Proposed Rule2026-18645
Allocation and Apportionment of Deductions to Foreign Source Section 951A Category Income and Deduction Eligible Income
Primary source
Metadata and text below are from the Federal Register, a public-domain U.S. government work. Always verify the official published version before relying on it for any legal matter.
Published
September 11, 2026
Issuing agencies
Treasury DepartmentInternal Revenue Service
Abstract
This document contains proposed regulations related to the allocation and apportionment of deductions to foreign source section 951A category income for foreign tax credit limitation purposes and for purposes of calculating deduction eligible income. The proposed regulations would affect taxpayers that operate in foreign countries through foreign corporations and domestic corporations that claim the deduction for foreign-derived deduction eligible income.
Full Text
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<title>Federal Register, Volume 91 Issue 175 (Friday, September 11, 2026)</title>
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[Federal Register Volume 91, Number 175 (Friday, September 11, 2026)]
[Proposed Rules]
[Pages 57832-57841]
From the Federal Register Online via the Government Publishing Office [<a href="http://www.gpo.gov">www.gpo.gov</a>]
[FR Doc No: 2026-18645]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-117273-25]
RIN 1545-BR90
Allocation and Apportionment of Deductions to Foreign Source
Section 951A Category Income and Deduction Eligible Income
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking.
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SUMMARY: This document contains proposed regulations related to the
allocation and apportionment of deductions to foreign source section
951A category income for foreign tax credit limitation purposes and for
purposes of calculating deduction eligible income. The proposed
regulations would affect taxpayers that operate in foreign countries
through foreign corporations and domestic corporations that claim the
deduction for foreign-derived deduction eligible income.
DATES: Written or electronic comments and requests for a public hearing
must be received by November 10, 2026.
ADDRESSES: Commenters are strongly encouraged to submit public comments
electronically. Submit electronic submissions via the Federal
eRulemaking Portal at <a href="http://www.regulations.gov">www.regulations.gov</a> (indicate IRS and REG-117273-
25) by following the online instructions for submitting comments.
Requests for a public hearing must be submitted as prescribed in the
``Comments and Requests for a Public Hearing'' section. Once submitted
to the Federal eRulemaking Portal, comments cannot be edited or
withdrawn. The Department of the Treasury (Treasury Department) and the
IRS will publish for public availability any comments to the IRS's
public docket. Send paper submissions to: CC:PA:01:PR (REG-117273-25),
Room 5503, Internal Revenue Service, P.O. Box 7604, Ben Franklin
Station, Washington, DC 20044.
FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations
generally, John Lee or Alex Kaplan at (202) 317-6936; and concerning
submissions of comments and requests for a public hearing, Publications
and Regulations at (202) 317-6901 (not toll-free numbers) or by sending
an email to <a href="/cdn-cgi/l/email-protection#dbabaeb9b7b2b8b3bebaa9b2b5bca89bb2a9a8f5bcb4ad"><span class="__cf_email__" data-cfemail="a5d5d0c7c9ccc6cdc0c4d7cccbc2d6e5ccd7d68bc2cad3">[email protected]</span></a> (preferred).
SUPPLEMENTARY INFORMATION:
Authority
This document contains proposed additions and amendments to 26 CFR
part 1 (proposed regulations) regarding section 904(b)(5) and section
250(b)(3) of the Internal Revenue Code (Code). The proposed regulations
are issued pursuant to the express delegations of authority under
sections 250(c) and 7805(a).
Background
I. Section 250(b)(3)
For taxable years beginning after December 31, 2025, section
250(a)(1)(A) provides a deduction to a domestic corporation equal to a
percentage of the corporation's foreign-derived deduction eligible
income (FDDEI). FDDEI is the deduction eligible income (DEI) of any
domestic corporation that is derived in connection with (i) property
that is sold by the taxpayer to any person who is not a United States
person and that the taxpayer establishes to the satisfaction of the
Secretary is for a foreign use, or (ii) services provided by the
taxpayer which the taxpayer establishes to the satisfaction of the
Secretary are provided to any person, or with respect
[[Page 57833]]
to property, not located within the United States. Section 250(b)(1).
Section 250(b)(3)(A) was amended by section 70322 of Public Law
119-21, 139 Stat. 72 (July 4, 2025), commonly known as the One, Big,
Beautiful Bill Act (the OBBBA). Prior to its amendment, section
250(b)(3)(A) defined DEI as the excess (if any) of a domestic
corporation's gross income determined without regard to six categories
of gross income, described in section 250(b)(3)(A)(i)(I) through (VI),
over the deductions (including taxes) properly allocable to such gross
income. Section 70322(b) of the OBBBA amended section 250(b)(3)(A)(ii)
to reduce gross income by the ``expenses and deductions (including
taxes), other than interest expense and research or experimental
expenditures, properly allocable to such gross income.'' Section
70322(b)(2) of the OBBBA provides that the amendment to section
250(b)(3)(A)(ii) applies to taxable years beginning after December 31,
2025.
II. Section 904(b)(5)
As discussed in more detail in part III of this Background, section
904(a) and (d) limit the foreign tax credit for foreign taxes
attributable to amounts described in section 904(d)(1)(A) (section 951A
category income) to the amount of U.S. tax imposed on the taxpayer's
net foreign source section 951A category income. To determine the
taxpayer's net foreign source section 951A category income, the
taxpayer must determine the amount of deductions that are allocated and
apportioned to foreign source section 951A category income. The rules
for allocating and apportioning deductions to foreign source section
951A category income, as well as to foreign source gross income in the
other categories listed in, or treated as listed in, section 904(d)(1)
(each, a ``separate category,'' \1\ and to gross income from sources
within the United States (U.S. source income), are generally found in
the regulations described in Sec. 1.861-8(a)(1) (the section 861
regulations).
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\1\ See Sec. 1.904-5(a)(4)(v).
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The OBBBA made several changes to the Code with respect to the
foreign tax credit rules, including rules for allocating and
apportioning deductions for purposes of determining the foreign tax
credit limitation. In particular, the OBBBA added section 904(b)(5),
which provides special rules for allocating and apportioning deductions
to foreign source income for purposes of applying section 904(a) with
respect to section 951A category income. Section 904(b)(5)(A) provides
that any deduction allowed under section 250(a)(1)(B) and any deduction
allowed under section 164(a)(3) for taxes imposed on amounts described
in section 250(a)(1)(B) are allocated and apportioned to foreign source
section 951A category income. Section 904(b)(5)(B) provides that no
amount of interest expense or research and experimental (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 and apportioned to foreign source section 951A category
income only if the deduction is directly allocable to such income.
Pursuant to the second sentence in section 904(b)(5), any amount or
deduction that would (but for section 904(b)(5)(B) and (C)) have been
allocated or apportioned to foreign source section 951A category income
is only allocated or apportioned to U.S. source income. Section
70311(c) of the OBBBA provides that the amendment to section 904(b)
applies to taxable years beginning after December 31, 2025.
III. The Foreign Tax Credit Limitation
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.
For this purpose, foreign source taxable income cannot exceed the
taxpayer's entire taxable income.
