxable income divided by your total taxable income from all sources. This ensures the credit only offsets the U.S. tax attributable to foreign operations.

A critical rule is that you must compute separate credits for different "categories" of income. In 2013, the main categories were passive category income (dividends, interest, royalties, and similar investment-type income) and general category income (active business income and most other foreign income). Special categories existed for income from sanctioned countries under section 901(j) and income re-sourced by treaty. You must file a completely separate Form 1118 for each applicable category—they cannot be combined.

The "look-through" rules add complexity but provide important benefits. When you receive dividends, interest, rents, or royalties from a controlled foreign corporation (CFC) where you own at least 10% of the voting stock, you must look through to determine what category of income generated those payments in the CFC. This prevents passive income treatment for what is really active business income earned by your foreign subsidiary.

Only certain taxes qualify for the credit. Eligible taxes must be income, war profits, or excess profits taxes imposed by a foreign country or U.S. possession. Taxes on mineral income, certain taxes related to international boycotts, taxes on excluded extraterritorial income, and taxes imposed by sanctioned countries are specifically disallowed. You must also reduce the credit for subsidies embedded in foreign tax systems.

If your foreign taxes exceed the limitation in a given year, you can carry the excess back one year and forward ten years (five years for certain older tax years). However, you cannot carry credits to years where you chose a deduction instead of a credit, and you must reduce carryovers by amounts you could have used if you'd claimed the credit in intervening years.

Step-by-Step (High Level)

Determine Applicable Income Categories and Forms

Begin by determining which separate categories of foreign income apply to your situation and gather a separate Form 1118 for each category. Most corporations will need at least one for general category income, and possibly another for passive category income if they have significant foreign investment income.

Schedule A: Report Foreign Source Income and Deductions

Start with Schedule A, where you report gross income from sources outside the United States for that category. List each foreign country using its two-letter code and break down income by type: deemed dividends from subpart F inclusions, other dividends, interest, rents and royalties, service income, and other income. Then allocate deductions that are definitely allocable to that foreign income and apportion a share of general deductions like interest expense and research costs using Schedule H. The result is your net foreign source income before adjustments.

Schedule C (and D/E): Compute Deemed Paid Credits

If your corporation owns at least 10% of a foreign subsidiary that paid dividends or where you had subpart F inclusions, move to Schedule C. This is where you calculate the "deemed paid" credit—the foreign taxes paid by your foreign corporation that are considered paid by you. The calculation involves taking the foreign corporation's post-1986 undistributed earnings and foreign income tax pools, determining what portion of those earnings were distributed to you, and crediting a proportional share of the foreign taxes. For multi-tier corporate structures, Schedules D and E perform similar calculations for second, third, and even lower-tier foreign subsidiaries.

Schedule B: Calculate the Foreign Tax Credit and Limitation

Next, complete Schedule B to calculate your actual credit. Report all foreign taxes you directly paid or accrued (with withholding taxes broken out separately), add deemed paid amounts from Schedule C, and subtract reductions from Schedule G (for things like boycott-related tax or taxes limited under section 901(e)). Apply the limitation formula by dividing your foreign source taxable income by total taxable income and multiplying by your total U.S. tax liability. Your allowable credit is the lesser of actual foreign taxes or this calculated limitation.

Schedule H: Apportion Nondirect Deductions

Schedule H must be completed only once (not for each category) to apportion deductions that aren't definitely allocable to any specific income source, primarily research and development expenses and interest expense. The results feed into Schedule A for each category.

Schedules J and K: Track Losses and Carryovers

If you have current year foreign losses or need to recapture prior year losses, Schedule J tracks these adjustments. Schedule K reconciles prior year foreign tax carryovers with current year carryovers.

Common Mistakes and How to Avoid Them

One frequent error is failing to file separate Forms 1118 for each category of income. When corporations combine passive and general category income on a single form, the IRS will reject the filing or require corrections. Always evaluate which categories apply before you begin and prepare distinct forms for each.

Many corporations incorrectly classify income categories, particularly when applying the look-through rules. When you receive a dividend from a controlled foreign corporation, you cannot automatically treat it as passive income. You must examine the underlying earnings and profits of the CFC and classify the dividend according to the same categories that applied to those earnings. Similarly, the "high-taxed income" exception can move what appears to be passive income into the general category if the foreign tax rate exceeds the highest U.S. corporate rate—currently this requires specific calculations and adjustments entered on separate lines of Schedule A.

