IRS Form 1120-F (Schedule H) – IRS Forms, Instructions, Pubs 2026

IRS Form 1120-F (Schedule H) – IRS Forms, Instructions, Pubs 2026 – In the complex world of U.S. taxation for foreign corporations, accurately reporting deductions is crucial to ensure compliance and optimize tax liabilities. IRS Form 1120-F Schedule H plays a pivotal role in this process, specifically addressing deductions allocated to effectively connected income (ECI). This comprehensive guide explores the form’s purpose, filing requirements, and step-by-step instructions, drawing from official IRS resources to help foreign corporations navigate Regulations Section 1.861-8.

What Is Effectively Connected Income (ECI)?

Effectively connected income refers to earnings derived from a foreign corporation’s engagement in a U.S. trade or business. Under U.S. tax law, ECI is subject to taxation at graduated rates, with deductions allowed to arrive at net taxable income. This includes income from sources within the U.S. that meets criteria such as the asset-use test (income associated with U.S. assets) or the business activities test (U.S. business activities materially contributing to income realization). Non-ECI, on the other hand, encompasses income not linked to U.S. operations, such as certain foreign-source earnings.

For foreign corporations, distinguishing ECI from non-ECI is essential, as only deductions properly allocated to ECI can reduce U.S. taxable income under Section 882(c). This allocation ensures that expenses are matched with the income they support, preventing over- or under-deduction.

Purpose of IRS Form 1120-F Schedule H

Schedule H (Form 1120-F) is designed for foreign corporations filing Form 1120-F to report deductible expenses—excluding interest and bad debts—that are allocated and apportioned between ECI and non-ECI under Regulations Sections 1.861-8, 1.861-17, and Temporary Regulations Section 1.861-8T. The form’s results feed into Form 1120-F, Section II, line 26, and for banks, Schedule M-3 (Form 1120-F), Part III, line 31.

The primary goal is to ensure deductions are only claimed against ECI if they are factually related, as per Section 882(c). This includes home office expenses and other deductions not recorded on U.S. books (Schedule L). Special rules apply for charitable contributions under Section 170, which reduce ECI regardless of direct connection.

Who Must File Schedule H (Form 1120-F)?

Any foreign corporation engaged (or treated as engaged) in a U.S. trade or business during the tax year and required to file Form 1120-F must attach Schedule H. This extends to corporations that are partners in partnerships allocating deductions to ECI under Regulations Section 1.861-8.

Exceptions include protective returns filed under Regulations Section 1.882-4(a)(3)(vi), which do not require Schedule H. Additionally, if a corporation relies on a U.S. income tax treaty to report business profits attributable to a U.S. permanent establishment using OECD Transfer Pricing Guidelines instead of Section 882(c) and related regulations, Schedule H is not needed—instead, disclose the treaty-based position on Form 8833.

Corporations receiving Schedule K-3 (Form 1065) from partnerships with foreign tax information must report expenses on Schedule H per its instructions for Part X, Sections 2 and 3.

Understanding Regulations Section 1.861-8

Regulations Section 1.861-8 provides the framework for computing taxable income by allocating and apportioning deductions to specific sources and activities. It applies to operative sections like 861(b), 863(a), 904, 951A, and 865, emphasizing factual relationships between deductions and gross income.

Allocation Rules

Deductions are first allocated to a “class of gross income” based on their factual connection. Classes are determined by the deductions, not predefined, and may include compensation, business income, interest, rents, royalties, dividends, and more. If a deduction supports an activity or property generating income, it is allocated to that class, even if no income is realized in the year or deductions exceed income.

Supportive deductions (e.g., overhead) can be grouped with related deductions or allocated using reasonable methods like departmental rates.

Apportionment Rules

Within a class, deductions are apportioned between statutory groupings (e.g., ECI for foreign corporations) and residual groupings (e.g., non-ECI) using factual methods like comparative asset values or gross income proportions. Unrelated deductions are ratably apportioned based on gross income ratios.

For foreign corporations, the statutory grouping is ECI from U.S. sources, and the residual is non-ECI (often foreign-source). Special rules cover stewardship expenses (allocated to dividends/inclusions and apportioned by asset values) and research and experimentation (R&E) expenses under Section 1.861-17.

Exempt or excluded income (e.g., under Sections 243, 245, 250, or 951A) is disregarded for apportionment, treating related assets as exempt.

