Form 1118: Foreign Tax Credit—Corporations (2018)

What Form 1118 Is For

Purpose of Form 1118

Form 1118 is the tool corporations use to claim a foreign tax credit for income, war profits, and excess profits taxes they've paid or accrued to foreign countries or U.S. possessions. Think of it as your way to avoid 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, Form 1118 helps you calculate how much of those foreign taxes can offset your U.S. tax bill.

2018 Changes and Added Complexity

The form serves a dual purpose: it computes both your foreign-source income in various categories and determines the maximum credit you can claim. This prevents you from getting a larger credit than your U.S. tax liability on that foreign income. The 2018 version incorporated significant changes from the Tax Cuts and Jobs Act, including new income categories for global intangible low-taxed income under section 951A and foreign branch income, making it substantially more complex than earlier versions.

When You’d Use Form 1118

Electing the Foreign Tax Credit vs. Deduction

You must file Form 1118 if your corporation elects to take the foreign tax credit rather than simply deducting foreign taxes as an expense. This election is made annually, giving you flexibility to choose whichever method saves more tax each year. The form must be attached to your corporate income tax return for the year you're claiming the credit.

Timing and Election Period

The good news about timing is that you have substantial flexibility. You can make or change your election to claim the foreign tax credit anytime within a special 10-year period under section 6511(d)(3), or longer if you've extended the statute of limitations by agreement with the IRS. This means if you initially deducted foreign taxes but later realize claiming the credit would be better, you can file an amended return within this window.

Late or Amended Returns

Late or Amended Returns become necessary in several situations. If accrued foreign taxes differ from what you actually paid, if you don't pay accrued taxes within two years of the tax year's close, or if you receive a refund of foreign taxes you've already claimed, you must file amended returns for all affected years. These amended returns are due by the due date—including extensions—of the tax year when the foreign tax change occurs. You'll need to submit a revised Form 1118 with updated schedules and provide detailed information about dates, amounts, exchange rates, and the nature of the changes.

Key Rules or Details for 2018

Separate Limitation Categories

Form 1118 operates under a "separate limitation" system, meaning you must complete a separate form for each category of income. The 2018 categories include section 951A category income, foreign branch income, passive income, section 901(j) income from sanctioned countries, income re-sourced by treaty, and general category income. Each category has its own credit limitation, preventing you from averaging high-tax and low-tax foreign income to maximize your credit.

Credit Limitation and Carrybacks/Carryforwards

The credit limitation itself is crucial: you can't claim more foreign tax credit than the U.S. tax you owe on foreign income. If your foreign taxes exceed this limitation, you're not out of luck—you can carry the excess back one year or forward ten years to offset taxes in those years, though this doesn't apply to section 951A income.

Foreign Taxes That Don’t Qualify

An important rule to understand is that you can't claim credits for foreign taxes you don't legally owe or that are eligible for refund from the foreign country. You must exercise available remedies to reduce foreign tax liability to what you actually owe. Additionally, certain taxes are simply ineligible for the credit, including those paid to sanctioned countries, taxes reduced under various provisions like international boycott rules, and the applicable percentage of taxes related to section 965 transition tax inclusions.

Step-by-Step (High Level)

Step 1: Determine Applicable Income Categories

While Form 1118 is genuinely complex, the high-level process follows these steps:

First, determine which income categories apply to your situation. You'll need separate forms for each category—if you have both general category and passive income, that's two complete Form 1118 packages.

Step 2: Gather Foreign Income and Tax Information

Second, gather your foreign income and tax information. This includes gross income from foreign sources, properly allocated deductions and expenses, and documentation of all foreign taxes paid or accrued. If you're converting foreign currency, prepare to explain your conversion methodology in an attached statement.

Step 3: Complete Required Schedules

Third, complete the required schedules in order. Schedule A computes your foreign income or loss before adjustments for each category. Schedule B determines your foreign tax credit after limitations. Schedules C through G handle various types of deemed paid taxes and required tax reductions. Schedule H apportions deductions that can't be directly allocated. Schedule I addresses foreign oil and gas income reductions. Schedule J reconciles separate limitation accounts and loss balances. Schedule K tracks foreign tax carryovers from year to year.

Step 4: Attach Forms and Maintain Documentation

Fourth, attach all completed forms and schedules to your corporate tax return and retain supporting documentation. While you don't attach receipts or foreign tax returns to Form 1118, you must be prepared to provide them if the IRS requests substantiation.

Common Mistakes and How to Avoid Them

Not Filing Separate Forms for Each Category

The most frequent error is failing to file a separate Form 1118 for each applicable income category. Corporations sometimes try to combine categories on one form, which the IRS will reject. Before starting, identify all your income categories and set up separate form packages.

Incomplete or Missing Schedules

Another common mistake is incomplete schedules. Every required schedule must be filled out according to the instructions. Missing or blank schedules when they're required will delay processing and may result in adjustment or denial of your credit.

