The Form 1116 High-Tax Kickout: What Gets Tested Together

The high-tax kickout moves passive category income, and the foreign tax on it, out of the passive category and into the general category when the foreign tax exceeds the highest US rate applied to that income. The rule that almost every published guide gets wrong is what gets tested: the regulation does not test each income type on its own, it tests groups. For a US citizen living in Britain that single point decides the answer, because nearly all UK investment income falls into one group and is tested blended, while UK rental profits are pulled out and tested alone.

This article is about the grouping rules in Treasury Regulation section 1.904-4(c) and how they land on a British portfolio. Every return and every position we take is reviewed and signed off by a licensed professional before it goes anywhere.

Where the rule comes from

Section 904(d)(2)(F) of the Internal Revenue Code defines high-taxed income as income that would otherwise be passive income where the foreign income taxes on it exceed "the highest rate of tax specified in section 1 or 11 (whichever applies) multiplied by the amount of such income". For an individual that is the top rate of US income tax, currently 37%. The regulation's own worked example uses exactly that figure for individuals.

Two things follow immediately, and both are settled across the Instructions for Form 1116 and the regulation. First, it is not an election. There is no box to tick and no filing position that disapplies it; if the test is met, the income moves. Second, the test is run on net figures. The instructions put it plainly: high-taxed income is income where the foreign taxes you paid on the income, "after allocation of expenses", exceed the highest US tax that can be imposed on the income.

We have already set out why this is not a contest between a UK headline rate and a US headline rate in our guide to why a Form 1116 credit cannot cross between categories. That piece deliberately stopped at the door of the regulation. This is what is behind it.

The test is applied to groups, not to income types

Paragraph (c)(3) of the regulation is the provision that the commercial guides skip. It opens by saying that, except where the special rules in (c)(5) apply, all passive income received by a US person is subject to its rules. It then sorts that income into four groups, and the operative words at the end of each are the same: the income in the group "shall be treated as one item of income".

The four groups turn on the foreign withholding tax the income bore:

two groups for passive income that suffered foreign withholding tax, split according to how heavy that withholding was;
one group for passive income subject to no withholding tax and no other foreign tax;
one group for passive income subject to no withholding tax but subject to a foreign tax other than a withholding tax — in other words, income taxed by assessment.

Before any of that is tested, paragraph (c)(2) does the arithmetic. Expenses, losses and other deductions are allocated and apportioned to each group first, and foreign taxes are allocated to groups as well. Where the deductions allocated to one group exceed its gross income, the excess "shall proportionately reduce income in the other groups (but not below zero)". Only then is the rate test applied.

What this means for a UK portfolio: one blended item

Ask which of the four groups a British investor's income falls into and the picture changes completely. The UK does not withhold tax at source from the income most Americans in Britain hold. HMRC's International Manual records that "the obligation to deduct tax from interest payments by deposit takers was repealed from 6 April 2016", and that from that date nearly all bank and building society interest is paid gross. UK tax on a UK resident's dividends is charged on the recipient through Self Assessment, not deducted before the money arrives.

So UK dividends, UK bank interest and most other UK investment income land in the same place: the group for income bearing no withholding tax but taxed by assessment. They are one item of income, and the rate test is run against the blend.

That is why the familiar shortcut misfires in both directions. UK dividend rates run at 10.75%, 35.75% and 39.35% above the £500 dividend allowance, and the additional rate is above the US 37% ceiling. Tested alone, an additional-rate dividend looks like a certainty for the kickout. Tested as the regulation requires, it is averaged with the interest sitting beside it in the same group — interest that may have borne little or no UK tax at all after the personal savings allowance and the starting rate for savings. The blended rate can easily fall below the line, and the dividends stay passive. Run the comparison the other way and the reverse happens: a modest dividend can be carried over the line by heavily taxed income grouped with it.

Two refinements matter here. Income inside an ISA bears no UK tax at all, so it sits in the no foreign tax group and can never be high-taxed — there is nothing to compare. And paragraph (c)(4), which some guides fold into the general grouping discussion, is not about ordinary portfolio dividends: it deals with controlled foreign corporations, substantial corporate holdings and foreign qualified business units. A dividend from a listed UK company is governed by (c)(3).

UK rental profits are tested on their own

Then comes the provision no page in the ranking set for this topic mentions. Paragraph (c)(5)(i) says that all items of rent or royalty income to which an item of rent or royalty expense is directly allocable "shall be treated as a single item of income and shall not be grouped with other amounts".

A UK buy-to-let with a mortgage, letting agent fees and repairs is exactly that. The rental profit is lifted out of the groups and tested by itself, after the directly allocable expenses have been set against it. It never blends with the dividends and interest, and the dividend rate is simply irrelevant to it.

This is why UK rental income is the single most likely source to be kicked out, and the reason has nothing to do with headline rates. The UK and the US measure the profit differently — the US permits depreciation and a full interest deduction that UK rules restrict — so the US net figure can be small while the UK tax computed on a larger profit stays stubbornly high. A high foreign tax measured against a thin net income produces a high effective rate, and the rental income and its UK tax move to the general category together.

