Form 1118: Foreign Tax Credit—Corporations (2014) – A Layman's Guide
What the Form Is For
Form 1118 is the tool corporations use to claim the foreign tax credit—a dollar-for-dollar reduction in U.S. taxes for income taxes paid to foreign countries or U.S. possessions. When a corporation earns income abroad and pays taxes to that foreign government, it could face double taxation: once by the foreign country and again by the United States. The foreign tax credit prevents this by allowing corporations to reduce their U.S. tax bill by the amount of foreign taxes they've already paid on that same income.
However, the credit comes with a critical limitation: corporations can't reduce their U.S. tax below what they would owe if all their income were domestic. The credit only covers the U.S. tax that would be owed on the foreign-source income itself. Form 1118 performs the complex calculations needed to determine exactly how much foreign tax credit a corporation can claim, ensuring it stays within IRS limits.
Corporations must elect to claim this credit, and the election applies to the entire tax year. Alternatively, corporations can choose to deduct foreign taxes as a business expense instead, but they can't mix and match within a single year—it's either a credit or a deduction for all eligible foreign taxes paid that year.
When You'd Use the Form (Late/Amended Filing)
Form 1118 must be attached to the corporation's regular income tax return (typically Form 1120) for the year in which the foreign taxes were paid or accrued, depending on the corporation's accounting method. Corporations have significant flexibility regarding when to claim the credit. The election to claim the foreign tax credit for any tax year may be made or changed at any time before the end of a special 10-year period described in Internal Revenue Code section 6511(d)(3), or longer if extended by agreement with the IRS.
Amended returns become necessary when foreign tax amounts change after the original filing—situations called "redeterminations." Common redetermination scenarios include receiving a refund of foreign taxes previously claimed as credits, paying different amounts than originally accrued, or failing to pay accrued taxes within two years of the tax year's close. For redeterminations occurring in tax years beginning after November 7, 2007, amended returns must be filed by the due date (including extensions) of the corporation's return for the tax year in which the foreign tax redetermination occurs. The amended return should include a revised Form 1118 showing corrected calculations, along with identifying information about the affected tax years and detailed explanations of the changes.
The IRS can also require amended filings if documentation is insufficient or if foreign tax credit splitting events under section 909 affect previously suspended taxes. Missing these deadlines can trigger penalties, including a $10,000 penalty under section 6689 for failing to report foreign tax redeterminations, plus interest on any resulting tax deficiency.
Key Rules or Details for the 2014 Tax Year
The foreign tax credit operates under several critical rules that determine eligibility and credit amounts. First, corporations must compute separate foreign tax credits for different "categories" of income. The 2014 form recognizes three main categories: passive category income (investment-type income like dividends, interest, and royalties that would be foreign personal holding company income), general category income (essentially everything else, including active business income and certain high-taxed passive income), and section 901(j) income (income from sanctioned countries like Cuba, Iran, North Korea, Sudan, and Syria, which receives no credit but requires separate tracking). Each category requires its own set of calculations on separate schedules.
Second, the credit is limited by a formula that prevents corporations from offsetting U.S.-source income taxes with foreign credits. The limitation for each income category equals foreign-source taxable income in that category divided by total worldwide taxable income, multiplied by the U.S. tax before credits. If foreign taxes exceed this limit, the excess cannot be used in the current year but can be carried back one year or carried forward ten years (five years for pre-October 2004 taxes) within the same income category.
Third, not all foreign taxes qualify. The credit only applies to income, war profits, and excess profits taxes—not value-added taxes, sales taxes, or property taxes. Corporations can only claim credits for taxes they legally owe; amounts eligible for refund from the foreign country don't qualify. Additionally, taxes paid to sanctioned countries, certain boycott-related taxes, and taxes on subsidized income face denial or reduction of credits.
