On September 11, 2026, the U.S. Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) published proposed regulations (REG-117273-25) under IRC Sections 904(b)(5) and 250(b)(3). The proposed regulations would implement provisions of the One Big Beautiful Bill Act (OBBBA) on the allocation and apportionment of deductions (i) to net CFC tested income (NCTI) category income for foreign tax credit (FTC) limitation purposes and (ii) to deduction-eligible income (DEI) and foreign-derived deduction-eligible income (FDDEI), respectively.

Once finalized, the proposed regulations would apply to tax years beginning after December 31, 2025. A taxpayer may rely on the proposed regulations before their finalization, provided that the taxpayer applies the rules under the respective section in their entirety. Comments are due by November 10, 2026.

Background

As enacted by OBBBA, IRC Sections 904(b)(5) and 250(b)(3) are effective for tax years beginning after December 31, 2025.

IRC Section 904(b)(5) provides special rules for allocating and apportioning deductions to NCTI category income for purposes of determining a taxpayer's FTC limitation. NCTI category income refers to the separate FTC limitation category applicable to a United States shareholder's NCTI inclusions under IRC Section 951A. IRC Section 904(b)(5) limits the deductions allocable to this category only to (i) the 40% (or potentially smaller) deduction allowable under IRC Section 250 with respect to the taxpayer's NCTI inclusion; (ii) certain deductions allowed to the taxpayer for state, local, and foreign income taxes under IRC Section 164(a)(3); and (iii) any other deductions that are allowed to the taxpayer and are "directly allocable" to NCTI category income. IRC Section 904(b)(5) does not permit interest expense or research or experimental (R&E) expenditures to be allocated or apportioned to foreign-source NCTI category income. Expenses that otherwise would have been allocated or apportioned to the foreign-source NCTI category income but for these limitations are instead allocated or apportioned to US-source income.

IRC Section 250(b)(3)(A) provides special rules for allocating and apportioning deductions to a taxpayer's gross DEI and, in turn, gross FDDEI (which is a subset of gross DEI). Specifically, a domestic corporation must reduce its gross DEI by expenses and deductions that are "properly allocable" to that income, other than interest expense and R&E expenditures.

The Treasury regulations under IRC Section 861 provide the general framework for allocating and apportioning deductions for various US federal income tax purposes, including the FTC limitation and DEI/FDDEI. Under those regulations, deductions are first allocated to a class of gross income based on the deduction's factual relationship to income-producing activities or assets and then apportioned among relevant statutory groupings within the class of gross income, with specific rules applicable to particular categories of deductions.

Proposed rules for deductions allocable to NCTI

Deductions allocable to foreign-source NCTI category income

Consistent with IRC Section 904(b)(5), the proposed regulations identify deductions that are specifically allocable or non-allocable to foreign-source NCTI category income. A taxpayer's IRC Section 250(a)(1)(B) deduction, as well as any deductions allowed for state or local income taxes under IRC Section 164(a)(3), are allocable to foreign-source NCTI category income, to the extent provided under existing IRC Section 861 regulations.

In contrast, interest expense that is deductible under IRC Section 163 (including original issue discount) and R&E expenditures that are deducted, including as amortization deductions, under IRC Sections 174, 174A and 59(e) are not allocable to foreign-source NCTI category income.

Other deductions may be allocated to foreign-source NCTI category income only if "directly allocable" thereto, as required by IRC Section 904(b)(5)(C).

Meaning of "directly allocable"

IRC Section 904(b)(5) does not define the term "directly allocable." The proposed regulations would treat a deduction as not directly allocable if it were "of a type" that may be apportioned using the relative value of assets or amounts of US gross income, even if not apportioned in that manner for a particular taxpayer.

For further clarity, the proposed regulations would not consider certain deductions to be directly allocable to foreign-source NCTI category income, including stewardship expenses, legal and accounting fees and expenses, damages awards, prejudgment interest, settlement payments, and other supportive expenses, such as overhead, general, administrative and supervisory expenses.

In contrast, the proposed regulations specify deductions that are directly allocable to foreign-source NCTI category income — specifically foreign currency losses recognized under IRC Section 986(c) on distributions of NCTI previously taxed earnings and profits (PTEP) and net operating loss (NOL) deductions — provided that the deductions would be allocated and apportioned to foreign-source NCTI category income under existing IRC Section 861 regulations.

