Taxpayers who receive more than $20,000 in foreign sourced dividends and capital gains may have to make an adjustment to those items when filing their Form 1116, Foreign Tax Credits. Besides having to separate income into “General” and “Passive” income items with a separate Form 1116 for each, Dividends and Capital Gains have to be reduced by a factor ranging from .2929 to .6212. If you do not apply the adjustment you may greatly overstate you Foreign Tax Credits that may produce penalties and interest.

The reason the adjustment must be made is because Form 1116 was formulated to determine your tax credits assuming the use of the ordinary income tax rates rather than the lower tax rates afforded dividends and capital gains. Form 1116 limits credits to an estimate of what US tax liability arises from the income, so it assumes ordinary tax rates. Dividends and Capital gains are not subject to the ordinary tax rates but are favored with much lower rates requiring the above adjustment.