Section 898(c) Transition Rule for Allocating Foreign Taxes and Section 960(d)(4) Foreign Tax Credit Disallowance, REG-115145-25, July 31, 2026

The Department of the Treasury and the Internal Revenue Service have issued proposed regulations under REG-115145-25 (RIN 1545-BR76) addressing two critical statutory changes introduced by the One, Big, Beautiful Bill Act (OBBBA), Public Law 119-21. The proposed regulations provide essential transition guidance for specified foreign corporations (SFCs) forced to alter their taxable years due to the repeal of the one-month deferral election under Section 898(c)(2), and implement the ten percent foreign tax credit (FTC) disallowance on distributions of previously taxed earnings and profits (PTEP) under Section 960(d)(4). This article explores the statutory impetuses, the specific regulatory modifications, the IRS’s legal justifications, and the transitional reliance rules available to practitioners.

Statutory Background and Reasons for Regulatory Action

Prior to the enactment of the OBBBA, Section 898(c)(1) generally required a specified foreign corporation to adopt the same taxable year as its majority U.S. shareholder. However, Section 898(c)(2) historically permitted an SFC to elect a taxable year beginning one month earlier than the majority U.S. shareholder year (the “one-month deferral election”), subject to the Secretary’s consent.

Section 70352 of the OBBBA repealed this one-month deferral election for taxable years of specified foreign corporations beginning after November 30, 2025. Under the transition rules of Section 70352(c) of the OBBBA, if a corporation was an SFC as of November 30, 2025, its first taxable year beginning after that date must end at the same time as its first required taxable year under Section 898(c)(1). Consequently, affected corporations that previously utilized the one-month deferral election are subject to a short, one-month taxable year (typically from December 1, 2025, to December 31, 2025) as their first required year.

To address the tax accounting mismatches resulting from this compressed short taxable year, Section 70352(c)(1)(C) of the OBBBA directs the Secretary to issue regulations or other guidance “allocating foreign taxes that are paid or accrued in such first taxable year and the succeeding taxable year among such taxable years in the manner the Secretary determines appropriate to carry out the purposes of this section”.

Simultaneously, the proposed regulations implement Section 960(d)(4), which was added to the Internal Revenue Code by Section 70312(b) of the OBBBA. Under Section 70312(a)(1) of the OBBBA, the deemed-paid credit percentage under Section 960(d)(1) for Global Intangible Low-Taxed Income (GILTI) inclusions was increased from 80 percent to 90 percent, thereby reducing the “haircut” on tested foreign income taxes from 20 percent to 10 percent. To align the treatment of subsequent distributions, Section 960(d)(4) disallows a foreign tax credit for 10 percent of foreign income taxes paid or accrued (or deemed paid under Section 960(b)(1)) with respect to a distribution of PTEP resulting from a GILTI (Section 951A) inclusion after June 28, 2025.

Proposed Section 1.898(c)-1: Foreign Tax Allocations for Transitioning SFCs

The core mechanism of proposed § 1.898(c)-1 is the allocation of “specified foreign income taxes” between an affected corporation’s short first required year and its succeeding taxable year.

The proposed regulations define a “specified foreign income tax” as “a foreign net income tax accrued without regard to this section by an affected corporation in its first required year for which the affected corporation is the section 901 taxpayer”. An “affected corporation” is defined as an SFC that “takes into account foreign income taxes under an accrual method of accounting and whose first taxable year beginning after November 30, 2025, ends pursuant to section 70352(c) of the OBBBA on the date prescribed by that section”.

In general, foreign net income taxes accrue on the final day of the foreign taxable year, which often remains a full 12-month period ending with or within the SFC’s short one-month U.S. tax year. Without an allocation rule, a full year’s worth of foreign net income tax would accrue in the one-month U.S. taxable year, while only one month of U.S. gross income would be recognized. The IRS noted that this mismatch:

“could result in the specified foreign corporation having a loss with respect to a particular income group for the first required year, resulting in foreign income taxes not being deemed paid by the affected corporation’s U.S. shareholders under section 960(a) or (d).”

