Form 1118 (2010) Foreign Tax Credit Guide for Corporations

or U.S. possessions. For the 2010 tax year, the foreign tax credit limitation calculation uses separate baskets for passive income and general income under the framework established by the American Jobs Creation Act of 2004, which became effective for tax years beginning after

December 31, 2006.

Eligibility Requirements for Form 1118

Only C corporations filing Form 1120 or foreign corporations filing Form 1120-F may claim the foreign tax credit on Form 1118. S corporations do not use this form because they are pass-through entities that pass foreign tax credits through to shareholders, who claim them on

Form 1116.

Your corporation must be subject to U.S. tax on worldwide income and must have paid or accrued foreign income taxes during 2010. You should verify whether your entity is a controlled foreign corporation, passive foreign investment company, or domestic corporation before proceeding.

Understanding the Two-Basket System

For the 2010 tax year, corporations must divide foreign-source income into two distinct limitation baskets: passive income and general income. This structure requires that foreign tax credit limits be calculated independently for each basket, and those limits continue to apply separately when credits are carried back or forward.

Passive income generally consists of dividend income, interest income, rents, and royalties received from unrelated parties. For 2010, this basket is applied without regard to the look-through rules that may otherwise apply to certain controlled foreign corporation dividends.

General income covers all remaining categories of foreign income, including active business earnings, foreign-source gross revenue from operations, and foreign-source wages. Each basket must be tracked and calculated separately from start to finish when completing Form

1118 to ensure the foreign tax credit is computed correctly.

Calculating Foreign-Source Taxable Income

Foreign-source taxable income must be calculated separately for each limitation basket under the 2010 tax rules, based on income and related deductions for the taxable year. Begin by identifying foreign-source gross income for each basket, then reduce that amount by allowable deductions that are properly allocated or apportioned to foreign-source income.

Certain deductions, including charitable contributions and meals and entertainment expenses, are subject to the limitation rules in effect for 2010 as outlined in the applicable IRS forms instructions. IRS Publication 514 attachment worksheets should be used to allocate deductions accurately between United States income and foreign-source income.

For 2010, deduction apportionment must be performed using either the gross income method or the net income method, and the chosen approach must be applied consistently for the entire taxable year. Switching between methods within the same year is not permitted unless proper authorization is obtained from U.S. tax authorities.

Computing U.S. Tax Before the Credit

Calculate the U.S. tax on worldwide taxable income before applying the foreign tax credit to your return. For Section 1250 property, note that real property placed in service after 1986 typically uses straight-line depreciation, resulting in no ordinary income recapture under Section

1250 for most corporate property.

You should add any net operating loss carryback or carryforward as applicable to 2010 taxable income and verify the relevant tax rate for your bracket. Determine your tentative tax before any foreign tax credit reduction using the applicable 2010 corporate tax rate under the Internal

Revenue Code.

Applying the Foreign Tax Credit Limitation Formula

Apply the limitation formula separately for each basket to calculate your maximum allowable credit for foreign income taxes paid or accrued. You must multiply your U.S. tax before credits by the ratio of foreign income in that basket to worldwide taxable income.

Multiply this result by the U.S. tax rate for 2010 to determine your limitation. The credit in each basket cannot exceed this calculated limit, and you must maintain separate calculations for passive and general income categories.

Reporting Foreign Taxes Paid or Accrued

List foreign income taxes paid or accrued during 2010 on a country-by-country basis in

Schedule A of your Form 1118. Include taxes paid on foreign income and qualified possession source investment income in your calculations, excluding taxes that are not creditable under the foreign tax credit rules.

You must exclude taxes on citizenship, license, occupation, or other taxes not based on income from your credit calculation under Reg. Sec. 1.901-2. Document foreign income taxes under the accrual method election on Form 1118, Part I, or attach schedules showing calculation detail for

IRS review on U.S. tax returns.

Allocating Taxes to Separate Baskets

Allocate creditable foreign income taxes to the passive income and general income baskets separately, in accordance with the rules in Section 901. If foreign income taxes in a basket exceed the limitation for that basket, the excess carryback is limited to one prior year, and the carryforward is limited to ten years.

Carryover periods for 2010 allow you to carry back excess credits one year to 2009 or forward ten years through 2020 under current law. You must maintain detailed workpapers for each basket that show the carryback and carryforward calculations to support your filing.

Completing Required Schedules and Attachments

Attach Form 1118 to your corporation's Form 1120 or applicable return by the filing deadline.

Include all required worksheets from the 2010 instructions, including the basket limitation worksheets for both passive and general income.

You must provide a schedule showing the country-by-country breakdown of foreign income taxes, foreign source gross income, and U.S. tax allocation. Schedule A requires reporting foreign-source taxable income by basket, with separate limitation calculations shown on the attached workpapers, consistent with the requirements established when the two-basket system became effective in 2007.

Coordinating Carryback and Carryforward Elections

If the foreign tax credit limitation prevents the use of all creditable foreign income taxes in 2010, you may elect to carry back the excess one year or carry forward ten years. Complete the carryback and carryforward worksheets in the 2010 Form 1118 instructions before filing your return.

Document the election method clearly on your workpapers to maintain compliance with IRS requirements. You should not file an amended 2009 return without first completing carryback calculations on the 2010 Form 1118 to ensure accuracy.

Understanding Deemed Paid Credit Rules

Corporations must calculate the deemed paid credit for dividend income received from controlled foreign corporations using the post-1986 pool method. The considered-to-be-paid credit applies to taxes paid by lower-tier foreign corporations on earnings distributed as dividend income to the U.S. parent corporation.

You must complete Schedule C of Form 1118 to compute taxes deemed paid under Section 902 for dividend income distributions. Document all considered to be paid credit calculations separately from direct foreign income taxes paid to maintain proper substantiation on U.S. tax returns.

Reviewing Special Income Categories

Confirm that foreign income from dividends, capital gains, Section 1231 gains, and other special categories is correctly classified within the appropriate basket. Apply 2010 sourcing rules for interest income, including the gross income method as specified in the Internal Revenue Code.

You must ensure that Section 861 through 865 sourcing rules are correctly applied to all income categories on your return to avoid classification errors that could trigger IRS examination.

Proper classification protects your corporation from potential adjustments during audit review.

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