How to Complete Form 1118 Schedule H

Form 1118, “Foreign Tax Credit – Corporations,” allows corporations to claim a credit for foreign taxes paid, which reduces their U.S. income tax liability and prevents double taxation on foreign source income. A part of this form is Schedule H, which is used to apportion deductions that are not directly related to a specific item of income. This apportionment is a required step in calculating the foreign tax credit limitation.

This limitation ensures the credit claimed for foreign taxes does not exceed the U.S. tax that would have been paid on the same foreign income. Schedule H provides a standardized format for assigning a portion of general overhead and other indirect costs against foreign source income.

Identifying Deductions for Apportionment

Schedule H deals with “deductions not definitely allocable.” These are expenses that a corporation incurs for the benefit of its business as a whole and cannot be directly tied to a specific class of gross income. Identifying these deductions from the company’s financial records is the first step. These expenses support all of the company’s business activities, both domestic and foreign, and must be divided among them.

Common examples of deductions that must be apportioned include:

• General and administrative (G&A) overhead: This category includes costs like executive salaries, accounting department expenses, and legal fees that are not associated with a particular income-producing activity.
• Interest expense: Most corporate interest expense relates to general corporate borrowing and is treated as fungible, meaning it is apportioned based on the value of the corporation’s assets.
• Research and experimentation (R&E) costs: These expenditures must be capitalized and amortized. It is the annual amortization deduction, not the total expenditure, that is apportioned between U.S. and foreign sources.
• Stewardship expenses: These are costs incurred by a parent company in overseeing its investments in foreign subsidiaries and are treated as not definitely allocable.

Selecting an Apportionment Method

Once deductions are identified, a corporation must use the apportionment method specified by Treasury Regulations, as the choice is not always optional. The primary methods are based on either gross income or the value of the corporation’s assets.

The gross income method is used for deductions like G&A expenses. Under this method, the deduction is apportioned by multiplying the expense by a fraction where the numerator is foreign source gross income and the denominator is total gross income. This method assumes the expense benefits all income-generating activities in proportion to the income they produce.

For certain deductions, regulations mandate a specific method. Interest expense must be apportioned using the asset method, which requires the corporation to value its assets that generate U.S. and foreign income using the tax book value method.

The annual amortization deduction for R&E has its own set of apportionment rules. These rules first require the taxpayer to apportion the R&E amortization to specific product categories based on North American Industry Classification System (NAICS) codes. After this, if more than 50% of the R&E activity for a product category occurs in a single geographic location, then 50% of the amortization for that category is exclusively apportioned to that source. The remainder is apportioned based on either gross sales or gross income.

Information and Calculations for Schedule H

Schedule H is separated into distinct parts to handle different types of deductions, ensuring all indirect expenses are properly accounted for when determining the foreign tax credit limitation.

Part I: Stewardship Expenses

This part is used for apportioning stewardship expenses. In column (a), the corporation lists the name of the domestic corporation that incurred the expenses. Column (b) requires the total amount of these deductions. The apportionment factor, a fraction based on the value of the foreign subsidiary’s stock relative to the value of all the parent’s assets, is entered in column (c). Column (d) shows the final apportioned amount of stewardship expense.

Part II: Asset-Based Deductions

Part II is for deductions apportioned based on assets, primarily interest expense. The corporation must determine the average value of its assets for the tax year, separated into those generating income in the relevant foreign tax credit category, other foreign source income, and U.S. source income. These values are entered in columns (a), (b), and (c), respectively, with column (d) as the sum. The total interest expense to be apportioned is entered at the top of column (f), and the amount apportioned is calculated by multiplying the total interest by the ratio of assets in column (a) to total assets in column (d).

Part III: Other Deductions

This section is a catch-all for other deductions not definitely allocable and not based on assets, such as G&A expenses and R&E amortization. For each type of deduction, the corporation enters a description and the total amount. It then determines the appropriate apportionment factor, usually based on gross income, and multiplies it by the total deduction to find the portion that reduces foreign source income.

Utilizing Schedule H Data in Form 1118

After all calculations on Schedule H are complete, the resulting figures must be transferred to the appropriate lines on Form 1118, Schedule A. Schedule A, titled “Taxable Income or (Loss) Before Adjustments,” is where the corporation computes its foreign source taxable income for each separate income category. The deductions apportioned on Schedule H directly reduce this income.

The total apportioned deductions from Schedule H are carried over to specific columns in Part III of Schedule A. The totals from Schedule H, Part I, column (d) and Part II, column (f), representing apportioned stewardship and interest expenses, are entered on Schedule A, line 15. Similarly, the totals for other apportioned deductions from Schedule H, Part III are carried over to the corresponding lines in Schedule A.

By reducing the foreign source gross income by these apportioned deductions, the corporation arrives at its net foreign source taxable income. This final net income figure from Schedule A becomes the numerator in the foreign tax credit limitation formula.