Chapter 36
How To Treat Foreign Earned Income

There is a tax incentive for working abroad—in 2017 up to $102,100 of income earned abroad may escape U.S. income taxes and you may be entitled to an exclusion or deduction for certain housing costs. In measuring the economic value of this tax savings, consider the extra cost of living abroad. In some areas, the high cost of living and currency exchange rates will erode your tax savings.

The exclusion does not apply to investment income or to any other earned income that does not meet the exclusion tests.

To claim a foreign income exclusion you must satisfy a foreign residence or physical presence test (36.5).

Employees of the U.S. government may not claim an exclusion based on the government pay earned abroad.

If you keep income in a foreign bank or other financial accounts, you may have special reporting requirements for the accounts (4.12, 48.7).

36.1 Claiming the Foreign Earned Income Exclusion

If your tax home is in a foreign country and you meet either the foreign residence test or physical presence test (36.3), you may exclude up to $102,100 of foreign earned income earned in 2017. You must file a U.S. return if your gross income exceeds the filing threshold for your personal status, even though all or part of your foreign earned income may be tax free. For years after 2017, the maximum $102,100 exclusion may be increased by an inflation adjustment. The exclusion is not automatic; you must elect it. You elect the foreign earned income exclusion on Form 2555, which you attach to Form 1040. The housing cost exclusion (36.4) is also elected on Form 2555.

You may file simplified Form 2555-EZ if your 2017 foreign wages are $102,100 or less, you do not have self-employment income, and you do not claim the foreign housing exclusion, housing deduction, business expenses, or moving expenses.

A separate exclusion is allowed for the value of meals and lodging received by employees living in qualified camps; see 36.8.

If you claim the foreign income exclusion of $102,100, you may not:

• Claim business deductions allocable to the excluded income;
• Make a deductible traditional IRA contribution, or a Roth IRA contribution, based on the excluded income; or
• Claim foreign taxes paid on excluded income as a credit or deduction.

In deciding whether to claim the exclusion, compare the overall tax (1) with the exclusion and (2) without the exclusion but with the full foreign tax credit and allocable deductions. Choose whichever gives you the lower tax; see 36.3 and 36.6.

Keep in mind that if you claim the exclusion, any taxable income not subject to the earned income and housing exclusions will be taxed at the same rates that would have applied had no exclusions been allowed. To apply this “stacking” rule, you must figure your regular tax liability using the Foreign Earned Income Tax Worksheet in the instructions to Form 1040. Also, to figure AMT liability, use the Foreign Earned Income Tax Worksheet in the instructions to Form 6251.

Election applies until revoked. Once you elect the exclusion, that election remains in effect for all future years unless you revoke it. If you revoke the election, you cannot elect the exclusion again during the next five years without IRS consent. A revocation is made in a statement attached to your return for the year you want it to take effect. The foreign earned income exclusion and the housing cost exclusion must be revoked separately.

The IRS may consent to a reinstatement of the exclusion following a revocation under the following circumstances: you return for a period of time to the United States, you move to another foreign country with different tax rates, you change employers, or there has been substantial change in the tax law of the foreign country of residence or physical presence.

36.2 What Is Foreign Earned Income?

For exclusion purposes, foreign earned income includes salaries, wages, commissions, professional fees, and bonuses for personal services performed while your tax home is in a foreign country and you meet either the foreign residence test or the physical presence test; see 36.3. Earned income also includes allowances from your employer for housing or other expenses, as well as the value of housing or a car provided by the employer. It may also include business profits, royalties, and rents, provided this income is tied to the performance of services. Earned income does not include pension or annuity income, payments for nonqualified employee trusts or nonqualified annuities, dividends, interest, capital gains, gambling winnings, alimony, or the value of tax-free meals or lodging under the rules in 3.13.

Foreign earned income does not include amounts earned in countries subject to U.S. government travel restrictions.

Courts have agreed with the IRS that income earned in Antarctica, in international waters, and in international airspace is not earned in a foreign country and thus cannot qualify for the exclusion.