Deemed paid credit calculations frequently contain errors in tracking earnings and profits pools and foreign tax pools. Corporations must maintain meticulous records of each foreign subsidiary's post-1986 undistributed earnings, opening and closing foreign tax balances, and taxes paid during each year. Mixing pre-1987 and post-1986 amounts or using incorrect exchange rates will produce wrong results. Always convert foreign currency amounts using the proper exchange rate rules: generally the average rate for the tax year for accrued taxes, but the payment date rate for taxes paid more than two years after they relate to or when making certain elections.

Another common mistake involves the limitation calculation itself. Some corporations fail to make required adjustments to taxable income before computing the limitation fraction. You must reduce foreign source capital gain net income when overall capital gains exceed foreign capital gains, and you must account for separate limitation losses, overall foreign losses, and overall domestic losses through the complex adjustments on Schedule J. Skipping these steps overstates your allowable credit.

Finally, many corporations overlook documentation requirements. Although you don't attach receipts or foreign tax returns to Form 1118, you must retain this proof and present it upon IRS request. Failure to substantiate the credit with proper documentation can result in complete disallowance. Similarly, when foreign tax amounts change after filing, many corporations fail to timely file the required amended returns with detailed explanations of the changes, triggering penalties under section 6689.

What Happens After You File

Once you attach Form 1118 to your corporate return and file, the IRS processes the credit claim as part of examining your overall tax return. The foreign tax credit reduces your tax liability dollar-for-dollar, so it directly affects the amount you owe or the refund you receive.

The IRS may select your return for examination, particularly if you claim substantial foreign tax credits or have complex multi-tier structures. During an audit, examiners will scrutinize whether foreign taxes were actually paid or properly accrued, whether they qualify as creditable income taxes versus other types of taxes, whether limitation calculations were performed correctly, and whether income was properly sourced and categorized. You must be prepared to produce foreign tax returns, receipts of payment, documentation of deemed paid calculations, and evidence supporting your earnings and profits computations.

If foreign tax amounts change after you file—perhaps you finally pay accrued taxes or receive a partial refund—you have ongoing obligations. For changes resulting in U.S. tax deficiencies, you must generally file an amended return by the due date of your return for the year the redetermination occurs. When filing the amended return, you must provide detailed information about the original accrual dates, payment dates, foreign currency amounts, and exchange rates. The IRS will calculate interest on any resulting deficiency or overpayment from the original return's due date.

Excess foreign taxes that cannot be used in the current year due to the limitation carry forward to future tax years. You must track these carryforwards carefully using Schedule K, which reconciles the prior year carryover with the current year usage and ending balance. These carryforwards can be used in any of the next ten years (subject to certain exceptions), but only against foreign income in the same limitation category. The carryforwards do not extend your filing deadline or require separate forms—they simply appear on future Forms 1118 when you have foreign income in that category.

The election to claim a foreign tax credit (versus a deduction) is made annually on a tax-year-by-tax-year basis. However, certain elections within Form 1118—such as the election to translate foreign taxes at the payment date exchange rate rather than the average rate—apply to all subsequent years and can only be revoked with IRS consent. Pay close attention to which choices are annual versus permanent.

FAQs

Can my corporation claim both a foreign tax credit and a deduction for foreign taxes in the same year?

No. The choice between claiming a credit or a deduction is made annually, and it applies to all foreign taxes paid or accrued during that year. You cannot split the treatment—taking a credit for some foreign taxes and a deduction for others. However, certain specific taxes disallowed for the credit (such as taxes related to international boycott operations) may still be deductible even when you elect the credit for your other foreign taxes. The election is made by completing and attaching Form 1118 to your return; failing to attach Form 1118 means you must take a deduction instead.

What happens if the foreign taxes I accrued turn out to be different from what I actually paid?

This creates a "foreign tax redetermination" that requires you to recalculate your U.S. tax liability. If you ultimately pay less foreign tax than you accrued and claimed as a credit, you owe additional U.S. tax plus interest. If you pay more, you're entitled to an additional credit (subject to the limitation). For tax years beginning after 1997, if you don't pay accrued foreign taxes within two years after the close of the tax year to which they relate, the same rules apply—you must reduce your credit. File an amended return with a revised Form 1118 and provide detailed information about the accrual dates, payment dates, amounts in foreign currency, and exchange rates. The special 10-year period under section 6511(d)(3) generally keeps the statute of limitations open for these adjustments.