Step-by-Step Guide to Completing Schedule H

Schedule H is divided into four parts. Complete it in U.S. dollars or functional currency, specifying the exchange rate if needed. Attach statements for adjustments, methods, and details as required.

This part identifies deductions from non-U.S. books (home office) that are definitely related to either ECI or non-ECI.

  • Line 1a: Enter total expenses from home office books (non-Schedule L), using financial statements under applicable standards.
  • Line 1b: Check the accounting method used (e.g., GAAP).
  • Line 2: Adjust for U.S. tax principles (e.g., capitalization under Section 263A); attach a categorized statement.
  • Line 3: Total deductible expenses before allocation (Line 1a + Line 2).
  • Lines 4-6: Subtract interest (Line 4) and bad debt (Line 5) expenses; sum on Line 6.
  • Line 7: Remaining deductions for allocation (Line 3 – Line 6).
  • Lines 8-10: Report non-ECI deductions (e.g., from subsidiaries, home country, or other sources); treat treaty-exempt ECI as non-ECI.
  • Line 11: ECI-related deductions (e.g., U.S.-specific personnel costs, research, stewardship).

Part II: Home Office Deductible Expenses Allocated and Apportioned to ECI

This part apportions residual deductions to ECI.

  • Line 13: Residual deductions (Line 7 – Line 12, where Line 12 sums Lines 8-11).
  • Line 14: Average exchange rate for conversions.
  • Line 15: Line 13 in U.S. dollars.
  • Line 16: Amount apportioned to ECI; attach method statement.
  • Line 17: Line 11 in U.S. dollars.
  • Line 18: Total home office to ECI (Line 16 + Line 17).
  • Line 19: Non-home office foreign deductions to ECI; attach by location.
  • Line 20: Total non-Schedule L deductions to ECI (Line 18 + Line 19).

Part III: Allocation and Apportionment Methods and Financial Records Used

Detail the methods employed.

  • Check boxes for new methods or interbranch amounts.
  • Line 21: Gross income ratio (ECI to worldwide).
  • Line 22: Asset ratio.
  • Line 23: Personnel ratio.
  • Lines 24-25: Statements for other ratio or non-ratio methods.
  • Lines 26-28: Indicate records used; list others if applicable.

Part IV: Allocation and Apportionment of Expenses on Schedule L Books

Reconcile U.S. book expenses.

  • Line 29: Total Schedule L expenses (eliminate interbranch).
  • Line 30: U.S. tax adjustments; attach statement.
  • Line 31: Adjusted expenses.
  • Lines 32-36: Subtract interest, bad debts, and other non-1.861-8 items.
  • Line 37: Deductions under 1.861-8.
  • Lines 38-41: Reconcile by ECI/non-ECI columns.

Key Definitions and Allocation Methods

  • Home Office Books: Non-U.S. records, excluding Schedule L.
  • Schedule L Books: U.S. branch books under Regulations Section 1.882-5(d)(2).
  • Worldwide Gross Income: Gross receipts minus cost of goods sold from reliable sources.

Methods include gross income, assets, or personnel ratios, or non-ratio approaches like time estimates. For R&E, follow Section 1.861-17.

Examples of Allocation and Apportionment

Consider a foreign corporation with $1,000,000 in residual deductions (Line 13) and an ECI gross income ratio of 30% (Line 21). Apportion $300,000 to ECI on Line 16.

In another scenario from the regulations, a foreign corporation with $100,000 in G&A expenses and $200,000 ECI/$800,000 non-ECI gross income apportions $20,000 to ECI.

For supportive expenses, apportion based on gross receipts or time devoted, as in examples where foreign and domestic portions are calculated proportionally.

Common Mistakes and Tips for Compliance

Avoid allocating interest or bad debts on Schedule H—use Schedule I or Form 1120-F line 15 instead. Always attach required statements to substantiate methods and adjustments. For banks, adhere to special reimbursement rules. Use consolidated statements if applicable, and eliminate interbranch transactions.

Consult the latest IRS instructions for updates, as tax rules evolve. Professional tax advice is recommended for complex situations.

Conclusion

Mastering IRS Form 1120-F Schedule H ensures foreign corporations correctly allocate deductions to ECI, complying with Regulations Section 1.861-8 while minimizing tax exposure. By following this guide, you can streamline filing and avoid penalties. For the official form, download from the IRS website.