To prevent this separation of income and tax, the proposed regulations generally exclude taxes that naturally align with income from the definition of “specified foreign income taxes.” Specifically, foreign withholding taxes are excluded because they “accrue close in time to the income to which [they relate]”. Similarly, cash-method SFCs are not “affected corporations” because they are “unlikely to make a single payment of foreign income tax in [their] first required year that would result in a loss with respect to a particular income group.”.

The Distributive Shares of Partnership CFTEs Election

By default, proposed § 1.898(c)-1(c)(2) excludes an affected corporation’s distributive share of partnership creditable foreign tax expenditures (CFTEs) from the definition of specified foreign income taxes. This prevents the separation of income and tax because the SFC partner will take into account both partnership income and partnership CFTEs at the same time at the end of the partnership’s taxable year under Section 706(a).

However, where a partnership itself is forced to change its taxable year under Section 706(b) because its SFC partner is transitioning taxable years under Section 70352 of the OBBBA, the partnership will also experience a short one-month taxable year. Under proposed § 1.898(c)-1(c)(2), taxpayers may elect to treat “all specified distributive shares of certain CFTEs of affected partnerships” as specified foreign income taxes eligible for allocation.

The Relevant Succeeding Year Taxes Election

While foreign taxes accrued in the succeeding taxable year are generally not allocated (due to administrative and compliance burdens), the IRS recognized that tax credit losses can occur if the SFC’s foreign taxable year does not align with its succeeding U.S. taxable year (e.g., a March 31 foreign year end and a December 31 U.S. year end). If the SFC earns different types of income in the succeeding year, the foreign tax accruing on March 31, 2026, could relate to passive or GILTI income from the 2025 short U.S. year, but cannot be credited in the 2026 U.S. year due to a lack of income in that specific category.

Accordingly, proposed § 1.898(c)-1(f) provides an irrevocable election to allocate “relevant succeeding year taxes” between the SFC’s first required year and its succeeding taxable year. A relevant succeeding year tax is a foreign net income tax accrued in the succeeding year for a foreign taxable year that “begins before the first day of the affected corporation’s succeeding taxable year”.

IRS Policy Analysis and Mandated Allocation Methodology

Rather than allowing taxpayers to use “any reasonable allocation method”, the proposed regulations require a single, prescriptive methodology to calculate the “allocation percentage”:

“Subject to the special rules... the amount of a specified foreign income tax assigned to each income group allocated to the first required year is the specified foreign income tax assigned to that income group multiplied by a fraction (the allocation percentage), the numerator of which is the portion of taxable income, as determined under foreign law, that is attributable to the first required year under the principles of § 1.1502-76(b), and the denominator of which is the total taxable income, as determined under foreign law, for the foreign taxable year with respect to which the specified foreign income tax is imposed.”

The IRS justified this strict mandate on several policy grounds:

It reduces the likelihood that foreign income taxes would not be deemed paid as a consequence of the repeal of Section 898(c)(2).
It leverages an existing, familiar methodology under Treasury Regulations (citing §§ 1.245A-5(e)(3)(i), 1.336-2(g)(3)(ii), 1.338-9(d), and 1.901-2(f)(5)).
It utilizes taxable income as determined under foreign law, an amount taxpayers are already required to compute under § 1.861-20.
It “better accommodate[s] affected corporations that may earn uneven amounts of income in the first required year, as compared to an allocation method that is based on a set ratio such as months or days.”
Formulating allocations to years preceding the first required year would violate the OBBBA statutory transition mandate.

Income Group Specific Allocation Election

Under the general rule, a single allocation percentage based on the SFC’s total foreign taxable income applies across all income groups. However, a transaction-heavy or uneven distribution of income (such as passive foreign personal holding company gain recognized solely within the short one-month year) could result in an allocation percentage that shifts substantial foreign taxes to the succeeding year where no corresponding category of income exists, causing a permanent loss of tax credits under Section 960(a).