U.S. government pay ineligible. If you are an employee of the U.S. government or its agencies, you may not exclude any part of your pay from your government employer. Courts have agreed with the IRS that U.S. government workers were U.S. employees even though they were paid from sources other than Congressionally appropriated funds. If you are not an employee of the U.S. government or any of its agencies, your pay is excludable even if paid by a government source. You are not considered a U.S. government employee if you work for a private employer that has contracted with the government, provided you are under the employer’s control and supervision, you are paid by the employer, and no U.S. government agency would be liable for your salary if your employer defaulted.

Under a special law, tax liability is waived for a civilian or military employee of the U.S. government killed in a military action overseas; see 35.6.

Profits from sole proprietorship or partnership. If your business consists solely of services (no capital investment), 100% of gross income is considered earned income. If services and capital are both income-producing factors, the value of your personal services, but no more than 30% of your share of the net profit, is considered earned income. Net profit is reduced by the deduction for the employer-equivalent portion of self-employment tax (12.2) before figuring your 30% share.

If you do not contribute any services to a business (for example, you are a “silent partner”), your share of the net profits is not earned income.

If you do not have a net profit, the portion of your gross profit that represents a reasonable allowance for personal services is considered earned income.

The partnership agreement generally determines the tax status of partnership income in a U.S. partnership with a foreign branch. Thus, if the partnership agreement allocates foreign earnings to partners abroad, the allocation will be recognized unless it lacks substantial economic effect.

Fringe benefits. The value of fringe benefits, such as the right to use company property and facilities, is added to your compensation when figuring the amount of your earned income.

Royalties. Royalties from articles or books are earned income if you receive them for transferring all of your rights to your work, or you have contracted to write the articles or book for an amount in cash plus a royalty on sales.

Royalties from the leasing of oil and mineral lands and from patents are not earned income.

Reimbursement of employee expenses. Do not include reimbursement of expenses as earned income to the extent they equal expenses that you adequately accounted for to your employer; see 20.31. If your expenses exceed reimbursements, the excess is allocated according to the rules in 36.6. If reimbursements exceed expenses, the excess is treated as earned income.

Straight commission salespersons or other employees who arrange with their employers, for withholding purposes, to consider a percentage of their commissions as attributable to their expenses treat such amounts as earned income.

Reimbursed moving expenses. Reimbursements of moving expenses are not reported as income if you adequately account to your employer for the expenses; see 12.8.

A reimbursement is taxable if received under a non-accountable plan or for moving expenses that are not deductible (12.3) or that you deducted in an earlier year. However, for purposes of claiming the earned income exclusion, the reimbursement may be considered to have been earned in a year other than the year of receipt. This is important because an exclusion is allowed only for the year income is earned. If the move is from the U.S. to a foreign country, the reimbursement is considered foreign earned income in the year of the move if you qualify under the foreign residence or physical presence test for at least 120 days during that tax year. Reimbursement of moving expenses from one foreign country to another is considered foreign earned income in the year of the move, if you qualify under the residency or physical presence test at the new location for at least 120 days during the tax year. If you do not meet one of these tests in the year of the move, the reimbursements are earned income that must be allocated between the year of the move and the following tax year.

A taxable reimbursement for a move back to the U.S. is considered income from U.S. sources if you continue to work for the same employer. If you move back to the U.S. and take a job with a new employer or if you retire and move back to the U.S. and your old employer reimburses your moving expenses under a prior written agreement or company policy, the reimbursement is considered to be for past services in the foreign country and qualifies as foreign earned income eligible for the exclusion. The reimbursement is considered earned in the year of the move if you qualified under the residency or physical presence test (36.5) for at least 120 days during the tax year. Otherwise, the reimbursement is allocated between the year of the move and the year preceding the move. See IRS Publication 54 for details.

36.3 Qualifying for the Foreign Earned Income Exclusion

You may elect the exclusion for foreign earned income only if your tax home is in a foreign country and you meet either the foreign residence test or the foreign physical presence test of 330 days. The foreign residence and physical presence tests are discussed in 36.5. Tax home is discussed at 20.7–20.9. If your tax home is in the U.S., you may not claim the exclusion but may claim the foreign tax credit and your living expenses while away from home if you meet the rules in 20.9 for temporary assignments that are expected to last, and actually do last, for one year or less. U.S. government employees may not claim either the earned income exclusion or housing exclusion based on government pay.

Exclusion prorated on a daily basis. If you qualify under the foreign residence or physical presence test for only part of 2017, the $102,100 exclusion limit is reduced on a daily basis.

