Tax

On September 11, 2026, the U.S. Treasury Department (“Treasury”) and the Internal Revenue Service (“IRS”) issued proposed regulations (REG-117273-25) under Sections 904(b)(5) and 250(b)(3) addressing the allocation and apportionment of deductions to foreign source Section 951A category income for foreign tax credit limitation purposes and the computation of deduction eligible income (“DEI”).¹

The Proposed Regulations implement changes enacted as part of the One, Big, Beautiful Bill Act (the “OBBBA”) that limit the deductions that reduce a taxpayer’s foreign source Section 951A category income for foreign tax credit limitation purposes and exclude interest expense and research or experimental (“R&E”) expenditures from the deductions that reduce DEI and foreign derived deduction eligible income (“FDDEI”).

Background on Sections 904(b)(5) and 250(b)(3)

Section 904(a) limits a taxpayer’s foreign tax credit to the amount of U.S. tax imposed on the taxpayer’s foreign source taxable income. Under Section 904(d), this limitation is applied separately with respect to each separate category of income, including Section 951A category income. Before the OBBBA, a taxpayer’s foreign source Section 951A category income for foreign tax credit limitation purposes was reduced by all deductions properly allocable to such income under the Section 861 regulations, including interest expense, R&E expenditures, stewardship expenses, and other general and administrative costs.

The OBBBA added Section 904(b)(5), which provides three special rules that significantly restrict the deductions allocated to foreign source Section 951A category income:

• Section 904(b)(5)(A) provides that the Section 250(a)(1)(B) deduction and any Section 164(a)(3) deduction for state and local income taxes to the extent imposed on the taxpayer’s net CFC tested income or the related Section 78 gross-up amount are allocated and apportioned to foreign source Section 951A category income.
• Section 904(b)(5)(B) provides that no amount of interest expense or R&E expenditures is allocated or apportioned to foreign source Section 951A category income.
• Section 904(b)(5)(C) provides that any other deduction is allocated to foreign source Section 951A category income only if the deduction is “directly allocable” to such income.

Any deduction that would have been allocated to foreign source Section 951A category income but for Section 904(b)(5)(B) and (C) is instead allocated to U.S. source income.

Separately, Section 250(b)(3)(A) defines DEI as the excess of a domestic corporation’s gross income over properly allocable expenses and deductions. The OBBBA amended Section 250(b)(3)(A)(ii) to exclude interest expense and R&E expenditures from the deductions that reduce DEI and FDDEI, effective for taxable years beginning after December 31, 2025. This change generally increases a domestic corporation’s DEI and, in turn, its Section 250 deduction for FDDEI.

Highlights of the Proposed Regulations

The Proposed Regulations provide guidance on the mechanics of Section 904(b)(5) and update the Section 250 regulations to reflect the OBBBA’s amendment to the DEI computation. Key aspects are highlighted below.

“Directly Allocable” Defined for Section 904(b)(5)(C)

• The Proposed Regulations would interpret “directly allocable” as requiring a closer, more direct relationship between the deduction and foreign source Section 951A category income than the standard “properly allocable” test under the Section 861 regulations.
• Under the proposed definition, a deduction is not directly allocable if it is of a type that, under the applicable allocation rules, is subject to apportionment based on the relative value of assets or amounts of U.S. gross income. The relevant inquiry is whether the type of deduction could be apportioned by proxy, not how a particular item is in fact apportioned.
• Deductions that would not be directly allocable include stewardship expenses, legal and accounting fees and expenses, damages awards, prejudgment interest, and settlement payments, and supportive expenses such as overhead, general and administrative, and supervisory expenses. These deductions would be reallocated to U.S. source income.
• Deductions that would be directly allocable include foreign currency losses recognized under Section 986(c) with respect to distributions of previously taxed earnings and profits and net operating loss (“NOL”) deductions allocated to Section 951A category income under the existing NOL sourcing rules.

R&E Expenditures Are Not Reallocated

• Under existing Reg. § 1.861-17, R&E expenditures are not allocated to Section 951A category income because a taxpayer’s Section 951A inclusions do not result from R&E expenditures incurred by the taxpayer. Treasury and the IRS confirm that this conclusion remains correct after the enactment of Section 904(b)(5).
• Because R&E expenditures are never allocated to foreign source Section 951A category income in the first instance, Section 904(b)(5) does not cause any R&E expenditures to be reallocated to U.S. source income.

Reallocated Deductions Increase U.S. Source Income for All Section 904 Purposes

• Deductions reallocated from foreign source Section 951A category income to U.S. source income would be treated as allocated to U.S. source income for all purposes of Section 904, including the determination of U.S. source losses, overall foreign losses, separate limitation losses, and overall domestic losses.
• This reallocation may cause or increase a domestic loss within the meaning of Section 904(g)(2)(B), which in turn may create or enlarge an overall domestic loss (“ODL”) subject to recapture in subsequent taxable years.

NOL Treatment

• Unlike the adjustments under Section 904(b)(2) and (4), Section 904(b)(5) would be taken into account in determining the source and separate category components of an NOL in the year the NOL arises. This prevents deductions that are reallocated away from foreign source Section 951A category income from creating a separate limitation loss in the Section 951A category that carries over to reduce Section 951A income in a different year.
• NOL deductions carried to a subsequent year that are allocated to foreign source Section 951A category income under existing rules would be treated as directly allocable to such income.

DEI Computation Updated Under Section 250(b)(3)

• The Proposed Regulations would update the Section 250 regulations to provide that a taxpayer’s gross DEI and gross FDDEI are reduced by deductions other than interest expense and R&E expenditures (in addition to certain other deductions such as the net operating loss deduction, that were already excluded under existing rules).
• Interest expense is defined as any amount deductible under Section 163 (including original issue discount). R&E expenditures are defined as any expenditure deducted (including as an amortization deduction) under Section 174, 174A, or 59(e)(2)(B).
• The Proposed Regulations would also add “expenses” as a new defined term to reflect that DEI and FDDEI are reduced by amounts a taxpayer deducts in the taxable year, consistent with DEI and FDDEI being measures of taxable income.

Timing and Next Steps

Comments and requests for a public hearing are due by November 10, 2026. Treasury and the IRS specifically request comments on the proposed approach to determining directly allocable deductions and whether further guidance is needed for other deductions under Section 904(b)(5).

If finalized, the Proposed Regulations would apply to taxable years beginning after December 31, 2025. Taxpayers may rely on the Proposed Regulations before finalization, provided that the taxpayer applies the rules in their entirety and in a consistent manner.

Weil Observation The Proposed Regulations should significantly increase the foreign tax credit limitation for Section 951A category income by removing most deductions from the foreign source Section 951A basket. For many taxpayers, this should result in a greater amount of creditable foreign taxes attributable to CFC tested income. However, the reallocation of those deductions to U.S. source income may create or enlarge ODLs that are subject to recapture under Section 904(g), which could reduce the benefit in subsequent years. Taxpayers should model the current year benefit of an increased Section 951A limitation against the potential for ODL recapture in later years, particularly where CFC tested income and associated foreign taxes fluctuate from year to year. Additionally, Treasury’s confirmation that R&E expenditures are not reallocated under Section 904(b)(5) preserves the current treatment for taxpayers with significant R&E expe