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Treasury and the IRS have proposed regulations (REG-117273-25) implementing changes made by the One Big Beautiful Bill Act (OBBBA) to the allocation and apportionment of deductions for foreign tax credit (FTC) limitation purposes and the computation of deduction eligible income (DEI) and foreign-derived deduction eligible income (FDDEI).
The rules, published Sept. 11, impact taxpayers’ Section 951A FTC limitation and FDDEI deduction amounts.
The proposed regulations implement new Section 904(b)(5), which significantly limits the deductions allocated to foreign source Section 951A category income for FTC limitation purposes to the Section 250(a)(1)(B) deduction, Section 164(a)(3) taxes imposed on those amounts and other “directly” allocable deductions. These rules would also update the Section 250 regulations to reflect OBBBA’s narrowing of the expenses allocable to gross DEI and gross FDDEI.
Under the proposal, interest expense and research and experimental (R&E) expenditures are no longer allocated to foreign source Section 951A category income or to gross DEI and gross FDDEI.
Grant Thornton insight:
The OBBBA amendments are ultimately a favorable change, and the proposed regulations provide further guidance on how they apply. Excluding interest expense and R&E expenditures from the DEI and FDDEI computations can significantly increase the Section 250 deduction, and even taxpayers that have not previously benefited from a Section 250 deduction should re-evaluate their position.
The FTC side has both favorable and unfavorable aspects — many taxpayers will need to rethink high-tax exceptions, overall domestic loss (ODL) impacts and similar items, and model the potential changes — but for most taxpayers the result is likely favorable and may allow more FTCs.
Background
Section 250(b)(3) FDDEI
For taxable years beginning after Dec. 31, 2025, Section 250(a)(1)(A) provides a domestic corporation with a deduction equal to a percentage of its FDDEI. FDDEI is the DEI of a domestic corporation derived in connection with (i) property sold by the taxpayer to a person who is not a U.S. person and that is for a foreign use or (ii) services provided to a person, or with respect to property, outside the U.S. Before the OBBBA amendment, Section 250(b)(3)(A) reduced gross DEI by deductions “properly allocable” to that income.
Section 70322(b) of OBBBA amended this formula so that, for taxable years beginning after Dec. 31, 2025, gross DEI is reduced only by “expenses and deductions (including taxes), other than interest expense and research or experimental expenditures, properly allocable” to that income.
Section 904(b)(5) FTC limitation
Section 904(a) and (d) limit the FTC for taxes attributable to Section 951A category income to the U.S. tax imposed on the taxpayer’s net foreign source Section 951A category income.
The OBBBA added Section 904(b)(5), which provides that: (A) the Section 250(a)(1)(B) deduction and the Section 164(a)(3) deduction for taxes imposed on amounts described in Section 250(a)(1)(B) are allocated and apportioned to foreign source Section 951A category income; (B) no interest expense or R&E expenditures are allocated or apportioned to such income; and (C) other deductions are allocated or apportioned to such income only if they are “directly allocable” to that income.
Any amount that would otherwise be allocated to foreign source Section 951A category income but for subparagraphs (B) and (C) is instead allocated to U.S. source income (reallocated deductions). The provision applies to taxable years beginning after Dec. 31, 2025.
Key elements of the proposed regulations
Updated allocation rules for DEI and FDDEI
The proposed regulations would amend Reg. Section 1.250(b)-1 to provide that a taxpayer’s deductions properly allocable to gross DEI and gross FDDEI are determined without regard to interest expense and R&E expenditures.
Interest expense is defined as any amount deductible under Section 163 (including original issue discount), and R&E expenditures are defined as amounts a taxpayer deducts or amortizes for the taxable year under Section 174 or 174A, or pursuant to an election under Section 59(e)(2)(B).
In addition, the proposed regulations add the term “expenses” to Reg. Section 1.250(b)-1(a) to reflect the OBBBA amendments to Section 250(b)(3)(A). The proposed regulations otherwise retain the existing rule excluding deductions under Sections 170(b)(2), 172, 246(b) and 250 from the deductions properly allocable to gross DEI.
The “directly allocable” standard under Section 904(b)(5)
For FTC limitation purposes, the proposed regulations would allocate to foreign source Section 951A category income only: (i) the Section 250(a)(1)(B) deduction and the Section 164(a)(3) deduction for taxes imposed on amounts described in Section 250(a)(1)(B), in each case as determined under the Section 861 regulations; and (ii) other deductions that are directly allocable to such income.
