Adjustments of foreign capital gains and losses for the foreign tax credit

As provided for in Sec. 901, in general, U.S. citizens, corporations, and certain resident aliens can claim a foreign tax credit (FTC) against income tax that they paid or accrued to foreign countries and U.S. possessions; this helps U.S. taxpayers avoid a double tax, since the United States taxes foreign income. Regs. Sec. 1.901-1(b) lists sections of the Code that impose limitations on the credit, the one most relevant to this article being Sec. 904(a), which limits the credit to the amount of tax that would have been paid to the United States on the foreign income. To meet that limitation, per Sec. 904(b)(2)(B), taxpayers may have to make certain adjustments to foreign capital gains and losses when reporting them.¹

These adjustments are complex, and many tax practitioners rely on the instructions to Form 1116, Foreign Tax Credit, and IRS Publication 514, Foreign Tax Credit for Individuals. The pertinent lines of Form 1116 are 1a (gross income from foreign sources) and 5 (losses from foreign sources). This article discusses and seeks to clarify some requirements of Form 1116 and the adjustments’ directions as laid out in Publication 514. This article also suggests some edits to Publication 514.

Taxpayers must consult the instructions for Form 1116 to determine whether they are required to make adjustments to their foreign capital gains and losses and, if so, whether they must use the instructions for Form 1116 or those in Publication 514 to make the adjustments.

Income categories and tax rate groups

Regs. Sec. 1.904-4(a) provides that foreign tax credit limitations must be computed separately for different income categories: passive, general, and additional categories. Reflecting this, Form 1116 differentiates foreign income into five income categories, each requiring its own Form 1116:

• Passive income;
• General income;
• Sec. 901(j) income (from sanctioned countries; income tax paid to these countries does not qualify for the FTC but is deductible);
• Certain income re-sourced by treaty; and
• Lump-sum distributions.

To calculate the adjustments, practitioners may also have to drill down and further partition income categories into tax rate groups: 28%, 25%, 20%, 15%, 0%, and short-term. So, for example, a taxpayer might have a passive income 20% capital gain, in which case the income category is passive and the rate group is 20%.

Capital gain and loss adjustments (Publication 514)

There are two overall types of adjustments for foreign capital gains and losses:

• U.S. capital loss adjustment, which reduces foreign capital gains via subtraction of an amount based on any U.S. net capital losses; and
• Capital gain rate differential adjustment, which reduces all or a portion of foreign capital gains and losses via multiplication by certain percentages to adjust for the differences between the various capital gains tax rates and the ordinary income tax rate. This adjustment has two scenarios:

  • Net capital gain in a Form 1116 income category tax rate group, or

  • Net capital loss in a Form 1116 income category tax rate group.

Note: Before making these adjustments, taxpayers must reduce their foreign net capital gain by any amount they elect to include in investment income on line 4g of Form 4952, Investment Interest Expense Deduction. Foreign gain they elect to include on line 4g of Form 4952 is included on line 1a of Form 1116 without adjustment.

U.S. capital loss adjustment

A taxpayer may have to adjust the amount of his or her foreign capital gains by the U.S. capital loss adjustment. The taxpayer must make the adjustment if the taxpayer’s foreign-source capital gain exceeds his or her worldwide capital gain. If foreign-source capital gains do not exceed worldwide capital gains, the adjustment is not necessary. The U.S. capital loss adjustment is the amount by which the foreign-source capital gain exceeds the amount of worldwide capital gain; for this to occur there must be a U.S. capital loss.

Foreign capital gain is the amount by which foreign capital gains (the sum of short- and long-term gains) exceed foreign capital losses (the sum of short- and long-term losses). Since foreign capital gain will be reduced by the amount of the U.S. capital loss adjustment, if foreign capital gains do not exceed foreign capital losses, a taxpayer skips the U.S. capital loss adjustment.

Worldwide capital gain is the amount by which the taxpayer’s worldwide (U.S. plus foreign) capital gains (sum of short- and long-term gains) exceed worldwide (U.S. plus foreign) capital losses (sum of short- and long-term losses). If the taxpayer’s worldwide capital losses equal or exceed worldwide capital gains, worldwide capital gain is zero.

