As provided for in Sec. 901, in general, U.S. citizens, corporations, and certain resident aliens can claim a foreign tax credit (FTC) against income tax that they paid or accrued to foreign countries and U.S. possessions; this helps U.S. taxpayers avoid a double tax, since the United States taxes foreign income. Regs. Sec. 1.901-1(b) lists sections of the Code that impose limitations on the credit, the one most relevant to this article being Sec. 904(a), which limits the credit to the amount of tax that would have been paid to the United States on the foreign income. To meet that limitation, per Sec. 904(b)(2)(B), taxpayers may have to make certain adjustments to foreign capital gains and losses when reporting them.1
These adjustments are complex, and many tax practitioners rely on the instructions to Form 1116, Foreign Tax Credit, and IRS Publication 514, Foreign Tax Credit for Individuals. The pertinent lines of Form 1116 are 1a (gross income from foreign sources) and 5 (losses from foreign sources). This article discusses and seeks to clarify some requirements of Form 1116 and the adjustments' directions as laid out in Publication 514. This article also suggests some edits to Publication 514.
Taxpayers must consult the instructions for Form 1116 to determine whether they are required to make adjustments to their foreign capital gains and losses and, if so, whether they must use the instructions for Form 1116 or those in Publication 514 to make the adjustments.
Income categories and tax rate groups
Regs. Sec. 1.904-4(a) provides that foreign tax credit limitations must be computed separately for different income categories: passive, general, and additional categories. Reflecting this, Form 1116 differentiates foreign income into five income categories, each requiring its own Form 1116:
- Passive income;
- General income;
- Sec. 901(j) income (from sanctioned countries; income tax paid to these countries does not qualify for the FTC but is deductible);
- Certain income re-sourced by treaty; and
- Lump-sum distributions.
To calculate the adjustments, practitioners may also have to drill down and further partition income categories into tax rate groups: 28%, 25%, 20%, 15%, 0%, and short-term. So, for example, a taxpayer might have a passive income 20% capital gain, in which case the income category is passive and the rate group is 20%.
Capital gain and loss adjustments (Publication 514)
There are two overall types of adjustments for foreign capital gains and losses:
- U.S. capital loss adjustment, which reduces foreign capital gains via subtraction of an amount based on any U.S. net capital losses; and
- Capital gain rate differential adjustment, which reduces all or a portion of foreign capital gains and losses via multiplication by certain percentages to adjust for the differences between the various capital gains tax rates and the ordinary income tax rate. This adjustment has two scenarios:
• Net capital gain in a Form 1116 income category tax rate group, or
• Net capital loss in a Form 1116 income category tax rate group.
Note: Before making these adjustments, taxpayers must reduce their foreign net capital gain by any amount they elect to include in investment income on line 4g of Form 4952, Investment Interest Expense Deduction. Foreign gain they elect to include on line 4g of Form 4952 is included on line 1a of Form 1116 without adjustment.
U.S. capital loss adjustment
A taxpayer may have to adjust the amount of his or her foreign capital gains by the U.S. capital loss adjustment. The taxpayer must make the adjustment if the taxpayer's foreign-source capital gain exceeds his or her worldwide capital gain. If foreign-source capital gains do not exceed worldwide capital gains, the adjustment is not necessary. The U.S. capital loss adjustment is the amount by which the foreign-source capital gain exceeds the amount of worldwide capital gain; for this to occur there must be a U.S. capital loss.
Foreign capital gain is the amount by which foreign capital gains (the sum of short- and long-term gains) exceed foreign capital losses (the sum of short- and long-term losses). Since foreign capital gain will be reduced by the amount of the U.S. capital loss adjustment, if foreign capital gains do not exceed foreign capital losses, a taxpayer skips the U.S. capital loss adjustment.
Worldwide capital gain is the amount by which the taxpayer's worldwide (U.S. plus foreign) capital gains (sum of short- and long-term gains) exceed worldwide (U.S. plus foreign) capital losses (sum of short- and long-term losses). If the taxpayer's worldwide capital losses equal or exceed worldwide capital gains, worldwide capital gain is zero.
Income category tax rate groups with net capital gains
Taxpayers reduce the amount of their foreign capital gains by the amount of their U.S. capital loss adjustment, as follows:
Step 1: Apportion the U.S. capital loss adjustment pro rata among the Form 1116 income categories that have short- or long-term net capital gains.
Step 2: Further drill down into each income category that has a net capital gain in more than one rate group and refine the U.S. capital loss adjustment by apportioning it pro rata to the tax rate groups with net capital gains (i.e., the capital gain in that rate group is greater than the capital loss in that rate group).
Example 1: D has a net $300 U.S. capital loss. D also has foreign capital gains and losses in the income categories shown in the table below,"D's Foreign Capital Gains and Losses by Income Categories." D's passive foreign net capital gain is $200 ($200 − $100 + $100). D's general foreign net capital gain is $400 ($700 − $300). D's foreign-source capital gain is $600 ($200 + $400). D's worldwide capital gain is $300 (the $300 U.S. capital loss plus the foreign capital gain).
