FEDTAX * IRS * HOME * PUB_514

Foreign Taxes for Which You Cannot Take a Credit

This part discusses the foreign taxes for which you cannot take a credit. These are:

  1. Taxes on excluded income,
  2. Taxes for which you can only take an itemized deduction,
  3. Taxes on foreign oil related income,
  4. Taxes on foreign mineral income,
  5. Taxes from international boycott operations,
  6. Taxes of U.S. persons controlling foreign corporations or partnerships, and
  7. Taxes on foreign oil and gas extraction income.

Taxes on Excluded Income

You may not take a credit for foreign taxes paid or accrued on income excluded from U.S. gross income.

Foreign Earned Income and Housing Exclusions

You must reduce your foreign taxes available for the credit by the amount of those taxes paid or accrued on income that is excluded from U.S. income under the foreign earned income exclusion or the foreign housing exclusion. See Publication 54 for more information on the foreign earned income and housing exclusions.

Wages completely excluded. If your wages are completely excluded, you cannot take a credit for any of the foreign taxes paid or accrued on these wages.

Wages partly excluded. If only part of your wages is excluded, you cannot take a credit for the foreign income taxes allocable to the excluded part. You find the amount allocable to your excluded wages by multiplying the foreign tax paid or accrued on foreign earned income received or accrued during the tax year by a fraction.

The numerator of the fraction is your foreign earned income and housing amounts excluded under the foreign earned income and housing exclusions for the tax year minus otherwise deductible expenses definitely related and properly apportioned to that income. Deductible expenses do not include the foreign housing deduction.

The denominator is your total foreign earned income received or accrued during the tax year minus all deductible expenses allocable to that income (including the foreign housing deduction). If the foreign law taxes foreign earned income and some other income (for example, earned income from U.S. sources or a type of income not subject to U.S. tax), and the taxes on the other income cannot be segregated, the denominator of the fraction is the total amount of income subject to the foreign tax minus deductible expenses allocable to that income.

Example. You are a U.S. citizen and a cash basis taxpayer, employed by Company X and living in Country A. Your records show the following:

Foreign earned income received $120,000
Unreimbursed business travel expenses 20,000
Income tax paid to Country A 30,000
Exclusion of foreign earned income and housing allowance 87,225

Because you can exclude part of your wages, you cannot claim a credit for part of the foreign taxes. To find that part, do the following.

First, find the amount of business expenses allocable to excluded wages and therefore not deductible. To do this, multiply the otherwise deductible expenses by a fraction. That fraction is the excluded wages over your foreign earned income.

$20,000 x ($87,225  $120,000) = $14,538

Next, find the numerator of the fraction by which you will multiply the foreign taxes paid. To do this, subtract business expenses allocable to excluded wages ($14,538) from excluded wages ($87,225). The result is $72,687.

Then, find the denominator of the fraction by subtracting all your deductible expenses from all your foreign earned income ($120,000 - $20,000 = $100,000).

Finally, multiply the foreign tax you paid by the resulting fraction.

$30,000 x $72,687  $100,000 = $21,806The amount of Country A tax you cannot take a credit for is $21,806.

Taxes on Income From Puerto Rico Exempt From U.S. Tax

If you have income from Puerto Rican sources that is not taxable, you must reduce your foreign taxes paid or accrued by the taxes allocable to the exempt income. For information on figuring the reduction, see Publication 570.

Possession Exclusion

If you are a bona fide resident of American Samoa and exclude income from sources in American Samoa, Guam, or the Northern Mariana Islands, you cannot take a credit for the taxes you pay or accrue on the excluded income. For more information on this exclusion, see Publication 570.

Extraterritorial Income Exclusion

You cannot take a credit for taxes you pay on qualifying foreign trade income excluded on Form 8873, Extraterritorial Income Exclusion. However, see Internal Revenue Code section 943(d) for an exception for certain withholding taxes.

Taxes for Which You Can Only Take An Itemized Deduction

You cannot claim a foreign tax credit for foreign income taxes paid or accrued under the following circumstances. However, you can claim an itemized deduction for these taxes. See Choosing To Take Credit or Deduction, earlier.

Taxes Imposed By Sanctioned Countries (Section 901(j) Income)

You cannot claim a foreign tax credit for income taxes paid or accrued to any country if the income giving rise to the tax is for a period (the sanction period) during which:

  1. The Secretary of State has designated the country as one that repeatedly provides support for acts of international terrorism,
  2. The United States has severed or does not conduct diplomatic relations with the country, or
  3. The United States does not recognize the country's government, unless that government is eligible to purchase defense articles or services under the Arms Export Control Act.

The following countries meet this description for 2001. Income taxes paid or accrued to these countries in 2001 do not qualify for the credit.

  • Cuba.
  • Iran.
  • Iraq.
  • Libya.
  • North Korea.
  • Sudan.
  • Syria.

Income that is paid through one or more entities is treated as coming from a foreign country listed above if the original source of the income is from one of the listed countries.