Other provisions in section 904 set forth additional rules for
determining the limitation on the amount of the foreign tax credit a
taxpayer is allowed. Section 904(d) provides that the limitation in
section 904(a) is applied separately with respect to each separate
category. Section 904(b) provides special rules for determining the
taxpayer's foreign source taxable income and entire taxable income
needed to compute the foreign tax credit limitation. Section 904(f)
provides rules that apply if a taxpayer sustains a loss from sources
within the United States (U.S. source loss), an overall foreign loss
(OFL), or a separate limitation loss (SLL) with respect to one or more
separate categories. Section 904(g) provides rules that apply if a
taxpayer sustains an overall domestic loss (ODL) for the taxable year.
To the extent a taxpayer has a U.S. source loss, the U.S. source
loss reduces foreign source taxable income in the separate categories
(separate limitation income (SLI)) on a proportionate basis. Section
904(f)(5)(D).
To the extent of an ODL (subject to limitations), a taxpayer's U.S.
source taxable income in subsequent taxable years is recharacterized as
foreign source taxable income. Under section 904(g)(2)(A), in the case
of a taxpayer that chooses to claim a foreign tax credit for the
taxable year, an ODL is a domestic loss for the taxable year that
offsets foreign source taxable income for the taxable year or for any
preceding taxable year (by reason of a carryback) in which the taxpayer
chose to claim a foreign tax credit. In the case of a taxpayer that
does not choose to claim a foreign tax credit for the taxable year, an
ODL is a domestic loss for the taxable year that offsets foreign source
taxable income for any preceding taxable year in which the taxpayer
chose to claim a foreign tax credit. Section 904(g)(2)(B) defines the
term ``domestic loss'' as the amount by which the deductions properly
apportioned or allocated to gross U.S. source income for the taxable
year exceed the gross U.S. source income (determined without regard to
any carryback from a subsequent taxable year).
IV. Allocation and Apportionment of Deductions
A. In General
The section 861 regulations provide general rules for allocating
and apportioning deductions for purposes of various sections of the
Code that require the determination of taxable income (each an
operative section), including sections 250(b), 871(b)(1), 882(a)(1),
and 904(d)(1). See Sec. 1.861-8(a)(1) and (f)(1). Generally,
deductions are allocated and apportioned based on the factual
relationship of the deduction to a class or a grouping of gross income.
See Sec. 1.861-8(b)(1) and Sec. 1.861-8T(c)(1). A deduction is first
allocated to a class of gross income and then, if necessary to make the
determination of taxable income required by the operative section of
the Code, apportioned within the class among the statutory and residual
groupings of gross income.
A class of gross income may consist of one or more items (or
subdivisions of these items) of gross income enumerated in section 61,
such as gross income derived from business and gains from dealings in
property. A deduction is allocated to a class of gross income if it is
definitely related to the class of gross income. A deduction is
definitely related to a class of gross income if it is incurred as a
result of, or incident to, an activity or in connection with property
that generates, has generated, or could reasonably have been expected
to generate gross income in the class. Sec. 1.861-8(b)(2). If a
deduction is not definitely related to a class of gross income
constituting less than all gross income, it is ordinarily treated as
[[Page 57834]]
definitely related and allocable to all of the taxpayer's gross income.
Sec. 1.861-8(b)(5). Certain deductions may not be definitely related
to any gross income. Sec. 1.861-8(e)(9).
After a deduction has been allocated to a class of gross income,
the deduction is apportioned among the statutory and residual groupings
within the class of gross income in a manner that reflects to a
reasonably close extent the factual relationship between the deduction
and the grouping of gross income. Sec. 1.861-8T(c)(1). A statutory
grouping is the gross income from a specific source or activity
relevant to the operative section. Gross income from other sources or
activities is included in the residual grouping. For example, section
904(d)(1) is the operative section when applying the section 861
regulations to determine foreign source taxable income in each separate
category for purposes of the foreign tax credit limitation.
Accordingly, the foreign source income in each separate category is a
statutory grouping, and U.S. source income is the residual grouping.
B. Interest Expense
Sections 1.861-9, 1.861-9T, 1.861-10, 1.861-10T, 1.861-11, and
1.861-11T, and related Sec. Sec. 1.861-12, 1.861-12T, and 1.861-13,
provide rules for allocating and apportioning interest expense that is
deductible under section 163. Under Sec. Sec. 1.861-9 and 1.861-9T,
interest expense is generally allocated to all gross income that the
taxpayer's assets generate and apportioned to statutory and residual
groupings based on the average total value of assets within each
grouping for the taxable year, as determined under the asset valuation
rules and asset characterization rules provided in those sections and
Sec. Sec. 1.861-12, 1.861-12T, and 1.861-13 (the asset method). See
also section 864(e)(2). In a set of narrow circumstances, the general
rule provided under Sec. Sec. 1.861-9 and 1.861-9T does not apply. In
those circumstances, interest expense is directly allocated to income
generated by certain assets or investments. See Sec. Sec. 1.861-10 and
1.861-10T.
C. Research and Experimental Expenditures
Section 1.861-17 provides rules for allocating and apportioning R&E
expenditures, as defined in Sec. 1.861-17(a). Section 1.861-17(b)
allocates R&E expenditures to gross intangible income (as defined in
Sec. 1.861-17(b)(2)) that is reasonably connected with the taxpayer's
Standard Industrial Classification (SIC) code category or categories.
Gross intangible income does not include dividends or any amounts
included in income under section 951, 951A, or 1293. See Sec. 1.861-
17(b)(2).
Section 1.861-17(d) apportions R&E expenditures among the statutory
and residual groupings within the class of gross intangible income in
proportion to the taxpayer's gross receipts (and gross receipts of
certain related and unrelated taxpayers) from sales and leases of
products or services that are related to gross intangible income in the
groupings. If, however, the taxpayer performs at least 50 percent of
the R&E activities in the United States or more than 50 percent of the
R&E activities outside the United States, then, for purposes of
determining the taxpayer's foreign tax credit limitation, Sec. 1.861-
17(c) apportions 50 percent of the taxpayer's R&E expenditures to U.S.
source gross intangible income or foreign source gross intangible
income, respectively (the exclusive apportionment rule). The remaining
50 percent of R&E expenditures is apportioned under Sec. 1.861-17(d).
D. Deductions Allowed Under Sections 250(a)(1)(B) and 164(a)(3)
Section 250(a) permits a domestic corporation a deduction for 33.34
percent of the domestic corporation's FDDEI and 40 percent of the
domestic corporation's net CFC tested income under section 951A and
related section 78 deemed dividend. Under Sec. 1.861-8(e)(14), the
portions of the section 250(a) deduction attributable to net CFC tested
income (reduced by a taxable income limitation under section
250(a)(2)(B)(ii)) and the related deemed dividend are considered
definitely related and allocable to the classes of gross income
included under section 951A(a) and section 78, respectively. To the
extent the class of gross income includes income in more than one
grouping, the respective portions of the section 250(a) deduction are
apportioned based on the relative amounts of gross income in each
grouping. Sec. 1.861-8(e)(14).
Section 164(a)(3) permits a deduction for State and local, and
foreign, income, war profits, and excess profits taxes paid or accrued
by the taxpayer in the taxable year. A deduction for State and local
taxes is considered definitely related and allocable to the gross
income on which the State and local taxes are imposed. Sec. 1.861-
8(e)(6).