A deduction is directly allocable only if, disregarding Section 904(b)(5), it would be allocated to Section 951A category income under the generally applicable rules and is not of a type subject to apportionment based on the relative value of assets or amounts of U.S. gross income. The inquiry looks to the nature of the deduction rather than to how a particular item of deduction is apportioned.
The proposed regulations identify stewardship expenses, legal and accounting fees, damages awards, prejudgment interest, settlement payments and supportive expenses, such as overhead and general and administrative expenses, as examples of deductions that are not directly allocable to foreign source Section 951A category income. These deductions are apportioned using proxies such as the relative value of assets or the amount of U.S. gross income.
By contrast, foreign currency loss recognized under Section 986(c) and assigned to the Section 951A category, and net operating loss (NOL) deductions allocated to that category, are treated as directly allocable because they are not apportioned using those proxies.
Separately, the proposed regulations implement Section 904(b)(5)'s exclusion of interest expense and R&E expenditures from allocation and apportionment to foreign source Section 951A category income.
Grant Thornton insight:
The rules, if finalized, would generally reduce the deductions allocated to foreign source Section 951A category income by implementing the statutory exclusion of interest expense and R&E expenditures. They also would interpret the directly allocable standard to require a closer, more direct relationship between a deduction and the relevant income.
As a result, taxpayers may have higher net foreign source Section 951A category income for FTC limitation purposes. Because these changes may affect the broader economics of post-OBBBA Section 951A computations, taxpayers should revisit existing FTC limitation and Section 951A category income modeling.
The proposed regulations increase the significance of how expenses are characterized for tax purposes. Amounts deducted or amortized under Sections 163, 174 or 174A, or pursuant to an election under Section 59(e), no longer reduce gross DEI or gross FDDEI, and no amount of interest expense or R&E is allocated or apportioned to foreign-source Section 951A category income.
Interest expense that ordinary allocation rules would have assigned to foreign-source Section 951A category income is instead assigned to U.S. source income for all purposes of Section 904. Taxpayers should re-examine what is currently characterized as Section 163 interest expense and as Section 174/174A/59(e)(2)(B) R&E expenditures. Items that migrate into or out of those categories may now more directly move the FDDEI deduction, the Section 951A limitation, and the U.S. source loss and ODL accounts.
Reallocation of deductions to U.S. source income
The proposed regulations adopt a two-step approach for determining the amount of reallocated deductions. First, deductions are allocated and apportioned to foreign source Section 951A category income under the existing expense allocation and apportionment rules. Second, deductions assigned to foreign source Section 951A category income in that initial computation are reallocated to U.S. source income under Section 904(b)(5).
Grant Thornton insight:
The proposed regulations clarify that because R&E expenditures generally are not allocated or apportioned to foreign source Section 951A category income under the existing expense allocation and apportionment rules, no amount of those expenditures is reallocated to U.S. source income under Section 904(b)(5).
The proposed regulations further confirm that the reallocated deductions are allocated to U.S. source income for all purposes of Section 904. This treatment may create or increase a loss from U.S. sources under Section 904(f)(5)(D) and a “domestic loss” under Section 904(g)(2)(B), which in turn may generate or increase an overall domestic loss (ODL) that could result in future U.S. source income being recharacterized as foreign source income under Section 904(g).
Grant Thornton insight:
Prior to the proposed regulations, commentators questioned whether deductions reallocated under Section 904(b)(5) should affect only the immediate FTC limitation calculation or should be treated as reducing U.S.-source income for all purposes of Section 904. The proposed regulations adopt the broader approach. As a result, deductions removed from the Section 951A category may create or increase an overall domestic loss, requiring a corresponding reduction in foreign-source income under the ODL rules.
Consequently, the anticipated benefit of removing deductions from the Section 951A category may be significantly reduced, as those same deductions can effectively be pushed back into the foreign tax credit limitation computation through the ODL regime.
Net operating losses
The proposed regulations clarify the interaction between Section 904(b)(5) and the NOL rules.
The reallocated deductions are taken into account in determining the separate limitation loss and U.S. source loss components of an NOL. The proposed regulations further provide that Section 904(b)(5) applies before determining the NOL components to be carried over. In addition, an NOL deduction allocated to the Section 951A category is treated as directly allocable to that category.
Applicability and reliance
The regulations as proposed would apply to taxable years beginning after Dec. 31, 2025.
The package amends Reg. Sections 1.250(b)-1, 1.861-8 and 1.904(b)-3, and adds new proposed Reg. Section 1.904(b)-4. Before the regulations are finalized, taxpayers may rely on the proposed rules, provided the taxpayer follows the proposed regulations in their entirety and in a consistent manner. Comments and requests for a public hearing must be received by Nov. 10, 2026.
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