Form 1118 Instructions: Schedules, Section 904 Limit, and Carryovers

The instructions for Form 1118 walk a domestic corporation through claiming the Foreign Tax Credit on its Form 1120: you sort foreign income into separate categories, allocate expenses to compute net foreign taxable income on Schedule A, report and verify the creditable foreign taxes on Schedule B (plus Schedules C, D, and E for taxes deemed paid through foreign subsidiaries), apply the Section 904 limitation formula for each category, and use Schedule K to carry any excess back one year or forward up to ten.¹ The credit offsets U.S. tax dollar for dollar, which is why most corporations with foreign operations file the form rather than take a deduction.

Who Files and Why Credit Beats Deduction

Any domestic corporation that elects the credit for foreign income taxes attaches Form 1118 to its Form 1120. The form covers taxes the corporation paid directly to a foreign government and taxes a foreign subsidiary paid that the parent is treated as having paid under IRC Section 960.² The deemed-paid credit applies when the domestic corporation is a “United States shareholder” of a controlled foreign corporation and includes that subsidiary’s income on its own return.³

A deduction only lowers taxable income, saving the tax rate times the amount. A credit reduces the tax bill itself. The election is made when you file, but if you later realize you should have taken the credit, you have 10 years from the original filing due date to make or change the election.⁴

Sorting Income Into Separate Categories

The credit is not one number. IRC Section 904 requires foreign income and the associated taxes to be sorted into separate “baskets,” with the credit limit calculated independently for each. This prevents cross-crediting, where high taxes in one country on one type of income would wipe out U.S. tax owed on unrelated income earned elsewhere.⁵

The statute defines four main categories:⁵

General category income, which covers most active business income.
Passive category income, such as interest, dividends, rents, and royalties.
Foreign branch income earned through a foreign branch of the domestic corporation.
GILTI, meaning Global Intangible Low-Taxed Income under Section 951A other than amounts that qualify as passive.

Additional subcategories can apply, including income from sanctioned countries under Section 901(j) and treaty-resourced income. Every later schedule flows from the classification you make here, so getting it right at the start matters.

Schedule A: Computing Foreign Taxable Income

Schedule A produces the net foreign income in each category. It is not simply the revenue that came from abroad. The corporation must allocate and apportion its deductions between U.S.-source and foreign-source income, which almost always shrinks the foreign number.⁶

Under the Treasury Regulations implementing IRC Section 861, expenses that clearly relate to a specific income type get assigned there first. Expenses without an obvious home get spread across all income under set formulas. Interest expense is the biggest line item in most filings. Domestic corporations must apportion interest using the “asset method,” which distributes it based on the average value of assets in each grouping.⁷ Research and development costs and general overhead also get partially assigned to foreign income.

Schedule H apportions deductions that cannot be traced to a specific income item, and Schedule J computes adjustments to the separate limitation income figures and tracks overall foreign loss and domestic loss account balances.⁶ The net foreign income coming out of Schedule A becomes the numerator of the limitation fraction, so every dollar of expense allocated to foreign income reduces the maximum credit available.

Deemed-Paid Taxes: Schedules C, D, and E

When a domestic corporation includes income from a controlled foreign corporation on its U.S. return, it can claim credit for the foreign taxes the subsidiary paid on that income. Form 1118 uses separate schedules by inclusion type:⁶

Schedule C computes deemed-paid taxes on Subpart F inclusions under Section 951(a)(1).
Schedule D computes deemed-paid taxes on GILTI inclusions under Section 951A.
Schedule E computes deemed-paid taxes on distributions of previously taxed income.

