What Are Foreign Tax Credit Baskets?

The U.S. foreign tax credit provides a way for taxpayers to mitigate double taxation on income earned outside the United States. When a U.S. person or corporation pays income tax to a foreign government, that tax may be used to reduce their U.S. income tax liability. Before the credit can be calculated, the Internal Revenue Code requires taxpayers to first sort their foreign income into distinct groups known as “baskets.” Each category of income is treated as a separate unit for the credit calculation, a process that prevents the mixing of different types of foreign earnings.

The Purpose of Income Baskets

The primary function of the foreign tax credit basket system is to enforce a limitation on the credit, preventing “cross-crediting.” This situation occurs when a taxpayer uses excess foreign tax credits from income in a high-tax country to offset U.S. tax on income from a low-tax jurisdiction. By requiring income to be segregated into baskets, the rules ensure that the credit for taxes paid in a high-tax country can only offset U.S. tax on income within that same category.

Consider a U.S. corporation with two streams of foreign income. One stream of $100,000 comes from a country with a 35% tax rate ($35,000 tax), and another $100,000 comes from a country with a 5% rate ($5,000 tax). If the U.S. tax rate is 21%, the U.S. tax on this $200,000 of foreign income would be $42,000. Without baskets, the company could use the full $40,000 of foreign taxes as a credit, but the basket system prevents this by isolating the high-tax income so the excess credit cannot shelter the low-taxed income.

Categories of Foreign Source Income

The Internal Revenue Code establishes several distinct categories, or baskets, for foreign source income. Taxpayers must classify their foreign earnings into one of these primary groups before any calculations can occur.

General Limitation Income

The general limitation income basket is the default category for active business earnings not fitting into other specialized baskets. It includes profits from manufacturing, sales, or services. For individuals, it also covers wages, salaries, and professional fees earned for services performed outside the United States. For corporations, it encompasses profits from their primary business operations not attributable to a foreign branch or classified as passive income.

Passive Category Income

The passive category income basket includes income not derived from active business, such as interest, dividends, rents, and royalties. A “high-tax kick-out” rule reclassifies passive income into the general basket if the foreign taxes paid on it exceed the U.S. tax that would have been owed. This prevents high taxes on one passive item from sheltering other low-taxed passive income.

Foreign Branch Income

This basket applies to the business profits of a U.S. person attributable to their foreign branches. A foreign branch is a qualified business unit (QBU), which is a distinct business operation in a foreign country with its own set of books. The net income generated by such a unit is classified as foreign branch income.

Global Intangible Low-Taxed Income

Global Intangible Low-Taxed Income (GILTI) is income that U.S. shareholders of Controlled Foreign Corporations (CFCs) must include in their gross income. A CFC is a foreign corporation where U.S. shareholders own more than 50% of it. This income is assigned to its own basket, and for corporate taxpayers, only 80% of the foreign taxes paid on GILTI can be claimed as a credit. However, if an item of GILTI also meets the definition of passive category income, it is treated as passive income and is not included in the GILTI basket.

Allocating and Apportioning Deductions

After gross income is categorized, the next step is to determine the taxable income for each basket. This requires assigning deductions to the income they helped generate to calculate the net income within each basket, which is the basis for the credit limitation.

The first principle is direct allocation, where expenses factually related to a specific class of gross income are allocated to it. For example, the cost of goods sold for inventory that generates foreign sales income is directly allocated to that income. Depreciation on a machine used exclusively for foreign markets would also be allocated to income from those sales.

Expenses not directly allocable, such as general administrative costs or interest expense, must be apportioned across the different income baskets. The regulations require apportionment on a basis that reasonably reflects the relationship between the deduction and the income. For instance, overhead might be apportioned based on the ratio of gross income in each basket to total gross income.

Calculating the Foreign Tax Credit Limitation

Once foreign source taxable income is determined for each basket, the foreign tax credit limitation must be calculated for each of those baskets. This calculation establishes the maximum amount of foreign tax that can be claimed as a credit for that income category. The limitation ensures that the credit cannot exceed the amount of U.S. tax that would be due on that same income.

The formula for the limitation is a ratio. It is calculated by taking the foreign source taxable income within a specific basket and dividing it by the taxpayer’s total taxable income from all sources. This fraction is then multiplied by the taxpayer’s U.S. income tax liability before any credits are applied.

For example, a corporation has $50,000 in taxable income in its general limitation basket and total taxable income of $500,000. If its pre-credit U.S. tax liability is $105,000 (at a 21% rate), the limitation for the general basket would be $10,500. The calculation is ($50,000 / $500,000) x $105,000.

This basket-specific calculation must be repeated for every basket with income. For most baskets, any foreign taxes paid that exceed the limitation can be carried back one year and carried forward for up to ten years. However, excess foreign tax credits in the GILTI basket cannot be carried back or forward.

Reporting on Tax Forms

After categorizing income, allocating deductions, and calculating the limitation for each basket, the final step is reporting this to the IRS. Individuals, estates, and trusts use Form 1116, “Foreign Tax Credit,” while corporations file Form 1118, “Foreign Tax Credit—Corporations.” These forms are structured to handle the basket system.

When completing Form 1116, a taxpayer must file a separate form for each category of foreign income for which they are claiming a credit. The taxpayer must check the box corresponding to the specific income basket being reported. The entire form is then completed with the figures pertaining only to that selected basket.

The form guides the taxpayer through the necessary calculations. Part I is used to report the taxable income from sources outside the United States for that basket, Part II is for the foreign taxes paid, and Part III computes the limitation.

For corporations, Form 1118 serves the same purpose but uses a series of schedules. A separate Schedule A must be completed for each income basket. The results from each schedule are then summarized to determine the corporation’s total allowable foreign tax credit.