IRS Proposes Sweeping Changes to Deduction Allocation Rules for Foreign Income

Today’s date is 9/25/2026.

The Internal Revenue Service issued proposed regulations on September 15, 2026, that would fundamentally reshape how multinational corporations allocate deductions between U.S. and foreign-source income, particularly for income subject to Section 951A (GILTI) and deduction eligible income (DEI) under Section 250. Published in the Internal Revenue Bulletin (IRB 2026-40), the proposed regulations—labeled REG-117273-25—attempt to implement changes mandated by the One Big Beautiful Bill Act (OBBBA), which was enacted in July 2025. These changes aim to tighten the rules governing foreign tax credit limitations and the allocation of expenses to foreign income categories that previously enjoyed favorable treatment.

The proposed regulations would fundamentally alter the allocation and apportionment of deductions to foreign source section 951A category income and reallocate certain deductions to U.S. source income for purposes of determining the foreign tax credit limitation. The IRS is also providing guidance on determining the amounts that reduce deduction eligible income (DEI) for purposes of the Section 250 deduction, which affects the Foreign-Derived Intangible Income (FDII) regime. With a public comment period open until November 10, 2026, affected taxpayers—especially multinational corporations with significant foreign operations, U.S. corporations claiming FDII deductions, and financial institutions managing cross-border interest allocations—are now racing to assess the potential financial and operational impact of these changes. The stakes are high: misallocation of deductions could result in disallowed foreign tax credits, reduced FDII deductions, or unexpected U.S. tax exposure, potentially affecting billions in tax positions already taken.

The Old Rule vs. The New: How OBBBA Reshaped Deduction Allocation

The IRS’s proposed regulations under REG-117273-25 mark a fundamental shift in how U.S. multinational corporations allocate deductions between foreign and domestic income—a change triggered by the One, Big, Beautiful Bill Act (OBBBA). This transformation is most visible in the redefinition of Deduction Eligible Income (DEI) under § 250(b)(3) and the new allocation framework for foreign source section 951A category income under § 904(b)(5). These amendments directly alter the calculation of Foreign-Derived Deduction Eligible Income (FDDEI) and the FDII deduction, reshaping tax planning strategies for corporations with cross-border operations. The stakes are not theoretical: misallocation of deductions could result in disallowed foreign tax credits, reduced FDII benefits, or unexpected U.S. tax exposure, potentially affecting billions in tax positions already taken.

Under the pre-OBBBA regime, § 250(b)(3)(A) defined DEI as the excess of a domestic corporation’s gross income—excluding six categories of income listed in § 250(b)(3)(A)(i)(I) through (VI)—over the deductions properly allocable to such gross income. This framework allowed taxpayers to broadly allocate deductions, including interest expense and research or experimental (R&E) expenditures, to reduce DEI and thereby increase the FDII deduction. The FDII deduction, authorized under § 250(a)(1)(A), applied to a percentage of FDDEI, which was itself a subset of DEI derived from sales of property to foreign persons for foreign use or services provided to foreign persons or with respect to foreign property. The IRS’s final regulations under § 250, issued in 2020, provided guidance on documenting foreign use and related-party transactions but did not alter the fundamental flexibility in allocating deductions to DEI.

The OBBBA fundamentally rewrote this equation. Section 70322(b) of the OBBBA amended § 250(b)(3)(A)(ii) to exclude from DEI calculation not only the six categories of gross income but also interest expense and research or experimental expenditures. This exclusion applies to taxable years beginning after December 31, 2025. The effect was immediate and profound: interest expense and R&E expenditures could no longer be used to reduce DEI when calculating FDDEI. The IRS’s proposed regulations now operationalize this statutory change by requiring that such deductions be excluded from the DEI calculation entirely, not merely reallocated elsewhere.

The OBBBA also introduced § 904(b)(5), a new statutory framework governing the allocation and apportionment of deductions to foreign source section 951A category income for purposes of the foreign tax credit limitation. Under § 904(b)(5)(A), deductions allowed under § 250(a)(1)(B) (the FDII deduction) and taxes imposed on FDII under § 164(a)(3) are allocated and apportioned to foreign source section 951A category income. However, § 904(b)(5)(B) explicitly prohibits the allocation or apportionment of interest expense or research and experimental expenditures to foreign source section 951A category income. Any other deduction may be allocated only if it is directly allocable to such income under § 904(b)(5)(C). The statute further provides that any amount or deduction that would otherwise have been allocated to foreign source section 951A category income—but for the exclusions in § 904(b)(5)(B) and (C)—must instead be allocated to U.S. source income.

The contrast between the old and new rules is stark:

The significance of these changes cannot be overstated. For a multinational corporation with significant foreign operations, the reallocation of interest expense and R&E expenditures to U.S. source income could increase U.S. taxable income and reduce the foreign tax credit limitation, potentially leading to higher U.S. tax liability. For corporations claiming FDII deductions, the exclusion of interest and R&E from DEI reduces the base against which the FDII deduction is applied, diminishing the benefit of the deduction. Financial institutions, which typically have high interest expense allocations, face particularly acute impacts, as their ability to allocate interest expense to foreign income is curtailed.