To remedy this, proposed § 1.898(c)-1(e)(3) provides an election to apply an “income group specific allocation percentage.” Under this method, taxpayers apply the closing of the books method under § 1.1502-76(b)(2)(i) separately to the foreign law items assigned to each income group under § 1.861-20. Notably, this income group specific method is mandatory if the taxpayer elects to allocate relevant succeeding year taxes under proposed § 1.898(c)-1(f).

Election to Forgo Allocation

To alleviate compliance burdens for taxpayers with minor foreign tax exposure or those who do not face credit limitation issues, proposed § 1.898(c)-1(e)(4) provides an “election to not allocate” specified foreign income taxes. If this election is made, all specified foreign income taxes are taken into account in the first required year under general tax accounting rules, and the taxpayer is barred from allocating succeeding year taxes under paragraph (f).

Proposed Section 1.960-3: Implementing the Section 960(d)(4) Disallowance

To implement the ten percent foreign tax credit disallowance on distributions of post-GILTI PTEP under Section 960(d)(4), the proposed regulations modify the accounting and tracking of PTEP groups.

Under current § 1.960-3(c)(2), a controlled foreign corporation maintains ten distinct PTEP groups within an annual PTEP account. The proposed regulations divide the “section 951A PTEP” and “reclassified section 951A PTEP” groups into pre-and-post-transition groups based on whether the underlying U.S. shareholder’s inclusion occurred in a taxable year ending on or before June 28, 2025, or ending after June 28, 2025:

Pre-06/29/25 section 951A PTEP (proposed § 1.960-3(c)(2)(x)) and Reclassified pre-06/29/25 section 951A PTEP (proposed § 1.960-3(c)(2)(v)).
Post-06/28/25 section 951A PTEP (proposed § 1.960-3(c)(2)(ix)) and Reclassified post-06/28/25 section 951A PTEP (proposed § 1.960-3(c)(2)(iv)).

Under proposed § 1.960-3(b)(6)(i), no credit under Section 901 is allowed for ten percent of the foreign income taxes paid or accrued, or deemed paid under Section 960(b)(1), that are attributable to a distribution of either “post-06/28/25 section 951A PTEP” or “reclassified post-06/28/25 section 951A PTEP”.

Practitioners must apply § 1.861-20 to attribute foreign withholding taxes to these specific PTEP groups. Proposed § 1.960-3(e)(3) provides a clear mathematical illustration of these mechanics:

Consider USP, a domestic calendar-year corporation that owns CFC1. CFC1 earns $100x of tested income in 2024 and 2025, resulting in GILTI inclusions of $100x to USP in each year. On January 1, 2026, CFC1 distributes $150x to USP, and Country X imposes a $30x withholding tax.

PTEP Accounts: The 2024 inclusion of $100x constitutes pre-06/29/25 section 951A PTEP. The 2025 inclusion of $100x constitutes post-06/28/25 section 951A PTEP.
Distribution Sourcing: Under Section 959(c) and § 1.959-3(b), the $150x distribution is sourced as $100x from the 2025 post-06/28/25 PTEP group (last-in, first-out ordering) and $50x from the 2024 pre-06/29/25 PTEP group.
Withholding Tax Attribution: Under § 1.861-20, the $30x withholding tax is allocated proportionally: $20x ($30x × $100x/$150x) is allocated to the post-06/28/25 statutory grouping, and $10x ($30x × $50x/$150x) is allocated to the pre-06/29/25 residual grouping.
Credit Disallowance: Under Section 960(d)(4) and proposed § 1.960-3(b)(6)(i)(A), ten percent of the $20x withholding tax allocated to the post-06/28/25 grouping is disallowed ($2x credit disallowance). The $10x withholding tax allocated to the pre-06/29/25 group is fully creditable, subject to general Section 904 limitations.