E. Other Deductions
Section 1.861-8 provides specific rules for the allocation and
apportionment of certain other deductions. Stewardship expenses that
are allocable to a class of gross income that includes gross income in
more than one grouping are apportioned based on the relative values of
the entity or entities in each grouping that are owned by the taxpayer
that incurred the stewardship expense. Sec. 1.861-8(e)(4)(ii)(C).
Legal and accounting fees and expenses may be allocable either to
specific classes of gross income or to all of the taxpayer's gross
income and are apportioned among statutory and residual groupings based
on the amounts of gross income in the groupings or some other
apportionment factor. Sec. Sec. 1.861-8(b)(5), (e)(5)(i) and 1.861-
8T(c)(1). See also Sec. 1.861-8(e)(5)(ii) and (iii) (apportioning
deductions arising from product liability and other claims for damages
on the basis of certain gross income or assets).
Net operating loss (NOL) deductions are allocated and apportioned
to statutory and residual groupings by reference to the statutory and
residual groupings of the components of the NOL. Sec. 1.861-
8(e)(8)(ii). An NOL is separated into components that are assigned to
statutory or residual groupings by reference to the loss in each
statutory or residual grouping that does not reduce income in other
groupings in the taxable year of the loss. Sec. 1.861-8(e)(8)(i). When
section 904 is the operative section, Sec. 1.861-8(e)(8)(i) determines
the source and separate category components of an NOL by reference to
the amounts of SLL and U.S. source loss (determined without regard to
adjustments required under section 904(b)) that are not allocated to
reduce U.S. source income or SLI in other separate categories under the
rules of section 904(f) for the taxable year in which the NOL arose.
Deductions that are supportive in nature (such as for overhead,
general and administrative, and supervisory expenses) may be allocated
and apportioned along with other deductions to which they relate that
are more readily allocated to gross income. Sec. 1.861-8(b)(3).
Alternatively, they may be attributed directly to activities or
property, in which case they will ordinarily be allocated to a broad
class of gross income or all gross income. Id. If allocated to all
gross income, supportive deductions are apportioned among the statutory
and residual groupings based on the amounts of gross income in the
groupings or some other apportionment factor. Sec. Sec. 1.861-8(b)(5)
and 1.861-8T(c)(1).
Rules for allocating and apportioning certain deductions are
contained in regulations other than the section 861 regulations. For
example, Sec. 1.904-4(p)
[[Page 57835]]
provides the rule for allocating foreign currency gain or loss under
section 986(c) with respect to a distribution of previously taxed
earnings and profits (PTEP) (section 986(c) gain or loss). Section
1.904-4(p) provides that section 986(c) gain or loss is assigned to the
separate category or categories of the PTEP from which the distribution
is made. Section 986(c) provides that the foreign currency gain or loss
with respect to distributions of PTEP is treated as from the same
source as the associated income inclusion.
Explanation of Provisions
I. Allocation and Apportionment of Deductions to DEI
Section 250(b)(3)(A), as amended by section 70322(b) of the OBBBA,
defines a domestic corporation's DEI as a net amount that is computed
by determining the excess of the corporation's gross income without
regard to certain excluded items (gross DEI) over expenses and
deductions (including taxes), other than interest expense and R&E
expenditures, properly allocable to gross DEI. Existing regulations
under section 250 (section 250 regulations) provide rules for computing
a taxpayer's DEI for a taxable year. Under these rules, first, a
taxpayer determines its gross DEI, gross FDDEI, and gross residual DEI
(gross RDEI), which is the portion of gross DEI for a taxable year that
is not gross FDDEI. Sec. 1.250(b)-1(c)(14) through (16) (defining
gross RDEI, gross DEI, and gross FDDEI, respectively). Next, the
taxpayer determines its deductions for the taxable year properly
allocable to gross DEI and gross FDDEI without regard to certain Code
sections, including section 163(j). Sec. 1.250(b)-1(d)(2)(ii). Lastly,
the taxpayer allocates and apportions its deductions for the taxable
year to gross DEI and gross FDDEI under the rules of Sec. Sec. 1.861-8
through 1.861-14T and 1.861-17 by treating: (i) section 250(b) as an
operative section described in Sec. 1.861-8(f), (ii) gross FDDEI and
gross RDEI as separate statutory groupings, and (iii) the items of
gross income that are excluded from gross DEI as the residual grouping.
Sec. 1.250(b)-1(d)(2)(i) and (c)(15)(i) through (vi).
The proposed regulations would update the section 250 regulations
to reflect the amendment to section 250(b)(3)(A)(ii) made by section
70322(b) of the OBBBA. First, the proposed regulations would provide
that a taxpayer's gross DEI and gross FDDEI for a taxable year are
reduced by the properly allocable expenses and other deductions
(referred to collectively as ``deductions'') that the taxpayer deducts
in the taxable year. Proposed Sec. 1.250(b)-1(a). The proposed
regulations would add the term ``expenses'' to existing Sec. 1.250(b)-
1(a) in order to reflect the addition of this term, and the related
term ``interest expense,'' in amended section 250(b)(3)(A)(ii). By
taking into account amounts that are deducted in the taxable year in
order to compute DEI and FDDEI, the proposed regulations would reflect
that DEI and FDDEI are measures of taxable income.
Second, the proposed regulations would provide that taxpayers must
determine their deductions for the taxable year properly allocable to
gross DEI and gross FDDEI without regard to interest expense and R&E
expenditures. Proposed Sec. 1.250(b)-1(d)(2)(ii). The proposed
regulations would define interest expense as any amount that is
deductible under section 163 (including original issue discount). To
reflect that interest expense is no longer allocable to gross DEI and
gross FDDEI, the proposed regulations would remove the reference to
section 163(j) in existing Sec. 1.250(b)-1(d)(2)(ii). The proposed
regulations would define R&E expenditures as any expenditure that a
taxpayer deducts (including as an amortization deduction) in a taxable
year under section 174, 174A, or 59(e)(2)(B). Proposed Sec. 1.250(b)-
1(d)(2)(ii). Lastly, the proposed regulations would update the general
references to the section 861 regulations to use the defined term
``section 861 regulations'' provided in Sec. 1.861-8(a). Proposed
Sec. 1.250(b)-1(d)(2)(i).
The Treasury Department and the IRS intend to issue separate
guidance regarding section 250, which would update the section 250
regulations to reflect other amendments made by the OBBBA. Separate
guidance would address, for example, the removal of the deemed tangible
income return and deemed intangible income from calculation of the
deduction provided under section 250(a)(1)(A) for taxable years
beginning after December 31, 2025.
II. Section 904(b)(5)
A. Deductions Allocated and Apportioned to Foreign Source Section 951A
Category Income for Purposes of Section 904(a)
1. Overview
As noted in part II of the Background section of this preamble, the
first sentence of section 904(b)(5) describes three categories of
deductions and specifies whether the category of deduction is allocated
or apportioned to foreign source section 951A category income for
purposes of section 904(a).
2. Deductions Under Section 250(a)(1)(B) and Section 164(a)(3)
The first category of deductions is described in section
904(b)(5)(A) and consists of the deduction allowed under section
250(a)(1)(B) and the deduction under section 164(a)(3) to the extent
tax is imposed on the taxpayer's net CFC tested income or section 78
gross-up attributable to such income.
