As a preliminary, I am a dual citizen of New Zealand and United States, resident in the United States, but I have New Zealand source passive income.
Under the New Zealand tax system, interest is taxable, but MOST capital gains and losses are not taxable (nor tax deductible). So, no matter if my New Zealand capital losses exceed my New Zealand sourced interest income, I would still owe income tax on, and (per tax treaty) have tax withheld on that interest income.
On the other hand, under the US tax system, capital losses are (in general) tax deductible, so I worry that my net passive foreign source income might work out to zero or a loss, when foreign source capital losses exceed my foreign source interest income. (What about the $3,000 capital loss limitation, would that be supposed to apply when figuring form 1116? I don't know).
So, if I followed Form 1116 instructions....
Normally even though I paid tax on the interest income in New Zealand, the tax credit would limited to an amount which is proportional to the fraction of my income which is foreign source, and that proportion could appear to be zero, or negative, if I have a net foreign source loss. [Or perhaps just $3,000 less than my foreign source interest income, if you are supposed to apply the limitation on total capital losses that is used for schedule D, again I am unclear on this.]
But then if I understand this right, it means that I will be subject to double taxation! Why? Well, first, in the United States, I cannot deduct any of the tax already paid, as a tax credit. And then in the New Zealand, I cannot use any of the capital loss to offset my interest income, so I must pay tax on the full amount of interest income. And so I could be taxed on my foreign interest income at the same marginal rate as if it had been US ordinary income without any foreign capital loss, and without any way to credit foreign tax paid against it. In other words my marginal tax rate on the foreign interest is not reduced by the tax paid, like it should be if I'm getting relief from double taxation!
So how do I avoid double taxation on the foreign earned interest income here? Seems like I should file form 8833, and claim that the calculations on form 1116, are causing double taxation of interest income. But which actual provision of the US tax code is being overruled?
(And also, is relief from double-taxation on interest covered by the treaty provisions? It certainly seems so to me, but maybe I misunderstood something.)