The IRS’s proposed regulations under REG-117273-25 implement these statutory changes by providing detailed rules for allocating and apportioning deductions under the new framework. They clarify that the exclusions in § 904(b)(5) apply not only to deductions under § 250 and § 164(a)(3) but also to any other deduction that would otherwise be allocable to foreign source section 951A category income. The regulations also define the term “directly allocable” in the context of § 904(b)(5)(C), aligning it with the principles of § 861 but tightening the standard to prevent circumvention of the new rules. Taxpayers must now reassess their allocation methodologies, documentation, and tax planning strategies to avoid disallowed deductions and unexpected tax exposure.

Section 904(b)(5): A New Framework for Foreign Tax Credits

The IRS’s proposed regulations under § 904(b)(5) introduce a targeted framework for allocating and apportioning deductions to foreign source section 951A category income, a critical adjustment in the wake of the One Big Beautiful Bill Act (OBBBA). This section, added by the OBBBA, fundamentally reshapes how taxpayers calculate their foreign tax credit (FTC) limitation by imposing three distinct categories of deductions, each with its own allocation and apportionment rules. The stakes are high: misallocations under these rules could result in disallowed deductions, unexpected tax exposure, or reduced FTCs, directly impacting multinational corporations (MNCs) with global operations.

The Purpose and Structure of § 904(b)(5)

Section 951A was introduced by the Tax Cuts and Jobs Act of 2017 to impose a minimum tax on income earned by controlled foreign corporations (CFCs) that is not subject to U.S. tax. Section 904(b)(5) was added to the Internal Revenue Code by the OBBBA to address gaps in the allocation and apportionment of deductions for purposes of determining the FTC limitation under § 904(a). The provision specifically targets foreign source section 951A category income, which includes Global Intangible Low-Taxed Income (GILTI) under § 951A. The FTC limitation under § 904(a) caps the credit at the amount of U.S. tax imposed on foreign source taxable income, making the proper allocation of deductions essential to avoiding over- or under-crediting of foreign taxes.

The framework established by § 904(b)(5) divides deductions into three categories, each governed by distinct allocation and apportionment rules:

1. Deductions allowed under § 250(a)(1)(B) and § 164(a)(3);
2. Deductions for interest expense and research and experimental (R&E) expenditures; and
3. Deductions directly allocable to foreign source section 951A category income.

The second sentence of § 904(b)(5) further reshapes the landscape by reallocating certain deductions to U.S. source income if they would otherwise be allocable to foreign source section 951A category income under the first two categories. This reallocation rule is designed to prevent taxpayers from overstating foreign source income and thereby inflating their FTC limitations.

The Three Categories of Deductions Under § 904(b)(5)

1. Deductions Allowed Under § 250(a)(1)(B) and § 164(a)(3)

Section 250(a)(1)(B) permits a domestic corporation to claim a deduction for foreign-derived intangible income (FDII), which is a portion of the corporation’s income derived from sales of property to foreign persons for foreign use or services provided to foreign persons. The deduction under § 250(a)(1)(B) is calculated as 37.5% of FDII (reduced to 21.875% for taxable years beginning after December 31, 2025). Section 164(a)(3), in contrast, allows a deduction for state and local income taxes paid by the taxpayer.

Under § 904(b)(5)(A), any deduction allowed under § 250(a)(1)(B) and any deduction allowed under § 164(a)(3) for taxes imposed on amounts described in § 250(a)(1)(B) are allocated and apportioned to foreign source section 951A category income. This rule ensures that deductions tied to FDII or taxes on FDII are matched to the foreign source income they generate, preventing taxpayers from offsetting U.S. source income with these deductions.

The significance of this rule lies in its direct impact on the FTC limitation. By allocating these deductions to foreign source section 951A category income, taxpayers reduce their foreign source taxable income in this category, which in turn lowers the FTC limitation under § 904(a). For example, a corporation claiming a $10 million FDII deduction would see its foreign source section 951A category income reduced by $10 million, directly affecting its FTC calculation.

2. Deductions for Interest Expense and R&E Expenditures

Section 904(b)(5)(B) addresses interest expense and research and experimental (R&E) expenditures, two of the most commonly apportioned deductions under the § 861 regulations. Under this provision, no amount of interest expense or R&E expenditures is allocated or apportioned to foreign source section 951A category income. Instead, these deductions are treated as allocable to U.S. source income under the second sentence of § 904(b)(5).

This rule represents a significant departure from prior practice, where interest expense and R&E expenditures were often apportioned between U.S. and foreign source income based on asset values or gross income. The OBBBA’s approach effectively shifts the burden of these deductions to U.S. source income, reducing the foreign source taxable income in the section 951A category and thereby limiting the foreign tax credit.

For taxpayers with significant interest expense or R&E expenditures, this change could result in higher U.S. tax liability due to the reduced FTC. For example, a corporation with $50 million in interest expense and $30 million in R&E expenditures would no longer be able to offset these deductions against its foreign source section 951A category income, leading to a higher taxable income in that category and a corresponding reduction in its FTC limitation.

3. Deductions Directly Allocable to Foreign Source Section 951A Category Income

Section 904(b)(5)(C) governs all other deductions, providing that such deductions are allocated and apportioned to foreign source section 951A category income only if they are directly allocable to such income. This rule aligns with the principles of § 861, which requires deductions to be allocated to the income they generate, but it tightens the standard for direct allocation to prevent circumvention of the new rules.

