When a U.S. tax treaty reclassifies income that would otherwise be U.S.-source as foreign-source, that income belongs in its own foreign tax credit basket, and the separate Form 1116 limitation for treaty re-sourced income has to be computed country by country under Internal Revenue Code Section 904(d)(6). You check box “f” at the top of a dedicated Form 1116, file one for each treaty partner country, and keep the numbers walled off from your general and passive baskets.1Office of the Law Revision Counsel. 26 USC 904 – Limitation on Credit
Why the Separate Basket Exists
Normal sourcing rules treat interest, dividends, and royalties paid by a U.S. entity as U.S.-source. U.S.-source income doesn’t generate a foreign tax credit, because the credit is there to relieve double taxation of foreign-source income. Treaties override that default. Many bilateral treaties include a “Relief from Double Taxation” article giving the foreign country the right to tax specific items and requiring the United States to grant a credit for the foreign tax. When you elect that treaty provision, the income becomes foreign-source for credit purposes.
Section 904(d)(6) then requires you to apply the foreign tax credit limitation separately to that re-sourced income. Lumping it in with your general-category or passive-category foreign income would let one basket’s excess limitation absorb another’s excess credits, which is exactly what the separate basket prevents.
One boundary worth flagging up front: the separate-basket rule does not apply to U.S. citizens residing in the treaty country whose income is re-sourced solely under the treaty’s relief-from-double-taxation article, as opposed to a sourcing article. That carve-out sits in Sections 865(h) and 904(h)(10). A U.S. citizen living in the U.K. whose income gets re-sourced only through the U.K. treaty’s double-taxation-relief article may not need the separate basket at all.
Which Income Qualifies
What can be re-sourced depends entirely on the specific treaty. The typical candidates are interest paid by U.S. borrowers, dividends from U.S. corporations, and royalties for intellectual property used in the United States. Normal rules would source each domestically, but the treaty assigns taxing rights to the foreign country and then re-sources the income so the credit mechanism works. Capital gains on personal property can qualify too if the treaty assigns taxing rights to the seller’s country of residence. Treaty articles differ, so read the one that applies to you. The IRS keeps a full list of U.S. income tax treaties with links to each text.2Internal Revenue Service. United States Income Tax Treaties – A to Z
The foreign country must actually tax the income. If the treaty gives the foreign country the right to tax dividends but that country exempts them, there is no double taxation and no foreign tax to credit. Re-sourcing without an actual foreign tax paid or accrued gets you nowhere.
Items that would otherwise be passive-category (portfolio interest, dividends) get pulled out of the passive basket once they’re re-sourced by treaty. The IRS treats them as “certain income re-sourced by treaty” regardless of their underlying passive character.3Internal Revenue Service. FTC Categorization of Income and Taxes
Filling Out Form 1116 for the Re-Sourced Basket
Check box “f” at the top of Form 1116 for “Certain income re-sourced by treaty.”4Internal Revenue Service. Form 1116, Certain Income Re-sourced by Treaty Enter the treaty partner country that taxed the income. If more than one country’s income is re-sourced, complete a separate Form 1116 for each country and combine the results on a summary Form 1116 in Part IV.5Internal Revenue Service. 2025 Instructions for Form 1116
In Part I, report the gross income covered by the treaty article. Label it clearly (“Re-sourced interest,” “Re-sourced dividends”) and allocate directly connected deductions and expenses. The net figure feeds the limitation fraction.
Part II is for the foreign taxes paid or accrued on that income. Enter both the foreign currency amount and the U.S. dollar equivalent. The IRS says to use the exchange rate that “most properly reflects your income,” pointing to Treasury Department published rates, the Federal Reserve, and commercial sources such as Oanda and xe.com.6Internal Revenue Service. Foreign Currency and Currency Exchange Rates
Part III runs the limitation itself: U.S. tax liability multiplied by a fraction with net re-sourced foreign income in the numerator and total taxable income in the denominator. The credit for this basket can’t exceed the U.S. tax attributable to the re-sourced income. Any foreign tax above that ceiling becomes an unused credit.
