How to Handle the Foreign Source Qualified Dividend Adjustment

U.S. taxpayers who receive qualified dividends from foreign sources and claim the Foreign Tax Credit must make an adjustment to their foreign source income. This adjustment is required to correctly calculate the allowable Foreign Tax Credit. Failing to make this adjustment can lead to an overstatement of the credit, potentially resulting in an underpayment of tax and associated penalties.

The Principle Behind the Adjustment

The reason for the foreign source qualified dividend adjustment is to prevent a double benefit. This situation arises from the intersection of two favorable tax treatments. The first is the preferential tax rate applied to qualified dividends under Internal Revenue Code Section 1(h), which are taxed at lower capital gains rates rather than higher ordinary income rates.

The second benefit is the Foreign Tax Credit, a dollar-for-dollar reduction of U.S. income tax liability for income taxes paid to a foreign country. The credit is intended to mitigate double taxation but is limited to the U.S. tax attributable to the foreign source income. A conflict occurs because the U.S. tax on foreign qualified dividends is already low due to the preferential rate. Allowing an unadjusted credit could permit it to offset U.S. tax on other, non-related income.

The adjustment under Internal Revenue Code Section 904 prevents this by synchronizing the two provisions. It reduces the amount of foreign source income used in the Foreign Tax Credit calculation to reflect the lower U.S. tax rate. This ensures the credit only offsets the U.S. tax liability on that specific foreign income, as a taxpayer cannot receive both a lower tax rate and a full tax credit on the same income.

Information Required for the Calculation

To perform the adjustment, a taxpayer must gather specific financial data. The accuracy of the calculation depends on the precision of these inputs.

• The total amount of foreign source qualified dividends, found on Form 1099-DIV, Box 1b, or on statements from the foreign payer.
• The total foreign source income, which includes foreign qualified dividends plus other foreign income like wages or interest.
• The total of all qualified dividends from both U.S. and foreign sources, aggregated from all Form 1099-DIVs.
• The amount of foreign income taxes paid or accrued on the dividend income, often provided on a brokerage statement or foreign tax document.

Note that only compulsory taxes qualify for the credit. If a tax treaty allows for a reduced rate, only that reduced amount is creditable, regardless of what was withheld.

Step-by-Step Calculation Guide

The calculation for the qualified dividend adjustment is a procedure outlined in the instructions for Form 1116, Foreign Tax Credit. This process is sometimes referred to as the “rate differential adjustment.” The core of the adjustment involves multiplying the foreign source qualified dividends by a specific factor that corresponds to the U.S. tax rate on those dividends. These factors can change, so consult the Form 1116 instructions for the specific tax year.

For example, for the 2023 tax year, the factor was 0.4054 for dividends taxed at the 15% rate and 0.5405 for dividends taxed at the 20% rate. Foreign qualified dividends taxed at the 0% rate are completely excluded from foreign source income on Form 1116, line 1a.

Assume a taxpayer has $2,000 in foreign qualified dividends taxed at the 15% rate and total foreign source income of $10,000. To calculate the adjusted foreign source income, the taxpayer subtracts the foreign qualified dividends from their total foreign source income, then adds back the adjusted amount of those dividends.

Using the 2023 factor for the 15% rate, the calculation is: ($10,000 total foreign income – $2,000 foreign qualified dividends) + ($2,000 0.4054) = $8,810.80. This final figure is the amount entered on line 1a of Form 1116.

Reporting the Adjustment on Tax Forms

After calculating the adjustment, the taxpayer must report these figures on Form 1116, Foreign Tax Credit (Individual, Estate, or Trust). The adjusted foreign source income is entered on line 1a of Form 1116. This adjusted income serves as the numerator in the formula that calculates the foreign tax credit limitation in Part III, ensuring the credit does not exceed the U.S. tax liability on the foreign income.

The foreign taxes paid or accrued on the dividends are included in the total foreign taxes reported in Part II of Form 1116. The final allowable Foreign Tax Credit, as calculated on the form, is then carried to Schedule 3 (Form 1040). This credit directly reduces the taxpayer’s total tax liability.

The foreign source qualified dividends are also included in the total qualified dividends on the “Qualified Dividends and Capital Gain Tax Worksheet” from the Form 1040 instructions. The adjustment on Form 1116 ensures that the benefit of the lower tax rate applied on the worksheet is properly coordinated with the calculation of the Foreign Tax Credit.