Under the § 861 regulations, a deduction is directly allocable to a class of gross income if it is incurred as a result of, or incident to, an activity or in connection with property that generates, has generated, or could reasonably have been expected to generate gross income in the class. The proposed regulations under § 904(b)(5)(C) adopt a stricter standard, requiring taxpayers to demonstrate a clear and direct nexus between the deduction and the foreign source section 951A category income.

For example, cost of goods sold (COGS) directly related to the sale of property generating FDII would qualify as directly allocable to foreign source section 951A category income. In contrast, general and administrative expenses or overhead costs would not qualify unless they can be specifically traced to the generation of such income. This stricter standard increases the burden on taxpayers to document and substantiate their allocation methodologies, as the IRS is likely to challenge any allocations that do not meet the heightened direct allocation test.

The Second Sentence of § 904(b)(5): Reallocating Deductions to U.S. Source Income

The second sentence of § 904(b)(5) serves as a safety valve to prevent taxpayers from overstating foreign source income in the section 951A category. It provides that any amount or deduction that would (but for § 904(b)(5)(B) and (C)) have been allocated or apportioned to foreign source section 951A category income is only allocated or apportioned to U.S. source income.

This rule effectively reallocates deductions that would otherwise reduce foreign source section 951A category income to U.S. source income, ensuring that the FTC limitation is not artificially inflated. For example, if a taxpayer attempts to allocate interest expense to foreign source section 951A category income under the general § 861 rules, the second sentence of § 904(b)(5) would override that allocation and require the interest expense to be allocated to U.S. source income instead.

The significance of this rule cannot be overstated. It closes a potential loophole in the allocation and apportionment process, ensuring that taxpayers cannot manipulate their allocation methodologies to maximize their FTC limitations. For taxpayers with significant deductions that could be allocated to foreign source section 951A category income, this rule could result in higher taxable income in the U.S. source category, leading to a higher overall tax liability.

The Broader Implications for Taxpayers

The framework established by § 904(b)(5) represents a paradigm shift in how deductions are allocated and apportioned for purposes of the FTC limitation. Taxpayers must now reassess their allocation methodologies, documentation, and tax planning strategies to avoid disallowed deductions and unexpected tax exposure. The stricter standards for direct allocation, the reallocation of interest expense and R&E expenditures to U.S. source income, and the heightened scrutiny of deductions under § 250(a)(1)(B) and § 164(a)(3) all serve to reduce the generosity of the foreign tax credit system for many taxpayers, particularly those with significant foreign operations or FDII deductions.

For MNCs, the impact of these rules will depend on their specific facts and circumstances, including the nature of their deductions, the composition of their income, and their global tax planning strategies. However, one thing is clear: the IRS’s proposed regulations under § 904(b)(5) will increase the complexity and compliance burden for taxpayers, while also reducing the generosity of the FTC system in the post-OBBBA era.

Defining 'Directly Allocable': A Tighter Standard for Deductions

The IRS’s proposed regulations under § 904(b)(5) introduce a narrower interpretation of the term "directly allocable" in § 904(b)(5)(C), departing from the broader "properly allocable" standard under the section 861 regulations. This shift reflects the IRS’s intent to limit the allocation of deductions to foreign source section 951A category income to only those expenses with a closer, more direct relationship to such income. The IRS reasoned that the post-OBBBA framework requires a stricter standard to prevent taxpayers from overstating foreign tax credits by allocating overly broad categories of deductions to foreign-source income.

Under the section 861 regulations, deductions are "properly allocable" if they are definitely related to a class of gross income—meaning they are incurred as a result of, or incident to, an activity or property that generates such income. See § 1.861-8(b)(2). This standard allows for significant flexibility, as deductions not directly tied to a specific income class are often treated as allocable to all gross income. § 1.861-8(b)(5). In contrast, § 904(b)(5)(C) requires deductions to be "directly allocable" to foreign source section 951A category income, a term the IRS interprets as demanding a more immediate and traceable connection between the deduction and the income.

The IRS’s reasoning for this tighter standard is rooted in the post-OBBBA foreign tax credit limitation framework. Section 904(b)(5)(C) provides that only deductions directly allocable to foreign source section 951A category income may be allocated to such income, while all other deductions are reallocated to U.S. source income. This reallocation mechanism reduces the generosity of the foreign tax credit system by limiting the pool of foreign-source income against which foreign taxes can be credited. The IRS emphasized that this approach aligns with the legislative intent behind OBBBA to tighten the foreign tax credit limitation and prevent cross-crediting of deductions across income categories.

To illustrate the distinction, the IRS provided examples of deductions that do not qualify as directly allocable to foreign source section 951A category income:

• Stewardship expenses: Costs incurred for overseeing a corporation’s investments or subsidiaries, such as board meeting expenses or corporate governance costs, lack a direct link to specific foreign-source income.
• Legal expenses: General corporate legal fees, including those related to compliance or litigation, are not directly allocable unless they are incurred in connection with a specific foreign-source transaction or activity.

Conversely, the IRS identified deductions that do qualify as directly allocable:

• Foreign currency loss under § 986(c): Losses arising from the translation of foreign currency into U.S. dollars are directly tied to foreign-source income, as they result from the operational activities generating such income.
• Net operating loss (NOL) deductions: If an NOL arises from foreign-source income, the IRS takes the position that the deduction is directly allocable to that income, provided the loss is attributable to the same foreign-source activities.

