The IRS has proposed new rules that could change how certain deductions affect foreign tax credit calculations and the FDII deduction for tax years beginning after 31 December 2025.
The proposal is most relevant to US C corporations claiming the FDII deduction and US shareholders of controlled foreign corporations (CFCs). It may also matter to non-US founders who own US entities that elect corporate treatment.
The IRS published the proposal as REG-117273-25 in Internal Revenue Bulletin 2026-40 on 28 September 2026. Written comments and requests for a public hearing must be submitted by 10 November 2026 through Regulations.gov.
The rules are still proposed. Their mechanics may change before finalisation. However, taxpayers may generally rely on them for qualifying tax years beginning after 31 December 2025, provided they follow the proposed rules in full.
Check whether the proposal affects your US group
You should review these changes if your business includes any of the following:
- A US C corporation claiming the section 250 FDII deduction.
- A US corporation with one or more foreign subsidiaries that are CFCs.
- A US-headquartered ecommerce, SaaS, agency or digital services group selling internationally.
- A UK, Canadian, Australian or UAE-based founder operating a US corporation.
- A foreign-owned US LLC or single-member entity that has elected corporate tax treatment.
- A group claiming foreign tax credits against foreign-source income.
The rules are less directly relevant to a foreign-owned US LLC that remains a disregarded entity for US federal income tax purposes. However, its reporting and bookkeeping records may still need to support the US entity’s tax classification, transactions and compliance filings.
Understand the new section 904(b)(5) allocation rules
The One Big Beautiful Bill Act (OBBBA), Public Law 119-21, added new section 904(b)(5). The change applies to tax years beginning after 31 December 2025.
Section 904 limits the foreign tax credit to the US tax attributable to foreign-source taxable income. To calculate that limitation, taxpayers must allocate and apportion deductions between US-source income and foreign-source income categories.
The proposed regulations create special rules for foreign-source section 951A category income, commonly associated with GILTI or CFC tested income.
Under the proposal:
- Section 250 deductions attributable to net CFC tested income are allocated to foreign-source section 951A category income.
- Certain state and local income tax deductions connected with that income are also allocated to the section 951A category.
- Interest expense is not allocated to foreign-source section 951A category income.
- Research and experimental expenditure deductions are not allocated to that category.
- Other deductions are allocated to section 951A category income only if they are directly allocable.
Any excluded deduction that would previously have been allocated to foreign-source section 951A category income is instead reallocated to US-source income.
This is important because the reallocation can change your foreign tax credit limitation, US-source loss position and future overall domestic loss calculations.
Identify which deductions are directly allocable
The IRS proposal interprets “directly allocable” more narrowly than “properly allocable”.
A deduction may be properly allocable under the general section 861 rules but still fail the closer connection required under section 904(b)(5).
The proposed rules specifically identify the following as not directly allocable to foreign-source section 951A category income:
- Stewardship expenses.
- Legal and accounting fees and expenses.
- Damages awards.
- Prejudgment interest.
- Settlement payments.
- Overhead costs.
- General and administrative expenses.
- Supervisory and other supportive expenses.
These costs may have supported the group’s wider operations. That does not necessarily create the direct connection required to reduce section 951A category income under the proposed rules.
The proposal identifies certain items that may be directly allocable, including:
- Section 986(c) foreign currency losses arising from distributions of previously taxed earnings and profits (PTEP).
- Net operating loss deductions allocated to the section 951A category under the applicable rules.
This makes accurate transaction tagging essential. For example, your accounting records should separately identify PTEP distributions, related foreign exchange movements and the CFC income category connected with each distribution.
See how reallocation can create a US-source loss
The IRS provides an example showing why these rules may produce a significant result.
In simplified terms, a US corporation has:
- $100x of US-source income.
- $60x of foreign-source section 951A category income.
- $50x of foreign-source general category income.
- Interest expense and supportive expenses that would previously have reduced section 951A income.
Under the proposed rules, $40x of interest expense and $10x of supportive deductions are reallocated to US-source income.
That changes the company’s US-source position from $30x of income to a $20x domestic loss.
The section 951A category income is no longer reduced by those reallocated deductions. Instead, the domestic loss may reduce foreign-source income across relevant categories under the section 904 rules. It may also create an overall domestic loss (ODL).
An ODL can affect how US-source income is treated as foreign-source income in later years. In practical terms, an allocation decision made for the current year may affect foreign tax credit calculations and income sourcing in future periods.
Recalculate DEI and FDDEI for the FDII deduction
The proposal also updates the calculation of deduction eligible income (DEI) and foreign-derived deduction eligible income (FDDEI) under section 250.
For tax years beginning after 31 December 2025, DEI and FDDEI are reduced by expenses and deductions, including taxes, that are properly allocable to the relevant gross income.
However, the calculation is made without regard to interest expense and research or experimental expenditures.
This means DEI and FDDEI are treated as measures of taxable income after the relevant deductions, but before interest expense and R&E deductions are taken into account for this purpose.
For an international seller, this may affect the amount of income eligible for the section 250 deduction. You should review how your accounting system identifies:
- Foreign-use sales.
- Services provided to non-US persons or relating to property outside the United States.
- Revenue by customer location.
- Revenue by product, service and market.
- Operating expenses connected with FDDEI.
- State and local income taxes.
- Interest expense and R&E expenditure categories.
The IRS has also stated that it intends to issue separate section 250 guidance on other OBBBA changes, including the removal of the deemed tangible income return and deemed intangible income from the FDII calculation.