Fourth, "deemed paid" credits extend the benefit to domestic corporations receiving dividends from foreign subsidiaries they own. When a first-tier foreign corporation pays dividends to its U.S. parent, the parent is deemed to have paid a proportionate share of the foreign taxes paid by the subsidiary on the earnings from which the dividend was paid. This deemed paid credit mechanism extends through multiple tiers of foreign corporations, up to six tiers deep for controlled foreign corporations.
Step-by-Step: How to Complete Form 1118 (High Level)
Completing Form 1118 requires careful coordination across multiple schedules, each serving a specific function in the credit calculation. The process begins by determining which separate income categories apply to your corporation's foreign-source income. You'll need to complete a separate set of core schedules for each applicable category.
Start with Schedule A
Start with Schedule A for each income category, where you calculate gross income from sources outside the United States. You'll report different types of income in separate columns (dividends, interest, rents, royalties, services income, and other income), broken down by foreign country using two-letter country codes. After listing gross income, you deduct directly allocable expenses and your share of apportioned expenses from Schedule H. The result is your income or loss before adjustments for that category.
Move to Schedule B, Parts I and II
Move to Schedule B, Parts I and II for each category, where you report foreign taxes. Part I tracks taxes paid or accrued directly (you must choose cash or accrual method consistently), broken down by type of income. You'll also include deemed paid taxes from Schedule C. Part II performs the limitation calculation—taking your foreign-source income from Schedule A (adjusted if necessary by Schedule J), dividing it by total worldwide taxable income, and multiplying by your U.S. tax before credits. The smaller of your actual foreign taxes or this calculated limitation becomes your allowable foreign tax credit for that category.
Complete Schedules C, D, and E
Complete Schedules C, D, and E if you receive dividends from foreign corporations or have subpart F inclusions from controlled foreign corporations. Schedule C calculates taxes deemed paid by your first-tier subsidiaries. Schedule D extends this to second- and third-tier foreign corporations, while Schedule E handles fourth-, fifth-, and sixth-tier corporations. These schedules require detailed information about each foreign corporation's earnings, profits, and foreign taxes paid.
Use Schedule F and Schedule G
Use Schedule F to separately report gross income and definitely allocable deductions from foreign branches. Schedule G documents required reductions in available foreign tax credits due to boycott penalties, section 6038 information reporting failures, or taxes suspended under section 909.
Complete Schedule H
Schedule H (completed only once, not per category) apportions deductions that can't be definitely allocated to specific income, such as research and development expenses and interest deductions.
Complete Schedule J and Schedule K
Complete Schedule J (once per form) if your corporation has overall foreign losses, overall domestic losses, or separate limitation losses requiring adjustments to your separate limitation income. Finally, use Schedule K for each category to reconcile prior-year foreign tax carryovers with current-year carryovers. Schedule B, Part III (completed once) summarizes your separate credits from each category and calculates your total foreign tax credit, which transfers to your corporate income tax return.
Common Mistakes and How to Avoid Them
Not Filing Separate Calculations for Each Income Category
One of the most frequent errors is failing to file separate Form 1118 calculations for each applicable income category. Corporations sometimes lump all foreign income together, mixing passive investment income with active business income. This creates incorrect credit calculations because each category has its own limitation. To avoid this, carefully classify all foreign-source income into the appropriate category before beginning calculations, and maintain separate Schedule A, B (Parts I & II), C through G, I, and K for each category.
Claiming Credits for Taxes Not Legally Owed
Another common mistake involves claiming credits for foreign taxes the corporation doesn't legally owe. Some corporations claim credits for the full amount of foreign tax assessed without investigating whether any portion is refundable under foreign law or subject to treaty provisions that reduce the tax. The IRS disallows credits for amounts the corporation could have had refunded but didn't pursue. Always verify what you actually legally owe and claim credits only for that amount.
Mishandling Reference ID Numbers
Improper handling of reference ID numbers causes processing delays and potential penalties. Reference ID numbers uniquely identify foreign corporations on Schedules C, D, and E. These must be consistent from year to year for the same foreign entity and must be properly reconciled when corporate structures change through mergers or reorganizations. Don't reuse reference IDs from defunct entities for new corporations. Create a tracking system that maintains reference ID continuity across tax years.