The IRS’s interpretation of "directly allocable" narrows the scope of deductions that can be allocated to foreign source section 951A category income, thereby reducing the amount of foreign-source income available for foreign tax credit purposes. This shift increases the compliance burden for taxpayers, particularly those with complex global operations, as they must now meticulously trace deductions to specific income categories. For multinational corporations (MNCs), this means re-evaluating their allocation methodologies, documentation, and tax planning strategies to ensure compliance with the new standard, which may require enhanced documentation and recordkeeping to substantiate the direct relationship between deductions and foreign-source income.

Reallocating Deductions: Shifting the Burden to U.S. Source Income

The IRS’s proposed regulations under § 904(b)(5) fundamentally alter how deductions are allocated between foreign and U.S. source income by reallocating certain deductions to U.S. source income after first determining their allocation to foreign source section 951A category income. This process, dictated by the second sentence of § 904(b)(5), creates a two-step framework that shifts the tax burden in unexpected ways for multinational corporations.

The IRS begins by allocating and apportioning deductions to foreign source section 951A category income without regard to § 904(b)(5). This initial allocation follows the general rules of the section 861 regulations, where deductions are first allocated to a class of gross income and then apportioned among statutory groupings within that class. For example, interest expense is generally allocated based on the factual relationship to the income generated by the taxpayer’s assets, while research and experimental (R&E) expenditures are allocated to gross intangible income and apportioned based on gross receipts or a 50% U.S.-source rule under § 1.861-17(c).

However, the second sentence of § 904(b)(5) then reallocates any deduction that would have been allocated or apportioned to foreign source section 951A category income—but for the exclusions in § 904(b)(5)(B) and (C)—to U.S. source income instead. This reallocation occurs regardless of whether the deduction was originally directly allocable to foreign source income or properly allocable under the section 861 regulations. The effect is to remove deductions from foreign source income and force them onto U.S. source income, thereby reducing foreign source taxable income and increasing the foreign tax credit limitation calculation.

Critically, R&E expenditures are not reallocated under this framework because § 904(b)(5)(B) explicitly prohibits their allocation to foreign source section 951A category income in the first place. Instead, R&E expenditures are allocated and apportioned under the general section 861 rules, with 50% deemed U.S.-source and the remainder apportioned based on sales. This exclusion means R&E costs remain deductible against U.S. source income, preserving their tax benefit in a way that other deductions are not.

The impact of these reallocated deductions on U.S. source income is substantial. By shifting deductions from foreign to U.S. source income, the proposed regulations increase U.S. source taxable income while simultaneously reducing foreign source taxable income. This has cascading effects on several key tax provisions:

• Foreign Tax Credit Limitation: The foreign tax credit limitation under § 904(a) is calculated as the U.S. tax imposed on foreign source taxable income. By reducing foreign source taxable income through reallocated deductions, the limitation becomes smaller, potentially reducing the amount of creditable foreign taxes a taxpayer can claim. This is particularly punitive for taxpayers with high foreign taxes, as the limitation may now fall below the foreign tax burden.

• Domestic Losses: The reallocation of deductions to U.S. source income can exacerbate domestic losses by increasing the gap between deductions and gross U.S. source income. Under § 904(f)(5)(D), U.S. source losses reduce foreign source taxable income in separate categories on a proportionate basis. If reallocated deductions create or expand a U.S. source loss, this reduction becomes more severe, further shrinking the foreign tax credit limitation.

• Overall Foreign Losses (OFLs): OFLs occur when foreign source deductions exceed foreign source gross income. The reallocation of deductions to U.S. source income reduces the pool of foreign source deductions, which can limit the ability to generate or carry forward OFLs. This is problematic for taxpayers that rely on OFLs to offset future foreign source income, as the proposed rules may eliminate or reduce the benefit of OFL carryovers.

• Recapture Rules under § 904(f) and (g): The recapture rules for OFLs and overall domestic losses (ODLs) are directly affected by the reallocation of deductions. Under § 904(f), OFLs are recaptured by recharacterizing U.S. source taxable income in subsequent years as foreign source income. If reallocated deductions reduce the OFL balance, the recapture amount may shrink, but the reduction in foreign source taxable income also limits the foreign tax credit limitation in those years. Similarly, § 904(g) treats ODLs as domestic losses that offset foreign source taxable income. The reallocation of deductions to U.S. source income can worsen ODLs, increasing the amount of foreign source income subject to recapture in future years.

For taxpayers, the consequences are immediate and material. Multinational corporations with significant foreign operations—particularly those earning section 951A category income—will face higher effective tax rates as deductions are stripped from foreign source income and forced onto U.S. source income. The compliance burden escalates as taxpayers must meticulously trace deductions through the allocation and reallocation process, ensuring that the direct relationship to foreign source section 951A category income is properly documented to avoid misallocation. This is particularly challenging for taxpayers with complex global supply chains, where indirect costs like interest and overhead must be carefully apportioned under the section 861 regulations before the reallocation step under § 904(b)(5) is applied.

The proposed regulations also create asymmetry in the treatment of different types of deductions. While interest expense and R&E expenditures are excluded from allocation to foreign source section 951A category income, other deductions—such as state and local taxes under § 164(a)(3) or general and administrative expenses—are subject to reallocation. This selective treatment means that taxpayers with high state tax burdens or significant administrative overhead may see their U.S. tax liability increase disproportionately, as these deductions are shifted away from foreign source income where they might otherwise reduce the foreign tax credit limitation.

