Tax Must Be an Income Tax (or Tax in Lieu of Income Tax): Foreign Tax Credits (2025 IRS Guide)

This guide covers “Tax Must Be an Income Tax (or Tax in Lieu of Income Tax)” within foreign tax credits. The following material presents the IRS treatment of this topic, including the qualifications, exceptions, and examples in the source section. Read the rules alongside the facts of your own situation before deciding what to report, deduct, or document.

Adapted from Publication 514 (2025), Foreign Tax Credit for Individuals, published by the Internal Revenue Service. This guide retains the source edition’s years, amounts, deadlines, and examples. It is guidance for that edition, not a statement that the same figures apply to every tax year.

Tax Must Be an Income Tax (or Tax in Lieu of Income Tax)

In most cases, only income, war profits, and excess profits taxes (income taxes) qualify for the foreign tax credit. Furthermore, foreign taxes on income can qualify even though they are not imposed under an income tax law if the tax is in lieu of an income, war profits, or excess profits tax. See Taxes in Lieu of Income Taxes, later.

Simply because the levy is called an income tax by the foreign taxing authority does not make it an income tax for this purpose. A foreign levy is a foreign income tax only if it meets both of the following requirements.

1. It is a tax; that is, you have to pay it and you get no specific economic benefit (discussed below) from paying it.

2. Either (a) the foreign tax is a net income tax that meets the requirements of Regulations section 1.901-2(b), or (b) the foreign tax is a tax in lieu of an income tax that meets the requirements of Regulations section 1.903-1.

Specific economic benefit.

In most cases, you get a specific economic benefit if you receive, or are considered to receive, an economic benefit from the foreign country imposing the levy, and:

1. If there is a generally imposed income tax, the economic benefit is not available on substantially the same terms to all persons subject to the income tax; or

2. If there is no generally imposed income tax, the economic benefit is not available on substantially the same terms to the population of the foreign country in general.

You are considered to receive a specific economic benefit if you have a business transaction with a person who receives a specific economic benefit from the foreign country and, under the terms and conditions of the transaction, you receive, directly or indirectly, all or part of the benefit.

However, see the exception discussed later under Pension, unemployment, and disability fund payments.

Economic benefits.

Economic benefits include the following.

• Goods.

• Services.

• Fees or other payments.

• Rights to use, acquire, or extract resources, patents, or other property the foreign country owns or controls.

• Reductions or discharges of contractual obligations.

In most cases, the right or privilege merely to engage in business is not an economic benefit.

Dual-capacity taxpayers.

If you are subject to a foreign country’s levy and you also receive a specific economic benefit from that foreign country, you are a “dual-capacity taxpayer.” As a dual-capacity taxpayer, you cannot claim a credit for any part of the foreign levy, unless you establish that the amount paid under a distinct element of the foreign levy is a tax, rather than a compulsory payment for a direct or indirect specific economic benefit.

For more information on how to establish amounts paid under separate elements of a levy, write to:

Internal Revenue Service
International Section
Philadelphia, PA 19255-0725

Pension, unemployment, and disability fund payments.

A foreign tax imposed on an individual to pay for retirement, old-age, death, survivor, unemployment, illness, or disability benefits, or for substantially similar purposes, is not payment for a specific economic benefit if the amount of the tax does not depend on the age, life expectancy, or similar characteristics of that individual.

No deduction or credit is allowed, however, for social security taxes paid or accrued to a foreign country with which the United States has a social security agreement. For more information about these agreements, see Pub. 54.

Net income tax.

A foreign tax is a net income tax if it is imposed on realized gross receipts reduced by costs and expenses related to those gross receipts. In addition, the foreign tax must meet the attribution requirement, described next. In order for the foreign tax to be a net income tax, the foreign tax must generally allow for deduction of significant costs and expenses, including capital expenditures, interest, rents, royalties, wages or other payments for services, and research and experimentation. However, the foreign tax does not need to allow deductions for costs and expenses attributable to wage income or to investment income that is not derived from a trade or business. For more information, see Regulations section 1.901-2(b)(4).

Attribution requirement.

A foreign tax must meet the attribution requirement in Regulations section 1.901-2(b)(5). For a tax that is imposed on nonresidents of a country, the foreign tax must meet one of the following three requirements.

