USA Update: IRS Proposes New Foreign Tax Credit Allocation Rules : What International Sellers Must Know

TITLE: New IRS Rules Could Reshape Foreign Tax Credits for International Seller Groups in 2026

The IRS and Treasury have proposed new rules that could change how international seller groups calculate US foreign tax credits for 2026 tax years.

The proposal affects the allocation and apportionment of deductions to foreign-source Section 951A category income, commonly associated with GILTI and now referred to as net CFC tested income. It also updates the calculation of deduction eligible income under Section 250.

The proposed regulations were published on 11 September 2026 as REG-117273-25, 91 FR 57832, document 2026-18645.

For many US corporations with foreign subsidiaries, the changes could increase the foreign tax credit limitation. However, they may also create US-source losses and affect future overall domestic loss recapture.

Check whether your US structure falls within the rules

The proposal is relevant if your group includes:

• A US domestic C corporation that owns or is a US shareholder of a controlled foreign corporation (CFC).
• A US corporation used by UK, EU, Canadian, or Australian founders to operate or sell into the US.
• An international ecommerce, SaaS, agency, or digital business with a US corporation and a foreign subsidiary.
• A domestic corporation claiming the Section 250 deduction for foreign-derived deduction eligible income (FDDEI).
• A US seller group reporting Section 951A income and claiming foreign tax credits.

The rules are not automatically relevant to every foreign-owned US business. For example, a foreign-owned US LLC taxed as a disregarded entity or partnership may not be the taxpayer directly affected by the Section 951A rules. The analysis depends on the entity’s US tax classification, ownership structure, CFC interests, and filing position.

Review the US entity structure first. This will help you identify whether the proposal affects your 2026 calculations.

Understand the three Section 904(b)(5) deduction categories

The One Big Beautiful Bill Act added new Section 904(b)(5). The provision creates special rules for allocating deductions to foreign-source Section 951A category income when calculating the foreign tax credit limitation.

The proposed regulations describe three broad categories.

1. Allocate Section 250 and certain state or local tax deductions

Section 904(b)(5)(A) requires the following deductions to be allocated and apportioned to foreign-source Section 951A category income:

• The Section 250(a)(1)(B) deduction relating to net CFC tested income.
• A Section 164(a)(3) deduction for state and local income taxes imposed on amounts included in Section 250(a)(1)(B).
• Related amounts attributable to the Section 951A income and associated Section 78 gross-up, where applicable.

This means the Section 250 deduction remains part of the calculation for the Section 951A foreign tax credit basket.

2. Do not allocate interest or R&E to the Section 951A basket

Section 904(b)(5)(B) provides that no interest expense or research and experimental expenditure may be allocated or apportioned to foreign-source Section 951A category income.

This is a significant change for many US corporations.

Under the proposed framework, interest expense that would previously have reduced foreign-source Section 951A income through asset-based allocation is removed from that basket. The result can be a higher amount of foreign-source income for the Section 904 limitation calculation.

The treatment of R&E requires care. Existing Section 1.861-17 rules generally do not allocate R&E expenditures to Section 951A income. Therefore, R&E is excluded from the Section 951A basket, but it is not necessarily reallocated to US-source income if it would not have been allocated to the basket under the existing rules.

Separate interest, R&E, and other operating expenses in your workpapers. Combining them could produce an incorrect foreign tax credit calculation.

3. Allocate other deductions only when directly allocable

Section 904(b)(5)(C) permits another deduction to reduce foreign-source Section 951A income only when it is directly allocable to that income.

The proposed regulations interpret “directly allocable” more narrowly than “properly allocable” under the general Section 861 rules.

A deduction is not directly allocable if it is the type of deduction that may be apportioned using:

• The relative value of assets.
• The amount of US gross income.
• Modified gross income or similar indirect allocation factors.

The proposed regulations specifically identify several deductions that are not directly allocable, including:

• Stewardship expenses.
• Legal fees and accounting fees.
• Damages awards, prejudgment interest, and settlement payments.
• Supportive expenses.
• Overhead, general and administrative, and supervisory expenses.

These costs may still be deductible. However, they may no longer reduce foreign-source Section 951A income for Section 904 limitation purposes.

The proposal identifies examples of deductions that may be directly allocable, including:

• Section 986(c) foreign currency losses on distributions of previously taxed earnings and profits (PTEP) assigned to the Section 951A category.
• Net operating loss deductions allocated and apportioned to foreign-source Section 951A category income under the proposed rules.