Winners and Losers: Who Benefits from the Proposed Regulations?

The IRS’s proposed regulations under REG-117273-25 fundamentally alter the allocation and apportionment of deductions for foreign source section 951A category income, reshaping the tax landscape for multinational corporations and domestic taxpayers alike. The changes target the direct allocation standard for deductions, particularly those tied to interest expense, research and experimental (R&E) expenditures, and state and local taxes (SALT). The proposed rules reallocate these deductions to U.S. source income when they cannot be directly allocated to foreign source section 951A category income, a shift designed to prevent base erosion and align with global tax policy goals under the OECD’s Pillar Two framework.

Winners

• Domestic corporations with significant foreign-derived deduction eligible income (FDDEI) but minimal interest expense or R&E expenditures The proposed regulations explicitly allocate deductions allowed under section 250(a)(1)(B)—such as the FDII deduction—and state and local taxes under § 164(a)(3) to foreign source section 951A category income. For corporations with high FDDEI but limited deductible expenses tied to foreign operations, this means foreign tax credits (FTCs) are preserved because deductions are not reallocated away from foreign source income. These taxpayers benefit from the preservation of FTCs under section 904(a), which limits the credit to U.S. tax on net foreign source income. By keeping deductions tied to foreign source income, the limitation is less likely to bind, allowing full utilization of foreign taxes paid.

• Taxpayers with directly allocable deductions to foreign source section 951A category income The proposed regulations retain the direct allocation standard for deductions that are "directly allocable" to foreign source section 951A category income under section 904(b)(5)(C). Taxpayers with clearly traceable expenses—such as cost of goods sold (COGS) for foreign sales or foreign branch operations—avoid reallocation to U.S. source income. This preserves the foreign tax credit limitation calculation, ensuring that deductions reduce foreign source taxable income rather than U.S. source income, where they would have less impact on the FTC limitation.

• Taxpayers in jurisdictions with high foreign tax rates The reallocation of deductions to U.S. source income disproportionately reduces the foreign tax credit limitation for taxpayers with high foreign tax burdens. By contrast, taxpayers in jurisdictions with lower foreign tax rates may see less impact from the reallocation, as their FTC limitation is less likely to bind. For these taxpayers, the proposed rules preserve the value of foreign taxes paid by keeping deductions tied to foreign source income, allowing full utilization of FTCs.

• Taxpayers with minimal state and local tax burdens The proposed regulations reallocate state and local taxes under § 164(a)(3) to U.S. source income when they cannot be directly allocated to foreign source section 951A category income. Taxpayers operating in high-tax states—such as California, New York, or New Jersey—the reallocation of SALT deductions to U.S. source income reduces the benefit of the deduction because U.S. source income is subject to the foreign tax credit limitation. This means the SALT deduction is less effective in reducing overall tax liability, particularly for taxpayers with high foreign tax burdens.

Losers

• Multinational corporations with high interest expense allocable to foreign source income The proposed regulations prohibit the allocation or apportionment of interest expense to foreign source section 951A category income under section 904(b)(5)(B). For multinational corporations with significant debt financing tied to foreign operations, this means interest expense is reallocated to U.S. source income, where it reduces U.S. taxable income rather than foreign source income. This increases the foreign tax credit limitation because the limitation is calculated based on U.S. tax on net foreign source income. The result is a reduction in the value of foreign tax credits, as the limitation binds more tightly, leaving excess foreign taxes unused.

• Taxpayers with high research and experimental (R&E) expenditures allocable to foreign source income Similar to interest expense, the proposed regulations prohibit the allocation or apportionment of R&E expenditures to foreign source section 951A category income under section 904(b)(5)(B). For taxpayers with substantial R&E activities abroad—such as pharmaceutical companies or technology firms—the reallocation of R&E deductions to U.S. source income reduces the benefit of foreign tax credits. The foreign tax credit limitation is calculated based on net foreign source income, and by shifting R&E deductions away from foreign source income, the limitation becomes more restrictive, limiting the ability to claim foreign taxes paid as credits.

• Taxpayers relying on the previous rules for allocating deductions to foreign source section 951A category income The proposed regulations tighten the definition of "directly allocable" deductions under section 904(b)(5)(C), requiring a higher standard of traceability to foreign source income. Taxpayers who previously relied on indirect allocation methods—such as apportioning general and administrative expenses based on gross income—will now face reallocation to U.S. source income, increasing their U.S. tax liability. This shift disproportionately affects taxpayers with complex global operations where expenses are not easily traceable to specific income categories.

• Taxpayers with significant state and local tax burdens The proposed regulations reallocate state and local taxes under § 164(a)(3) to U.S. source income when they cannot be directly allocated to foreign source section 951A category income. For taxpayers operating in high-tax states—such as California, New York, or New Jersey—the reallocation of SALT deductions to U.S. source income reduces the benefit of the deduction because U.S. source income is subject to the foreign tax credit limitation. This means the SALT deduction is less effective in reducing overall tax liability, particularly for taxpayers with high foreign tax burdens.