If you are married and you and your spouse each have foreign earned income and meet the foreign residence or physical presence test, you may each claim a separate exclusion. If your permanent home is in a community property state, your earned income is not considered community property for purposes of the exclusion.

Foreign earnings from a prior year. Foreign income earned in a prior year but paid in 2017 does not qualify for the 2017 exclusion. However, if the income was attributable to foreign services performed in 2016, the pay is tax free in 2017 to the extent that you did not use the full 2016 exclusion of $101,300. Under another exception, payments received in 2017 for 2016 services are treated as 2017 income if the payment was within a normal payroll period of 16 days or less that included the last day of 2016. If the services were performed before 2016, no exclusion is available to shelter the pay. You cannot exclude income that you receive after the end of the year following the year in which you provide the services.

Income for services performed in the U.S. does not qualify for the exclusion, even though it is paid to you while you are abroad.

Foreign tax credit. Foreign taxes paid on tax-free foreign earned income do not qualify for a credit or deduction. But if your foreign pay for 2017 exceeds $102,100, you may claim a foreign tax credit or deduction for the foreign taxes allocated to taxable income. The instructions to Form 1116 and IRS Publication 514 provide details for making the computation.

36.4 How To Treat Housing Costs

The housing costs of employees and self-employed persons are treated differently by the tax law. Employees get a housing exclusion; self-employed persons get a deduction from taxable foreign earned income. If you live in a special camp provided by your employer, all housing costs are excluded; see 36.8.

Exclusion for employer-financed housing costs. The housing exclusion is the excess of the employer-financed reasonable housing expenses (see below) over a “base housing amount.” The daily base housing amount is 16% of the maximum foreign earned income exclusion, prorated for the number of your qualifying days of foreign residence or presence for the year. Thus, for 2017, the base housing amount is $16,336 ($102,100 maximum foreign earned income exclusion × 16%) if you qualify under the foreign residence or physical presence test for the entire year. If you qualify under the residence or presence test for only part of the year, the $16,336 maximum base amount is prorated on a daily basis, so $44.76 ($16,336 ÷ 365) is allowed for each qualifying day in 2017.

In figuring housing expenses in excess of the base housing amount, there is a limit on the expenses that can be taken into account. Generally, the housing expenses cannot exceed 30% of the maximum earned income exclusion, prorated as applicable by the number of qualifying days of foreign residence or presence for the year. Thus, for 2017, the limit on housing expenses is generally $30,630 (30% × $102,100), or $83.92 per day, and the maximum housing exclusion is generally $14,294 ($30,630 − $16,336 maximum base amount). However, the expense limit, and thus the exclusion, may be significantly more than this if you work in a high cost locality. The IRS raises the annual limit for housing expenses in expensive foreign areas. The adjusted limits for high cost areas are provided in a table included in the instructions to Form 2555. In addition, when the IRS announces the high cost area limits for 2018 (in a notice likely to be released in March or April 2018), it is likely that it will allow taxpayers to use those 2018 limits to figure their housing exclusion for 2017 if the 2018 limit for housing expenses (full-year or daily) is higher than the amount allowed by the high cost area table in the 2017 Form 2555 instructions.

On Form 2555, your foreign earned income exclusion is limited to the excess of your foreign earned income (including employer-financed housing costs) over your housing exclusion.

Reasonable housing expenses. Include your rent, utilities other than telephone costs, insurance, parking, furniture rentals, and household repairs. The following expenses do not qualify: cost of purchasing a home, furniture, or accessories; pay television, home improvements; payments of mortgage principal; domestic labor; and depreciation on a home or on improvements to leased housing. Furthermore, interest and taxes that are otherwise deductible do not qualify for the exclusion.

You may include the costs of a separate household that you maintain outside the U.S. for your spouse and dependents because living conditions at your foreign home are adverse.

Self-employed persons. On Form 2555, self-employed individuals may claim a limited deduction (but not an exclusion) for housing costs exceeding the base housing amount. You may claim this deduction only to the extent it offsets taxable foreign earned income. The deduction is claimed “above-the-line" on Line 36 of Form 1040, even if you do not itemize deductions.