How does the foreign tax credit work when my U.S. corporation receives dividends from a foreign subsidiary?

The credit potentially includes both direct taxes withheld on the dividend and a portion of the taxes the foreign subsidiary paid on its earnings. The withholding tax is straightforward—it's reported on Schedule B as foreign taxes directly paid. The deemed paid credit is more complex. Under section 902, when your U.S. corporation owns at least 10% of the voting stock of a foreign corporation and receives a dividend, you are deemed to have paid a proportionate share of the foreign corporation's income taxes. You calculate this on Schedule C by dividing the dividend by the subsidiary's total earnings and profits, then multiplying by the subsidiary's foreign tax pool. This deemed paid amount is both added to your income (the "gross-up" under section 78) and claimed as a credit. For multi-tier structures, you must trace through each level using Schedules D and E.

Are there any foreign taxes that don't qualify for the credit even if they're income taxes?

Yes, several categories of foreign income taxes are specifically excluded. Taxes imposed by countries designated under section 901(j) as supporting international terrorism or with which the U.S. lacks diplomatic relations cannot be credited (as of 2013, this included Cuba, Iran, North Korea, Sudan, and Syria). Taxes reduced under section 901(e) relating to minerals or section 901(f) relating to oil and gas extraction have limitations. Taxes for which the corporation is entitled to a subsidy or refund from the foreign country aren't creditable to the extent of the subsidy. Taxes paid with respect to income excluded from U.S. gross income (such as extraterritorial income exclusions) don't qualify. Additionally, if you don't meet minimum holding periods for stock or are obligated to make related payments on similar property positions under sections 901(k) or 901(l), the related taxes may be disallowed.

What should my corporation do if we have more foreign tax credits than we can use in the current year?

The excess credits can be carried back one year and then carried forward up to ten years (five years for some older credits). These carryovers must stay within the same limitation category—you cannot use an excess general category credit against passive income, for example. To carry back the excess to the prior year, file an amended return for that year with a revised Form 1118 showing the carryback. The credit can only be used to the extent you had foreign source income in that category in the prior year and had not already maximized your limitation. For carryforwards, track them on Schedule K and report them on line 5 of Part II of Form 1118 in the year you use them. You cannot carry credits to a year where you claimed a deduction rather than a credit for foreign taxes, and you must reduce carryovers by the amount you could have used in intervening years even if you chose not to claim the credit in those years.

How does my corporation choose the right "category of income" for foreign earnings?

Start with the basic distinction: passive category income consists primarily of investment-type income (interest, dividends, rents, royalties, and income from passive foreign investment companies), while general category income includes active business income and everything else not specifically categorized as passive or other special categories. However, the look-through rules require you to trace through certain payments from controlled foreign corporations. When your corporation owns at least 10% of a CFC and receives dividends, interest, rents, or royalties from it, you must look at the underlying earnings of the CFC and assign the payment to the same categories that applied to those earnings—not automatically to the passive category. Additionally, the "high-taxed income" rule can reclassify passive income to general category if the foreign tax rate exceeds the highest U.S. corporate rate. You report these reclassifications on separate lines of Schedule A using the code "HTKO" and make corresponding tax adjustments on Schedule B. Complete a separate Form 1118 for each category that applies to your situation.

Do we need to attach receipts or foreign tax returns when filing Form 1118?

No, you don't attach documentation to Form 1118 when you file. However, you must retain proof of foreign taxes paid or accrued, including foreign tax returns and receipts of payment, and produce this documentation upon IRS request. The IRS can require a bond on Form 1117 before allowing a credit for accrued but unpaid taxes. If you cannot substantiate the credit when examined, the IRS will disallow it. Keep detailed records of all foreign tax computations, earnings and profits calculations, exchange rates used, and the source of each piece of information for at least as long as the statute of limitations remains open—generally three years from filing, but potentially longer for foreign tax credit issues given the 10-year adjustment period under section 6511(d)(3).

Sources

Source: IRS Form 1118 Instructions (2013) and IRS Form 1118 (2013)

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