Section 1.904-4: Foreign Tax Credit Income Categories

The U.S. foreign tax credit serves to relieve the burden of double taxation for U.S. taxpayers who earn income from foreign sources. When income is earned in another country, that country often imposes a tax. To prevent that same income from being fully taxed again by the United States, the U.S. allows taxpayers to claim a credit for the foreign taxes they have paid or accrued.

The availability of the foreign tax credit is not unlimited. A calculation known as the foreign tax credit limitation caps the amount of the credit a taxpayer can claim. This limit is designed to ensure the credit only offsets the U.S. tax liability on the taxpayer’s foreign source income, not their U.S. source income. This prevents the credit from being used to reduce U.S. taxes on domestic earnings.

To properly apply this limitation, tax law requires that foreign source income be segregated into distinct categories, often referred to as “baskets.” The rules governing how to assign income to these specific baskets are detailed in U.S. Treasury Regulation Section 1.904-4. By separating income, the tax code prevents certain types of income, particularly those subject to low foreign taxes, from being blended with high-taxed income to maximize the foreign tax credit.

The Passive Category Income Basket

The passive category income basket captures income that is of an investment nature rather than from the active conduct of a business. This category includes income that would be considered foreign personal holding company income under the tax code. The types of income that fall into this basket are:

• Dividends
• Interest
• Royalties
• Rents
• Annuities

It also encompasses the net gain from the sale of property that produces these types of income or from property that does not generate any income.

Certain types of income that might appear passive are explicitly excluded from this category. For instance, rents and royalties derived from the active conduct of a trade or business are not treated as passive. This separates income earned from actively managing properties or licensing intellectual property as a core business from incidental investment returns. Similarly, export financing interest, which is interest derived from financing the sale of U.S. manufactured goods for use outside the United States, is also excluded.

A provision known as the “high-taxed income kick-out” prevents the averaging of high foreign taxes paid on one stream of passive income against low-taxed passive income. Under this rule, if an item of passive income is subject to foreign income taxes at a rate that exceeds the highest U.S. corporate tax rate, that income is “kicked out” of the passive basket. Once removed, this high-taxed income is reclassified into the general category income basket.

To illustrate, consider a U.S. corporation that receives a $1,000 royalty from a foreign country, which is subject to a 30% foreign withholding tax ($300). If the highest U.S. corporate tax rate is 21%, the foreign tax rate is higher. Consequently, the $1,000 royalty and the associated $300 of foreign taxes are removed from the passive category and moved to the general category for calculating the foreign tax credit limitation.

The General Category Income Basket

The general category income basket functions as the default or residual category for foreign source income. Any item of foreign income that does not meet the specific definitions for the other baskets is assigned to the general category. This basket includes income derived from the active conduct of a trade or business, such as revenue from the sale of goods or the performance of services in foreign markets.

A primary feature of the general category involves the “look-through rules” applicable to payments received from a Controlled Foreign Corporation (CFC). A CFC is a foreign corporation where U.S. shareholders own more than 50% of the voting power or value. When a U.S. shareholder receives payments like dividends, interest, rents, or royalties from a CFC, the character of that income is determined by looking through to the underlying earnings of the CFC that funded the payment.

This look-through treatment means the payment is not automatically categorized based on its legal form. Instead, the income is divided between the different foreign tax credit baskets in the same proportion as the CFC’s underlying income. For example, if a CFC’s total earnings consist of 80% general category income from active business operations and 20% passive category income from investments, a $100,000 dividend paid to its U.S. shareholder will be treated as $80,000 of general category income and $20,000 of passive category income. This approach ensures the foreign tax credit limitation aligns with the nature of the underlying economic activity.

The Foreign Branch Income Basket

The foreign branch income basket is a category for business profits attributable to the operations of a U.S. person’s foreign branch. This category was created to isolate the income and taxes associated with direct business operations in a foreign country from other types of foreign income.

A “foreign branch” is defined as a qualified business unit (QBU) that operates in a foreign country. A QBU is a separate and clearly identified unit of a taxpayer’s trade or business that maintains its own distinct set of books and records. This could be a factory, a sales office, or any other fixed place of business that functions as a self-contained operation.

The process of assigning income to the foreign branch basket is based on an attributional system. Gross income is attributed to a foreign branch if it is reflected on the branch’s separate books and records, subject to certain adjustments to conform to U.S. tax principles. This method distinguishes foreign branch income, which is defined by its connection to a specific business unit, from other baskets defined by the character of the income. However, income that meets the definition of passive category income is generally not included in the foreign branch basket, even if it is earned by the branch.

The Global Intangible Low-Taxed Income Basket

The foreign tax credit system includes a separate basket for Global Intangible Low-Taxed Income (GILTI). The GILTI rules require a U.S. shareholder of a CFC to include in its current income its share of the CFC’s earnings that exceed a certain routine return on the CFC’s tangible assets. Any income that a U.S. shareholder includes under the GILTI provisions is assigned to its own unique foreign tax credit limitation basket.

A consequence of this separation is the prohibition of cross-crediting between the GILTI basket and other income baskets. Foreign taxes paid or accrued on income in the general, passive, or foreign branch categories cannot be used to reduce the U.S. tax on GILTI. Conversely, foreign taxes attributable to the GILTI inclusion cannot be used to offset U.S. tax on income in any other basket.

This “no cross-crediting” rule has significant implications for U.S. multinational corporations. It means that a company with excess foreign tax credits in its general category basket, perhaps from operating in a high-tax country, cannot use those excess credits to lower the U.S. tax on its GILTI. The GILTI tax liability must be satisfied either with foreign taxes specifically attributable to the GILTI inclusion or with U.S. dollars.

Special Rules and Other Income Categories

Beyond the primary income baskets, Treasury Regulation Section 1.904-4 outlines several special rules and more narrowly defined income categories that apply in specific situations. These categories address unique circumstances where the standard classification rules would not achieve the intended policy outcome.

One such category is for “income re-sourced by treaty.” This basket applies when a tax treaty between the United States and another country treats what would otherwise be U.S. source income as foreign source income. This allows a U.S. taxpayer to claim a foreign tax credit for foreign taxes paid on that income, which would not be possible if the income were treated as U.S. source.

Another special category pertains to income derived from countries subject to U.S. sanctions. The law denies the foreign tax credit for taxes paid to certain sanctioned countries. Income derived from these countries is placed in its own separate limitation category for each such country. This segregation ensures that the denial of the credit is applied precisely to the income and taxes from the specific sanctioned nation.