Where you may not deduct expenses because you do not have taxable foreign earned income, expenses may be carried forward to the next year and deducted in that year to the extent of taxable foreign earned income. Only a one-year carryover is allowed. If you have a carryover from 2017 to 2018 that cannot be claimed for 2018, that amount is lost.

If you are an employee and self-employed during the same year. Housing expenses above the base amount are partly excludable and partly deductible. For example, if half of your foreign earned income is from services as an employee, half of the excess housing expenses over the base amount are excludable. The remaining excess housing costs are deductible to the extent you have taxable foreign earned income after reducing it by the total of your allowable earned income exclusion plus your housing exclusion. Follow the instructions to Form 2555.

Countries ineligible for tax benefits. Housing expenses incurred in a country subject to a U.S. government travel restriction are not eligible for the tax benefits explained in this section. See Form 2555 instructions for a list of countries to which travel restrictions apply.

36.5 Meeting the Foreign Residence or Physical Presence Test

To qualify for the foreign earned income exclusion, you must be (1) a U.S. citizen (or U.S. resident alien who is a citizen or national of a country with which the U.S. has a tax treaty) who meets the foreign residence test, or (2) a U.S. citizen or resident alien meeting the physical presence test in a foreign country. The following areas are not considered foreign countries: Puerto Rico, Virgin Islands, Guam, Commonwealth of the Northern Mariana Islands, American Samoa, or the Antarctic region. The Tax Court has held that income earned in international airspace (by a flight attendant, for example) or in international waters (by a ship officer, for example) is not earned in a foreign country and thus does not qualify for the foreign earned income exclusion.

If, by the due date of your 2017 return (April 17, 2018), you have not yet satisfied the foreign residence or physical presence test, but you expect to meet either test after the filing date, you may either file on the due date and report your earnings or ask for a filing extension under the rules at 36.7.

Waiver of time test. If war or civil unrest prevented you from meeting the foreign residence or physical presence test, you may claim the exclusion for the period you actually were a resident or physically present abroad. Foreign locations and the time periods that qualify for the waiver of the 2017 residency and physical presence tests will be listed in the Internal Revenue Bulletin early in 2018.

Foreign residence test. You must be a U.S. citizen who is a bona fide resident of a foreign country for an uninterrupted period that includes one full tax year; a full tax year is from January 1 through December 31 for individuals who file on a calendar-year basis. A U.S. resident alien who is a citizen or national of a country with which the U.S. has an income tax treaty and meets the full-year foreign residence test also qualifies. Business or vacation trips to the U.S. or another country will not disqualify you from satisfying the foreign residence test. If you are abroad more than one year but less than two, the entire period qualifies if it includes one full tax year.

To prove you are a foreign resident, you must show your intention to be a resident of the foreign country. Evidence tending to confirm your intention to stay in a foreign country includes: (1) your family accompanies you; (2) you buy a house or rent an apartment rather than a hotel room; (3) you participate in the foreign community activities; (4) you can speak the foreign language; (5) you have a permanent foreign address; (6) you join clubs there; or (7) you open charge accounts in stores in the foreign country.

You will not qualify if you take inconsistent positions toward your foreign residency. That is, you will not be treated as a bona fide resident of a foreign country if you have earned income from sources within that country, filed a statement with the authorities of that country that you are not a resident there, and have been held not subject to the income tax of that country. However, this rule does not prevent you from qualifying under the physical presence test.

If you cannot prove that you are a resident, check to determine if your stay qualifies under the physical presence test.

Physical presence test. To qualify under this test, you must show you were on foreign soil 330 full days (about 11 months) during a 12-month period. Whether you were a resident or a transient is of no importance. You have to show you were physically present in a foreign country or countries for 330 full days during any 12-consecutive-month period. The 330 qualifying days do not have to be consecutive. The 12-month period may begin with any day. There is no requirement that it begin with your first full day abroad. It may begin before or after arrival in a foreign country and may end before or after departure from a foreign country. A full day is from midnight to midnight (24 consecutive hours). You must spend each of the 330 days on foreign soil. In departing from U.S. soil to go directly to the foreign country, or in returning directly to the U.S. from a foreign country, the time you spend on or over international waters does not count toward the 330-day total.