• Taxpayers with foreign operations in low-tax jurisdictions The proposed regulations are designed to prevent base erosion by ensuring that deductions are not used to reduce foreign source income in low-tax jurisdictions. For taxpayers with operations in jurisdictions with low foreign tax rates, the reallocation of deductions to U.S. source income increases the foreign tax credit limitation, reducing the value of foreign taxes paid. This is particularly punitive for taxpayers in tax haven jurisdictions, where the foreign tax rate is minimal, and the FTC limitation binds tightly.

Broader Policy Alignment

The proposed regulations align with the OECD’s Pillar Two global minimum tax framework, which seeks to prevent base erosion and profit shifting (BEPS) by ensuring that multinational corporations pay at least a 15% tax on income in each jurisdiction where they operate. By reallocating deductions to U.S. source income and tightening the "directly allocable" standard, the IRS is limiting the ability of taxpayers to use deductions to reduce foreign source income in low-tax jurisdictions, thereby ensuring that foreign taxes paid are more likely to be creditable against U.S. tax liability.

For taxpayers, the stakes are high: foreign tax credits are a critical component of cross-border tax planning, and the proposed regulations could significantly reduce their value for multinational corporations with high interest expense, R&E expenditures, or state and local tax burdens. The winners are those who can preserve deductions tied to foreign source income, while the losers are those who rely on indirect allocation methods or operate in jurisdictions with low foreign tax rates. The proposed rules reflect a fundamental shift in U.S. international tax policy, prioritizing the prevention of BEPS over traditional tax planning strategies.

Examples in Action: Applying the Proposed Regulations

The IRS’s proposed regulations under § 904(b)(5) include four detailed examples to illustrate how the new deduction allocation rules apply in practice. These examples clarify the IRS’s interpretation of the statute and provide taxpayers with concrete guidance on navigating the proposed changes. Below is a breakdown of each example, highlighting the key takeaways for stakeholders.

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Example 1: Section 986(c) loss and its direct allocability to foreign source section 951A category income

• Facts: USP, a domestic corporation using the U.S. dollar as its functional currency, owns CFC, a controlled foreign corporation using the British pound (£) as its functional currency. CFC distributes £300x, which is a dividend under § 316 (determined without regard to § 959(d)). All of CFC’s previously taxed earnings and profits (PTEP) result from USP’s income inclusions under § 951(a)(1)(A) (general category income) and § 951A (section 951A PTEP). The spot rate on the distribution date is $1 = £0.8, and the average exchange rate during the inclusion year is $1 = £0.75.

• Analysis:

  • The distribution is made pro rata from both § 951(a)(1)(A) PTEP and § 951A PTEP. Of the £300x distribution, £240x is assigned to § 951A PTEP, of which £120x is foreign source.
  • Under § 986(c), USP must recognize foreign currency gain or loss on the distribution of PTEP. This gain or loss is assigned to the same separate category as the associated income inclusion.
  • USP’s § 986(c) loss with respect to the distribution of foreign source § 951A PTEP is calculated as follows:
    • Translate the £120x foreign source § 951A PTEP into U.S. dollars using the spot rate on the distribution date: £120x × ($1/£0.8) = $150x.
    • Subtract the dollar basis of the PTEP, translated using the average exchange rate during the inclusion year: £120x × ($1/£0.75) = $160x.
    • The resulting § 986(c) loss is $10x ($150x - $160x), which is directly allocable to foreign source § 951A category income.

• Key Takeaway: The IRS clarifies that § 986(c) losses arising from the distribution of foreign source § 951A PTEP are directly allocable to the foreign source § 951A category income. This ensures that taxpayers properly account for currency fluctuations in their foreign tax credit calculations.

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Example 2: Reallocation of deductions and its impact on U.S. source income and domestic losses

• Facts: USP, a domestic corporation, owns a controlled foreign corporation and chooses to claim foreign tax credits for the taxable year. USP has no loss carried back to the taxable year. USP’s deductions that would have been allocated and apportioned to foreign source § 951A category income but for § 904(b)(5) consist of interest expense and supportive deductions. After allocation and apportionment of all deductions except interest expense and supportive deductions, USP has:

  • $100x of U.S. source income,
  • $60x of foreign source § 951A category income, and
  • $50x of foreign source general category income.
  • USP has $100x of interest expense, with $10x allocated and apportioned to foreign source general category income. Before § 904(b)(5), $50x of interest expense would have been allocated and apportioned to U.S. source income, and $40x to foreign source § 951A category income. USP also has $50x of supportive deductions, with $20x allocated and apportioned to foreign source general category income. Before § 904(b)(5), $20x of supportive deductions would have been allocated and apportioned to U.S. source income, and $10x to foreign source § 951A category income.

• Analysis:

  • But for § 904(b)(5), USP would have had:
    • $30x of U.S. source income ($100x - $50x - $20x),
    • $10x of foreign source § 951A category income ($60x - $40x - $10x), and
    • $20x of foreign source general category income ($50x - $10x - $20x).
  • The $40x of interest expense and $10x of supportive deductions that would have been allocated and apportioned to foreign source § 951A category income are reallocated deductions under the proposed regulations. These reallocated deductions are allocated to U.S. source income, reducing U.S. source income to $20x ($100x - $50x - $20x - $40x - $10x).
  • After the allocation of reallocated deductions, USP has a $20x loss from sources within the United States ($20x - $40x), which is a domestic loss under § 904(g)(2)(B). Under § 904(f)(5)(D), the $20x domestic loss reduces USP’s foreign source § 951A category income and foreign source general category income on a pro rata basis. As a result:
    • USP’s foreign source § 951A category income is $45x ($60x - $20x × $60x/$80x), and
    • USP’s foreign source general category income is $15x ($20x - $20x × $20x/$80x).
  • The $20x domestic loss also results in an overall domestic loss (ODL) of $20x under § 904(g)(2)(A). In later years, the ODL causes USP’s U.S. source income to be treated as foreign source income under § 904(g) and the regulations thereunder.