Carrybacks and Carryforwards Stay in the Basket
Unused foreign taxes on treaty re-sourced income carry back one year and forward up to ten years, applied in chronological order so the oldest credits absorb first.7eCFR. 26 CFR 1.904-2 – Carryback and Carryover of Unused Foreign Tax Those carryovers stay locked in the same limitation category. Excess credits from the re-sourced basket can only offset U.S. tax on re-sourced income in another year; they don’t spill into the general or passive basket.
That’s a real risk when re-sourced income fluctuates. If you have a big foreign tax bill in year one and no re-sourced income in years two through eleven, the credits expire unused. Track carryforwards by basket and by year so nothing falls off the ten-year cliff.
When Form 8833 Is Required, and When It Isn’t
Form 8833 is the disclosure form for treaty-based return positions. The Form 1116 instructions say you “may be required” to file it for re-sourced income, not that you always must.5Internal Revenue Service. 2025 Instructions for Form 1116 The regulations carve out several exceptions. The most relevant one here exempts individuals who re-source income under a treaty’s double-taxation-relief provision for foreign tax credit purposes. A separate exception applies where the total treaty-affected payments don’t exceed $10,000 in the tax year.8eCFR. 26 CFR 301.6114-1 – Treaty-Based Return Positions Other exceptions cover dependent personal services income, pensions, Social Security, and positions already disclosed by a pass-through entity.
If none of the exceptions applies, file Form 8833. Identify the specific treaty article supporting the re-sourcing, and match the income description to what you reported on Form 1116. Discrepancies between the two forms invite audit attention.
The penalty for skipping a required Form 8833 is $1,000 per failure under Section 6712, or $10,000 for C corporations. The IRS can waive it for reasonable cause and good faith.9Office of the Law Revision Counsel. 26 USC 6712 – Failure to Disclose Treaty-Based Return Positions
Interaction With the Foreign Earned Income Exclusion
Section 911 doesn’t let you exclude foreign earned income on Form 2555 and also claim a credit for the foreign tax on that same income. If you claim both exclusion and credit in the same year on different pools, reduce the foreign taxes on Form 1116 by the portion allocable to the excluded earnings.10Internal Revenue Service. Foreign Earned Income Exclusion Adjustment
The allocation fraction puts excluded income (minus related deductions) over total foreign earned income (minus related deductions). Multiply that fraction by the foreign taxes paid on earned income to get the disallowed portion, then enter it on line 12 of Form 1116 as a “Reduction in Foreign Taxes.” If you excluded all of your foreign earned income, none of the foreign taxes on it are creditable. The same math applies where treaty re-sourced income overlaps with income you excluded on Form 2555.
State Taxes Don’t Follow the Treaty
Federal tax treaties bind the United States and foreign governments, not state taxing authorities. The IRS itself notes that income tax treaties don’t cover state income taxes, and several states refuse to honor treaty benefits when computing state tax.11Internal Revenue Service. State Income Taxes – IRS Courseware A successful federal re-sourcing may still leave the same income treated as U.S.-source on your state return with no offset. Check with the state tax department. Some states run their own foreign tax credit rules independent of the federal system.
Ten-Year Window to Claim or Amend
You have ten years from the original due date of the return for the year the foreign taxes were paid or accrued to make or change your foreign tax credit election. Refund claims tied to the credit follow the same ten-year window.12Internal Revenue Service. Foreign Tax Credit – Special Issues This matters for treaty-related income in particular, because foreign tax assessments often get adjusted years after filing. If a foreign country later increases the tax on income you already re-sourced, you can amend the earlier Form 1116 and pick up the additional credit inside that ten-year window.
Documentation to Keep
Before filing, and for at least ten years after, hold on to:
- The specific treaty article that authorizes re-sourcing your income type, from the “Relief from Double Taxation” article or its equivalent.
- Proof of foreign tax: assessments, payment receipts, or a copy of your foreign tax return, translated into English if originally in another language.
- The exchange rate you used and its source, whether Treasury, Federal Reserve, USDA, or a commercial provider like Oanda or xe.com.6Internal Revenue Service. Foreign Currency and Currency Exchange Rates
- The date each foreign tax was paid or accrued, which determines the tax year for the credit.
Attach Form 1116, and Form 8833 when required, to your Form 1040. If the IRS follows up, expect a request for the treaty article, the foreign return, and payment proof; an organized file makes the response routine.