1. Activities nexus: The base of the foreign tax must be determined based on gross receipts and costs that are attributable to the activities (without using the location of customers as a criterion) of the nonresident.

2. Source-based nexus: For a tax that is imposed on the basis of source, the foreign country’s source rules must be reasonably similar to U.S. source rules.

3. Property situs nexus: For a tax imposed on gain from the sale or disposition of property, the base of the tax only includes gains from the sale or disposition of real property located in the foreign country (or interest in a resident entity that owns real property) or gain from the sale or disposition of interest in a pass-through entity that is attributable to business property forming part of a taxable presence in the foreign country.

For a tax that is imposed on residents of the foreign country, the rules for allocating income, deduction, and losses between related parties must be consistent with arm’s-length principles.

Caution:

Notice 2023-55, issued on July 21, 2023, provides temporary relief in determining whether a foreign tax meets the definition of a foreign income tax under section 901. For foreign taxes paid or accrued during any tax year within the relief period, taxpayers may apply former sections 1.901-2(a) and (b), before it was amended by Treasury Decision 9959, subject to a modification to the nonconfiscatory gross basis tax rule as described in the Notice. Those former regulations do not include the attribution requirement described above. The rules described in this Notice were modified in part by a Notice released on December 11, 2023, to address their application to partnerships and their partners and to extend the relief period until further notice. For more information, see Treasury Decision 9959, 2022-03 I.R.B. 328, available at IRS.gov/irb/2022-03_IRB#TD-9959; Notice 2023-55, 2023-32 I.R.B. 427, available at IRS.gov/irb/2023-32_IRB#NOT-2023-55; and Notice 2023-80, 2023-52 I.R.B. 1583, available at IRS.gov/irb/2023-52_IRB#NOT-2023-80.

Soak-up taxes.

An amount paid to a foreign country is not an amount of foreign income tax paid and does not qualify for the foreign tax credit to the extent it is a soak-up tax. A tax is a soak-up tax to the extent that liability for it depends on the availability of a credit for it against income tax imposed by another country. This rule applies only if and to the extent that the foreign tax would not be imposed if the credit were not available.

Penalties and interest.

Amounts paid to a foreign government to satisfy a liability for interest, fines, penalties, or any similar obligation are not taxes and do not qualify for the credit.

Taxes not based on income.

Foreign taxes based on gross receipts or the number of units produced, rather than on realized net income, do not qualify unless they are imposed in lieu of an income tax, as discussed next. Taxes based on assets, such as property taxes, do not qualify for the credit.

Taxes in Lieu of Income Taxes

A tax paid or accrued to a foreign country qualifies for the credit if it is imposed in lieu of an income tax otherwise generally imposed. A foreign levy is a tax in lieu of an income tax only if it meets both of the following requirements.

• It is not payment for a specific economic benefit, as discussed earlier.

• The tax meets the attribution requirement and is imposed in place of, and not in addition to, a generally imposed net income tax.

A tax in lieu of an income tax does not have to be based on realized net income. A foreign tax imposed on gross income, gross receipts or sales, or the number of units produced or exported can qualify for the credit. However, the tax must meet the attribution requirement, described earlier. That means that a withholding tax imposed on gross interest, dividends, royalties, or other gross income of a nonresident is only creditable if the foreign country’s source rule for those items of income is reasonably similar to U.S. source rules.

In most cases, soak-up taxes (discussed earlier) do not qualify as a tax in lieu of an income tax. However, if the foreign country imposes a soak-up tax in lieu of an income tax, the amount that does not qualify for foreign tax credit is the lesser of the following amounts.

• The soak-up tax.

• The foreign tax you paid that is more than the amount you would have paid if you had been subject to the generally imposed income tax.

Using the guidance

Keep the documents that establish the dates, amounts, and circumstances described above. References to other chapters, forms, worksheets, or earlier and later sections refer to the linked IRS publication. Check the full publication and its updates before relying on a rule for a different tax year or a situation not addressed here.

Sources and further reading

• Publication 514 (2025), Foreign Tax Credit for Individuals: What Foreign Taxes Qualify for the Credit? — Tax Must Be an Income Tax (or Tax in Lieu of Income Tax) — Internal Revenue Service; 2025 edition.

The cited U.S. government text is in the public domain. Source accessed October 28, 2026. Fynoptic has organized this material for educational use and is independent of, and not endorsed by, the IRS.