• Key Takeaway: The IRS demonstrates how reallocated deductions under § 904(b)(5) shift the burden to U.S. source income, creating domestic losses that reduce foreign source income. This example highlights the potential tax planning challenges for multinational corporations with significant interest expense or supportive deductions tied to foreign source income.

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Example 3: Reallocation of deductions and its effect on separate limitation losses

• Facts: USP, a domestic corporation, owns a controlled foreign corporation and chooses to claim foreign tax credits for the taxable year. After allocation and apportionment of all deductions except reallocated deductions, USP has:

  • $500x of U.S. source income, and
  • $100x of foreign source § 951A category income.
  • USP has a reallocated deduction of $400x that would have been allocated to foreign source § 951A category income but for § 904(b)(5).

• Analysis:

  • But for § 904(b)(5)(B) and (C), the reallocated deduction of $400x would have created a separate limitation loss of $300x with respect to the income category described in § 904(d)(1)(A) (the § 951A category).
  • Under the proposed regulations, the $400x reallocated deduction is allocated to U.S. source income, reducing U.S. source income to $100x ($500x - $400x). USP has no separate limitation loss with respect to the § 951A category.

• Key Takeaway: The IRS illustrates how reallocated deductions under § 904(b)(5) prevent the creation of separate limitation losses in foreign source income categories. This example underscores the IRS’s intent to limit the erosion of foreign tax credits through strategic deduction allocation.

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Example 4: Treatment of R&E expenditures

• Facts: USP, a domestic corporation, owns a controlled foreign corporation. USP deducted research and experimental (R&E) expenditures under § 174A for the taxable year. Before taking into account § 904(b)(5), all of the R&E expenditures would be allocated to foreign source income.

• Analysis:

  • No amount of the R&E expenditures is a reallocated deduction because, before taking into account § 904(b)(5), none of the R&E expenditures would have been allocated or apportioned to foreign source § 951A category income. See § 1.861-17(b)(2).
  • Therefore, none of the R&E expenditures is allocated to U.S. source income under § 904(b)(5).

• Key Takeaway: The IRS clarifies that R&E expenditures are not subject to reallocation under § 904(b)(5) unless they would have been allocated to foreign source § 951A category income but for the provision. This example provides certainty for taxpayers with significant R&E expenditures, ensuring that such expenditures remain allocable to the income they support.

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These examples collectively demonstrate the IRS’s strict interpretation of § 904(b)(5) and its broader implications for multinational corporations. Taxpayers with high interest expense, R&E expenditures, or state and local tax burdens must carefully evaluate how the proposed regulations will affect their deduction allocation strategies. The examples serve as a practical roadmap for compliance, highlighting the need to preserve deductions tied to foreign source income while avoiding indirect allocation methods that may trigger domestic losses or separate limitation losses.

Applicability Dates and Reliance: What Taxpayers Need to Know

The proposed regulations under sections 250(b)(3) and 904(b)(5)—issued pursuant to delegated authority under sections 250(c) and 7805(a) of the Internal Revenue Code—were issued to implement changes required by the One Big Beautiful Bill Act (OBBBA), enacted in July 2025. For section 250(b)(3), the amendments apply to taxable years beginning after December 31, 2025, as specified in section 70322(b)(2) of the OBBBA. This means domestic corporations claiming the deduction for foreign-derived deduction eligible income (FDDEI) under section 250(a)(1)(A) must comply with the new rules for tax years starting January 1, 2026, or later.

For section 904(b)(5), the applicability date is similarly tied to the OBBBA’s effective date. Section 70311(c) of the OBBBA provides that the amendments to section 904(b) apply to taxable years beginning after December 31, 2025. This section introduces special rules for allocating and apportioning deductions to foreign source section 951A category income, including the prohibition on allocating interest expense or research and experimental expenditures to such income. Taxpayers must therefore apply these rules to tax years starting January 1, 2026, or later.

Taxpayers may rely on these proposed regulations before they are finalized, but only if they follow the regulations in their entirety. The IRS explicitly permits reliance on proposed regulations as authoritative guidance under certain conditions, provided the taxpayer applies all provisions consistently and does not cherry-pick selective parts of the proposed rules. This reliance provision is critical for multinational corporations seeking to plan around the new deduction allocation framework, particularly those with high interest expense, R&E expenditures, or state and local tax burdens. Failure to follow the proposed regulations in their entirety could result in inconsistent treatment and potential audit exposure.

The IRS has indicated that separate guidance will be issued to address other amendments made by the OBBBA, including the removal of the deemed tangible income return and deemed intangible income from the section 250(a)(1)(A) deduction calculation. Taxpayers should monitor future IRS notices or revenue rulings for updates on these additional changes, as they may further refine the deduction eligible income (DEI) calculation for FDDEI purposes. Until such guidance is released, taxpayers relying on the proposed regulations for section 250(b)(3) and section 904(b)(5) must proceed with caution, ensuring full compliance with the existing proposed framework to avoid future adjustments during finalization.