The regulation's own illustration is an individual, not a company: a US citizen with a foreign tax home whose royalty income stays in the passive category while his rental income is kicked out, in the same year, on the same return. Two passive sources, two different answers, because of grouping.

When a group nets to zero or below

The sequencing in paragraph (c)(2) has a consequence that catches people with a loss-making UK letting or a capital loss on a UK holding. Excess deductions in one group spill over and proportionately reduce the income in the others before the test runs. Push a group's income down to nothing and you have not escaped the rule.

Paragraph (c)(1) covers that case directly: where passive income is zero or less than zero, the foreign taxes on it are treated as related to the category the income would have been assigned to had it been high-taxed — the general category. The credit follows the income to a category whose limitation it may not be able to use. The regulation works an example in which the groups are reduced to zero and the taxes on both the rental and the royalty income go to the general category anyway.

Three things the test is not

It is not a comparison of UK and US band rates. UK income tax at 20% to £37,700, 40% to £125,140 and 45% above tells you nothing on its own. The regulation measures tax actually paid on a group, after expense allocation, against 37% of that group's net income.
It does not take the capital gain adjustments into account first. Paragraph (c)(2)(iii) states that the determination is made before any adjustment under section 904(b) and before any allocation or recapture of a separate limitation loss or overall foreign loss. The qualified dividend and net capital gain rate differential adjustment is a limitation calculation, and it does not feed this test.
It is not avoidable by skipping Form 1116. There is a small-credit election that lets some filers claim foreign tax directly without the form, but it is capped so far below the figures at which a kickout can arise that it is unavailable to anyone this rule touches — and electing it blocks carrybacks and carryovers for the year in any event.

Getting it right on the return

Where the kickout applies, the Form 1116 instructions are specific. You enter "HTKO" on line i of the Forms 1116 for passive category income and for the category the income is reclassified into, and use a separate column in Part I. The reclassified income goes on line 1a in the HTKO column as a negative number on the passive form and as a positive number on the receiving form, with the related deductions mirrored the same way on line 6, and nothing entered on lines 2 through 5 of that column. The foreign taxes are adjusted correspondingly: a negative amount on the passive form and a positive amount on the other.

Two timing points sit alongside this and are worth settling at the same time. Income and taxes are translated into dollars before the kickout is applied, not after — which runs straight into the question of which US year a UK tax year's tax belongs to. And if HMRC later amends the UK liability, the foreign tax changes, which can change the grouping result and is itself a redetermination — covered in our guide to which US year an HMRC adjustment reopens.

None of this is guesswork once the numbers are in front of you, but it is not something a rate table will answer. You can model the underlying position with our calculators, and our US-UK tax specialists work through this grouping on British portfolios routinely. Every position is reviewed and signed off by a licensed professional — an IRS Enrolled Agent who is also ACCA-qualified. To have your own figures looked at, book a consultation, or see our pricing.

Sources

Frequently asked questions

What is HTKO on Form 1116?+

HTKO stands for high-tax kickout. It is the rule in section 904(d)(2)(F) and Treasury Regulation section 1.904-4(c) that takes income which would otherwise be passive category income, together with the foreign tax paid on it, and treats it as general category income instead. The Instructions for Form 1116 state the test as income where the foreign taxes you paid, "after allocation of expenses", exceed the highest US tax that can be imposed on the income. On the return it appears as a separate "HTKO" column in Part I of two Forms 1116.

How do I prevent high tax kickout treatment?+

You cannot. It is mandatory, not an election, and there is no filing position that disapplies it. Tax software offers switches to suppress the treatment, but those exist to correct a program's own classification of an item, not to opt out of the rule. If your groups genuinely fail the test, the income and the tax move. What is worth checking is whether the test was applied correctly in the first place — most commonly whether expenses were allocated before the comparison, and whether the income was grouped as the regulation requires rather than tested type by type.

Why did my passive income move to the general category?+

Because the foreign tax allocated to that group of income exceeded 37% of the group's net income after expenses were allocated to it. The reclassification is not a penalty and it does not disallow the credit: the income and its foreign tax both land in the general category, where they meet that category's separate limitation. Whether that helps or hurts depends on how much room you have in each category. It also follows automatically where a group's income is reduced to zero or less — the regulation sends the tax to the general category in that case too.

Do UK dividends at 39.35% automatically trip the kickout?+

No, and this is the most common error in published guidance. The additional rate on UK dividends is 39.35%, above the US top rate of 37%, but the regulation does not compare band rates and does not test dividends on their own. Because the UK charges tax on a resident's dividends and interest by assessment rather than withholding it at source, those sources fall into the same group under paragraph (c)(3) and are treated as one item of income. The dividends are averaged with whatever else sits in that group before any comparison is made, so the blended result can fall on either side of the line.

What do I enter on Form 1116 when HTKO applies?+

The Instructions for Form 1116 direct you to enter "HTKO" on line i of the Forms 1116 for passive category income and for the category the income is reclassified into, and to use a separate column in Part I. The high-taxed income goes on line 1a in that column as a negative number on the passive form and as a positive number on the receiving form, with the related deductions entered the same way on line 6 and nothing on lines 2 through 5. The foreign taxes are adjusted to match, negative on the passive form and positive on the other.