Waiver of denial of the credit. A waiver can be granted to a sanctioned country if the President of the United States determines that granting the waiver is in the national interest of the United States and will expand trade and investment opportunities for U.S. companies in the sanctioned country. The President must report to Congress his intentions to grant the waiver and his reasons for granting the waiver not less than 30 days before the date on which the waiver is granted.

Limit on credit. In figuring the foreign tax credit limit, discussed later, income from a sanctioned country is a separate category of foreign income. You must fill out a separate Form 1116 for this income. This will prevent you from claiming a credit for foreign taxes paid or accrued to the sanctioned country.

Table 1. Countries Removed From the Sanctioned List

Example. You lived and worked in Libya until August, when you were transferred to Italy. You paid taxes to each country on the income earned in that country. You cannot claim a foreign tax credit for the foreign taxes paid on the income earned in Libya. Because the income earned in Libya is a separate category of foreign income, you must fill out a separate Form 1116 for that income. You cannot take a credit for taxes paid on the income earned in Libya, but that income is taxable in the United States.

Figuring the credit when a sanction ends. Table 1 lists the countries for which sanctions have been lifted. For any of these countries, you can claim a foreign tax credit for the taxes paid or accrued to that country on the income for the period that begins after the end of the sanction period.

Example. The sanctions against Country X were lifted on July 31. On August 19, you receive a distribution from a mutual fund of Country X income. The fund paid Country X income tax for you on the distribution. Because the distribution was made after the sanction was lifted, you may include the foreign tax paid on the distribution to compute your foreign tax credit.

Amounts for the nonsanctioned period. If a sanction period ends during your tax year and you are not able to determine the actual income and taxes for the nonsanctioned period, you can allocate amounts to that period based on the number of days in the period that fall in your tax year. Multiply the income or taxes for the year by the following fraction to determine the amounts allocable to the nonsanctioned period.

Number of nonsanctioned days in year  Number of days in year

Example. You are a calendar year filer and received $20,000 of income from Country X in 2001 on which you paid tax of $4,500. Sanctions against Country X were lifted on July 11, 2001. You are unable to determine how much of the income or tax is for the nonsanctioned period. Because your tax year starts on January 1, and the Country X sanction was lifted on July 11, 2001, 173 days of your tax year are in the nonsanctioned period. You would compute the income for the nonsanctioned period as follows:

173  365  $20,000 = $9,479You would compute the tax for the nonsanctioned period as follows:

173  365  $4,500 = $2,133

To figure your foreign tax credit, you would use $9,479 as the income from Country X and $2,133 as the tax.

Further information. The rules for figuring the foreign tax credit after a country's sanction period ends are more fully explained in Revenue Ruling 92-62, Cumulative Bulletin 1992-2, page 193. This Cumulative Bulletin can be found in many libraries and IRS offices.

Taxes Imposed on Certain Dividends

You cannot claim a foreign tax credit for withholding tax on dividends paid or accrued after September 4, 1997, if either of the following applies to the dividends.

  1. The dividends are on stock you held for less than 16 days during the 30-day period that begins 15 days before the ex-dividend date.
  2. The dividends are for a period or periods totaling more than 366 days on preferred stock you held for less than 46 days during the 90-day period that begins 45 days before the ex-dividend date. If the dividend is not for more than 366 days, rule (1) applies to the preferred stock.

When figuring how long you held the stock, count the day you sold it, but do not count the day you acquired it or any days on which you are protected from risk or loss.

Regardless of how long you held the stock, you cannot claim the credit to the extent you have an obligation under a short sale or otherwise to make payments related to the dividend for positions in substantially similar or related property.

Withholding tax. For this purpose, withholding tax includes any tax determined on a gross basis. It does not include any tax which is in the nature of a prepayment of a tax imposed on a net basis.

Ex-dividend date. The ex-dividend date is the first date on which, if the stock were sold, the dividend would be payable to the seller rather than the buyer.

Example 1. You bought common stock from a foreign corporation on November 3. You sold the stock on November 19. You received a dividend on this stock because you owned it on the ex-dividend date of November 5. To claim the credit, you must have held the stock for at least 16 days within the 30-day period that began on October 21 (15 days before the ex-dividend date). Since you held the stock for 16 days, from November 4 until November 19, you are entitled to the credit.

Example 2. The facts are the same as in Example 1 except that you sold the stock on November 14. You held the stock for only 11 days. You are not entitled to the credit.

Exception. If you are a securities dealer who actively conducts business in a foreign country, you may be able to claim a foreign tax credit for qualified taxes paid on dividends regardless of how long you held the stock. See section 901(k)(4) of the Internal Revenue Code for more information.

Taxes in Connection With the Purchase or Sale of Oil or Gas

You cannot claim a foreign tax credit for taxes paid or accrued to a foreign country in connection with the purchase or sale of oil or gas extracted in that country if you do not have an economic interest in the oil or gas, and the purchase price or sales price is different from the fair market value of the oil or gas at the time of purchase or sale.

Taxes on Foreign Oil Related Income

You cannot claim a foreign tax credit for foreign taxes paid or accrued on foreign oil related income to the extent that the tax imposed by the foreign country on such income is considered to be materially greater than the tax imposed by that country on other kinds of income. See regulations section 1.907(b)-1. The amount of tax not allowed as a credit under this rule is allowed as a business expense deduction.