Missing Foreign Tax Redetermination Requirements
Corporations often miss redetermination requirements when foreign tax amounts change. If you receive a refund of foreign taxes, pay different amounts than accrued, or fail to pay accrued taxes within two years, you must file an amended return with a revised Form 1118. Failing to report these changes triggers penalties. Set up internal controls to track foreign tax payments, refunds, and timing, and review these before finalizing subsequent year returns.
Poor Documentation Practices
Documentation failures also create problems. While you don't attach tax receipts or foreign returns to Form 1118, you must maintain this documentation and provide it if the IRS requests it. Some corporations dispose of records prematurely or can't locate foreign tax documentation years later during an audit. Maintain organized files with foreign tax returns, payment receipts, and documentation of exchange rates for at least as long as your U.S. tax returns remain subject to audit (generally three years, but potentially longer).
Using Incorrect Exchange Rates
Incorrect exchange rate usage generates frequent adjustments. For accrual-basis taxpayers, the general rule requires using an average exchange rate for the tax year. However, special rules apply for taxes paid more than two years after accrual, or for taxes paid before the year they relate to—these must use the exchange rate on the date of payment. Corporations can also elect to use payment-date exchange rates for all foreign taxes. Apply the correct exchange rate methodology and document your calculations.
What Happens After You File
Once you file Form 1118 with your corporate tax return, several scenarios can unfold. If your foreign taxes paid, accrued, or deemed paid exceed the foreign tax credit limitation for a particular income category, the excess cannot be used in that year but isn't lost. The excess credit is first carried back one year to offset U.S. taxes on foreign income in the same category from the prior year. If the prior year can't absorb the entire excess, the remaining amount carries forward for up to ten years. Carrybacks and carryforwards must stay within their income category and apply to the earliest available year first. You cannot carry a credit to any year in which you claimed a deduction instead of a credit for foreign taxes.
The IRS may request documentation to substantiate your claimed credit. Although you don't attach receipts or foreign tax returns initially, you must provide these upon request. Regulations section 1.905-2 specifies the proof requirements. For accrued but unpaid taxes, the IRS may require you to furnish a surety bond (Form 1117) before allowing the credit, particularly if there's uncertainty about whether the foreign tax will actually be paid.
Foreign tax credit calculations require ongoing monitoring after filing because redeterminations trigger amended return requirements. If you receive a refund of foreign taxes previously claimed as credits, you must file an amended return for the year you claimed those taxes, reducing your foreign tax credit and paying additional U.S. tax (plus interest). Similarly, if accrued taxes differ from amounts actually paid, or if accrued taxes remain unpaid two years after the tax year's close, redetermination and amended returns become necessary.
For corporations with foreign subsidiaries, the deemed paid credit calculations create perpetual tracking requirements. You must maintain pools of earnings and profits and foreign taxes for each foreign corporation across all years. When foreign tax amounts for a subsidiary change due to refunds or adjustments, you must adjust the pools in the year the foreign tax redetermination occurs (not necessarily the year to which the taxes relate). These pool adjustments can affect multiple years of deemed paid credits.
Interest computations apply to any resulting deficiency or overpayment from foreign tax adjustments. The IRS calculates interest from the original due date of the affected return, meaning delays in reporting redeterminations increase interest charges. Penalties also apply for non-compliance: a $10,000 penalty for failing to report foreign tax redeterminations timely, plus potential penalties under section 6038 for failing to supply required information about foreign corporations (initially $10,000, escalating to $50,000 for continued failure after IRS notice).
FAQs
Can I choose between claiming a foreign tax credit or taking a deduction for my foreign taxes?