For purposes of determining the extent to which a deduction under
section 250(a)(1)(B) is allocated or apportioned to foreign source
section 951A category income, the proposed regulations would apply the
allocation and apportionment rules of Sec. 1.861-8(e)(14). Proposed
Sec. 1.904(b)-4(b)(1)(i).
The first category also includes any deduction under section
164(a)(3) for a tax with the same or similar tax base as the Federal
income tax such that all or a portion of the tax is attributable to the
taxpayer's net CFC tested income amount or the section 78 gross-up
attributable to that amount. This may arise, for instance, where a
State income tax reflects a policy of Federal-State conformity and
therefore includes in the tax base all or a portion of a taxpayer's net
CFC tested income amount or the section 78 gross-up attributable to
that amount. For purposes of determining the extent to which a
deduction for State or local income taxes under section 164(a)(3) is
imposed on net CFC tested income (or the associated section 78 gross-
up) and allocated or apportioned to foreign source section 951A
category income, the proposed regulations would apply the allocation
and apportionment rules of Sec. 1.861-8(e)(6). Proposed Sec.
1.904(b)-4(b)(1)(ii). The proposed regulations would not include in the
first category a deduction for foreign income taxes under section
164(a)(3) because foreign income taxes are not expected to be imposed
on a U.S. shareholder's net CFC tested income amount or the section 78
gross-up attributable to that amount.
3. Deductions for Interest Expense and Research and Experimental
Expenditures
Deductions in the second category consist of the deductions for
interest expense and R&E expenditures. Section 904(b)(5)(B). The
proposed regulations would define interest expense to mean any expense
that is deductible under section 163 (including original issue
discount) and R&E expenditures to mean any expenditure that a taxpayer
deducts (including as an amortization deduction) in a taxable year
under
[[Page 57836]]
section 174, 174A, or 59(e)(2)(B). Proposed Sec. 1.904(b)-4(b)(3).
4. Directly Allocable Deductions
Deductions in the third category consist of any other deduction
that is ``directly allocable'' to foreign source section 951A category
income. Section 904(b)(5)(C).
Section 904(b)(5) does not define the term ``directly allocable.''
While the term appears in several other Code sections, those sections
also do not define the term, and the term has no consistent accepted
meaning. In comparison, the term ``properly allocable'' (or the
variation ``properly apportioned or allocated'') appears more
frequently in the Code, including in sections 861, 862, 863, and 904.
For those sections, the section 861 regulations provide the general
framework for determining the deductions properly allocable to the
relevant gross income. Under the section 861 regulations, a deduction
may be allocated and apportioned to a grouping of income because the
deduction resulted from activities or property that generated income in
the grouping. If the deduction is instead related to all the taxpayer's
gross income, a portion of the deduction may be allocated and
apportioned to each grouping.
The Treasury Department and the IRS interpret the term ``directly
allocable'' in section 904(b)(5) as requiring a closer, more direct
relationship between the deduction and income than the term ``properly
allocable'' as construed under the section 861 regulations. This
interpretation is supported by the statute's use of the word
``directly'' and further supported by the structure of the statute.
Section 904(b)(5)(C) provides that any deduction that is not in the
first or second category is allocated and apportioned to foreign source
section 951A category income only if the deduction is directly
allocable to such income. This language indicates that ``directly
allocable'' deductions are a subset of the ``properly allocable''
deductions that, before the enactment of section 904(b)(5), would have
reduced foreign source section 951A category income.
The scope of deductions that may be properly allocable to foreign
source section 951A category income but do not have the requisite
degree of direct relationship to be considered directly allocable is
informed by the deductions that the statute, in section 904(b)(5)(B),
disregards in determining foreign source section 951A category income
for purposes of applying section 904(a). Both interest expense and R&E
expenditures are typically apportioned among statutory and residual
groupings by use of proxies. Section 1.861-9T generally requires
taxpayers to apportion interest expense based on the relative value of
assets within statutory and residual groupings. See also section
864(e)(2). Section 1.861-17 requires that all or, where the exclusive
apportionment rule of Sec. 1.861-17(c) applies, a portion of R&E
expenditures be apportioned based on the relative amount of gross
receipts within statutory and residual groupings. This type of
apportionment by proxy does not reflect the type of direct link between
a deduction and foreign source section 951A category income required
for a deduction to be ``directly allocable'' to such income.
Accordingly, the proposed regulations would first allocate and
apportion deductions to foreign source section 951A category income
without regard to section 904(b)(5) and then reallocate to U.S. source
income those deductions that are not directly allocable. Under the
proposed regulations, a deduction is not directly allocable if it is of
a type that, under the applicable rules for allocating and apportioning
deductions (without regard to section 904(b)(5)), is subject to
apportionment based on the relative value of assets or amounts of U.S.
gross income (including modified gross income). Proposed Sec.
1.904(b)-4(b)(2)(i). The relevant inquiry is not how a particular item
of deduction is in fact apportioned, but rather whether the item of
deduction is of a type that may in some cases be apportioned based on
the relative value of assets or amounts of U.S. gross income.
To provide clarity to taxpayers, proposed Sec. 1.904(b)-
4(b)(2)(ii) would specify certain deductions that are not directly
allocable under this definition and certain deductions that are
directly allocable under this definition. Stewardship expenses, for
example, would not be directly allocable to foreign source section 951A
category income because stewardship expenses are a type of deduction
that is apportioned based on the relative values of entities in the
statutory and residual groupings. See Sec. 1.861-8(e)(4)(ii)(C). Legal
expenses also would not be directly allocable to foreign source section
951A category income. See Sec. 1.861-8(e)(5).
On the other hand, foreign source section 986(c) loss that is
assigned to the separate category described in section 904(d)(1)(A)
(section 951A category) would be directly allocable to foreign source
section 951A category income. Section 986(c) loss is not a type of
deduction that is subject to apportionment based on the relative value
of assets or amounts of gross income. Rather, section 986(c) loss is
determined separately with respect to PTEP in each separate category.
Any section 986(c) loss is assigned to the separate category of the
distributed PTEP and has the same source as the associated income
inclusion. See Sec. 1.904-4(p) and section 986(c).
Comments are requested on whether further guidance is needed on the
application of section 904(b)(5) to other deductions.
5. Net Operating Loss Carryovers and Deductions
a. Application of Section 904(b)(5) in a Taxable Year in Which an NOL
Arises
Proposed Sec. 1.861-8(e)(8)(i) would provide that, unlike the
other adjustments in section 904(b), section 904(b)(5) is taken into
account in determining the SLL and U.S. source loss components of an
NOL. Otherwise, the portion of an NOL that is attributable to a
deduction that would be allocated or apportioned to foreign source
section 951A category income but for section 904(b)(5) could create an
SLL with respect to the section 951A category that is carried over to
reduce foreign source section 951A category income in a different
taxable year. The Treasury Department and the IRS are of the view that
this would be contrary to the instruction of section 904(b)(5).
Proposed Sec. 1.861-8(e)(8)(i) would continue to provide that
section 904(b)(2) and (4) are disregarded when determining the source
and separate category components of an NOL. The different treatment of
the adjustments under section 904(b)(2) and (4) and the adjustment
under section 904(b)(5) reflects the fact that, unlike section
904(b)(5), section 904(b)(2) and (4) adjust amounts of deductions and
affect worldwide taxable income for purposes of the foreign tax credit
limitation.