Each schedule identifies the foreign taxes the subsidiary paid and determines how much is “properly attributable” to the income the parent included on its own return.³

Schedule B: Reporting Foreign Taxes and Checking Creditability

Schedule B totals the foreign taxes for each category and applies any required reductions to reach the final creditable amount, with Schedule G detailing specific reductions to taxes paid, accrued, or deemed paid.⁶

Not every foreign tax qualifies. Under IRC Section 901, the tax must function as an income tax by U.S. standards. Final regulations issued in 2022 added a “net income” test, requiring the tax base to allow for recovery of significant costs and expenses, and an “attribution” test, requiring the foreign country to base its tax on the taxpayer’s activities within that country, on income sourced there under rules reasonably similar to U.S. sourcing principles, or on the location of property.² A tax based solely on where the customer sits, for example, may not qualify. If you operate in a jurisdiction with an unusual tax structure, verify creditability before you file.

The Section 904 Limitation Formula

Even creditable foreign taxes are capped. For each category, the credit cannot exceed:⁵

(Foreign-Source Taxable Income ÷ Worldwide Taxable Income) × U.S. Tax Liability Before Credits

The numerator is the net foreign income from Schedule A after expense allocation. The denominator is worldwide taxable income. The fraction tells you what share of your U.S. tax bill relates to foreign income, and the credit cannot exceed that share. Operate in a low-tax country and you will typically absorb the full credit with room to spare. Operate in a high-tax country and the limitation will likely cap the credit below what you actually paid.

Schedule K: Carrying Excess Credits

Foreign taxes exceeding the limitation in a category are not lost. The excess carries back one year and then forward up to 10 years, usable in any year with limitation room in that same category.⁸ Schedule K reconciles prior-year carryover, current-year usage, and remaining balance.⁶

Excess must go to the carryback year first, and only what remains moves forward. Many corporations carry balances in the general or passive category for years, especially after a spike in foreign tax payments.

Schedule L: Redeterminations and Records

If a foreign government changes the tax owed for a prior year, the corporation reports the change on Schedule L, even when the adjustment does not change U.S. tax liability.¹ Foreign audit adjustments, refunds from foreign governments, and currency fluctuations between accrual and payment can all trigger a redetermination.

Keep foreign tax receipts, proof of payment or accrual, expense allocation workpapers, and documentation of the corporate ownership structure. Because the FTC election can be changed for 10 years, these records may need to be preserved well beyond the three-year window for most tax documents.⁴

Where Filers Get Into Trouble

An overstated foreign tax credit that produces a U.S. tax underpayment can trigger the accuracy-related penalty under IRC Section 6662, generally 20% of the underpayment. For corporations other than S corporations and personal holding companies, a “substantial understatement” exists when the understatement exceeds the lesser of 10% of the tax required to be shown on the return (or $10,000 if greater) and $10,000,000.⁹

Three error patterns show up most often: claiming credit for taxes that fail the creditability tests, misallocating expenses so the limitation fraction is inflated, and placing income in the wrong basket. The expense allocation schedules draw the most examination attention because that is where the dollar impact is largest.

One boundary worth flagging. If you acquire a foreign business in a transaction treated as a “covered asset acquisition” under Section 901(m), such as a stock purchase with a Section 338 election, an asset acquisition for U.S. purposes that is a stock acquisition under foreign law, or a partnership interest acquisition with a Section 754 election in effect, part of the foreign tax on income from the acquired assets can be disallowed as a credit and only deducted.¹⁰ That calculation runs separately from the standard Form 1118 mechanics above.

1
Internal Revenue Service. About Form 1118 – Foreign Tax Credit – Corporations
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Office of the Law Revision Counsel. 26 US Code 901 – Taxes of Foreign Countries and of Possessions of United States
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Office of the Law Revision Counsel. 26 US Code 960 – Deemed Paid Credit for Subpart F Inclusions
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Office of the Law Revision Counsel. 26 US Code 6511 – Limitations on Credit or Refund
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Office of the Law Revision Counsel. 26 US Code 904 – Limitation on Credit
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Internal Revenue Service. Instructions for Form 1118 (Rev. December 2025)
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eCFR. 26 CFR 1.861-9T – Allocation and Apportionment of Interest Expense
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Internal Revenue Service. FTC (Business) General Principles
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Internal Revenue Service. Accuracy-Related Penalty
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Internal Revenue Service. Notice 2014-44 – Foreign Tax Credit Guidance under Section 901(m)