Public Comment and Next Steps: How to Engage with the IRS

The IRS’s proposed regulations under sections 250(b)(3) and 904(b)(5)—issued pursuant to the One, Big, Beautiful Bill Act (OBBBA)—are now open for public comment. These regulations, published in the Federal Register on September 28, 2026, seek to redefine how deductions are allocated for foreign income under section 250, which governs the Foreign-Derived Intangible Income (FDII) deduction and section 904, which limits foreign tax credits. Stakeholders have until November 10, 2026, to submit written or electronic comments or requests for a public hearing.

The IRS strongly encourages electronic submissions via the Federal eRulemaking Portal at www.regulations.gov, referencing IRS and REG-117273-25 in the submission. Once comments are submitted, they cannot be edited or withdrawn. The Treasury Department and IRS will publish all comments for public availability in the docket. Paper submissions should be sent to: CC:PA:01:PR (REG-117273-25), Room 5503 Internal Revenue Service PO Box 7604, Ben Franklin Station Washington, D.C. 20044

For further inquiries, stakeholders may contact:

• John Lee or Alex Kaplan at (202) 317-6936 for general questions about the proposed regulations.
• Publications and Regulations at (202) 317-6901 or via email at publichearings@irs.gov for submissions of comments or requests for a public hearing.

The IRS emphasizes the importance of stakeholder engagement during this comment period, as feedback will shape the final regulations. Taxpayers relying on the proposed framework for section 250(b)(3) FDDEI calculations or section 904(b)(5) foreign tax credit allocations should monitor these developments closely, as future adjustments may impact compliance strategies.

The Broader Context: Aligning with Global Tax Policy Goals

The IRS’s proposed regulations on deduction allocation for foreign income arrive amid a sweeping global effort to curb base erosion and profit shifting (BEPS) by multinational enterprises. These rules, issued under the authority of the One Big Beautiful Bill Act (OBBBA), are not isolated technical adjustments but part of a coordinated U.S. response to international tax reform initiatives spearheaded by the OECD and G20. At their core, the changes seek to realign the U.S. tax system with the global minimum tax framework established under Pillar Two of the OECD’s BEPS 2.0 project, which aims to ensure that large multinational corporations pay at least a 15% tax on income in each jurisdiction where they operate.

The OBBBA, enacted in July 2025, amended key provisions of the Internal Revenue Code—including Section 250, which governs the Foreign-Derived Intangible Income (FDII) deduction, and Section 904, which limits foreign tax credits—to address longstanding concerns that U.S. tax rules inadvertently facilitate profit shifting. The proposed regulations, particularly those under Section 904(b)(5), directly implement these statutory changes by tightening the allocation of deductions to foreign-source income, particularly income subject to the Global Intangible Low-Taxed Income (GILTI) regime under Section 951A. This shift reflects a broader policy pivot: from encouraging outbound investment through incentives like FDII to ensuring that income is taxed where economic activity occurs.

The IRS’s focus on Section 904(b)(5) is particularly consequential in this context. The provision, introduced by the OBBBA, mandates that certain deductions—including those allowed under Section 250 for FDII and Section 164(a)(3) for foreign taxes—must be allocated to foreign source section 951A category income. This effectively reduces the foreign tax credit limitation by shrinking the pool of foreign-source income against which foreign taxes can be credited. The practical effect is to limit the ability of U.S. multinationals to use foreign tax credits to offset U.S. tax on GILTI, thereby increasing the U.S. tax burden on low-taxed foreign income. This aligns with the OECD’s goal of preventing tax competition that erodes the global tax base.

The proposed regulations also redefine what constitutes a “directly allocable” deduction under Section 861, tightening the standard to prevent taxpayers from inappropriately shifting deductions away from high-tax foreign jurisdictions. Under the new framework, only deductions with a clear and direct factual relationship to foreign-source income will be allocated to that income, while broader deductions—such as interest expense and research and experimental (R&E) expenditures—will be reallocated to U.S. source income. This change is designed to counteract strategies that exploit the current rules to reduce taxable income in high-tax countries while inflating deductions in low-tax jurisdictions.

For multinational corporations, the implications are significant. The reallocation of deductions to U.S. source income will reduce the foreign tax credit limitation, potentially increasing U.S. tax liabilities on foreign earnings. This is particularly acute for companies with substantial foreign operations in low-tax jurisdictions, where the new rules could result in double taxation—once by the foreign jurisdiction and again by the U.S. Treasury. Conversely, companies with high-tax foreign operations may benefit from the tighter allocation rules, as their foreign tax credits will be more effectively utilized to offset U.S. tax on foreign income.

The IRS’s proposed regulations under REG-117273-25 implement these statutory changes by providing detailed rules for allocating and apportioning deductions under the new framework. They clarify that the exclusions in § 904(b)(5) apply not only to deductions under § 250 and § 164(a)(3) but also to any other deduction that would otherwise be allocable to foreign source section 951A category income. The regulations also define the term “directly allocable” in the context of § 904(b)(5)(C), aligning it with the principles of § 861 but tightening the standard to prevent circumvention of the new rules. Taxpayers must now reassess their allocation methodologies, documentation, and tax planning strategies to avoid disallowed deductions and unexpected tax exposure.