The proposed regulations would also amend Sec. 1.904(b)-3(d)(2) to
clarify that, when determining the components of an NOL, the rules in
section 904(f) and (g) are applied without taking into account the
adjustments under section 904(b)(4).
b. Application of Section 904(b)(5) in a Taxable Year in Which an NOL
Carryover Is Deducted
In the taxable year in which a taxpayer deducts an NOL carryover,
section 904(b)(5) and the rules for allocating and apportioning
deductions apply to determine the U.S. and foreign source taxable
income in separate categories before determining the NOL components to
be carried over and
[[Page 57837]]
combined with the U.S. and foreign source taxable income in the
separate categories under Sec. 1.904(g)-3(b). Section 904(b)(5)
applies before determining the NOL components to be carried over
because Sec. 1.904(g)-3 applies after deductions for the current
taxable year (other than the NOL deduction) have been allocated and
apportioned among the statutory and residual groupings before
determining the amounts of the NOL components to be carried over.
c. Treatment of NOLs as Directly Allocable Deductions
The proposed regulations would provide that an NOL deduction under
section 172 that is allocated and apportioned to foreign source section
951A category income under Sec. 1.861-8(e)(8) is directly allocable to
foreign source section 951A category income. See proposed Sec.
1.904(b)-4(b)(2)(ii)(B). This approach reflects the fact that NOL
deductions are not subject to apportionment based on the relative value
of assets or amounts of U.S. gross income. See Sec. 1.861-8(e)(8).
Moreover, for NOLs that arise after the applicability date of section
904(b)(5), the component of an NOL that is assigned to foreign source
section 951A category income under proposed Sec. 1.861-8(e)(8)(i) will
already exclude amounts that are not allocated or apportioned to
foreign source section 951A category income by reason of section
904(b)(5). Accordingly, treating that component of those NOLs as
directly allocable to foreign source section 951A category income
preserves the same outcome that would have occurred if the deductions
had reduced income in the taxable year in which they were incurred.
B. Reallocation of Deductions to U.S. Source Income
1. Deductions That Are Reallocated
Section 904(b)(5)(B) and (C) identify deductions that are not
allocated to foreign source section 951A category income for purposes
of section 904(a): interest expense, R&E expenditures, and deductions
that are not ``directly allocable'' to foreign source section 951A
category income (collectively, excluded deductions). The second
sentence of section 904(b)(5) provides that, to the extent an amount of
the excluded deductions would have been allocated or apportioned to
foreign source section 951A category income but for section
904(b)(5)(B) and (C), that amount of the excluded deductions is
allocated to U.S. source income (reallocated deductions).
The proposed regulations would determine the reallocated deductions
by first allocating and apportioning deductions to foreign source
section 951A category income using existing rules for allocating and
apportioning deductions. This preliminary allocation and apportionment
is performed without regard to section 904(b)(5) and is performed for
purposes of determining the amount of reallocated deductions. Only
deductions that are allocated and apportioned to foreign source section
951A category income under this preliminary step may be reallocated to
U.S. source income as a result of the second sentence of section
904(b)(5). See proposed Sec. 1.904(b)-4(c).
This approach produces different outcomes as applied to the
different categories of excluded deductions. A deduction that is not
directly allocable to foreign source section 951A income may, or may
not, have been allocated or apportioned to such income under existing
expense allocation and apportionment rules. Similarly, a deduction for
interest expense may be allocable to foreign source section 951A
category income under the section 861 regulations, including Sec. Sec.
1.861-9, 1.861-9T, 1.861-10, 1.861-10T, 1.861-11, and 1.861-11T. Under
Sec. 1.861-17, however, deductions for R&E expenditures cannot be
allocated to section 951A category income. In order to reallocate any
amount of R&E expenditures to U.S. source income under the second
sentence of section 904(b)(5), Sec. 1.861-17 would need to be revised
to allocate and apportion R&E expenditures to foreign source section
951A category income in the first instance. The preamble to the final
Sec. 1.861-17 regulations states that R&E expenditures cannot be
allocated to section 951A category income because R&E expenditures,
whether or not ultimately successful, are incurred to produce
intangible property and a taxpayer's section 951A inclusions do not
result from R&E expenditures incurred by the taxpayer. 85 FR 71,998,
72,005-06. The preamble states that, even if the section 951A inclusion
relates to a CFC licensee of the intangible property produced by the
R&E expenditures, the use of the intangible property by the CFC results
in income to the taxpayer from the arm's length price paid by the CFC
to the taxpayer (or, if the intangible property is transferred to the
CFC in an exchange described in section 351 or 361, from a section
367(d) inclusion) rather than from the section 951A inclusion. Id.
Accordingly, under Sec. 1.861-17, a deduction for R&E expenditures is
not allocable to section 951A category income. The Treasury Department
and the IRS are of the view that these conclusions remain correct after
the enactment of section 904(b)(5). Changing Sec. 1.861-17 to allocate
R&E expenditures to section 951A category income would require a theory
for how R&E expenditures by a U.S. shareholder supports the production
of section 951A category income, such as by identifying some portion of
a CFC's tested income that is attributable to the use of the intangible
property (which is owned by the U.S. shareholder and was produced as a
result of the U.S. shareholder's R&E expenditures) for which the U.S.
shareholder is not required to be fully compensated under section 482
principles.
Comments are requested on this proposed approach of applying
existing rules for allocating and apportioning deductions to section
951A category income in the context of determining the deductions that
are reallocated to U.S. source income.
2. Effect of Reallocated Deductions
Proposed Sec. 1.904(b)-4(c) would provide that reallocated
deductions are allocated to U.S. source income and confirms that this
reallocation occurs for all purposes of section 904 including when
applying rules, such as the section 861 regulations, when section 904
is the operative section. It follows that a taxpayer's aggregate
foreign source taxable income will not exceed the taxpayer's entire
taxable income, which is a requirement of section 904(a).
Likewise, because reallocated deductions are treated as allocated
to U.S. source income for purposes of section 904(g)(2)(B), reallocated
deductions may cause the taxpayer to sustain, or increase the amount
of, a domestic loss within the meaning of section 904(g)(2)(B) that is
taken into account in determining the taxpayer's ODL under section
904(g)(2)(A). If reallocated deductions were not allocated to U.S.
source income for purposes of section 904(g)(2)(B), then the domestic
loss, and therefore the ODL, would not reflect the amount by which the
taxpayer's aggregate foreign source taxable income was reduced as a
result of the U.S. source loss. In that case, the taxpayer would be
unable to benefit from the full amount of recapture in subsequent years
under section 904(g).
Similarly, because the reallocated deductions reduce U.S. source
income, the reallocated deductions are not treated as ``properly
apportioned and allocated'' to foreign source income in determining any
OFL under section
[[Page 57838]]
904(f)(2). Reallocated deductions are treated as reducing U.S. source
income, and not foreign source section 951A category income, for
purposes of determining the amount of SLL or SLI in the section 951A
category. Accordingly, the reallocation may affect the recapture of
foreign source income in a separate category as U.S. source income or
as foreign source income in a different separate category in subsequent
years.
The Treasury Department and the IRS are studying whether any
further changes to the regulations under section 904(f) and (g) are
needed to reflect the approach described above.
