On 15 May 2023, the U.S. IRS published a practice unit regarding Foreign Tax Credit – Categorization of Income and Taxes Into Proper Basket. This Practice Unit is revised to address changes from the implementation of the Tax Cuts and Jobs Act (TCJA) and covers the appropriate identification of the types of foreign-sourced income and taxes to determine assignment into their proper categories. This Practice Unit supersedes the December 1, 2016, Practice Unit titled “Categorization of Income and Taxes into Proper Basket.”

The Foreign Tax Credit (FTC) calculation must be applied separately to each category of income, sometimes referred to as income baskets. The foreign income and related taxes from one category cannot be combined with another category. This prevents averaging low- taxed income in one category with high-taxed income in another category which could overstate the FTC. The FTC limitation must be calculated separately for different categories of foreign source income according to Internal Revenue Code (IRC) 904(d). TCJA, effective for taxable years starting after 2017, increased the number of income baskets from five to seven by adding categories for IRC 951A category income and foreign branch category income. The remaining categories include passive category income, general category income, IRC 901(j) income, certain income resourced by treaty and lump-sum distributions. Passive and general categories of income are the most common.

The limitation formula is based on the taxable income for each category. It is necessary to determine foreign source taxable income for each category of income. Taxable income for a particular FTC category is the gross income of that category, less any relevant expenses.