Choosing the 12-month period. You qualify under the physical presence test if you were on foreign soil 330 days during any period of 12 consecutive months. Since there may be several 12-month periods during which you meet the 330-day test, you should choose the 12-month period allowing you the largest possible exclusion if you qualify under the physical presence test for only part of 2017.

36.6 Claiming Deductions

You may not deduct expenses that are allocable to the foreign earned income and housing exclusions. If you elect the earned income exclusion, you deduct expenses as follows:

Personal or nonbusiness deductions, such as medical expenses, mortgage interest, and real estate taxes paid on a personal residence, are deductible if you itemize deductions. Business expenses that are attributable to earning excludable income are not deductible. Dependency exemptions are fully deductible; see Example 1 below.

If your foreign earnings exceed the exclusion ceiling, you allocate expenses between taxable and excludable income and deduct the amount allocated to taxable earned income; see Example 2 below.

If your job expenses are reimbursed and the expenses are adequately accounted for to your employer (20.30), the reimbursements are not reported as income on your Form W-2. If the reimbursement is less than expenses, the excess expenses are allocated as in Example 2 above.

You may have to allocate state income taxes paid on your income.

If either you or your spouse elects the earned income or housing exclusion, you may not claim an IRA deduction based on excluded income.

If you were reimbursed by your employer under a non-accountable plan, or if the reimbursement is for expenses that you deducted in an earlier year, the reimbursement is considered earned income in the year of receipt and is added to other earned income before taking the exclusion and making the allocation. See 36.2 for allocating reimbursements of moving expenses between the year of the move and the following year for purposes of claiming the exclusion.

If, after working in a foreign country, your employer transfers you back to the U.S. or you move back to the U.S. to take a different job, your moving expenses are deductible under the general rules discussed in 12.3. If your residence and principal place of work was outside the U.S. and you retire and move back to the U.S., your moving expenses are also deductible, except that you do not have to meet the 39-week test for employees or the 78-week test for the self-employed and partners.

Survivors of workers abroad returning to U.S. If you are the spouse or dependent of a worker who died while his or her principal place of work was outside the U.S., you may deduct your moving expenses back to the U.S. For the costs to be deductible, the move must begin within six months of the worker’s death. The requirements for deducting moving expenses apply, except for the 39-week test for employees or the 78-week test for the self-employed and partners.

Compulsory home leave. Foreign service officers stationed abroad must periodically return to the U.S. Because the home leave is compulsory, foreign service officers may deduct their travel expenses; travel expenses of the officer’s family are not deductible.

36.7 Exclusion Not Established When Your Return Is Due

When your 2017 return is due, you may not have been abroad long enough to qualify for the exclusion. If you expect to qualify under either the residence or physical presence test after the due date for your 2017 return, you may either (1) ask for an extension of time for filing your return on Form 2350 until after you qualify under either rule or (2) file your return on the due date, reporting the foreign income on the return, pay the full tax, and then file for a refund when you qualify.

If you will have tax to pay even after qualifying for the exclusion—for example, your earned income exceeds the exclusion—you may file for an extension to file but you will owe interest on the tax due. To avoid interest charges on the tax, you may take one of the following steps:

1. File a timely return and pay the total tax due without the application of the exclusion. When you do qualify, make sure you file a timely (47.2) refund claim; or
2. Pay the estimated tax liability when you apply for the extension to file on Form 2350. If the extension is granted, the payment is applied to the tax shown on your return when you file.

36.8 Tax-Free Meals and Lodging for Workers in Camps

If you must live in a camp provided by your employer, you may exclude from income (3.13) the value of the lodging and meals furnished to you if the camp is (1) provided because you work in a remote area where satisfactory housing is not available; (2) located as near as is practical to the worksite; and (3) in an enclave that normally houses at least 10 employees and in which lodgings are not offered to the general public.

You also may qualify for the earned income exclusion; see 36.1.

36.9 U. S. Virgin Islands, Samoa, Guam, and Northern Marianas

The U.S. Virgin Islands, Puerto Rico, Guam, American Samoa, and the Commonwealth of the Northern Mariana Islands have their own independent tax departments. Therefore, contact the particular tax authority for the proper treatment of your income and obtain a copy of IRS Publication 570, Tax Guide for Individuals With Income From U.S. Possessions, which provides phone, mail, and internet contact information.