III. Applicability Dates and Reliance
Under section 7805(b)(2) of the Code, the proposed regulations
regarding section 250(b)(3) are proposed to apply to taxable years
beginning after December 31, 2025. Proposed Sec. 1.250-1(b). A
taxpayer may rely on the proposed regulations regarding section
250(b)(3) for taxable years beginning after December 31, 2025 and
before the date the proposed regulations are published as final
regulations in the Federal Register, provided the taxpayer follows the
proposed regulations regarding section 250(b)(3) in their entirety.
Under section 7805(b)(2) of the Code, proposed Sec. 1.904(b)-4 and
the proposed amendment to Sec. 1.861-8(e)(8) would apply to taxable
years beginning after December 31, 2025. Proposed Sec. 1.904(b)-4(e).
A taxpayer may rely on those proposed regulations for taxable years
beginning after December 31, 2025 and before the date those proposed
regulations are published as final regulations in the Federal Register,
provided the taxpayer follows them in their entirety.
Special Analyses
I. Regulatory Planning and Review--Economic Analysis
The Office of Management and Budget's Office of Information and
Regulatory Analysis has determined that this proposed regulation is not
significant and is not subject to review under section 6(b) of
Executive Order 12866. Therefore, a regulatory impact assessment is not
required.
II. Paperwork Reduction Act
The Paperwork Reduction Act of 1995 (44 U.S.C. 3501-3520) (PRA)
generally requires that a Federal agency obtain the approval of the
Office of Management and Budget before collecting information from the
public, whether such collection of information is mandatory, voluntary,
or required to obtain or retain a benefit. An agency may not conduct or
sponsor, and a person is not required to respond to, a collection of
information unless it displays a valid control number assigned by the
Office of Management and Budget.
The collection of information in these proposed regulations
includes recordkeeping requirements that are necessary for the
allocation and apportionment of deductions to net CFC tested income and
to deduction eligible income. These recordkeeping requirements are
considered general tax records under Sec. 1.6001-1. For PRA purposes,
general tax records are already approved by OMB control number 1545-
0047 for tax-exempt filers, 1545-0074 for individual filers, 1545-0092
for trust and estate filers, and 1545-0123 for business filers.
III. Regulatory Flexibility Act
When an agency issues a rulemaking proposal, the Regulatory
Flexibility Act (5 U.S.C. chapter 6) (RFA) requires the agency to
prepare and make available for public comment an initial regulatory
flexibility analysis that will describe the impact of the proposed rule
on small entities. See 5 U.S.C. 603(a). Section 605 of the RFA provides
an exception to this requirement if the agency certifies that the
proposed rulemaking will not have a substantial economic impact on a
substantial number of small entities. A small entity is defined as a
small business, small nonprofit organization, or small governmental
jurisdiction. See 5 U.S.C. 601(3) through (6).
The proposed regulations will not have a significant economic
impact on a substantial number of small entities within the meaning of
section 601(3) through (6) of the RFA. The proposed regulations provide
guidance on issues regarding sections 250(b)(3) and 904(b)(5) but do
not change the economic impact of the existing regulations or impose
any new costs on small entities. The proposed regulations do not impose
any economic impact on taxpayers beyond what is imposed by the statute
itself. Any economic impact on taxpayers flows directly from the
underlying statute. It is hereby certified that this regulation will
not have a significant economic impact on a substantial number of small
entities.
The Treasury Department and the IRS request comments from the
public with respect to this certification.
IV. Submission to the Small Business Administration
Pursuant to section 7805(f) of the Code, the proposed regulations
have been submitted to the Chief Counsel for Advocacy of the Small
Business Administration for comment on their impact on small
businesses.
V. Unfunded Mandates Reform Act
Section 202 of the Unfunded Mandates Reform Act of 1995 requires
that agencies assess anticipated costs and benefits and take certain
other actions before issuing a final rule that includes any Federal
mandate that may result in expenditures in any one year by a State,
local, or Tribal government, in the aggregate, or by the private
sector, of $100 million in 1995 dollars, updated annually for
inflation. The proposed regulations do not include any Federal mandate
that may result in expenditures by State, local, or Tribal governments,
or by the private sector in excess of that threshold.
VI. Executive Order 13132: Federalism
Executive Order 13132 (Federalism) prohibits an agency from
publishing any rule that has federalism implications if the rule either
imposes substantial, direct compliance costs on State and local
governments, and is not required by statute, or preempts State law,
unless the agency meets the consultation and funding requirements of
section 6 of the Executive order. The proposed regulations do not have
federalism implications, do not impose substantial direct compliance
costs on State and local governments, and do not preempt State law
within the meaning of the Executive order.
Comments and Requests for a Public Hearing
Consideration will be given to comments that are submitted timely
to the IRS as prescribed in the preamble under the ADDRESSES section.
In addition to the comments specifically requested in the Explanation
of Provisions, the Treasury Department and the IRS request comments on
all aspects of the proposed regulations. Any comments submitted will be
made available at <a href="http://www.regulations.gov">www.regulations.gov</a> or upon request.
A public hearing will be scheduled if requested in writing by any
person who timely submits written comments. Requests for a public
hearing are encouraged to be made electronically. If a public hearing
is scheduled, notice of the date and time for the public hearing will
be published in the Federal Register.
Statement of Availability of IRS Documents
Any IRS Revenue Procedures, Revenue Rulings, Notices, or other
[[Page 57839]]
guidance cited in this document are published in the Internal Revenue
Bulletin (or Cumulative Bulletin) and are available from the
Superintendent of Documents, U.S. Government Publishing Office,
Washington, DC 20402, or by visiting the IRS website at <a href="http://www.irs.gov">www.irs.gov</a>.
Drafting Information
The principal authors of these regulations are John Lee and Alex
Kaplan, Office of Associate Chief Counsel (International). However,
other personnel from the IRS and the Treasury Department participated
in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, the Treasury Department and the IRS propose to amend
26 CFR part 1 as follows:
PART 1--INCOME TAXES
0
Paragraph 1. The authority citation for part 1 continues to read as
follows:
Authority: 26 U.S.C. 7805 * * *
* * * * *
0
Par. 2. Section 1.250-1 is amended by adding two sentences at the end
of paragraph (b) to read as follows:
Sec. 1.250-1 Introduction.
* * * * *
(b) * * * Section 1.250(b)-1(a) and (d)(2) apply to taxable years
beginning after December 31, 2025. For taxable years beginning on or
after January 1, 2021, and beginning before January 1, 2026, see Sec.
1.250(b)-1(a) and (d)(2) as contained in 26 CFR part 1 revised as of
April 1, 2026.
* * * * *
0
Par. 3. Section 1.250(b)-1 is amended by:
0
1. Revising the fourth sentence of paragraph (a);
0
2. Revising the first and second sentences of paragraph (d)(2)(i); and
0
3. Revising paragraph (d)(2)(ii).
The revisions read as follows:
Sec. 1.250(b)-1 Computation of foreign-derived intangible income
(FDII).
(a) * * * Paragraph (d) of this section provides rules for
computing gross income and allocating and apportioning expenses and
other deductions (referred to collectively in this section as
``deductions''), for purposes of computing deduction eligible income
(DEI) and foreign-derived deduction eligible income. * * *
* * * * *
(d) * * *
(2) * * *
(i) * * * For purposes of determining a domestic corporation's
deductions that are properly allocable to gross DEI and gross FDDEI,
the corporation's deductions are allocated and apportioned to gross DEI
and gross FDDEI under the section 861 regulations (as defined in Sec.