Yes, but the choice applies to your entire tax year—you cannot claim a credit for some foreign taxes and a deduction for others within the same year. The credit generally provides greater tax savings because it reduces your U.S. tax dollar-for-dollar, while a deduction only reduces taxable income. However, a deduction might be preferable if your foreign taxes exceed the credit limitation and you can't effectively use carrybacks or carryforwards. You can change your election for any tax year within the 10-year special period under section 6511(d)(3), giving you significant flexibility to optimize your tax position retroactively.
What happens if my foreign taxes exceed the limitation—do I lose those credits?
No, excess credits aren't lost immediately. You can carry the excess back to the prior tax year (within the same income category) and then forward for up to ten years. The excess applies to the earliest available year first. However, you can't carry credits to years where you claimed a deduction instead of a credit for foreign taxes. Additionally, you must reduce any carryback or carryforward by the amount you would have used if you had consistently claimed credits in all years. If you can't use the credits within the carryforward period, they do ultimately expire unused.
Do I need to complete Form 1118 if I only paid taxes to one foreign country?
Yes, if you're claiming the foreign tax credit. Even with a single foreign country, you must still complete Form 1118 because the form performs the limitation calculations that ensure your credit doesn't exceed the U.S. tax attributable to foreign-source income. You'll need to determine the applicable income category (passive, general, or section 901(j)) and complete the necessary schedules. The complexity doesn't depend on the number of countries but on the types of income, the corporate structure, and whether you have foreign subsidiaries or branches.
What if I accrued foreign taxes but haven't paid them yet—can I still claim the credit?
Yes, if you use the accrual method of accounting and make an election under section 905(a). Once made, you must consistently use the accrual method for foreign tax credits in all subsequent years. However, the IRS may require you to furnish a surety bond (Form 1117) before allowing the credit for unpaid accrued taxes. Additionally, you must actually pay the accrued taxes within two years after the close of the tax year to which they relate, or you'll face a redetermination requiring an amended return. The exchange rate generally used for accrued taxes is the average rate for the tax year, unless the payment occurs more than two years later or before the year they relate to.
How do I handle foreign taxes if I own shares in a foreign corporation that pays dividends?
The answer depends on your ownership percentage. If you own 10% or more of the voting stock and meet certain requirements, you may be entitled to a deemed paid credit—treating a portion of the foreign corporation's income taxes as if you paid them yourself, proportional to the dividend received. You'll calculate this on Schedule C (for first-tier subsidiaries) or Schedules D and E (for lower-tier subsidiaries). You must also include a "gross-up" in your income—adding the deemed paid foreign taxes back to your income, then claiming them as a credit. If you own less than 10%, you can only claim credits for taxes withheld at source when the dividend was paid to you.
What should I do if I receive a refund of foreign taxes I claimed as a credit in a previous year?
You must file an amended return for the year in which you claimed the credit for those refunded taxes. The amended return should include a revised Form 1118 reducing your foreign tax credit by the refunded amount. You'll owe additional U.S. tax for that year, plus interest calculated from the original due date of that year's return. Attach a statement to the amended return explaining the refund details: the date the taxes were originally accrued and paid, the dates and amounts refunded (in foreign currency), and the exchange rates used. File the amended return by the due date (including extensions) of your return for the tax year in which the refund occurred.
If my corporation earns income from a country on the sanctions list, what do I report on Form 1118?
Income from sanctioned countries (as of 2014: Cuba, Iran, North Korea, Sudan, and Syria under section 901(j)) receives no foreign tax credit for taxes paid to those countries. However, you must still compute a separate foreign tax credit limitation for income from each sanctioned country using a separate Form 1118 for each country. Check the section 901(j) box at the top of the form and identify the specific sanctioned country. This separate tracking ensures the income is properly limited and isolated from other foreign income categories. Note that presidential waivers can remove countries from the sanctioned list (Libya was removed effective December 10, 2004).
All information is sourced from the IRS official Instructions for Form 1118 (Rev. December 2014) and Form 1118 available at IRS.gov.