Trace every material deduction to its underlying activity. This creates a stronger compliance file and helps support the treatment used in the tax calculation.

Model the potential foreign tax credit benefit

The foreign tax credit limitation generally restricts credits to the US tax attributable to net foreign-source taxable income in the relevant category.

The proposed rules can increase that limitation because fewer deductions reduce the Section 951A basket.

Example: US corporation with a foreign subsidiary

Assume a US corporation is owned by international sellers based in the UK, Canada, and Australia. The US corporation owns a foreign subsidiary that generates tested income and pays foreign income tax.

The US corporation also has:

• Interest expense on a US borrowing facility.
• Central overhead and general administrative costs.
• Accounting and legal fees.
• Foreign tax credits connected with the foreign subsidiary’s income.

Under the proposed Section 904(b)(5) rules:

• Interest expense cannot be allocated to foreign-source Section 951A income.
• General administrative and overhead expenses are not directly allocable.
• Legal and accounting fees are not directly allocable.
• The Section 951A income basket is therefore not reduced by those deductions for the Section 904 limitation calculation.
• The US corporation may have a higher foreign-source Section 951A income amount and a higher limitation for claiming foreign tax credits.

The benefit depends on the complete tax profile. It is not an automatic refund or credit increase. The corporation must still calculate the relevant foreign income, foreign taxes, deductions, Section 250 amounts, losses, and limitations correctly.

Watch for US-source losses and domestic loss recapture

The proposal does more than increase the Section 951A basket.

Deductions that would have reduced foreign-source Section 951A income under the normal allocation rules, but are excluded by Section 904(b)(5), are reallocated to US-source income.

That reallocation can:

• Create or increase a US-source loss for the year.
• Reduce the US tax attributable to US-source income.
• Affect the overall foreign tax credit limitation when US-source income is reduced or turned into a loss.
• Trigger or increase an overall domestic loss (ODL) that must be recaptured in later years.

An overall domestic loss arises when a US-source loss exceeds US-source income and a portion of that loss offsets foreign-source income. The reallocated deductions may increase an ODL balance. That balance must generally be recaptured in future years, which can reduce the foreign tax credit limitation in those years.

This means the immediate benefit of a higher Section 951A basket could be offset by future recapture. Groups with existing ODL balances should model both the current-year benefit and the future recapture effect.

Track ODL balances alongside the Section 951A limitation. The two interact, and a change to one can affect the other.

Plan for the 2026 tax year now

The proposed regulations are not yet final. However, they signal the direction of travel for Section 904(b)(5) and the Section 951A foreign tax credit basket.

Practical steps for international seller groups include:

1. Confirm your entity classification and CFC status. Determine whether your US corporation is a US shareholder of one or more CFCs and whether it reports Section 951A income.
2. Map your deductions by category. Identify Section 250 amounts, state and local taxes, interest expense, R&E, and other deductions that may be directly or indirectly allocable.
3. Isolate interest and R&E. These should not be allocated to the Section 951A basket under the proposal.
4. Test “directly allocable” for each material deduction. Do not assume that general overhead, administrative, legal, or accounting costs can reduce Section 951A income.
5. Model the foreign tax credit limitation. Compare the limitation under the proposed rules with the current calculation.
6. Review ODL balances and recapture. Consider how reallocated deductions could create or increase US-source losses and future recapture.
7. Document your position. Keep a clear workpaper trail that supports the allocation and apportionment treatment used.

Speak to your US tax adviser before filing. The rules are proposed, and the final regulations may differ. However, early modelling can help you plan for 2026 and avoid surprises.

Key takeaways

• The proposed regulations under REG-117273-25, 91 FR 57832, document 2026-18645, address the allocation and apportionment of deductions to foreign-source Section 951A category income.
• New Section 904(b)(5) creates three categories: deductions that must be allocated to the Section 951A basket, deductions that cannot be allocated (interest and R&E), and deductions that may be allocated only if directly allocable.
• The Section 250 deduction relating to net CFC tested income remains part of the Section 951A basket calculation.
• Interest expense and R&E cannot be allocated or apportioned to foreign-source Section 951A category income.
• General overhead, administrative, legal, accounting, and similar expenses are not directly allocable and may no longer reduce the Section 951A basket.
• A higher Section 951A basket can increase the foreign tax credit limitation, but reallocated deductions may create US-source losses and increase overall domestic loss recapture in future years.
• International seller groups with US corporations and foreign subsidiaries should model the impact now and review their entity structure, deduction mapping, and ODL balances.