1.861-8(a)) by treating section 250(b) as an operative section
described in Sec. 1.861-8(f). In allocating and apportioning
deductions under the section 861 regulations, gross FDDEI and gross
RDEI are treated as separate statutory groupings. * * *
(ii) Determination of deductions to allocate. For purposes of
determining the deductions of a domestic corporation for a taxable year
properly allocable to gross DEI and gross FDDEI, the deductions of the
corporation for the taxable year are determined without regard to
interest expense, research or experimental expenditures, and sections
170(b)(2), 172, 246(b), and 250. For purposes of this paragraph
(d)(2)(ii), interest expense means any expense that is deductible under
section 163 (including original issue discount) and research or
experimental expenditures means any expenditure that a taxpayer deducts
(including as an amortization deduction) in a taxable year under
section 174, 174A, or 59(e)(2)(B).
* * * * *
0
Par. 4. Section 1.861-8 is amended by:
0
1. Revising the fourth sentence of paragraph (b)(1);
0
2. Revising the second sentence of paragraph (e)(8)(i); and
0
3. Adding paragraph (h)(5).
The revisions read as follows:
Sec. 1.861-8 Computation of taxable income from sources within the
United States and from other sources and activities.
* * * * *
(b) * * *
(1) * * * Allocation is accomplished by determining, with respect
to each deduction, the class of gross income to which the deduction is
definitely related and then allocating the deduction to such class of
gross income (without regard to the taxable year in which such gross
income is received or accrued or is expected to be received or
accrued). * * *
* * * * *
(e) * * *
(8) * * *
(i) * * * For example, for purposes of applying this paragraph
(e)(8)(i) with respect to section 904 as the operative section, the
source and separate category components of a net operating loss are
determined by reference to the amounts of separate limitation loss and
U.S. source loss (determined without regard to adjustments required
under section 904(b), other than section 904(b)(5)) that are not
allocated to reduce U.S. source income or income in other separate
categories under the rules of sections 904(f) and 904(g) for the
taxable year in which the net operating loss arose. * * *
* * * * *
(h) * * *
(5) Paragraph (e)(8)(i) of this section applies to taxable years
beginning after December 31, 2025. For taxable years that both begin
after December 31, 2017, and end on or after December 2, 2018, and also
begin on or before December 31, 2025, see Sec. 1.861-8(e)(8)(i) as
contained in 26 CFR part 1 revised as of April 1, 2026.
0
Par. 5. Section 1.904(b)-3 is amended by revising paragraph (d)(2) to
read as follows:
* * * * *
(d) * * *
(2) Net operating losses. If the taxpayer has a net operating loss
in the current taxable year, then solely for purposes of determining
the source and separate category of the net operating loss, the overall
foreign loss rules in section 904(f) and the overall domestic loss
rules in section 904(g) are applied without taking into account the
adjustments required under section 904(b)(4) and this section.
* * * * *
0
Par. 6. Add Sec. 1.904(b)-4 to read as follows:
Sec. 1.904(b)-4 Deductions treated as allocable to foreign source
section 951A category income.
(a) In general. Section 904(b)(5) provides special rules for
purposes of section 904 for allocating and apportioning deductions to
foreign source income described in section 904(d)(1)(A) (foreign source
section 951A category income) and for reallocating certain deductions
to U.S. source income. Paragraph (b) of this section provides rules for
determining deductions allocated and apportioned to foreign source
section 951A category income, including deductions that are directly
allocable to such income. Paragraph (c) of this section provides rules
for reallocating to U.S. source income deductions that would have been
allocated and apportioned to foreign source section 951A category
income but for section 904(b)(5). Paragraph (d) of this section
contains examples illustrating the rules set forth in this section.
Paragraph (e) of this section provides the applicability date of this
section.
[[Page 57840]]
(b) Deductions allocated and apportioned to foreign source section
951A category income--(1) In general. For purposes of section 904,
foreign source section 951A category income is determined by allocating
and apportioning to such income only those deductions that are--
(i) Allowed under section 250(a)(1)(B) to the extent allocated and
apportioned to foreign source section 951A category income in
accordance with Sec. 1.861-8(e)(14);
(ii) Allowed under section 164(a)(3) for State and local income
taxes to the extent allocated and apportioned to foreign source section
951A category income in accordance with Sec. 1.861-8(e)(6); or
(iii) Directly allocable to foreign source section 951A category
income under paragraph (b)(2) of this section.
(2) Directly allocable--(i) In general. A deduction (other than a
deduction described in paragraph (b)(1)(i), (ii), or (b)(3) of this
section) that, under the applicable rules for allocating and
apportioning deductions (without regard to section 904(b)(5)), is
allocated and apportioned to foreign source section 951A category
income is directly allocable to foreign source section 951A category
income only if the deduction is of a type that is not subject to
apportionment based on the relative value of assets or amounts of U.S.
gross income (including modified gross income). It is not relevant how
a particular item of deduction is in fact apportioned, but instead
whether the item of deduction is of a type that could be apportioned
based on the relative value of assets or amounts of U.S. gross income.
(ii) Application--(A) Non-directly allocable deductions. For
purposes of this paragraph (b)(2), deductions that are not directly
allocable to foreign source section 951A category income include
deductions for 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).
(B) Directly allocable deductions. For purposes of this paragraph
(b)(2), deductions that are directly allocable to foreign source
section 951A category income, if allocated and apportioned to foreign
source section 951A category income under the applicable rules for
allocating and apportioning deductions (without regard to section
904(b)(5)), include foreign currency loss recognized under section
986(c) with respect to a distribution of previously taxed earnings and
profits (as described in section 959 or 1293(c)) (see Sec. 1.904-4(p))
and net operating loss deductions (see Sec. 1.861-8(e)(8)).
(3) Non-allocable deductions. No amount of interest expense or
research and experimental expenditures is allocated or apportioned to
foreign source section 951A category income for purposes of section
904. For purposes of this paragraph (b)(3), interest expense means any
expense that is deductible under section 163 (including original issue
discount) and research and experimental expenditures means any
expenditure that a taxpayer deducts (including as an amortization
deduction) in a taxable year under section 174, 174A, or 59(e)(2)(B).
(c) Reallocation to U.S. source income. Any deduction that, but for
paragraph (b) of this section, would have been allocated or apportioned
to foreign source section 951A category income for purposes of section
904 is instead allocated to U.S. source income for all purposes of
section 904 (reallocated deduction). Thus, for example, a reallocated
deduction is allocated to U.S. source income for purposes of
determining a loss from sources within the United States under section
904(f)(5)(D) and a domestic loss under section 904(g)(2)(B). Similarly,
a reallocated deduction is treated as allocated or apportioned to U.S.
source income for purposes of applying other rules where section 904 is
the operative section, for example, in assigning interest income from a
downstream partnership loan under Sec. 1.861-9(e)(8) or upstream
partnership loan under Sec. 1.861-9(e)(9).
(d) Examples. The following examples illustrate the application of
this section.