Possession exclusion. A possession exclusion applies to bona fide residents of American Samoa for the entire year. On Form 4563, such residents may exclude for U.S. tax purposes their income from sources in American Samoa and income effectively connected with a business in American Samoa. The exclusion applies to amounts earned for services as an employee of the American Samoan government or its agencies but does not apply to pay as an employee, whether civilian or military, of the U.S. government or its agencies.

36.10 Earnings in Puerto Rico

If you are a U.S. citizen or resident alien who is also a resident of Puerto Rico for the entire year, you generally report all of your income on your Puerto Rico tax return. Where you report income from U.S. sources on the Puerto Rico tax return, a credit against the Puerto Rico tax may be claimed for income taxes paid to the United States.

If you are not a resident of Puerto Rico, you report on a Puerto Rico return only income from Puerto Rico sources. Wages earned for services performed in Puerto Rico for the U.S. government or for private employers are treated as income from Puerto Rico sources.

U.S tax returns. As a U.S. citizen, you must file a U.S. tax return reporting income from all sources. But if you are a bona fide resident of Puerto Rico for an entire tax year, you do not report on a U.S. tax return any income earned in Puerto Rico during your residence there, except amounts received for services performed in Puerto Rico as an employee of the U.S. government. Similar rules apply if you have been a bona fide resident of Puerto Rico for at least two years before changing your residence from Puerto Rico. On a U.S. tax return, you may not deduct expenses or claim tax credits allocable to the excludable income. Personal exemptions are fully deductible.

If you are not a bona fide resident of Puerto Rico for the entire tax year, or were not a bona fide resident for two years prior to the tax year, you report on your U.S. tax return all income you earned in Puerto Rico, as well as all income from other sources. If you are required to report income earned in Puerto Rico on your U.S. tax return, you may claim a credit for income tax paid to Puerto Rico. You figure the credit on Form 1116.

See IRS Publication 570, Tax Guide for Individuals With Income from U.S. Possessions, for further information on filing U.S. and Puerto Rico tax returns.

36.11 Tax Treaties With Foreign Countries

Tax treaties between the United States and foreign countries modify some of the rules discussed in this chapter. The purpose of the treaties is to avoid double taxation. Consult your tax advisor about the effect of these treaties on your income. IRS Publications 54 and 901 have information about the tax treaties the U.S. maintains with foreign countries; also find information at www.irs.gov/Businesses/International-Businesses/United-States-Income-Tax-Treaties — A-to-Z.

36.12 Exchange Rates and Blocked Currency

Income reported on your federal income tax return must be stated in U.S. dollars. Where you are paid in foreign currency, you report your pay in U.S. dollars on the basis of the exchange rates prevailing at the time the income is actually or constructively received. You use the rate that most closely reflects the value of the foreign currency. Be prepared to justify the rate you use.

Fulbright grants. If 70% or more of a Fulbright grant is paid in nonconvertible foreign currency, U.S. tax may be paid in the foreign currency. See IRS Publication 54 for details.

Blocked currency. A citizen or resident alien may be paid in a foreign currency that cannot be converted into American dollars and removed from the foreign country. If your income is in blocked currency, you may elect to defer the reporting of that income until: (1) the currency becomes convertible into dollars, (2) you actually convert it into dollars, or (3) you use it for personal expenses. Purchase of a business or investment in the foreign country is not the kind of use that is treated as a conversion. (4) You make a gift of it or leave it in your will. (5) You are a resident alien and you give up your U.S. residence.

If you use this method to defer the income, you may not deduct the expenses of earning it until you report it. You must continue to use this method after you choose it. You may only change with permission of the IRS.

You do not defer the reporting of capital losses incurred in a country having a blocked currency.

There may be these disadvantages in deferring income:

• Many years’ income may accumulate and all be taxed in one year.
• You have no control over the year in which the blocked income becomes taxable. You usually cannot control the events that cause the income to become unblocked.

You choose to defer income in blocked currency by filing a tentative tax return reporting your blocked taxable income and explaining that you are deferring the payment of income tax because your income is not in dollars or in property or currency that is readily convertible into dollars. You must attach to your tentative return a regular return, reporting any unblocked taxable income received during the year or taxable income that became unblocked during the year. When the currency finally becomes unblocked or convertible into a currency or property convertible to dollars, you pay tax on the earnings at the rate prevailing in the year the currency became unblocked or convertible. On the tentative return, note at the top: “Report of Deferrable Foreign Income, pursuant to Revenue Ruling 74-351.” File separate returns for each country from which blocked currency is received. The election must be made by the due date for filing a return for the year in which an election is sought.