Proposed § 1.960-3(e)(4) details similar mechanics for tiered CFC distributions where deemed paid taxes under Section 960(b)(1) are reduced by ten percent when distributed up a chain of CFCs to a domestic shareholder.

Specific Revisions, Additions, and Deletions to Current Regulations

The notice of proposed rulemaking implements these changes through targeted amendments to 26 CFR Part 1. Practitioners should note that no current regulations are deleted in their entirety; instead, existing regulations are modified via paragraph revisions or sentence additions, and one brand-new section is added.

Section 1.163(j)-7 (Business Interest Limitation): Amended by revising paragraph (k)(29)(i)(B) to remove references to the one-month deferral election under Section 898(c)(2) and align with the majority shareholder required year.
Section 1.441-1 (Computation of Taxable Income Period): Amended by revising paragraph (b)(2)(ii)(C) to strike the reference allowing SFCs to make the one-month deferral election, maintaining only the 52-53-week taxable year election.
Section 1.441-2 (52-53-Week Taxable Year): Amended by revising the fourth sentence of paragraph (b)(1)(i) to strike the reference to the one-month deferral election.
Section 1.442-2 (Change in accounting period): Conforming amendments are made to paragraph (b)(1)(i) of this section.
Section 1.901-1 (Allowance of Foreign Tax Credit): Amended by revising paragraph (b) to add "960(d)(4)" to the list of Code sections that reduce, defer, or limit allowable foreign tax credits.
Section 1.960-3 (Taxes Deemed Paid under Section 960(b)): Heavily revised, including the section heading, paragraph (a), paragraph (b)(1), and paragraph (c)(2) to implement the 10 percent credit disallowance, separate pre-and-post transition Section 951A PTEP groups, and add paragraph (b)(6) containing the primary disallowance rules.
Section 1.960-7 (Applicability Dates): Amended by revising paragraph (a) and adding paragraph (c) to coordinate the effective dates for the Section 960(d)(4) rules.
Section 1.987-11 (Suspended Section 987 Loss): Amended by revising paragraph (c)(3)(ii) to evaluate suspended Section 987 losses of a CFC by reference to the owner’s required year described in Section 898(c)(1).
Addition of Section 1.898(c)-1: Added as a brand-new regulatory section under the undesignated center heading "Miscellaneous Provisions" to govern the allocation of foreign taxes of SFCs affected by the OBBBA year-end transition.

Applicability Dates and Taxpayer Reliance Rules

The Treasury Department and the IRS have stated that they expect to finalize these proposed regulations by January 4, 2027. Under the retroactive authority of Section 7805(b)(2), the proposed regulations establish the following applicability and reliance rules:

Section 898(c) Rules

Proposed § 1.898(c)-1 is proposed to apply to taxable years of specified foreign corporations beginning after November 30, 2025. Crucially, taxpayers may rely on these proposed regulations for foreign taxes paid or accrued before the date final regulations are published in the Federal Register, provided that the taxpayer “applies the proposed regulations regarding section 898(c) in their entirety and in a consistent manner to the first required year and succeeding taxable year of a specified foreign corporation.”.

Section 960(d)(4) Rules

Proposed § 1.960-3(b)(6) is proposed to apply to foreign income taxes paid or accrued (or deemed paid under Section 960(b)(1)) with respect to an amount excluded from gross income under Section 959(a) by reason of a Section 951A inclusion, to the extent the inclusion occurs in a U.S. shareholder’s taxable year ending after June 28, 2025.

The corresponding updates to PTEP groups made by proposed § 1.960-3(c)(2) are proposed to apply to taxable years of foreign corporations ending with or within taxable years of U.S. shareholders ending after June 28, 2025. Taxpayers may rely on these proposed regulations regarding Section 960(d)(4) for taxable years of U.S. shareholders beginning before the final regulations are published, provided that the taxpayer “follows the proposed regulations regarding section 960(d)(4) in their entirety and in a consistent manner for all applicable taxable years.”.

Prepared with assistance from NotebookLM.