(1) Example 1: Section 986(c) loss--(i) Facts. USP is a domestic
corporation that uses the U.S. dollar as its functional currency. USP
owns all the shares of the only class of stock of CFC, a controlled
foreign corporation that uses the British pound ([pound]) as its
functional currency. CFC makes a [pound]300x distribution of money with
respect to its stock. The distribution is a dividend (as defined in
section 316), determined without regard to section 959(d). All of CFC's
previously taxed earnings and profits (PTEP) result from USP's income
inclusions under sections 951(a)(1)(A) and 951A in the taxable year of
the distribution. The income inclusion under section 951(a)(1)(A) is
general category income. The table below shows CFC's PTEP immediately
before the distribution (which reflects adjustments for income
inclusions under sections 951(a)(1)(A) and 951A in the taxable year of
the distribution). The spot rate on the date of the distribution is $1
= [pound]0.8. The average exchange rate in the year of the inclusion is
$1 = [pound]0.75.
Table 1 to Paragraph (d)(1)(i) of This Section
----------------------------------------------------------------------------------------------------------------
PTEP from section 951(a)(1)(A) inclusion (section 951(a)(1)(A) PTEP from section 951A inclusion (section 951A
PTEP) PTEP)
----------------------------------------------------------------------------------------------------------------
Foreign source U.S. source Foreign source U.S. source
----------------------------------------------------------------------------------------------------------------
[pound]0............................. [pound]100x............ [pound]200x............ [pound]200x
----------------------------------------------------------------------------------------------------------------
(ii) Analysis. The distribution is made pro rata from section
951(a)(1)(A) PTEP and section 951A PTEP. Therefore, [pound]240x
([pound]300x x [pound]400x/[pound]500x) is assigned to section 951A
PTEP of which [pound]120x is foreign source ([pound]240x x [pound]200x/
[pound]400x). Under section 986(c), USP is required to recognize
foreign currency gain or loss on the distribution of PTEP. Foreign
currency gain or loss recognized under section 986(c) is assigned to
the separate category or categories of the PTEP from which the
distribution is made. Sec. 1.904-4(p). The section 986(c) gain or loss
is from the same source as the associated income inclusion. Section
986(c)(1). USP's section 986(c) loss with respect to the distribution
of foreign source section 951A PTEP is determined by translating the
PTEP into U.S. dollars using the spot rate on the date of the
distribution ([pound]120x x $1/[pound]0.8 = $150x) and then subtracting
from that U.S. dollar amount the dollar basis of the PTEP ([pound]120x
x $1/[pound]0.75 = $160x). Thus, USP's section 986(c) loss with respect
to the distribution of foreign source section 951A PTEP is $10x ($150x-
$160x). The section 986(c) loss of $10x is directly allocable to
foreign source section 951A category income.
(2) Example 2: Reallocation of Deductions--(i) Facts. USP is a
domestic corporation that owns all the stock of a controlled foreign
corporation. USP chooses to claim
[[Page 57841]]
foreign tax credits for the taxable year and all prior taxable years.
USP has no loss carried back to the taxable year from a subsequent
taxable year. USP's deductions that would have been allocated and
apportioned to foreign source section 951A category income but for
section 904(b)(5) consist of interest expense and supportive
deductions. After allocation and apportionment of all deductions except
interest expense and supportive deductions, USP has $100x of U.S.
source income, $60x of foreign source section 951A category income, and
$50x of foreign source general category income (within the meaning of
section 904(d)(1)(D)). USP has $100x of interest expense, $10x of which
is allocated and apportioned to foreign source general category income
and, before taking into account section 904(b)(5), $50x of which would
be allocated and apportioned to U.S. source income and $40x of which
would be allocated and apportioned to foreign source section 951A
category income. USP also has $50x of supportive deductions, $20x of
which is allocated and apportioned to foreign source general category
income and, before taking into account section 904(b)(5), $20x of which
would be allocated and apportioned to U.S. source income and $10x of
which would be allocated and apportioned to foreign source section 951A
category income.
(ii) Analysis. But for section 904(b)(5), USP would have U.S.
source income of $30x ($100x-$50x-$20x), foreign source section 951A
category income of $10x ($60x-$40x-$10x), and foreign source general
category income of $20x ($50x-$10x-$20x). The $40x of interest expense
and $10x of supportive deductions which, but for section 904(b)(5),
would have been allocated and apportioned to foreign source section
951A category income are reallocated deductions. Under paragraph (c) of
this section, the reallocated deductions are allocated to U.S. source
income. After the allocation of reallocated deductions, USP has a $20x
loss from sources within the United States within the meaning of
section 904(f)(5)(D) ($30x-$50x), foreign source section 951A category
income of $60x, and foreign source general category income of $20x. The
$20x loss is a domestic loss within the meaning of section
904(g)(2)(B). Under section 904(f)(5)(D), the $20x loss reduces USP's
foreign source section 951A category income and foreign source general
category income on a pro rata basis. As a result, USP's foreign source
section 951A category income is $45x ($60x-$20x x $60x/$80x) and USP's
foreign source general category income is $15x ($20x-$20x x $20x/$80x).
The $20x domestic loss also results in an overall domestic loss within
the meaning of section 904(g)(2)(A) (ODL) of $20x. In later years, the
ODL causes USP's U.S. source income to be treated as foreign source
income in accordance with section 904(g) and the regulations
thereunder.
(3) Example 3: Reallocation of Deductions--(i) Facts. USP is a
domestic corporation that owns all the stock of a controlled foreign
corporation. USP chooses to claim foreign tax credits for the taxable
year. After allocation and apportionment of all deductions except
reallocated deductions, USP has $500x of U.S. source income and $100x
of foreign source section 951A category income. USP has a reallocated
deduction of $400x that would have been allocated to foreign source
section 951A category income but for section 904(b)(5).
(ii) Analysis. But for section 904(b)(5)(B) and (C), the
reallocated deduction of $400x would have created a separate limitation
loss of $300x with respect to the income category described in section
904(d)(1)(A) (section 951A category). Under the rules in paragraph (c)
of this section, all $400x is allocated to U.S. source income, reducing
U.S. source income to $100x. USP has no separate limitation loss with
respect to the section 951A category.
(4) Example 4: Research and Experimental Expenditures--(i) Facts.
USP is a domestic corporation that owns all the stock of a controlled
foreign corporation. USP deducted research and experimental
expenditures under section 174A for the taxable year. Before taking
into account section 904(b)(5), all of the research and experimental
expenditures would be allocated to foreign source income.
(ii) Analysis. No amount of the research and experimental
expenditures is a reallocated deduction because, before taking into
account section 904(b)(5), none of the research and experimental
expenditures would have been allocated or apportioned to foreign source
section 951A category income. See Sec. 1.861-17(b)(2). Therefore, none
of the research and experimental expenditures is allocated to U.S.
source income under section 904(b)(5).
(e) Applicability date. This section applies to taxable years
beginning after December 31, 2025.
0
Par. 7. Section 1.904(g)-3(c) is amended by revising the section
heading to read as follows:
Step Two: Section 904(b)(2) and (4) adjustments.
* * * * *
Frank J. Bisignano,
Chief Executive Officer.
[FR Doc. 2026-18645 Filed 9-10-26; 8:45 am]
BILLING CODE 4830-01-P
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</html>Indexed from Federal Register on September 11, 2026.
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