How To Figure the Credit As already indicated, you can claim a foreign tax credit only forforeign taxes on income, war profits, or excess profits, or taxes inlieu of those taxes. In addition, there is a limit on the amount ofthe credit that you can claim. You figure this limit and your crediton Form 1116. Your credit is the amount of foreign tax you paid oraccrued or, if smaller, the limit. If you have foreign taxes available for credit but you cannot usethem because of the limit, you may be able to carry them back to the 2previous tax years and forward to the next 5 tax years. SeeCarryback and Carryover , later. Also, certain tax treaties have special rules that you mustconsider when figuring your foreign tax credit. See Tax Treaties,later. Exemption from foreign tax credit limit.You will not be subject to this limit and will be able to claim thecredit without using Form 1116 if the following requirements are met. You are an individual. Your only foreign source gross income for the tax year ispassive income (see Passive Income later underSeparate Limit Income). Your qualified foreign taxes for the tax year are not morethan $300 ($600 if filing a joint return). All of your gross foreign income and the foreign taxes arereported to you on a payee statement (such as a Form 1099-DIV or1099-INT). You elect this procedure for the tax year. If you make this election, you cannot carry back or carry over anyunused foreign tax to or from this tax year. Caution: This election exempts you only from the limit figured on Form 1116not from the other requirements described in thispublication. For example, the election does not exempt you from therequirement that the foreign tax be a nonrefundable income tax. Limit on the Credit Your foreign tax credit cannot be more than your total U.S. taxliability multiplied by a fraction. The numerator of the fraction isyour taxable income from sources outside the United States. Thedenominator is your total taxable income from U.S. and foreignsources. For purposes of figuring the limit, your U.S. tax liability is theamount on line 40, Form 1040, less any amounts on lines 41through 45 and any mortgage interest credit and District of Columbiafirst-time homebuyer credit on line 47 of Form 1040. To determine the limit, you must separate your foreign sourceincome into categories, as discussed under Separate LimitIncome. The limit treats all foreign income and expenses in eachseparate category as a single unit and limits the credit to the U.S.income tax on the taxable income in that category from all sourcesoutside the United States. Separate Limit Income You must figure the limit on a separate Form 1116 for each of thefollowing categories of income: Passive income, High withholding tax interest, Financial services income, Shipping income, Certain dividends from a domestic international salescorporation (DISC) or former DISC, Certain distributions from a foreign sales corporation (FSC)or former FSC, Any lump-sum distributions from employer benefit plans forwhich the special averaging treatment is used to determine yourtax, Section 901(j) income, Income re-sourced by treaty, and General limitation income. This is all other income notincluded in the above categories. In figuring your separate limits, you must combine the income (andlosses) in each category from all foreign sources, and then apply thelimit. Income from controlled foreign corporations.As a U.S. shareholder, certain income that you receive or accruefrom a controlled foreign corporation (CFC) is treated as separatelimit income. You are considered a U.S. shareholder in a CFC if youown 10% or more of the total voting power of all classes of thecorporation's stock. Subpart F inclusions, interest, rents, and royalties from a CFC aregenerally treated as separate limit income if they are attributable tothe separate limit income of the CFC. A dividend paid or accrued outof the earnings and profits of a CFC is treated as separate limitincome in the same proportion that the part of earnings and profitsattributable to income in the separate category bears to the totalearnings and profits of the CFC. Partnership distributive share.In general, a partner's distributive share of partnership income istreated as separate limit income if it is from the separate limitincome of the partnership. However, if the partner owns less than a10% interest in the partnership, the income is generally treated aspassive income. For more information, see section 1.904-5(h) ofthe regulations. Passive Income Except as described above under Income from controlled foreigncorporations and Partnership distributive share,passive income generally includes dividends, interest, rents,royalties, and annuities. It also includes net gain from the sale ofnon-income-producing investment property or property that generatespassive income. Net gain from commodities transactions is included,except for hedging and active business gains or losses of producers,processors, merchants, or handlers of commodities. Passive income alsoincludes amounts you must include as foreign personal holding companyincome under section 551(a) or 951(a) of the Internal Revenue Code andamounts includible under section 1293 of the Internal Revenue Code(relating to certain passive foreign investment companies). If you receive foreign source distributions from a mutualfund that elects to pass through to you the foreign tax credit,the income is generally considered passive. The mutual fund will needto provide you with a written statement showing the amount of foreigntaxes it elected to pass through to you. What is not passive income.Passive income does not include any of the following. Gains or losses from the sale of inventory property orproperty held mainly for sale to customers in the ordinary course ofyour trade or business. Export financing interest. High-taxed income. Active business rents and royalties from unrelatedpersons. Any income that is defined in another separate limitcategory. Export financing interest.This is interest derived from financing the sale or otherdisposition of property for use outside the United States if: The property is manufactured or produced in the UnitedStates, and 50% or less of the value of the property is due to importsinto the United States. High-taxed income.This is passive income subject to foreign taxes that are higherthan the highest U.S. tax rate that can be imposed on the income. Thehigh-taxed income and the taxes imposed on it are moved from thepassive income category into the general limitation income category.See section 1.904-4(c) of the regulations for more information. High Withholding Tax Interest High withholding tax interest is interest (except export financinginterest) that is subject to a foreign withholding tax or other taxdetermined on a gross basis of at least 5%. If interest is not highwithholding tax interest because it is export financing interest, itis usually general limitation income. However, if it is received by afinancial services entity, it is financial services income. Financial Services Income Financial services income generally is income received or accruedby a financial services entity. This is an entity predominantlyengaged in the active conduct of a banking, financing, insurance, orsimilar business. If you qualify as a financial services entity,financial services income includes income from the active conduct ofthat business, passive income, high-taxed income, certain incidentalincome, and export financing interest which is subject to a foreignwithholding or gross-basis tax of at least 5%. Shipping Income This is income derived from, or in connection with, the use (orhiring or leasing for use) of any aircraft or vessel in foreigncommerce or income derived from space or ocean activities. It alsoincludes income from the sale or other disposition of these aircraftor vessels. Shipping income that is also financial services income istreated as financial services income. DISC Dividends This dividend income generally consists of dividends from aninterest charge domestic international sales corporation (DISC) orformer DISC that are treated as foreign source income. FSC Distributions These are: Distributions from a foreign sales corporation (FSC) orformer FSC out of earnings and profits attributable to foreign tradeincome, or Interest and carrying charges incurred by an FSC or formerFSC from a transaction that results in foreign trade income. Lump-Sum Distribution If you receive a foreign source lump-sum distribution (LSD) from aretirement plan, and you figure the tax on it using the specialaveraging treatment for LSDs, you must make a special computation. TaxTip: The special averaging treatment for LSDs is elected by filing Form4972, Tax on Lump-Sum Distributions. Follow the Form 1116 instructions and complete the worksheet inthose instructions to determine your foreign tax credit on the LSD. Section 901(j) Income This is income earned from activities conducted in certainsanctioned countries. Income derived from each such country is subjectto a separate foreign tax credit limitation. Therefore, you must use aseparate Form 1116 for income earned from each such country. SeeTaxes Imposed By Certain Foreign Countries (Section 901(j)income), under Foreign Taxes for Which You Cannot Take aCredit, earlier. Income Re-sourced By Treaty If a sourcing rule in an applicable income tax treaty treats any ofthe income described below as foreign source, and you elect to applythe treaty, the income will be treated as foreign source. Certain gains (section 865(h)). Certain income from a U.S.-owned foreign corporation(section 904(g)(10)). See Regulations section 1.904-5(m)(7) foran example. You must compute a separate foreign tax credit limitation for anysuch income for which you claim benefits under a treaty, using aseparate Form 1116 for each amount of re-sourced income from a treatycountry. General Limitation Income This is income from sources outside the United States that does notfall into one of the other separate limit categories. It generallyincludes active business income as well as wages, salaries, andoverseas allowances of an individual as an employee. Allocation of Foreign Taxes If you paid or accrued foreign income tax for a tax year on incomein more than one separate limit income category, allocate the tax tothe income category to which the tax specifically relates. If the taxis not specifically related to any one category, you must allocate thetax to each category of income. You do this by multiplying the foreign income tax related to morethan one category by a fraction. The numerator of the fraction is thenet income in a separate category. The denominator is the total netforeign income. You figure net income by deducting from the gross income in eachcategory and from the total foreign income any expenses, losses, andother deductions definitely related to them under the laws of theforeign country or U.S. possession. If the expenses, losses, and otherdeductions are not definitely related to a category of income underforeign law, they are apportioned under the principles of the foreignlaw. If the foreign law does not provide for apportionment, use theprinciples covered in the U.S. Internal Revenue Code. Example.You paid foreign income taxes of $3,200 to Country A on wages of$80,000 and interest income of $3,000. These were the only items ofincome on your foreign return. You also have deductions of $4,400that, under foreign law, are not definitely related to either thewages or interest income. Because the foreign tax is not specifically for either item ofincome, you must allocate the tax between the wages and the interestunder the tax laws of Country A. For purposes of this example, assumethat the laws of Country A do this in a manner similar to the U.S.Internal Revenue Code. First figure the net income in each category byallocating those expenses that are not definitely related to eithercategory of income. You figure the expenses allocable to wages (general limitationincome) as follows: $80,000 (wages) $83,000 (total income) $4,400= $4,241The net wages are $75,759 ($80,000 - $4,241). You figure the expenses allocable to interest (passive income) asfollows: $3,000 (interest) $83,000 (total income) $4,400 = $159The net interest is $2,841 ($3,000 - $159). Then, to figure the foreign tax on the wages, you multiply thetotal foreign income tax by the following fraction: $75,759 (net wages)$78,6000(total net income) $3,200 = $3,084 You figure the foreign tax on the interest income as follows. $2,841 (net income)$78,600(total income)$3,200=$116 Foreign Taxes From a Partnership or anS Corporation If foreign taxes were paid or accrued on your behalf by apartnership or an S corporation, you will figure your credit usingcertain information from the Schedule K-1 you received from thepartnership or S corporation. To figure your credit for taxes paid oraccrued on your behalf by the partnership, refer to lines 17a through17g of Schedule K-1 (Form 1065) or box 9 of Schedule K-1(Form 1065-B). To figure your credit for taxes paid or accruedon your behalf by the S corporation, refer to lines 15a through 15g onSchedule K-1 (Form 1120S). Figuring the Limit Before you can determine the limit on your credit, you must firstfigure your total taxable income from all sources beforethe deduction for personal exemptions. This is the amount shownon line 37 of Form 1040. Then for each category of income, you mustfigure your taxable income from sources outside the United States. Foreign earned income.For this computation, taxable income does not include any incomethat is exempt from tax under the foreign earned income exclusion orthe foreign housing exclusion. These exclusions from income arediscussed in detail in Publication 54. Table 4. Source of Income Determining Source of Income Before you can figure your taxable income in each category fromsources outside the United States, you must first determine whetheryour gross income in each category is from U.S. sources or foreignsources. Some of the general rules for figuring the source of incomeare outlined in Table 4. Sales or exchanges of certain personal property.Generally, if personal property is sold by a U.S. resident, thegain or loss from the sale is treated as U.S. source. If personalproperty is sold by a nonresident, the gain or loss is treated asforeign source. This rule does not apply to the sale of inventory, intangibleproperty, or depreciable property, or property sold through a foreignoffice or fixed place of business. The rules for these types ofproperty are discussed later. U.S. resident.The term "U.S. resident," for this purpose, means a U.S.citizen or resident alien who does not have a tax home in a foreigncountry. The term also includes a nonresident alien who has a tax homein the United States. Generally, your tax home is the general area ofyour main place of business, employment, or post of duty, regardlessof where you maintain your family home. Your tax home is the placewhere you are permanently or indefinitely engaged to work as anemployee or self-employed individual. If you do not have a regular ormain place of business because of the nature of your work, then yourtax home is the place where you regularly live. If you do not fiteither of these categories, you are considered an itinerant and yourtax home is wherever you work. Nonresident.A nonresident is any person who is not a U.S. resident. U.S. citizens and resident aliens will not be treated asnonresidents for a sale of personal property unless anincome tax of at least 10% of the gain on the sale is paid to aforeign country. This rule also applies to losses recognized after January 10, 1999,if the foreign country would have imposed a 10% or higher tax had thesale resulted in a gain. You can choose to apply this rule to lossesrecognized in tax years beginning after 1986. For details about makingthis choice, see section 1.865-1T(f)(2) of the regulations. Forstock losses, see section 1.865-2(e) of the regulations. Inventory.Income from the sale of inventory that you purchased is sourcedwhere the property is sold. Generally, this is where title to theproperty passes to the buyer. Income from the sale of inventory that you produced in the UnitedStates and sold outside the United States (or vice versa) is sourcedbased on an allocation. For information on making the allocation, seesection 1.863-3 of the Regulations. Intangibles.Income from the sale of intangible property (such as a patent,copyright, trademark, or goodwill) that is contingent on theproductivity, use, or disposition of the property is sourced in thecountry where the property is used. If the income is not contingent onthe productivity, use, or disposition of the property, the income issourced according to the seller's tax home as discussed earlier.Payments for goodwill are sourced in the country where the goodwillwas generated if the payments are not contingent on the productivity,use, or disposition of the property. Depreciable property.The gain from the sale of depreciable personal property, up to theamount of the previously allowable depreciation, is sourced in thesame way as the original deductions were sourced. Thus, to the extentthe previous deductions for depreciation were allocable to U.S. sourceincome, the gain is U.S. source. To the extent the depreciationdeductions were allocable to foreign sources, the gain is foreignsource income. Gain in excess of the depreciation deductions issourced the same as inventory. If personal property is used predominantly in the UnitedStates, luxury hotels in Faaborgtreat the gain from the sale, up to the amount of theallowable depreciation deductions, entirely as U.S. source income. If the property is used predominantly outside the UnitedStates, treat the gain, up to the amount of the depreciationdeductions, entirely as foreign source income. A loss recognized after January 10, 1999, is sourced in the sameway as the depreciation deductions were sourced. However, if theproperty was used predominantly outside the United States, the entireloss reduces foreign source income. You can choose to apply this ruleto losses recognized in tax years beginning after 1986. For detailsabout making this choice, see section 1.865-1T(f)(2) of theregulations. Depreciation includes amortization and any other allowablededuction for a capital expense that is treated as a deductibleexpense. Sales through foreign office or fixed place of business.Income earned by U.S. residents from the sale of personal propertythrough an office or other fixed place of business outside the UnitedStates is generally treated as foreign source if: The income from the sale is from the business operationslocated outside the United States, and At least 10% of the income is paid as tax to the foreigncountry. If less than 10% is paid as tax, the income is U.S. source. This rule also applies to losses recognized after January 10, 1999,if the foreign country would have imposed a 10% or higher tax had thesale resulted in a gain. You can choose to apply this rule to lossesrecognized in tax years beginning after 1986. For details about makingthis choice, see section 1.865-1T(f)(2) of the regulations. Forstock losses, see section 1.865-2(e) of the regulations. This rule does not apply to income sourced under therules for inventory property, depreciable personal property,intangible property (when payments in consideration for the sale arecontingent on the productivity, use, or disposition of the property),or goodwill. Determining Taxable Income From Sources Outside the UnitedStates To figure your taxable income in each category from sources outsidethe United States, you first allocate to specific classes(kinds) of gross income the expenses, losses, and other deductions(including the deduction for foreign housing costs) that aredefinitely related to that income. Definitely related.A deduction is definitely related to a specific class of grossincome if it is incurred either: As a result of, or incident to, an activity from which thatincome is derived, or In connection with property from which that income isderived. Classes of gross income.You must determine which of the following classes of gross incomeyour deductions are definitely related to. Compensation for services, including wages, salaries, fees,and commissions. Gross income from business. Gains from dealings in property. Interest. Rents. Royalties. Dividends. Alimony and separate maintenance. Annuities. Pensions. Income from life insurance and endowment contracts. Income from cancelled debts. Your share of partnership gross income. Income in respect of a decedent. Income from an estate or trust. Exempt income.When you allocate deductions that are definitely related to one ormore classes of gross income, you take exempt income into account forthe allocation. However, do not take exempt income into account toapportion deductions that are not definitely related to a separatelimit category. Interest expense and state income taxes.You must allocate and apportion your interest expense and stateincome taxes under the special rules discussed later underInterest expense and State income taxes. Class of gross income that includes more than one separatelimit category.If the class of gross income to which a deduction definitelyrelates includes either: More than one separate limit category, or At least one separate limit category and U.S. sourceincome, you must apportion the definitely related deductionswithin that class of gross income. To apportion, you can use any method that reflects a reasonablerelationship between the deduction and the income in each separatelimit category. One acceptable method for many individuals is based ona comparison of the gross income in a class of income to the grossincome in a separate limit income category. Use the following formula to figure the amount of the definitelyrelated deduction apportioned to the income in the separate limitcategory: Gross income in separate limit categoryTotal gross income in the classdeductionDo not take exempt income into accountwhen you apportion the deduction. However, income excluded under theforeign earned income or foreign housing exclusion is notconsidered exempt. You must, therefore, apportion deductions tothat income. Interest expense.Generally, you apportion your interest expense on the basis of yourassets. However, certain special rules apply. If you have grossforeign source income (including income that is excluded under theforeign earned income exclusion) of $5,000 or less, your interestexpense can be allocated entirely to U.S. source income. Business interest.Apportion interest incurred in a trade or business using the assetmethod based on your business assets. Under the asset method, you apportion the interest expense to yourseparate limit categories based on the value of the assets thatproduced the income. You can value assets at fair market value or thetax book value. Investment interest.Apportion this interest on the basis of your investment assets. Passive activity interest.Apportion interest incurred in a passive activity on the basis ofyour passive activity assets. Partnership interest.General partners and limited partners with partnership interests of10% or more must classify their distributive shares of partnershipinterest expense under the three categories listed above. They mustapportion the interest expense according to the rules for thosecategories by taking into account their distributive share ofpartnership gross income or pro rata share of partnership assets. Forspecial rules that may apply, see section 1.861-9T(e) of theregulations. Home mortgage interest.This is your deductible home mortgage interest from Schedule A(Form 1040). Apportion it under a gross income method, taking intoaccount all income (including business, passive activity, andinvestment income), but excluding income that is exempt under theforeign earned income exclusion. The gross income method is based on acomparison of the gross income in a separate limit category with totalgross income. The Instructions for Form 1116 have a worksheet for apportioningyour deductible home mortgage interest expense. For this purpose, however, any qualified residence that is rentedis considered a business asset for the period in which it is rented.You therefore apportion this interest under the rules for passiveactivity or trade or business interest. Example.You are operating a business as a sole proprietorship. Yourbusiness generates only U.S. source income. Your investment portfolioconsists of several less-than-10% stock investments. You have stockswith an adjusted basis of $100,000. Some of your stocks (with anadjusted basis of $40,000) generate U.S. source income. Your otherstocks (with an adjusted basis of $60,000) generate foreign passiveincome. You own your main home, which is subject to a mortgage of$120,000. Interest on this loan is home mortgage interest. You alsohave a bank loan in the amount of $40,000. The proceeds were dividedequally between your business and your investment portfolio. Yourgross income from your business is $50,000. Your investment portfoliogenerated $4,000 in U.S. source income and $6,000 in foreign sourcepassive income. All of your debts bear interest at the annual rate of10%. The interest expense for your business is $2,000. It is apportionedon the basis of the business assets. All of your business assetsgenerate U.S. source income; therefore, they are U.S. assets. This$2,000 is interest expense allocable to U.S. source income. The interest expense for your investments is also $2,000. It isapportioned on the basis of investment assets. $800 ($40,000/$100,000 $2,000) of your investment interest is apportioned to U.S.source income and $1,200 ($60,000/$100,000 $2,000) isapportioned to foreign passive income. Your home mortgage interest expense is $12,000. It is apportionedon the basis of all your gross income. Your gross income consists of$60,000, $54,000 of which is U.S. source income and $6,000 of which isforeign source passive income. Thus, $1,200 ($6,000/$60,000 x $12,000)of the home mortgage interest is apportioned to foreign source passiveincome. State income taxes.State income taxes (and certain taxes measured by taxable income)are definitely related and allocable to the gross income on which thetaxes are imposed. If state income tax is imposed in part on foreignsource income, the part of your state tax imposed on the foreignsource income is definitely related and allocable to foreign sourceincome. Foreign income not exempt from state tax.If the state does not specifically exempt foreign income from tax,the following rules apply. If the total income taxed by the state is greater thanthe amount of U.S. source income for federal tax purposes, thenthe state tax is allocable to both U.S. source and foreign sourceincome. If the total income taxed by the state is less than orequal to the U.S. source income for federal tax purposes, noneof the state tax is allocable to foreign source income. Foreign income exempt from state tax.If state law specifically exempts foreign income from tax, thestate taxes are allocable to the U.S. source income. Example.Your total income for federal tax purposes, before deducting statetax, is $100,000. Of this amount, $25,000 is foreign source income and$75,000 is U.S. source income. Your total income for state taxpurposes is $90,000, on which you pay state income tax of $6,000. Thestate does not specifically exempt foreign source income from tax. Thetotal state income of $90,000 is greater than the U.S. source incomefor federal tax purposes. Therefore, the $6,000 is definitely relatedand allocable to both U.S. and foreign source income. Assuming that $15,000 ($90,000 - $75,000) is the foreignsource income taxed by the state, $1,000 of state income tax isapportioned to foreign source income, figured as follows: $15,000$90,000$6,000=$1,000 Deductions not definitely related.You must apportion to your foreign income in each separate limitcategory a fraction of your other deductions that are notdefinitely related to a specific class of gross income. If youitemize, these deductions are medical expenses, charitablecontributions, and real estate taxes for your home. If you do notitemize, this is your standard deduction. You should also apportionany other deductions that are not definitely related to a specificclass of income, including deductions shown on Form 1040, lines23-31a. The numerator of the fraction is your gross foreignincome in the separate limit category, and the denominatoris your total gross income from all sources. For this purpose,gross income includes income that is excluded under the foreign earnedincome provisions. Itemized deduction limit.For 1999, you may have to reduce your itemized deductions onSchedule A (Form 1040) if your adjusted gross income is more than$126,600 ($63,300 if married filing separately). This reduction doesnot apply to medical and dental expenses, casualty and theft losses,gambling losses, and investment interest. You figure the reduction by using the Itemized DeductionsWorksheet in the instructions for Schedule A (Form 1040). Line 3of the worksheet shows the total itemized deductions subject to thereduction. Line 9 shows the amount of the reduction. To determine your taxable income from sources outside the UnitedStates, you must first divide the reduction (line 9 of the worksheet)by the itemized deductions subject to the reduction (line 3 of theworksheet). This is your reduction percentage. Then, multiply eachitemized deduction subject to the reduction by your reductionpercentage. Subtract the result from the itemized deduction todetermine the amount you can allocate to income from sources outsidethe United States. Example.You are single and have an adjusted gross income of $150,000. Thisis the amount on line 5 of the worksheet. Your itemized deductionssubject to the reduction total $20,000. This is the amount on line 3of the worksheet. Reduce your adjusted gross income (line 5) by$126,600. Enter the result ($23,400) on line 7. The amount on line 8is $702 ($23,400 3%). This amount is also entered on line 9. You have a charitable contribution deduction of $12,000 shown onSchedule A (Form 1040) that is subject to the reduction. Yourreduction percentage is 3.5% (702/$20,000). You must reduce your$12,000 deduction by $420 (3.5% $12,000). The reduceddeduction, $11,580 ($12,000 - $420), is used to determine yourtaxable income from sources outside the United States. Treatment of personal exemptions.Do not take the deduction for personal exemptions, includingexemptions for dependents, in figuring taxable income from sourcesoutside the United States. Capital Gains and Losses If you have any capital gains or losses, you may have to makecertain adjustments when figuring your foreign source taxable incomeand your foreign tax credit. If you file a Schedule D (Form 1040), Capital Gains andLosses, and both lines 16 and 17 of that schedule are gains, youmust adjust the amount you enter on line 17 of Form 1116. You mustalso make this adjustment if you received capital gain distributionsand you figured your tax using the Capital Gain Tax Worksheet(found in the Form 1040 instructions). Complete theWorksheet for Line 17, found in the Form 1116 instructions,to figure this amount. If you have any foreign source capital gain or loss, you mustadjust the amount of capital gain or capital loss you enter on line 1or 5 of Form 1116. See Adjustment for Foreign Source CapitalGains and Losses. Adjustment for Foreign Source Capital Gains and Losses You must adjust your foreign source capital gains to reflect U.S.capital gains tax rates. You do this by completing Worksheet Ain the instructions for Form 1116. Also, your foreign source capitalgain net income included in the amount on line 1 of Form 1116 cannotexceed your worldwide capital gain net income. You must adjust your foreign source net capital loss (to the extenttaken into account in determining worldwide capital gain net income)based on the U.S. tax rate applicable to the worldwide capital gainthe loss offsets. You can use Worksheet B in the Form 1116instructions to make this required adjustment. A "foreign Schedule D" is used to make these adjustments toyour foreign source capital gains and losses. However, a "foreign Capital Gain Tax Worksheet" is used tomake adjustments to your foreign source capital gain distributions ifyou figured your tax using the Capital Gain Tax Worksheet,instead of Schedule D. TaxTip: You must complete the "foreign Schedule D" or the"foreign Capital Gain Tax Worksheet" before completingWorksheet A or B. Foreign Schedule D. If you had a foreign source capital gain (and line 17 of theSchedule D you file with your U.S. tax return shows zero or a positivenumber) or a foreign source capital loss, you must complete a separateSchedule D using only your foreign source capital gains and losses. Onthis "foreign Schedule D," complete Parts I, II, and III. If Part lll, line 17, is a gain, complete Part lV (through line 50)of that Schedule D. Also complete the Worksheet for Line 17and Worksheet A (Capital Gains) in the instructions forForm 1116. If Part lll, line 17, is a loss, you can use Worksheet B(Capital Losses) in the instructions for Form 1116 to make theadjustment. Caution: Use your foreign Schedule D only to compute the adjusted amounts.Do not file it with your return. Foreign Capital Gain Tax Worksheet.If you figured your tax using the Capital Gain Tax Worksheetand some or all of your capital gain distributions were foreignsource, you must complete a separate Capital Gain Tax Worksheetusing only foreign capital gain distributions. See theInstructions for Form 1116 Maastricht hotels for special instructions forcompleting this foreign Capital Gain Tax Worksheet andWorksheet A. Caution: Use your foreign Capital Gain Tax Worksheet only tocompute the adjusted amounts. Do not file it with yourreturn. More than one category.If you have foreign source capital gains or losses from more thanone separate limit income category, complete a separate foreignSchedule D for each category. Then, depending on whether the categoryhas a gain or a loss on line 17, use whichever of the followingprocedures applies. Loss categories.For each category for which line 17 of the foreign Schedule D showsa loss, you must adjust the amount of your foreign loss (to the extenttaken into account in determining your worldwide capital gain netincome) based on the tax rate applicable to the worldwide gain theloss offsets. You can use Worksheet B (Capital Losses) inthe Form 1116 instructions to make this required adjustment. To do so,add together the net losses (from line 17 of your foreign Schedules D)of all the separate limitation categories that have losses on line 17of the foreign Schedule D. Enter the total of all the net losses, tothe extent taken into account in determining your worldwide capitalgain net income, on line 1 of Worksheet B. Use only oneWorksheet B for all of your loss categories. Your adjustednet capital loss appears on line 16 of Worksheet B. Thentake the following steps. Add together the net losses (from line 17 of your foreignSchedules D) of all of your loss categories. For each loss category, divide the loss from line 17 of thatcategory's foreign Schedule D by the amount in step 1. For each loss category, multiply the amount from step 2 byyour adjusted net loss (line 16 of Worksheet B) . This isyour adjusted net loss amount for that loss category that you includeon line 5 of that category's Form 1116. The amount on line 5 of thatcategory's Form 1116 cannot include more capital loss than theadjusted net loss amount for that category. Gain categories.If you have foreign source capital gains from more than oneseparate limitation income category, take the following steps. For each separate limitation income category that has a gain(or zero) on line 17 of its foreign Schedule D, completeWorksheet A in the Form 1116 instructions. Complete aseparate Worksheet A for each gain category. Total your adjusted capital gains from line 12 of eachWorksheet A. From this total subtract the total of all ofyour adjusted foreign source capital losses in all loss categories(which appears on line 16 of Worksheet B , as discussedunder Loss categories above). Compare the amount from step 2 to the amount on line 12 ofthe Worksheet for line 17 in the Form 1116 instructions.(The foreign capital gain net income taken into account for purposesof the foreign tax credit cannot exceed your worldwide capital gainnet income.) If the amount on line 12 of the Worksheet for line 17 isequal to or greater than the amount in step 2, no further adjustmentis necessary. For each category, include the amount determined in step1 as capital gain on line 1, Form 1116, or the amount determined underLoss categories as capital loss on line 5, Form 1116. Theamount of capital gain included on line 1 of a category's Form 1116cannot exceed the amount determined under step 1. Caution: See Allocation of Foreign Losses and Recapture ofForeign Losses, later. If the amount on line 12 of the Worksheet for line 17 isless than the amount from step 2, you must allocate the difference toyour gain categories. You reduce the gain for each category by anamount figured by multiplying the difference by the adjusted gain in aparticular category divided by the total of all adjusted capital gainsfrom all gain categories (not your net gain from step 2, which hasbeen reduced by losses). Examples.The following examples show how to make the required adjustmentsif you have foreign source capital gains and losses in more than oneseparate limitation income category. Example 1. Your total adjusted foreign capital gain is $25,000 (determined byadding the adjusted capital gains from line 12 of your Worksheets Afor each of your gain categories). All categories have gains on line16 and line 17 of their foreign Schedules D. $5,000 is from thegeneral limitation category. The amount from step 2 under Gaincategories is $35,000. The amount on line 12 of theWorksheet for line 17 is $22,580. Since that amount is lessthan the amount from step 2, you must allocate the difference, $12,420($35,000 - $22,580) to each of the categories. You must reducethe gain in the general limitation category by $2,484($5,000/$25,000 $12,420). On the Form 1116 that youcomplete for the general limitation category, you would include $2,516($5,000 - $2,484) of your capital gain on line 1. If you had$10,000 of ordinary income in the general limitation category, thetotal amount on line 1 of that category's Form 1116 would be $12,516($2,516 of capital gain + $10,000 of ordinary income). Example 2. Your total foreign loss is $5,000. It consists of a passivecategory loss of $2,000 and a general limitation category loss of$3,000 (as shown on line 17 of your foreign Schedules D for thosecategories). Assume your adjusted net capital loss (from line 16 ofWorksheet B) is $2,222. For the passive category, theamount of capital loss to include on line 5 of Form 1116 is $889($2,000/$5,000 $2,222). Example 3. You have a net gain on line 17 of the Schedule D you are filingwith your Form 1040. You have net foreign source capital gains in yourpassive separate limit category and your general limitation category(from line 17 of the foreign Schedules D for those categories). Youhave a net foreign source capital loss in your shipping separate limitcategory (shown on line 17 of your foreign Schedule D for thatcategory). You complete Worksheet A in the Form 1116 instructionsseparately for the passive and general limitation categories. Theamount on line 12 of Worksheet A is $2,000 for the passivecategory and $3,000 for the general limitation category. Therefore,your total adjusted foreign capital gain is $5,000 ($2,000 + $3,000). You complete Worksheet B for the shipping category, andthe amount on line 16 of that worksheet is $1,000. Because theshipping category is your only loss category, all of the $1,000adjusted foreign capital loss belongs in that category. The excess ofyour adjusted gains over your adjusted losses (your net adjustedcapital gain) is $4,000 ($5,000 - $1,000). Assume $1,500 appears on line 12 of the Worksheet for line 17in the Form 1116 instructions. This amount is less than yourforeign net adjusted capital gain. The excess of your net adjustedcapital gain over the amount from the Worksheet for line 17(your worldwide net adjusted capital gain) is $2,500 ($4,000 -$1,500). Because your foreign capital gain cannot exceed yourworldwide capital gain in the foreign tax credit calculation(reflected on the Form 1116), you must allocate this $2,500 excess, asa reduction, between your foreign net capital gain categories based onthe portion of your total foreign adjusted capital gain that isattributable to each category. On line 1 of your passive category Form1116, you include $1,000 ($2,000 - ($2,500 $2,000/$5,000)). On line 1 of your general limitation category Form 1116, youinclude $1,500 ($3,000 - ($2,500 $3,000/$5,000)). For the shipping category, the $1,000 adjusted capital loss shouldbe included on line 5 of the Form 1116. Example 4. The facts are the same as in Example 3, except that line12 of the Worksheet for Line 17 shows $6,000. This amountis more than your $4,000 foreign net adjusted capital gain, so nofurther adjustment is necessary. Include the $2,000, $3,000, and$1,000 amounts on the Forms 1116 for the appropriate categories. Example 5. You have net capital losses of $3,000 in the passive separate limitcategory and $4,000 in the general limitation category (from line 17of the foreign Schedules D for those categories). You have a net capital gain of $2,000 in the shipping category(from line 17 of the foreign Schedule D for that category). Your total foreign source capital loss is $7,000 ($3,000 + $4,000).All $7,000 is taken into account in determining worldwide capital gainnet income for the year, so all $7,000 must be adjusted. You includeall $7,000 on line 1 of Worksheet B in the Form 1116instructions. Assume $4,500 is the amount on line 16 of WorksheetB. The amount to include on line 5 of your passive category Form1116 is $1,929 ($4,500 $3,000/$7,000). The amount toinclude on line 5 of your general limitation category Form 1116 is$2,571 ($4,500 $4,000/$7,000). Complete Worksheet Ain the Form 1116 instructions for your shipping category, to determinethe amount of capital gain to include on line 1 of your shippingcategory Form 1116. Allocation ofForeign Losses If you have a foreign loss when figuring your taxable income in aseparate limit income category, and you have income in one or more ofthe other separate categories, you must first reduce the income inthese other categories by the loss before reducing income from U.S.sources. Example.You have $10,000 of income in the passive income category and incura loss of $5,000 in the general limitation income category. You usethe $5,000 loss to offset $5,000 of the income in the passivecategory. How to allocate.You must allocate foreign losses among the separate limit incomecategories in the same proportion as each category's income bears tototal foreign income. Example.You have a $2,000 loss in the general limitation income category,$3,000 of passive income, and $2,000 in distributions from an FSC. Youmust allocate the $2,000 loss to the income in the other separatecategories. 60% ($3,000/$5,000) of the $2,000 loss (or $1,200) reducespassive income and 40% ($2,000/$5,000) or $800 reduces FSCdistributions. Loss more than foreign income.If you have a loss remaining after reducing the income in otherseparate limit categories, use the remaining loss to reduce U.S.source income. When you use a foreign loss to offset U.S. sourceincome, you must recapture the loss as explained later underRecapture of Foreign Losses. Recharacterization of subsequent income in a loss category.If you use a loss in one separate limit category (category A) toreduce the amount of income in another category or categories(category B and/or category C) and, in a later year you have income incategory A, you must, in that later year, recharacterize some or allof the income from category A as income from category B and/orcategory C. Caution: Do not recharacterize the tax. Example.Using the same facts as in the previous example, in the next yearyou have $4,000 of passive income, $1,000 in FSC distributions, and$5,000 of general limitation income. Since $1,200 of the generallimitation loss was used to reduce your passive income in the previousyear, $1,200 of the current year's general limitation income of $5,000must be recharacterized as passive income. This makes the currentyear's total of passive income $5,200 ($4,000 + $1,200). Similarly,$800 of the general limitation income must be recharacterized as FSCdistributions, making the current year's total of FSC distributions$1,800 ($1,000 + $800). The total income in the general limitationcategory is then $3,000. U.S. losses.Allocate any net loss from sources in the United States among thedifferent categories of foreign income after: Allocating all foreign losses as described above, Recapturing any prior year overall foreign loss as describedbelow, and Recharacterizing foreign source income as described above. Recapture of Foreign Losses If you have only losses in your separate limit categories, or ifyou have a loss remaining after allocating your foreign losses toother separate categories, you have an overall foreign loss. If youuse this loss to offset U.S. source income (resulting in a reductionof your U.S. tax liability), you must recapture your loss in eachsucceeding year in which you have taxable income from foreign sourcesin the same separate limit category. You must recapture the overallloss regardless of whether you chose to claim the foreign tax creditfor the loss year. You recapture the loss by treating part of your taxable income fromforeign sources in a later year as U.S. source income. In addition, ifyou sell or otherwise dispose of property used in your foreign tradeor business, you may be considered to have had a gain on the sale orother disposition because of the recapture-of-foreign-lossesprovision. See Dispositions, later. The amount you treat asU.S. source income reduces the foreign source income, and thereforereduces the foreign tax credit limit. You must establish separate accounts for each type of foreign lossthat you sustain. The balances in these accounts are the overallforeign loss subject to recapture. Reduce these balances at the end ofeach tax year by the loss that you recaptured. You must attach astatement to your Form 1116 to report the balances (if any) in youroverall foreign loss accounts. Overall foreign loss.An overall foreign loss is the amount by which your gross incomefrom foreign sources for a tax year is exceeded by the sum of yourexpenses, losses, or other deductions that you allocated andapportioned to foreign income under the rules explained earlier underDetermining Taxable Income From Sources Outside The UnitedStates. But see Losses not considered, later, forexceptions. Example.You are single and have gross dividend income of $10,000 from U.S.sources. You also have a greater-than-10% interest in a foreignpartnership in which you materially participate. The partnership has aloss for the year, and your distributive share of the loss is $15,000.Your share of the partnership's gross income is $100,000, and yourshare of its expenses is $115,000. Your only foreign source income isyour share of partnership income which is in the general limitationincome category. You are a bona fide resident of a foreign country andyou elect to exclude your foreign earned income. You exclude themaximum $74,000. You also have itemized deductions of $4,700 that arenot definitely related to any item of income. In figuring your overall foreign loss in the general limitationcategory for the year, you must allocate a ratable part of the $4,700in itemized deductions to the foreign source income. You figure theratable part of the $4,700 that is for foreign source income, based ongross income, as follows: $100,000 (foreign gross income)$110,000(total gross income)$4,700=$4,273 Therefore, your overall foreign loss for the year is$8,173, figured as follows: Foreign gross income $100,000 Less: Foreign earned income exclusion $74,000 Allowable definitely related expenses($26,000/100,000 $115,000) 29,900 Ratable part of itemized deductions     4,273    108,173 Overall foreign loss    $8,173 Losses not considered.You do not consider the following in figuring an overall foreignloss in a given year. Net operating loss deduction. Foreign expropriation loss not compensated by insurance orother reimbursement. Casualty or theft loss not compensated by insurance or otherreimbursement. Recapture provision.If you have an overall foreign loss for any tax year and use theloss to offset U.S. source income, part of your foreign source taxableincome (in the same separate limit category as the loss) for eachsucceeding year is treated as U.S. source taxable income. The partthat is treated as U.S. source taxable income is the leastof: The balance in the applicable overall foreign loss account, 50% (or a larger percentage that you can choose) of yourforeign source taxable income for the succeeding tax year, or The foreign source taxable income for the succeeding taxyear which is in the same separate limit category as the loss afterthe allocation of foreign losses (discussed earlier). Example.During 1998 and 1999, you were single and a 20% general partner ina partnership that derived its income from Country X. You alsoreceived dividend income from U.S. sources during those years. For 1998, the partnership had a loss and your share was $20,000,consisting of $80,000 gross income less $100,000 expenses. Your netloss from the partnership was $2,000, after deducting the foreignearned income exclusion and definitely related allowable expenses.Thisis income in the general limitation category. Your U.S. dividendincome was $20,000. Your itemized deductions totaled $5,000 and werenot definitely related to any item of income. In figuring your taxableincome for 1998, you deducted your share of the partnership loss fromCountry X from your U.S. source income. During 1999, the partnership had net income from Country X. Yourshare of the net income was $40,000, consisting of $100,000 grossincome less $60,000 expenses. Your net income from the partnership was$10,400, after deducting the foreign earned income exclusion and thedefinitely related allowable expenses. This is income in the generallimitation category. You also received dividend income of $20,000 fromU.S. sources. Your itemized deductions were $6,000, which are notdefinitely related to any item of income. You paid income taxes of$4,000 to Country X on your share of the partnership income. When figuring your foreign tax credit for 1999, you must find theforeign source taxable income that you must treat as U.S. sourceincome because of the foreign loss recapture provisions. You figure the foreign taxable income that you must recapture asfollows: A. Determination of 1998 Overall ForeignLoss 1) Partnership loss from Country X $2,000 2) Add: Part of itemized deductions allocable to grossincome from Country X $80,000$100,000$5,000=$4,000 3) Overall foreign loss for 1998    $6,000 B. Amount of Recapture for 1999 1) Balance in general limitation categoryforeign loss account    $6,000 2) Foreign source taxable income $10,400 Less: Itemized deductions allocable to foreign sourcetaxable income ($100,000 / $120,000 $6,000)     5,000     $5,400 3) 50% of taxable income subject to recapture     $2,700 4) Taxable income in general limitation categoryafter allocation of foreign losses--General limitation taxableincome $11,000 Less: Itemized deductions allocable to that income ($100,000/ $120,000 $6,000)     5,000 General limitation taxable income lessallocated foreign losses : ($5,400 - 0)    $5,400 5) Recapture for 1999 (least of (1), (3), or(4))    $2,700 The amount of the recapture is shown on line 15, Form 1116. Recapturing more overall foreign loss than required.If you want to make an election or change a prior election torecapture a greater part of the balance of an overall foreign lossaccount than is required (as discussed earlier), you must attach astatement to your Form 1116 making the election. If you change a prioryear's election, you should file Form 1040X. The statement you attach to Form 1116 must show: The percentage and amount of your foreign taxable incomethat you are treating as U.S. source income, and The balance (both before and after the recapture) in theoverall foreign loss account that you are recapturing. Deduction for foreign taxes.You can recapture part (or all, if applicable) of an overallforeign loss in tax years in which you deduct, rather than credit,your foreign taxes. You recapture the lesser of: The balance in the applicable overall foreign loss account,or The foreign source taxable income of the same separate limitcategory that resulted in the overall foreign loss minus the foreigntaxes imposed on that income. Dispositions.If, before you have fully recaptured an overall foreign loss, youdispose of trade or business property used predominantly outside theUnited States, the disposition is subject to the recapture rules. Youare considered to have received and recognized foreign taxable incomein the year you dispose of the property. The foreign source income that you are considered to have receivedand recognized on the property and that you must treat as U.S. sourceincome is 100% of the lesser of: The fair market value of the property that is more than youradjusted basis, or The remaining amount of the overall foreign loss not treatedas U.S. source income in the current year or any prior tax year. Predominant use outside U.S.Property is used predominantly outside the United States if it waslocated outside the United States more than 50% of the time during the3-year period ending on the date of disposition. If you used theproperty fewer than 3 years, count the use during the period it wasused in a trade or business. Disposition defined.A disposition includes the following transactions. A sale, exchange, distribution, or gift of property. A transfer upon the foreclosure of a security interest (butnot a mere transfer of title to a creditor or debtor upon creation ortermination of a security interest). An involuntary conversion. A contribution to a partnership, trust, orcorporation. A transfer at death. Any other transfer of property whether or not gain or lossis normally recognized on the transfer. The character of the income recognized solely because of thedisposition rules is the same as if you had sold or exchanged theproperty. However, a disposition does not include: A disposition of property that is not a material factor inproducing income, or A transaction in which gross income is not realized. Basis adjustment.If gain is recognized on a disposition solely because of an overallforeign loss account balance at the time of the disposition, therecipient of the property can increase its basis by the amount of gaindeemed recognized. If the property was transferred by gift, its basisin the hands of the donor immediately prior to the gift is increasedby the amount of gain deemed recognized. Tax Treaties The United States is a party to tax treaties that are designed, inpart, to prevent double taxation of the same income by the UnitedStates and the treaty country. Certain treaties have special rules youmust consider when figuring your foreign tax credit if you are a U.S.citizen residing in the treaty country. These rules generally allow anadditional credit for part of the tax imposed by the treaty partner onU.S. source income. It is separate from, and in addition to, yourforeign tax credit for foreign taxes paid or accrued on foreign sourceincome. The treaties that provide for this additional credit includethose with Australia, Austria, Canada, Czech Republic, Finland,France, Germany, Ireland, Israel, Mexico, the Netherlands, NewZealand, Portugal, Slovak Republic, South Africa, Spain, Sweden, andSwitzerland. There is a worksheet at the end of this publicationto help you figure the additional credit. But do not use thisworksheet to figure the additional credit under the treaties withAustralia and New Zealand. Envelope: You can get more information, and the worksheet to figure theadditional credit under the Australia and New Zealand treaties, bywriting to: Internal Revenue Service Assistant Commissioner (International) Attention: OP:IN:D:CS 950 L'Enfant Plaza South, SW Washington, DC 20024. Germany HOtelsYou can also contact the United States Revenue ServiceRepresentatives at the U.S. Embassies in Berlin, London, Mexico City,Paris, Rome, Singapore, and Tokyo, as appropriate, for assistance. Report required.You may have to report certain information with your return if youclaim a foreign tax credit under a treaty provision. For example, if atreaty provision allows you to take a foreign tax credit for aspecific tax that is not allowed by the Internal Revenue Code, youmust report this information with your return. To report the necessaryinformation, use Form 8833, Treaty-Based Return PositionDisclosure Under Section 6114 or 7701(b). If you do not report this information, you may have to pay apenalty of $1,000. TaxTip: You do not have to file Form 8833 if you are claiming theadditional foreign tax credit (discussed previously).