Form 1118: Foreign Tax Credit—Corporations (2015)
What the Form Is For
Form 1118 is the official IRS document that corporations use to claim a foreign tax credit for income, war profits, and excess profits taxes paid or accrued to foreign countries or U.S. possessions. The foreign tax credit allows U.S. corporations to reduce their U.S. tax liability dollar-for-dollar by the amount of foreign taxes they've already paid on income earned abroad, thereby preventing double taxation on the same income.
This form is required whenever a corporation chooses to take a credit (rather than a deduction) for eligible foreign taxes. The form includes numerous schedules that help calculate the allowable credit based on complex rules about different categories of income, deemed-paid taxes from foreign subsidiaries, and various limitations. Corporations must complete a separate Form 1118 for each applicable category of income, such as passive category income (dividends, interest, royalties) and general category income (most other foreign-source income).
The form serves as both a computation tool and supporting documentation that must be attached to the corporation's regular income tax return. It requires detailed reporting of foreign-source gross income, definitely allocable deductions, foreign taxes paid or accrued, and calculations showing that the credit doesn't exceed certain statutory limits designed to ensure the credit applies only to U.S. tax on foreign-source income.
When You'd Use It (Including Late and Amended Filings)
Corporations file Form 1118 with their annual income tax return whenever they elect to claim the foreign tax credit. This election can be made for the first time, or changed from a deduction to a credit, at any time before the end of a special 10-year period described in section 6511(d)(3) of the Internal Revenue Code. This extended timeframe gives corporations significant flexibility to evaluate whether taking the credit or deduction provides greater tax benefit in any given year.
Amended returns with revised Forms 1118 become necessary when foreign tax redeterminations occur. A redetermination is required when accrued foreign taxes differ from amounts actually paid, when accrued taxes aren't paid within two years after the tax year ends, or when foreign taxes are refunded either partially or fully. Corporations must file amended returns by specific deadlines: for redeterminations occurring after November 7, 2007, the amended return is due no later than the due date (with extensions) of the corporation's return for the tax year in which the redetermination occurs.
Corporations also file amended Forms 1118 to carry back excess foreign tax credits to earlier years. If foreign taxes paid in the current year exceed the credit limitation, the excess can be carried back one year or carried forward ten years (five years for certain pre-2004 taxes). To claim a carryback, the corporation must file an amended tax return with a revised Form 1118 and Schedule K showing the carryback calculation. The IRS may require a surety bond on Form 1117 if credits are claimed on an accrual basis before taxes are actually paid.
Key Rules to Know
Foreign Tax Credit Limitation
The foreign tax credit operates under a fundamental limitation: you cannot reduce your U.S. tax by more than the amount of U.S. tax that applies to your foreign-source income. This prevents corporations from using excess foreign taxes on foreign income to offset U.S. tax on domestic income. The limitation is calculated separately for each category of income, which is why multiple Forms 1118 may be needed.
Cash vs. Accrual Method and Legal Liability
Corporations can choose between the cash method (crediting taxes when paid) or accrual method (crediting taxes when accrued) of accounting for foreign taxes, but once the accrual election is made, it applies to all subsequent years unless permission is obtained to change. Importantly, corporations cannot claim a credit for taxes they don't legally owe, including amounts eligible for refund from the foreign government. If the corporation fails to exercise available remedies to reduce its foreign tax liability to what it legally owes, the excess cannot be credited.
Direct vs. Deemed-Paid Taxes
The form requires separate tracking of taxes paid directly by the domestic corporation versus taxes ""deemed paid"" on distributions from foreign subsidiaries. For dividends received from controlled foreign corporations and certain other foreign entities, the domestic shareholder may be deemed to have paid a proportionate share of the foreign taxes paid by the subsidiary. This deemed-paid credit involves complex calculations based on the subsidiary's post-1986 undistributed earnings and foreign income taxes, with different rules applying to first-tier, second-tier, and even sixth-tier foreign corporations.
Taxes That Don’t Qualify or Must Be Reduced
Several categories of foreign taxes are either ineligible for the credit or must be reduced. No credit is allowed for taxes paid to sanctioned countries (which in 2015 included Cuba, Iran, North Korea, Sudan, and Syria unless waived), taxes reduced under boycott provisions, certain taxes on subsidized income, or taxes on amounts that don't constitute income under U.S. tax principles. These reductions must be reported on Schedule G of the form.
Step-by-Step (High Level)
Step 1: Determine the Category of Income and Report Gross Income
Begin by determining which separate category of income applies to your foreign-source income—passive category income or general category income being the most common. You'll need to complete a separate Form 1118 for each applicable category. On Schedule A, report your gross income from foreign sources for that category, broken down by country using two-letter country codes. Include dividends, interest, rents, royalties, services income, and other foreign-source income in the appropriate columns.
