A corporation taxed on income it has already paid foreign tax on can claim relief, and this is the return that claims it.
The relief is capped by reference to what would otherwise have been payable here, computed separately for each category of income, which is why the credit is frequently worth less than the tax actually paid abroad.
This covers who files, how income is separated into categories, how the limitation works, how excess credits are carried to other years, and the documentation a claim rests on.
US corporations that pay or accrue income taxes to foreign governments can use Form 1118 to claim a foreign tax credit against their US federal income tax. This credit prevents the same income from being taxed twice, once by the foreign country and once by the United States. Form 1118 is complex and multi-schedule, but this guide breaks down the key concepts.
Who Files Form 1118?
C-corporations (not S-corporations or partnerships) that paid or accrued foreign income taxes during the tax year. The corporation has the option to either deduct foreign taxes on Schedule C of Form 1120 or claim the credit on Form 1118. The credit is almost always more valuable than the deduction.
Claims here fail on evidence far more often than on entitlement. You need proof the foreign tax was imposed and actually paid, translated where it is not in English, converted at a rate you can show. Assemble that with the year's file, not two years later from another country.
Ankit Sarawagi, CPA, CA, MBA · LinkedInIncome Categories (Baskets)
The foreign tax credit limitation is computed separately for different categories of income, known as baskets. Foreign taxes in one basket cannot offset US tax on income in another basket.
| Income Basket | Description |
|---|---|
| General category income | Wages, active business income, most income |
| Passive category income | Dividends, interest, rents, royalties (unless active business) |
| GILTI (Global Intangible Low-Taxed Income) | Income from controlled foreign corporations above a routine return |
| Foreign branch category income | Income from foreign branches of US corporations |
| Section 901(j) income | Income from sanctioned or embargoed countries |
The Foreign Tax Credit Limitation
The credit cannot exceed the US tax that would apply to the same income. The limitation formula is:
FTC Limitation = US Tax Before Credit x (Foreign-Source Taxable Income / Total Worldwide Taxable Income)
Any foreign taxes paid in excess of the limitation create a carryback (1 year) or carryforward (10 years) credit.
GILTI and Form 1118
GILTI (Global Intangible Low-Taxed Income) is income earned by controlled foreign corporations (CFCs) above a 10% return on tangible assets. US corporations include GILTI in income and can claim a foreign tax credit for 80% of the CFC's foreign taxes allocated to GILTI. The GILTI basket is separate from the general basket.
GILTI High-Tax Exclusion
Under final regulations, a US shareholder can elect to exclude GILTI that was subject to a foreign effective tax rate of more than 18.9% (90% of the US 21% corporate rate). This election prevents GILTI inclusion for high-taxed foreign income.
Completing Form 1118
Schedule A, Taxes Paid or Accrued
Lists each foreign country, the type of tax paid, the amount in foreign currency, and the US dollar equivalent. A separate Schedule A is required for each income basket.
Schedule B, Separate Foreign Tax Credit Limitation
Computes the limitation separately for each basket by allocating and apportioning deductions between foreign-source and US-source income.
Schedule C, Foreign Tax Credit Computation
Compares taxes eligible for the credit (from Schedule A) against the limitation (from Schedule B) to determine the credit for each basket.
Schedule G, Reductions in Taxes Paid or Accrued
Accounts for treaties, refunds, and disallowed taxes under the matching rules.
Carryback and Carryforward
If foreign taxes exceed the limitation, the excess is carried back 1 year and then forward 10 years. Track carryovers carefully, unused credits expire after 10 years.
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Frequently Asked Questions
Can a corporation take both the foreign tax deduction and the foreign tax credit?
No, they are mutually exclusive for each tax year. The election to credit or deduct applies to all foreign taxes for the year. The credit is generally more valuable, but running the numbers both ways is advisable in unusual situations.
Does the foreign tax credit apply to VAT paid overseas?
Generally no. The foreign tax credit applies to income taxes. VAT (value added tax) is a consumption tax and is not creditable. However, some foreign taxes labeled as VAT or sales taxes may qualify depending on their legal structure.
What supporting documentation do I need?
Retain receipts, tax returns filed in foreign countries, withholding certificates, and schedules supporting the allocation of deductions between US and foreign income. The IRS may request these documents in an examination.
What documentation supports a claim for foreign taxes?
Evidence that the tax was actually imposed and actually paid or accrued: the foreign return or assessment, the receipts or remittance advice, and a translation where the original is not in English. Amounts also have to be converted at the appropriate rate, so the record should show the rate used and why. Claims fail more often on evidence than on entitlement.
Why is the credit sometimes worth less than the tax paid?
Because the relief is capped by reference to the tax that would otherwise have been payable on that income, computed separately for each category. Tax paid abroad at a higher effective rate than applies here therefore produces more credit than can be used in the year, and the excess is carried to other years rather than refunded. Modelling the limitation before the year end is what turns this from a surprise into a plan.
Written by
Ankit Sarawagi, CPA, CA, MBA
Ankit leads the finance team at Profitjets, where he has worked with 500+ businesses across the US on bookkeeping, tax and CFO-level strategy. He writes about the habits that keep small business books accurate all year. Connect on LinkedIn
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