Income category tax rate groups with net capital gains

Taxpayers reduce the amount of their foreign capital gains by the amount of their U.S. capital loss adjustment, as follows:

Step 1: Apportion the U.S. capital loss adjustment pro rata among the Form 1116 income categories that have short- or long-term net capital gains.

Step 2: Further drill down into each income category that has a net capital gain in more than one rate group and refine the U.S. capital loss adjustment by apportioning it pro rata to the tax rate groups with net capital gains (i.e., the capital gain in that rate group is greater than the capital loss in that rate group).

Example 1: D has a net $300 U.S. capital loss. D also has foreign capital gains and losses in the income categories shown in the table below,”D’s Foreign Capital Gains and Losses by Income Categories.” D’s passive foreign net capital gain is $200 ($200 − $100 + $100). D’s general foreign net capital gain is $400 ($700 − $300). D’s foreign-source capital gain is $600 ($200 + $400). D’s worldwide capital gain is $300 (the $300 U.S. capital loss plus the foreign capital gain).

As mentioned above, the U.S. capital loss adjustment is the amount by which the foreign-source capital gain exceeds the amount of worldwide capital gain: $600 − $300 = $300.

Step 1: The $300 U.S. capital loss adjustment must be apportioned between the foreign passive and general income categories. D apportions $100 of the $300 U.S. capital loss adjustment to passive category income ($300 × [$200 ÷ $600]) and $200 of the U.S. capital loss adjustment to general category income ($300 × [$400 ÷ $600]).

Step 2: Since D has net capital gain in more than one rate group in the passive category, the $100 apportioned to the passive category income must be apportioned again between the short-term rate group and the 28% rate group, based on the amount of net capital gain in those two rate groups; $66.67 to the 28% rate group ($100 × [$200 ÷ $300]) and $33.33 to the short-term rate group ($100 × [$100 ÷ $300]). The result is shown in the table “D’s Capital Gains and Losses After U.S. Capital Loss Adjustment.”

Notice that the passive income category’s 15% capital loss is not affected by the U.S. capital loss adjustment; only foreign gains are offset by the U.S. capital loss adjustment. Notice also that $266.67 of the $300 U.S. capital loss adjustment was used to reduce long-term gains (this will be important in the next adjustment).

Capital gain rate differential adjustment of long-term capital gain

After the U.S. capital loss adjustment, taxpayers must make the capital gain rate differential adjustment to further reduce foreign long-term (but not short-term) capital gains and also capital losses, by multiplying a portion of them by a percentage.

Two important definitions:

• Taxpayers have a U.S. net long­-term capital loss if their U.S. long-term capital losses are more than their U.S. long-term capital gains.
• The U.S. long-term loss adjustment equals the U.S. net long-term capital loss (defined above) minus the amount by which by the taxpayer earlier reduced foreign long-term capital gains via the U.S. capital loss adjustment ($200 + $66.67 = $266.67 in the example above). Notice that even though the U.S. capital loss adjustment also reduces foreign short-term capital gains (in the above example by $33.33), here the only concern is with the amount of U.S. capital loss adjustment that reduced foreign long-term capital gains.

How much of a rate group’s net long-term capital gain, remaining after the U.S. capital loss adjustment, must be adjusted by the capital gain rate differential adjustment? Publication 514 for 2016, page 18, states:

You must adjust the entire amount of that remaining net capital gain if you do not have a net long-term capital loss from U.S. sources or you do not have any short-term capital gains. If you have a net long-term capital loss from U.S. sources and you have any short-term capital gains, you only need to adjust a portion of the remaining net capital gain in each separate category long-term rate group.²

Rate groups with net capital gains

If taxpayers have Form 1116 income category rate groups with net long-term capital gains, they do the following:

Step 1: Calculate the U.S. long-term loss adjustment.