Taxes On Foreign Mineral Income

You must reduce any taxes paid or accrued to a foreign country or possession on mineral income from that country or possession if you were allowed a deduction for percentage depletion for any part of the mineral income.

Taxes From International Boycott Operations

If you participate in or cooperate with an international boycott during the tax year, your foreign taxes resulting from boycott activities will reduce the total taxes available for credit. See the instructions for line 12 in the Form 1116 instructions to figure this reduction.

This rule generally does not apply to employees with wages who are working and living in boycotting countries, or to retirees with pensions who are living in these countries.

List of boycotting countries. A list of the countries which may require participation in or cooperation with an international boycott is published by the Department of the Treasury each calendar quarter. As of the date this publication was printed, the following countries are listed.

  • Bahrain.
  • Iraq.
  • Kuwait.
  • Lebanon.
  • Libya.
  • Oman.
  • Qatar.
  • Saudi Arabia.
  • Syria.
  • United Arab Emirates.
  • Republic of Yemen.

Envelope: For information concerning changes to the list, write to:
 

Internal Revenue Service
International Section
P.O. Box 920
Bensalem, PA 19020-8518

Determinations of whether the boycott rule applies. You may request a determination from the Internal Revenue Service as to whether a particular operation constitutes participation in or cooperation with an international boycott. The procedures for obtaining a determination from the Service are outlined in Revenue Procedure 77-9 in Cumulative Bulletin 1977-1. You can buy the Cumulative Bulletin from the Government Printing Office. Copies are also available in most IRS offices and you are welcome to read them there.

Public inspection. A determination and any related background file is open to public inspection. However, your identity and certain other information will remain confidential.

Reporting requirements. You must file a report with the IRS if you or any of the following persons have operations in or related to a boycotting country or with the government, a company, or national of a boycotting country.

  1. A foreign corporation in which you own 10% or more of the voting power of all voting stock but only if you own the stock of the foreign corporation directly or through foreign entities.
  2. A partnership in which you are a partner.
  3. A trust you are treated as owning.

Form 5713 required. If you have to file a report, you must use Form 5713, International Boycott Report, and attach all supporting schedules.

You must file the form in duplicate when your tax return is due, including extensions. Send one copy to the Internal Revenue Service Center, Philadelphia, PA 19255. Attach the other copy to your income tax return that you file with your usual Internal Revenue Service Center. Your reports submitted as part of the tax return are confidential.

Penalty for failure to file. If you willfully fail to make a report, in addition to other penalties, you may be fined $25,000 or imprisoned for no more than one year, or both.

Taxes on Foreign Oil and Gas Extraction Income

You must reduce your foreign taxes by a portion of any foreign taxes imposed on foreign oil and gas extraction income. The amount of the reduction is the amount by which your foreign oil and gas extraction taxes exceed the amount of your foreign oil and gas extraction income multiplied by a fraction equal to your pre-credit U.S. tax liability (Form 1040, line 40) divided by your worldwide income. You may be entitled to carry over to other years taxes reduced under this rule. See Internal Revenue Code section 907(f).

Taxes of U.S. Persons Controlling Foreign Corporations and Partnerships

If you had control of a foreign corporation or a foreign partnership for the annual accounting period of that corporation or partnership that ended with or within your tax year, you may have to file an annual information return. If you do not file the required information return, you may have to reduce the foreign taxes that may be used for the foreign tax credit. See Penalty for not filing Form 5471 or Form 8865, later.

U.S. persons controlling foreign corporations. If you had control of a foreign corporation for an uninterrupted period of at least 30 days during the annual accounting period of that corporation, you may have to file an annual information return on Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations. Under this rule, you generally had control of a foreign corporation if at any time during the corporation's tax year you owned:

  • Stock possessing more than 50% of the total combined voting power of all classes of stock entitled to vote, or
  • More than 50% of the total value of shares of all classes of stock of the foreign corporation.

U.S. persons controlling foreign partnerships. If you had control of a foreign partnership at any time during the partnership's tax year, you may have to file an annual information return on Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships. Under this rule, you generally had control of the partnership if you owned more than 50% of the capital or profits or interest, or an interest to which 50% of the deductions or losses are allocated.

You also may have to file Form 8865 if at any time during the tax year of the partnership, you owned a 10% or greater interest in the partnership while the partnership was controlled by U.S. persons owning at least a 10% interest. See the Instructions for Form 8865 for more information.

Penalty for not filing Form 5471 or Form 8865. Generally, there is a dollar penalty of $10,000 for each annual accounting period for which you fail to furnish information. Additional penalties apply if the failure continues for more than 90 days after the day on which notice of the failure to furnish the information is mailed.

If you fail to file either Form 5471 or Form 8865 when due, you may also be required to reduce by 10% all foreign taxes that may be used for the foreign tax credit. This 10% reduction shall not exceed the greater of $10,000 or the income of the foreign corporation or foreign partnership for the accounting period for which the failure occurs. This foreign tax credit penalty is also reduced by the amount of the dollar penalty imposed.