Step 2: Calculate and Report Deductions
Next, calculate and report your deductions on Schedule A. Enter definitely allocable deductions (such as expenses directly tied to foreign income) and your apportioned share of deductions not definitely allocable (calculated on Schedule H based on asset values or other allocation methods). Subtract total deductions from gross income to arrive at your income before adjustments for each country and for the category as a whole.
Step 3: Report Foreign Taxes Paid, Accrued, or Deemed Paid
On Schedule B, Part I, report all foreign taxes paid, accrued, or deemed paid for the category. Indicate whether you're using the cash or accrual method and provide the dates. Include taxes withheld at source on dividends, interest, and other payments, plus other foreign income taxes paid directly. If you received dividends from foreign subsidiaries, complete Schedules C, D, and E to calculate deemed-paid taxes, which flow to Schedule B, Part I, column 3.
Step 4: Compute the Foreign Tax Credit Limitation
Calculate your credit limitation in Schedule B, Part II. This involves taking your foreign-source taxable income for the category (line 7), dividing it by your worldwide taxable income (line 8c), then multiplying that fraction by your total U.S. income tax. The result is the maximum credit you can claim for that category. Compare your total foreign taxes (line 6) to this limitation (line 11), and enter the smaller amount as your separate foreign tax credit (line 12). If you have credits in multiple categories, summarize them all in Part III.
Step 5: Complete Supporting Schedules and Attach to Your Return
Finally, compile supporting schedules. Schedule F reports foreign branch income and deductions. Schedule G documents any required reductions of taxes. Schedule H apportions deductions like research and development expenses and interest expense that aren't definitely allocable to specific income. If you have carryovers from prior years or carrybacks, complete Schedule K. Attach all schedules to your Form 1118 and attach the complete Form 1118 to your corporate income tax return.
Common Mistakes and How to Avoid Them
Claiming Credit for Taxes Not Legally Owed or Refundable
One frequent error is attempting to claim a credit for foreign taxes the corporation doesn't legally owe or failing to seek refunds from foreign governments when entitled. Before claiming the credit, verify that you've exhausted all remedies to reduce your foreign tax to what you legally owe. If the foreign country would refund part of the tax upon proper application, you cannot credit the refundable portion.
Failing to File Amended Returns After Foreign Tax Redeterminations
Many corporations fail to file required amended returns when foreign tax redeterminations occur. If taxes you accrued and claimed differ from what you actually paid, or if you receive a refund of foreign taxes, or if you don't pay accrued taxes within two years of the year-end, you must file an amended return with a revised Form 1118 by the specified deadline. Set up systems to track payment dates of accrued taxes and any correspondence from foreign tax authorities about refunds or adjustments.
Poor Documentation and Recordkeeping
Another common mistake is incomplete or inadequate documentation. While the IRS doesn't require you to attach receipts or foreign tax returns when you file, you must maintain this documentation and provide it upon request. Keep records showing the amount of foreign taxes paid in both foreign currency and U.S. dollars, conversion rates used, dates of accrual and payment, and copies of foreign tax returns. For deemed-paid credits, maintain detailed records of foreign subsidiary earnings and profits pools and foreign tax pools.
Not Separating Categories of Income Correctly
Corporations sometimes fail to compute credits separately for each required category of income or neglect to file separate Forms 1118 for different categories. Review your foreign-source income carefully to classify it correctly as passive or general category. Income that is ""high-taxed"" (where foreign taxes exceed a certain threshold) gets reclassified from passive to general category, requiring adjustments on Schedule A and Schedule B.
Errors in Deemed-Paid Tax Calculations
Errors in calculating deemed-paid taxes are particularly common due to their complexity. When computing deemed-paid credits from foreign subsidiaries, ensure you're using the correct earnings and profits pools (post-1986 versus pre-1987), applying the right foreign tax pools, and correctly computing the ratio of dividends received to total earnings. Mistakes in these calculations can significantly overstate or understate your allowable credit.
What Happens After You File
IRS Review and Documentation Requests
The IRS reviews your Form 1118 as part of examining your corporate income tax return. The agency may request supporting documentation including receipts of foreign tax payments, foreign tax returns, exchange rate calculations, and detailed records of foreign subsidiary earnings and taxes. Even though you don't submit this documentation initially, you must maintain it and produce it upon request. Failure to provide adequate substantiation can result in disallowance of the claimed credit.
Processing Carrybacks and Carryforwards
If you carry back an excess foreign tax credit to a prior year, the IRS processes the amended return and Schedule K showing the carryback. This may generate a refund of U.S. taxes previously paid. The IRS applies carrybacks and carryforwards in chronological order, first to the earliest eligible year. You cannot carry a credit to any year in which you claimed a deduction rather than a credit for foreign taxes.