36.13 Foreign Tax Credit or Deduction for Foreign Taxes Paid

You do not have to live abroad to have paid foreign taxes; the taxes may result from having foreign investments. You may claim an itemized deduction (Schedule A, Form 1040) for qualified foreign income taxes or you may claim a foreign tax credit. You must file Form 1116 to compute your credit unless the de minimis exception applies; see below. You may not claim a foreign tax credit or deduction for taxes paid on income not subject to U.S. tax. If all of your foreign earned income is excluded, none of the foreign taxes paid on such income may be taken as a credit or deduction on your U.S. return. If you exclude only part of your foreign pay, you determine which foreign taxes are attributable to excluded income and thus barred as foreign tax credits by applying the fractional computation provided in the instructions to Form 1116 and IRS Publication 514.

For any tax year, you may not elect to deduct some foreign taxes and claim others as a credit. One method must be applied to all taxes paid or accrued during the tax year. If you are a cash-basis taxpayer, you may claim a credit for accrued foreign taxes, but you must consistently follow this method once elected.

Exemption from credit limit for de minimis foreign taxes. If you have $300 or less of creditable foreign taxes, $600 or less if married filing jointly, you may elect to be exempt from the overall limitation on the credit, provided that your only foreign source income is qualified passive income and all the income and any foreign taxes paid on it were reported to you on a qualified payee statement such as Form 1099-DIV, Form 1099-INT, or Schedule K-1 of Form 1041, 1065, 1065-B, or 1120S. If the election is made, a foreign tax credit may be claimed directly on Line 48 of Form 1040 without filing Form 1116. See the instructions to Form 1116 for rules on making this election.

Credit disallowed. The credit may not be claimed if:

• You are a nonresident alien. However, under certain circumstances, if you are a bona fide resident for an entire taxable year in Puerto Rico you may be able to claim the credit. Also, a nonresident alien engaged in a U.S. trade or business may be able to claim a credit for foreign taxes paid on foreign source income effectively connected to that U.S. business.
• You are a citizen of a U.S. possession (except Puerto Rico) but not a U.S. citizen or resident.

No credit is allowed for taxes imposed by a country designated by the government as engaging in terroristic activities; see IRS Publication 514 for a list of these countries.

Taxes qualifying for the credit. The credit is allowed only for foreign income tax, excess profits taxes, and similar taxes in the nature of an income tax. It is not allowed for any taxes paid to foreign countries on sales, gross receipts, production, the privilege to do business, personal property, or export of capital. See the instructions to Form 1116 and IRS Publication 514 for other taxes that may qualify for the credit.

Reporting foreign income on your return. You report the gross amount of your foreign income in terms of United States currency. You also attach a schedule showing how you figured the foreign income in United States currency.

Limit on credit. Your credit for foreign income taxes paid or accrued is subject to a limitation on Form 1116 unless you qualify for and elect the exemption for de minimis taxes discussed above. The limitation is your total U.S. regular tax liability multiplied by a fraction: the numerator is your net foreign source taxable income (after required adjustments), and the denominator is your total taxable income from all sources. To determine the limit, you must separate your foreign source income into either the passive income category or the general income category. If you have both categories of foreign source income, you must figure the credit limit for each category on a separate Form 1116. If you have income from activities in sanctioned countries, or certain income re-sourced by treaty as foreign source income, or you paid taxes on a foreign source lump-sum distribution from a pension plan, a separate Form 1116 must be used to figure the limit for these categories as well. If you have more than one category of income, you combine the credits for the separate categories on Part IV of the Form 1116 with the largest credit. Part IV is not completed on the other Forms 1116, which are filed as attachments. See IRS Publication 514 and the instructions to Form 1116 for the details on these computations.

Carryback and carryover of excess foreign tax credit. If you are unable to claim all of the qualified foreign taxes paid or accrued during the year because of the limit on the credit, the balance may be carried back one year and then carried forward 10 years. For further details, see IRS Publication 514 and the instructions to Form 1116.