Regarding NOLs, the proposed regulations would apply IRC Section 904(b)(5) when determining the source and separate category components of a current-year NOL. Consequently, a taxpayer generating an NOL in a year to which IRC Section 904(b)(5) applies would reallocate certain deductions (such as interest) from foreign-source NCTI category income to US-source income (as explained later) before determining the source and separate category of the NOL carryforward. In a tax year in which a taxpayer deducts an NOL carryforward, IRC Section 904(b)(5) would apply before determining the NOL components that are carried to, and deducted in, that year. Thus, if NOL carryforwards were generated in tax years preceding the effective date of IRC Section 904(b)(5) and have a foreign-source NCTI category component, that component of the NOL carryforward would be treated as directly allocable to the foreign-source NCTI category when deducted, even if deducted in a year to which IRC Section 904(b)(5) applies.

Deductions reallocated to US-source income

Under the proposed regulations, any deduction that otherwise would have been allocated or apportioned to foreign-source NCTI category income but is excluded from that income under the rules described previously would instead be allocated to US-source income for all IRC Section 904 purposes, including for purposes of determining a taxpayer's overall domestic loss (ODL), overall foreign loss, or separate limitation loss. As a consequence, these expenses could indirectly (by creating or increasing an ODL) reduce the NCTI category FTC limitation in the year the deduction accrues (because an ODL reduces FTC limitations in each category). ODLs generally result in an increase to FTC category limitations in later years when there is US-source income.

Proposed rules for deductions allocable to DEI and FDDEI

The proposed regulations would also implement the OBBBA amendments to IRC Section 250(b)(3)(A)(ii). Consistent with the statute, the proposed regulations provide that a domestic corporation would determine expenses and deductions "properly allocable" to gross DEI and gross FDDEI under existing IRC Section 861 regulations, without regard to interest expense and R&E expenditures. Similar to the proposed regulations under IRC Section 904(b)(5), interest expense means any expense that is deductible under IRC Section 163 (including original issue discount); R&E expenditures means any expense that is deductible, including as an amortization deduction, under IRC Sections 174, 174A, and 59(e)(2)(B).

Applicability dates and reliance

The proposed regulations would apply to tax years beginning after December 31, 2025. A taxpayer may rely on the proposed regulations under IRC Section 904(b)(5) and the proposed amendment to the IRC Section 861 regulations for tax years beginning after that date and before the regulations are finalized, provided the taxpayer applies those proposed regulations in their entirety. Similarly, a taxpayer may rely on the proposed regulations under IRC Section 250(b)(3) for tax years before finalization, provided that the taxpayer applies those regulations in their entirety.

Implications

The proposed regulations provide the first guidance implementing the OBBBA limitations on deductions allocated and apportioned to foreign-source NCTI category income, DEI and FDDEI. For FTC limitation purposes the proposed regulations would interpret the statutory "directly allocable" standard narrowly. The proposed regulations would resolve uncertainty about whether certain deductions, such as stewardship and other supportive expenses, would be considered directly allocable to foreign-source NCTI category income, confirming they are not.

The proposed regulations would confirm that reallocated deductions reduce US-source income for all IRC Section 904 purposes, including in determining a US-source loss and an ODL. The proposed regulations would not modify the loss-allocation and ODL rules. Consequently, a portion of the reallocated deductions may ultimately reduce current-year NCTI-FTC-limitation capacity notwithstanding IRC Section 904(b)(5). While this offset could recharacterize future US-source taxable income as foreign-source income in the NCTI category, the realization of that ODL benefit would depend on the taxpayer having future US-source income and foreign taxes in the NCTI category in the year the ODL is recaptured.

For taxpayers claiming the FDDEI deduction, the proposed regulations track the OBBBA's exclusion of interest and R&E expenses but do not significantly expand on the statute. The proposed regulations do not indicate that any change is intended for the allocation and apportionment of other deductions such as stewardship and other supportive expenses for purposes of computing DEI and FDDEI. As a result, the proposed regulations would create divergence between the FTC limitation and the DEI and FDDEI computations resulting from the OBBBA amendments and proposed regulations.