Currency Conversion Errors

Currency conversion errors plague many filers. When converting foreign currency to U.S. dollars, you must use appropriate exchange rates and attach a statement explaining your methodology. Using inconsistent rates or failing to document your approach invites scrutiny.

Overlooking Required Tax Reductions

Many corporations overlook required tax reductions. If you have income subject to special rules—such as international boycott participation, failure to file required information returns about foreign corporations, or percentage depletion benefits—you must reduce your allowable credit accordingly. Missing these reductions can trigger penalties.

Ignoring Redetermination Requirements

Perhaps the most consequential mistake is ignoring redetermination requirements. When your foreign tax situation changes after filing—whether you paid different amounts than accrued, didn't pay within two years, or received refunds—you must file amended returns. Failing to do so can result in substantial interest and penalties.

What Happens After You File

IRS Review and Documentation Requests

Once you've filed Form 1118 with your corporate return, several things may occur. The IRS may request supporting documentation at any time, so maintain organized records of foreign tax returns, receipts, payment documentation, and currency conversion calculations. These records substantiate your credit claim and protect you in case of audit.

Redeterminations and Interest

If your foreign tax situation changes after filing, you'll trigger the redetermination process. The IRS will recompute your allowable credit and your U.S. tax liability for the affected years. If you underpaid, interest accrues from the original due date. If you overpaid, you'll receive interest on the overpayment. In most cases, interest is computed automatically under sections 6601 and 6611.

Penalties and Information Return Noncompliance

Penalties can apply in several situations. If you don't comply with redetermination filing requirements within the prescribed time limits, section 6689 penalties may be assessed. If you failed to file required information returns about controlled foreign corporations or foreign partnerships—such as Forms 5471 or 8865—your allowable foreign tax credit may be reduced by 10 percent, and additional monetary penalties may apply.

Ongoing Carryover Tracking

Your carryover tracking continues year after year. Schedule K reconciles your foreign tax carryovers, showing beginning balances, current year additions from excess credits or usage from prior excess credits, and ending balances. These carryovers require meticulous tracking because they can be used only in the same income category in which they arose.

FAQs

Can I choose between taking a credit or a deduction for my foreign taxes?

Yes, you make this choice annually. Generally, you'll want to run the numbers both ways because the credit typically provides more tax savings, but in some situations—particularly with low-taxed foreign income—a deduction might be better. Just remember: if you elect the credit for a year, generally none of those foreign taxes can be deducted in that year or any subsequent year.

What if I accrued foreign taxes on my return but ended up paying a different amount?

You must file an amended return for the year you claimed the credit, along with a revised Form 1118. Include detailed information about the original accrual, the actual payment, the dates involved, and the applicable exchange rates. If you paid within two years and the difference is minor, the redetermination process is straightforward, but significant changes or payments beyond two years involve more complex reporting requirements.

Do I need to attach receipts or foreign tax returns to Form 1118?

No, documentation doesn't get attached to your Form 1118. However, you absolutely must keep these records and be ready to provide them if the IRS requests substantiation. If you claim credits for accrued but unpaid taxes, the IRS may require you to post a bond on Form 1117 before allowing the credit.

What happens if I have excess foreign taxes I can't use this year?

Excess foreign tax credits can be carried back one year and forward ten years within the same income category. To claim a carryback, file an amended return for the earlier year with a revised Form 1118 and Schedule K. Carryforwards are claimed on Schedule K of your Form 1118 in future years. The credits apply to the earliest possible year first, working forward chronologically.

Can I claim credits for taxes paid to countries like Iran or North Korea?

Generally, no. Section 901(j) denies credits for taxes paid to sanctioned countries, which as of 2018 included Iran, North Korea, Sudan, and Syria. However, if you paid taxes to another country on income sourced from a sanctioned country, you may be able to claim those credits. Each sanctioned country requires a separate Form 1118, and special rules apply—this is an area where professional guidance is especially valuable.

What if I control a foreign corporation but forgot to file the required Form 5471?

This triggers harsh consequences. Your allowable foreign tax credit must be reduced by 10 percent for any taxes related to that foreign corporation. Additionally, you face potential monetary penalties of $10,000 per form per year, with penalties increasing if you continue failing to file after IRS notification. The lesson is clear: information return compliance is critical to preserving your foreign tax credit.

How do I handle currency exchange rates?

Convert all amounts to U.S. dollars using appropriate exchange rates for the dates transactions occurred. For taxes paid, use the exchange rate on the payment date. For accrued taxes, use the rate on the accrual date. You must attach a statement to Form 1118 explaining your conversion methodology. Consistency matters—use the same approach throughout your return and from year to year unless facts warrant a change.

Sources:

All information in this summary comes exclusively from official IRS sources: Instructions for Form 1118 (Rev. December 2018), Form 1118 (Rev. December 2018), and About Form 1118 from IRS.gov.

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