Reporting Foreign Tax Redeterminations
When a foreign tax redetermination occurs after filing, you must report it by filing an amended return with revised Form 1118 and detailed information about the redetermination. You must explain the dates and amounts of foreign taxes accrued, paid, and refunded, provide exchange rates used, and demonstrate how the change affects your U.S. tax liability. For foreign taxes deemed paid by foreign corporations, adjustments are generally made to the foreign corporation's earnings and profits pools and tax pools rather than requiring amended returns for every affected year.
Penalties for Noncompliance
If you don't comply with redetermination reporting requirements or miss filing deadlines, the IRS can assess penalties under section 6689 (potentially up to 10 percent of the deficiency attributable to the failure) plus interest on any tax deficiency. Interest runs from the due date of the return for the year to which the foreign taxes relate, potentially accumulating for years if redeterminations aren't promptly reported.
Tracking and Using Excess Credit Carryforwards
For excess credits carried forward, track them on Schedule K each year, reducing the carryforward balance as you use the credits and letting unused credits expire after ten years (or five for certain pre-2004 credits). The carried-forward credits remain in their original separate category, so passive category carryforwards can only offset future passive category income limitations.
FAQs
Can I switch between taking a credit and taking a deduction for foreign taxes from year to year?
Yes, you can choose each year whether to take a credit or a deduction for all eligible foreign taxes paid or accrued that year. You cannot split the treatment—taking a credit for some foreign taxes and a deduction for others in the same year. You also have up to ten years to change your election for any given tax year, providing flexibility to reassess which treatment is more beneficial as your tax situation becomes clearer. However, once you elect the accrual method for claiming credits, you must continue using it in subsequent years unless you obtain IRS permission to change.
What's the difference between taxes I paid directly and taxes deemed paid?
Taxes paid directly are foreign income taxes your domestic corporation actually paid to a foreign government on income it earned directly. Taxes deemed paid are foreign taxes that foreign subsidiaries paid on their income, which are attributed to you proportionately when those subsidiaries distribute earnings to your U.S. corporation as dividends or when you include certain amounts in your income under Subpart F rules. The deemed-paid credit recognizes that earnings distributed from foreign subsidiaries have already borne foreign tax at the subsidiary level.
Do I need to file a separate Form 1118 for each foreign country where I paid taxes?
No, you don't file separate forms by country. Instead, you file separate Forms 1118 for each applicable separate category of income (such as passive category income and general category income). Within each Form 1118, you list multiple countries on Schedule A and Schedule B, using two-letter country codes, and report income and taxes for all countries in that category. However, you must use a separate Form 1118 for income from sanctioned countries and for income re-sourced by tax treaty.
What happens if my foreign taxes exceed the limitation so I can't use all my credits this year?
Excess foreign tax credits in a separate category can be carried back one year and then carried forward up to ten years (five years for certain pre-2004 credits). The excess is applied first to the earliest eligible year, then to the next earliest, and so on. To claim a carryback, file an amended return with a revised Form 1118 and Schedule K. For carryforwards, report them on Schedule K each year and claim them when you have excess limitation in that category in future years. Credits expire if not used within the carryforward period.
If I accrued and claimed credit for foreign taxes but then didn't pay them within two years, what do I do?
You must file an amended return for the year in which you claimed the credit, removing the credit for the unpaid taxes. This may result in additional U.S. tax owed for that earlier year, plus interest and potentially penalties if the amended return isn't filed timely. If you later pay the foreign taxes, you can claim the credit in the year of payment using the cash method, subject to that year's limitation. This rule ensures credits are allowed only for foreign taxes actually paid.
How do I know if my income is passive category or general category?
Passive category income generally includes dividends, interest, rents, royalties, and other investment-type income that would be foreign personal holding company income if earned by a controlled foreign corporation. General category income includes most active business income, including services income, sales income, and manufacturing income. However, passive income is reclassified to general category if it's ""high-taxed,"" meaning the foreign taxes paid on it exceed the highest U.S. corporate tax rate. The instructions provide detailed definitions and exceptions, and in many cases, look-through rules apply to dividends and interest from controlled foreign corporations based on the underlying character of the income.
What proof do I need to keep to substantiate my foreign tax credit claim?
Although you don't attach documentation to Form 1118 when filing, you must maintain records including receipts of foreign tax payments (or foreign tax returns if you use the accrual method), documents showing the amount of taxes in foreign currency, exchange rates used for conversion to U.S. dollars, dates when taxes were accrued and paid, and evidence that the taxes are creditable income taxes rather than other types of levies. For deemed-paid credits, keep detailed records of foreign subsidiary earnings and profits, distributions received, and foreign taxes paid by subsidiaries. The IRS can request this documentation during an examination, and failure to provide adequate proof can result in disallowance of the credit.
Sources
All information in this summary comes directly from official IRS materials:
