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Form 1118 foreign tax credit limitation: baskets, the 90% rule and carryovers

Reviewed 2026-09-15 · AI-assisted draft and editing; sources and limitations remain visible for independent review.

Answer: Order matters more than arithmetic here. Step one asks whether the levy is a creditable foreign income tax at all, which § 1.901-2(a)(1)(ii) resolves by requiring that it be a foreign tax and either a net income tax or a tax in lieu of an income tax under § 1.903-1(b), determined independently for each separate levy. Step two assigns the tax and the related income to a separate limitation category; §904(d)(1) lists four, covering amounts includible under §951A other than passive category income, foreign branch income, passive category income, and general category income. Step three applies the §904(a) fraction, which caps the credit by the ratio of foreign-source taxable income to entire taxable income. Step four handles excess credits, which §904(c) allows to be carried back to the first preceding year and forward to any of the first 10 succeeding years, in that order, but expressly not for taxes on amounts described in §904(d)(1)(A). A workpaper that jumps to the fraction has usually skipped the two steps that decide it. Two live qualifications apply: the current Form 1116 instructions require more separate categories on the form than the statute lists, and they record relief permitting prior rules in place of certain rules in the 2022 creditability regulations.

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Scope

Jurisdiction: United States — federal

Tax periods: 1.901-2: tax years from 2021-12-28, Form 1116 instructions: tax year 2025, Sec. 904 and 960 changes: after 2025, Statute checked 2026-09-15

Assumptions

Exclusions

1. Step one: is the levy a creditable foreign income tax

Section 901(a) allows the credit only if the taxpayer chooses the benefits of the subpart, and it makes the allowance subject to the limitation of §904. Section 901(b) then splits the allowance by taxpayer class, with separate paragraphs for citizens and domestic corporations, residents of the United States or Puerto Rico, alien residents, and nonresident alien individuals and foreign corporations. Identify the class before anything else, because the scope of creditable taxes differs across them.

Regulation § 1.901-2(a)(1)(ii) states the test in two parts: a foreign levy is a foreign income tax only if it is a foreign tax and either it is a net income tax as defined in § 1.901-2(a)(3) or it is a tax in lieu of an income tax as defined in § 1.903-1(b). The regulation adds two framing rules that decide many close cases. Whether a levy is a foreign income tax is determined independently for each separate levy, and a foreign tax either is or is not a foreign income tax in its entirety, for all persons subject to it. There is no partial creditability of a single levy by taxpayer.

Regulation § 1.901-2(a)(2)(i) then defines tax: a compulsory payment pursuant to a foreign country's authority to levy taxes, determined by principles of US law rather than by the foreign country's characterization. A penalty, fine, interest or similar obligation is not a tax, and neither is a customs duty. Where a person subject to a levy receives a specific economic benefit in exchange, that element is not a tax, and the regulation requires the two elements to be separated, with dual capacity taxpayers routed to § 1.901-2A.

One coordination rule is easy to miss. Regulation § 1.901-2(a)(1)(iii) provides that a foreign levy modified by an applicable income tax treaty may qualify as a foreign income tax even though the unmodified levy would not satisfy the requirements, if the levy as modified does, and it points to § 1.901-2(d)(1)(iv) for treating a treaty-modified tax as a separate levy. A treaty can therefore change the creditability answer, not merely the rate.

2. The net gain requirement has four named components

Regulation § 1.901-2(b)(1) says a foreign tax satisfies the net gain requirement only if it satisfies the realization, gross receipts, cost recovery and attribution requirements in § 1.901-2(b)(2), (3), (4) and (5) respectively, or if it is a surtax described in § 1.901-2(b)(6). It also directs that those paragraphs be applied solely on the basis of the foreign tax law governing calculation of the foreign taxable base, and without any consideration of the rate imposed. A low rate is not a creditability problem; a base built the wrong way is.

The attribution requirement in § 1.901-2(b)(5) is the component that changed the analysis for many foreign levies, and it is not one rule but two branches. Gross receipts and costs in the base must be determined under § 1.901-2(b)(5)(i) for a separate levy imposed on nonresidents, or under § 1.901-2(b)(5)(ii) for a levy imposed on residents. For nonresidents, § 1.901-2(b)(5)(i)(A) permits attribution based on the nonresident's activities in the taxing country under reasonable principles, and expressly excludes rules that take as a significant factor the mere location of customers, users, or any other similar destination-based criterion. § 1.901-2(b)(5)(i)(B) permits source-based inclusion only where it is limited to gross income from sources within the taxing country and the foreign sourcing rules are reasonably similar to the Code's, with services required to be sourced by place of performance rather than the location of the recipient, royalties by the place of use, and gains on sales routed to the activities or situs branches instead. § 1.901-2(b)(5)(i)(C) handles situs of property under rules reasonably similar to §897.

Record which of the four components is in doubt, and why, rather than recording a conclusion. Creditability disputes are usually about one component of the base, and a workpaper that says only creditable or not creditable cannot be reviewed.

For a levy on residents, § 1.901-2(b)(5)(ii) allows the base to include all of the resident's worldwide gross receipts, but requires the foreign law to determine transfer-pricing allocations under arm's length principles without taking a destination-based criterion into account as a significant factor. The practical read is that the attribution requirement asks who the levy is aimed at before it asks how the base is built, and the sourcing sub-rules in the nonresident branch echo the Code's own categories, which is why a sourcing analysis feeds this step.

3. The applicability date and the relief posture

Regulation § 1.901-2(h) states that, except as otherwise provided in that paragraph, the section applies to foreign taxes paid, within the meaning of § 1.901-2(g), in taxable years beginning on or after December 28, 2021. For foreign taxes that relate to taxable years beginning before that date and are remitted later by an accrual-basis taxpayer, it directs the reader to § 1.901-2 as contained in the part 1 regulations revised as of April 1, 2021. A separate rule addresses certain taxes paid to Puerto Rico. Which version applies is therefore a function of the year the tax was paid and the year it relates to.

The posture is not simply the regulation as written. The current Form 1116 instructions, in their reminders, record that final foreign tax credit regulations were published on January 4, 2022 and that relief has been provided permitting taxpayers to apply prior rules in place of certain rules in those regulations, referring to a notice issued in 2023 and a further notice issued in December 2023 that extended the relief until further notice and addressed application to partnerships. Treat that as the operative posture to verify in the current bulletin before a creditability conclusion is signed, and treat the phrase until further notice as a reason to check rather than a permanent state.

The instructions also flag, in their what-is-new section, the 2025 addition of §960(d)(4), which disallows part of the credit for foreign taxes on distributions of previously taxed net CFC tested income, and they give that paragraph its own effective date. That is a rule-level flag to run against the facts, not a computation this page performs.

4. Step two: assign the tax to a separate limitation category

Section 904(d)(1) requires §904(a), (b) and (c) and the related sections to be applied separately with respect to four categories: any amount includible in gross income under §951A other than passive category income, foreign branch income, passive category income, and general category income. That list is unchanged by the 2025 legislation. What the 2025 legislation did change are two stale cross-references inside §904(d): the amendment notes record that §904(d)(2)(H)(i) now reads paragraph (1)(D) where it read paragraph (1)(B), and §904(d)(4)(C)(ii) now reads paragraph (1)(C) where it read paragraph (1)(A). Those are conforming corrections to the lettering, not new baskets, but a memo quoting the older cross-reference will point at the wrong category.

The form does not stop at four. The current Form 1116 instructions direct that a separate Form 1116 be completed for each separate category, and the categories they enumerate run to seven: the four statutory baskets, then §901(j) income, certain income re-sourced by treaty, and lump-sum distributions. This four-against-seven mismatch is a common review finding: the statute organizes the limitation, while the form organizes the computation and the disclosure, and a workpaper keyed only to the statute will be short of the schedules the return requires.

Two related provisions belong in the same step. Section 901(j) denies the credit for taxes paid to specified countries, with its own start and end conditions and a presidential waiver, which is why it appears as a form category rather than merely as a disallowance. Section 901(k) imposes holding period conditions for withholding taxes on dividends, expressed as 15 days within a 31-day window around the ex-dividend date, with a longer 45-day requirement within a 91-day period for certain preference dividends. Section 901(m) disallows the disqualified portion of foreign income taxes attributable to a covered asset acquisition. Each is a screen to run before the tax reaches a basket.

5. Step three and four: the fraction, the 2025 additions, and the carryover carve-out

Section 904(a) caps the credit at the same proportion of the tax against which the credit is taken as the taxpayer's taxable income from sources without the United States, but not in excess of entire taxable income, bears to entire taxable income for the year. The numerator is therefore a sourcing and expense-allocation result, not a foreign-return figure, which is why sourcing is the upstream question rather than a detail.

Three paragraphs of §904(b) act directly on that numerator, and one of them is often assumed to have been repealed. Section 904(b)(4) is in the current text: for a domestic corporation that is a United States shareholder of a specified 10-percent owned foreign corporation, foreign-source taxable income and entire taxable income are determined without regard to the foreign-source portion of any dividend from that corporation and without regard to deductions properly allocable to income other than §951(a)(1) and §951A(a) amounts with respect to that stock.

Section 904(b)(5), added in 2025, applies solely for purposes of §904(a) with respect to amounts described in §904(d)(1)(A). It allocates the §250(a)(1)(B) deduction, and any §164(a)(3) deduction for taxes on those amounts, to that income; allocates no interest expense and no research and experimental expenditures to it; and allocates any other deduction to it only if the deduction is directly allocable. Amounts that would otherwise have been apportioned there are allocated to United States source income instead. Section 904(b)(6), also added in 2025, treats a portion of income from the sale outside the United States of inventory produced in the United States, for use outside the United States, attributable to a foreign office or fixed place of business, as from sources without the United States, capped at 50 percent of the income from that sale. Both changes apply to taxable years beginning after December 31, 2025.

For excess credits, §904(c) allows the excess to be deemed paid in the first preceding taxable year and in any of the first 10 succeeding taxable years, in that order, to the extent the limitation for those years exceeds the taxes already paid or accrued there. The ordering is mandatory and the carryover is tracked by category. Read the final sentence of §904(c) before building a carryover schedule: it states that the subsection does not apply to taxes paid or accrued with respect to amounts described in §904(d)(1)(A). Excess credits in that category are not carried back or forward at all, which is a different answer from the other three baskets and is the kind of assumption that survives quietly in a spreadsheet for years.

One more 2025 change sits just outside §904 but lands on the same computation. Section 960(d)(1) now deems a domestic corporation with a §951A inclusion to have paid foreign income taxes equal to 90 percent of the product of its inclusion percentage and the aggregate tested foreign income taxes paid or accrued by controlled foreign corporations; the amendment note records that 90 percent was substituted for 80 percent, applicable to taxable years beginning after December 31, 2025. The same legislation added §960(d)(4), headed disallowance of foreign tax credit with respect to distributions of previously taxed net CFC tested income, which denies a credit under §901 for 10 percent of any foreign income taxes paid or accrued, or deemed paid under §960(b)(1), with respect to an amount excluded from gross income under §959(a) by reason of an inclusion under §951A(a). Its effective date is not the same as the other one: the note applies it to such taxes after June 28, 2025, rather than to taxable years beginning after December 31, 2025. Neither is computed here, but a credit model carrying 80 percent into a 2026 year is wrong on its face, and one that applies the new disallowance only from 2026 is wrong the other way.

6. The workpaper, the forms, and a next step

Build one row per levy with: the foreign country and the levy as named on the foreign assessment, the class of taxpayer under §901(b), the creditability conclusion with the § 1.901-2 paragraph relied on and the component in doubt, which version of the regulation applies under § 1.901-2(h) and whether relief was applied, any §901(j), §901(k) or §901(m) screen, the category assigned, the amount, the limitation figures, and the carryback or carryover result by category.

Then map that to the return. The IRS states that Form 1116 is filed by individuals, estates and trusts, with Schedule B reconciling prior and current year foreign tax carryovers and Schedule C identifying current-year foreign tax redeterminations. Form 1118 is the corporate form, with Schedule I for the reduction of foreign oil and gas taxes, Schedule J for adjustments to separate limitation income and account balances, Schedule K as the foreign tax carryover reconciliation and Schedule L for foreign tax redeterminations. The carryover and redetermination schedules are where a category assignment made years earlier is either supported by the file or is not.

This page assumes the sourcing result rather than deriving it; the sibling page titled US-source vs. foreign-source income: a sourcing fact checklist by income type covers that step, including the rule that treats certain inclusions as dividends from the corporation that generated them. The page titled Is it a CFC? A classification issue map across the 2026 statutory boundary covers the classification that puts an amount in the §904(d)(1)(A) category in the first place. The statute was read in the preliminary United States Code release stating it contains those laws in effect on September 14, 2026, and §1.901-2 in the electronic Code of Federal Regulations, up to date as of September 14, 2026. Ask Taxterity to assemble the creditability authority for one foreign levy, or to build a Federal Tax Memo on the category assignment and on which version of the regulation applies, then verify every citation yourself before the workpaper is signed.

Related research

Official sources

  1. 26 U.S.C. 901 - Taxes of foreign countries and of possessions of the United States — Sec. 901(a) election and subjection to the section 904 limitation; 901(b)(1)-(4) taxpayer classes; 901(j) denied countries; 901(k) dividend holding periods; 901(m) covered asset acquisitions
  2. 26 U.S.C. 904 - Limitation on credit — Sec. 904(a) limitation fraction; 904(c) carryback to the first preceding year and carryover to the first 10 succeeding years, and its final sentence excluding taxes on amounts described in subsection (d)(1)(A)
  3. 26 U.S.C. 904 - Separate categories and 2025 additions — Sec. 904(d)(1)(A)-(D) four separate limitation categories; 904(b)(4) section 245A dividends; 904(b)(5) and 904(b)(6) added by the 2025 legislation; Amendments and Effective Date of 2025 Amendment notes
  4. 26 CFR 1.901-2 - Definition of a foreign income tax (eCFR, title 26 current as of 2026-09-14) — Sec. 1.901-2(a)(1)(i) separate levy and all-or-nothing rules; (a)(1)(ii)(A)-(B) two-part test; (a)(1)(iii) treaty coordination; (a)(2)(i) compulsory payment, specific economic benefit and dual capacity; (a)(3) net income tax
  5. 26 CFR 1.901-2 - Net gain requirement and applicability dates (eCFR, title 26 current as of 2026-09-14) — Sec. 1.901-2(b)(1) realization, gross receipts, cost recovery and attribution components; (b)(5)(i)(A)-(C) nonresident branches; (b)(5)(ii) residents; (h) applicability to taxes paid in tax years beginning on or after December 28, 2021
  6. IRS: Instructions for Form 1116 (2025) — What's New, including 2025 legislation restricting credits for certain CFC distributions; Reminders on the January 4, 2022 final regulations and the 2023 relief notices; separate category list requiring a separate Form 1116 for each
  7. IRS: About Form 1116 — Filed by an individual, estate or trust that paid or accrued certain foreign taxes; Schedule B foreign tax carryover reconciliation; Schedule C foreign tax redeterminations; page last reviewed or updated 20-Jul-2026
  8. IRS: About Form 1118 — Corporations use this form to compute the foreign tax credit; Schedule I foreign oil and gas tax reduction; Schedule J separate limitation adjustments; Schedule K carryover reconciliation; Schedule L redeterminations; reviewed 20-Jul-2026
  9. IRS: Foreign tax credit — Qualifying foreign taxes imposed on the taxpayer by a foreign country or US possession; credit versus deduction; no credit for taxes on income excluded under the foreign earned income or housing exclusion; page reviewed 09-Jul-2026
  10. 26 U.S.C. 960 - Deemed paid credit for subpart F inclusions — Sec. 960(d)(1) deemed-paid credit equal to 90 percent of the product of the inclusion percentage and aggregate tested foreign income taxes; 960(d)(2) inclusion percentage; Amendments note substituting 90 percent for 80 percent; 960(d)(4)

Limitations