Step 2:

1. Multiply the U.S. long-term loss adjustment (from Step 1) by a fraction. The numerator is the net long-term capital gain in the rate group (that remains after the earlier U.S. capital loss adjustment), and the denominator is the total amount of net long-term foreign capital gains in all rate groups (that remain after the earlier U.S. capital loss adjustment).
2. For each rate group, subtract the amount in Step 2(a) from its net long-term capital gain.
3. Multiply the amount arrived at in Step 2(b) by the following appropriate percentage, and include that adjusted amount on Form 1116, line 1a:
   1. For net capital gain in the 0% rate group, multiply by 0.
   2. For the 15% rate group, multiply by 0.3788.
   3. For the 20% rate group, multiply by 0.5051.
   4. For the 25% rate group, multiply by 0.6313.
   5. For the 28% rate group, multiply by 0.7071.

The remaining portion of net capital gain in the separate category long-term rate group must be entered on line 1a of Form 1116 without adjustment. Notice that if there is no net long-term capital loss from U.S. sources, this results in adjusting the entire amount of the long-term net foreign capital gain.

This completes the capital gain rate differential adjustment.

Example 2: Now revisit D’s situation from Example 1 (after he applied the U.S. capital loss adjustment), as shown in the table “D’s Capital Gains and Losses After U.S. Capital Loss Adjustment,” below.

Step 1: D’s U.S. long-term loss adjustment equals the total $300 U.S. capital loss adjustment minus the portion of the U.S. capital loss adjustment that was used to reduce foreign long-term capital gain, $33.33 ($300 − $200 − $66.67).

Step 2:

1. D’s total net foreign long-term capital gain in all rate groups is $333.33 ($133.33 + $200).

   • The net long-term capital gain for the passive income category is $133.33.

   • The net long-term capital gain for the general income category is $200.

   Calculate the U.S. long-term loss adjustments for the income categories:

   • For the passive category 28% rate group: $13.33 ($33.33 × [$133.33 ÷ $333.33]).

   • For the general category 15% rate group: $20 ($33.33 × [$200 ÷ $333.33]).

2. For the passive category 28% rate group: $120 ($133.33 − $13.33).

   • For the general category 15% rate group: $180 ($200 − $20).

3. Multiply the adjustment amounts from Step 2(b) by the appropriate percentage:

   • For the passive category 28% rate group: $120 × 0.7071 = $84.85.

   • For the general category 15% rate group: $180 × 0.3788 = $68.18.

Therefore, D includes on Form 1116, line 1a, $186.36 ($13.33 + $20 + $84.85 + $68.18).

Rate group with net capital loss

For this scenario do not take into account any capital gain rate differential adjustment reduction made to any foreign net capital gain, above. If an income category rate group has a net capital loss, taxpayers must adjust that loss by netting it against U.S. and foreign capital gains, as follows:

1. Determine the rate group of capital gain(s) offset by the net capital loss.
2. Make the capital gain rate differential adjustment, via multiplication by a certain percentage.

To determine which capital gain(s) should be offset by a rate group’s net capital loss, use the following steps:

Step 1: Net capital loss from each rate group is netted against any net capital gain in the same rate group in the other foreign income categories. For example, a $200 15% passive loss will be netted against a $150 15% general gain, to leave a $50 15% passive loss.

Step 2: U.S. capital losses are netted against U.S. capital gains in the same rate group. This amount is used in Step 3. For example, a $100 U.S. 15% loss netted against a $300 U.S. 15% gain leaves a $200 U.S. 15% gain.

Step 3: For each foreign rate group, leftover net capital losses after Step 1 are netted against remaining foreign net capital gains and U.S. net capital gains in the following order:

1. Against U.S. net capital gains in the same rate group (from Step 2).
2. Against net capital gains in other rate groups (whether these net capital gains are U.S. or foreign), as follows:
   1. A foreign net capital loss in the short-term rate group is first netted against any net capital gain in the 28% rate group, then any excess loss against any net capital gain in the 25% rate group, then the 20% rate group, then the 15% rate group, and finally the 0% rate group.
   2. A foreign net capital loss in the 28% rate group is netted first against any net capital gain in the 25% rate group, then the 20% rate group, then the 15% rate group, and finally the 0% rate group.
   3. A foreign net capital loss in the 20% rate group is netted first against any net capital gain in the 15% rate group, then the 0% rate group, then the 28% rate group, and finally the 25% rate group.
   4. A foreign net capital loss in the 15% rate group is netted first against any net capital gain in the 0% rate group, then the 28% rate group, then the 25% rate group, and finally the 20% rate group. (The author believes that the 20% rate group was inadvertently left out of the text of this step in Publication 514.)

Any net capital losses in a rate group are treated as coming pro rata from the income categories that have net losses in that same rate group, to the extent netted in Step 1 or Step 3. (See example below.)

Step 4: Capital gain rate differential adjustment for net capital loss:After determining the rate group of capital gain to be offset by the net capital loss, make the capital gain rate differential adjustment by:

To the extent the net capital loss in a rate group offsets (equals) a capital gain in the:

• 0% rate group, multiply the offset amount by zero. For example, if the amount of net foreign capital loss in a rate group is $50, and there is a net capital gain of $60 in the offset rate group per the above ordering rules, then $50 × 0 = $0 loss will be included on Form 1116, line 5. The remaining $10 of loss will be reported, as is, on Form 1116, line 5, if there are no other gains to offset it per the above ordering rules.
• 15% rate group, multiply the offset amount by 0.3788.
• 20% rate group, multiply the offset amount by 0.5051.
• 25% rate group, multiply the offset amount by 0.6313.
• 28% rate group, multiply the offset amount by 0.7071.

Include the results on line 5 (losses from foreign sources) of the applicable Form 1116. The amount of loss that does not offset gains is included, without adjustment, on Form 1116, line 5.

Example 3: N has the foreign and U.S. capital gains and losses as shown in the table “N’s Foreign and U.S. Capital Gains and Losses.”

Step 1: The foreign net capital loss from the 15% rate group is $20 + $40 = $60.

Step 2: U.S. capital gain is $50 in the 15% rate group.

Step 3(a): Of the $60 net capital loss in Step 1, $50 is treated as offsetting $50 of U.S. capital gain in the same 15% rate group.

Any net capital losses in a rate group are allocated pro rata to the income categories (in this case, passive and general) that have net losses in that rate group; therefore:

• $16.67 ($50 × [$20 ÷ $60]) of the $50 is treated as coming from passive category income, and
• $33.33 ($50 × [$40 ÷ $60]) of the $50 is treated as coming from general category income.

The remaining $10 of foreign net capital loss in the 15% rate group that was not treated as offsetting the $50 U.S. net capital gain in the 15% rate group is treated as offsetting net capital gain in the 28% rate group per Step 3(b)(iv) on the previous page; therefore:

• $3.33 ($10 × [$20 ÷ $60]) is treated as coming from the passive income category, and
• $6.67 ($10 × [$40 ÷ $60]) is treated as coming from the general income category.

Step 4: Apply the capital gain rate differential adjustment and include on Form 1116, line 5:

• From passive income: $6.31 ($16.67 × 0.3788) plus $2.35 ($3.33 × 0.7071) = $8.66.
• From general income: $12.63 ($33.33 × 0.3788) plus $4.72 ($6.67 × 0.7071) = $17.35

N also includes $35.36 ($50 × 0.7071) of capital gain on Form 1116, line 1a, from the foreign passive income category.

Notice a key difference in the adjustment between a net foreign gain in a rate group and a net loss. Taxpayers adjust the amount of the gain that is in excess of the U.S. long-term loss amount, but for a loss, they adjust the amount that is equal to the capital gain that is treated as being offset.

In summary, to correctly limit the amount of the foreign tax credit, taxpayers may have to adjust foreign capital gains and losses, because of their lower tax rate, before including them on Form 1116. As part of the computation, foreign capital gains and losses are subject to being differentiated into income categories and tax rate groups. Both U.S. and foreign capital gains and losses might be used to make these adjustments, via either subtraction or multiplication by a percentage.  

Footnotes

¹For a detailed explanation of the adjustment math, see Vermeer, Korb, and Sigler, “How Reduced Rates for Capital Gains and Qualified Dividends Affect the FTC,” 37 The Tax Adviser 414 (July 2006).

²What do short-term capital gains have to do with our discussion of adjusting long-term capital losses via the capital gain rate differential adjustment? This author suggests removing mention of short-term capital gains from the above two sentences of Publication 514.