EXECUTIVE SUMMARY

This article addresses certain U.S. federal income tax issues for U.S. corporations with Israeli research and development subsidiaries. It focuses on four interconnected issues that create complexity and potential tax liabilities:

1. the mandatory capitalization of foreign R&D expenditures under Section 174 of the Internal Revenue Code of 1986, as amended¹ (the Code), over 15 years;
2. the requirement that a controlled foreign corporations (CFC) prepare their financial accounts under U.S. tax principles for purposes of calculating Net CFC Tested Income (NCTI) under Section 951A (formerly the GILTI regime), including application of Section 174 to the CFC's own R&D expenditures;
3. the treatment of the CFC's net operating losses and other tax attributes when calculating the effective foreign tax rate for the high-tax exception under Section 954(b)(4); and
4. whether electing to treat the Israeli subsidiary as a disregarded entity resolves these issues or merely creates different complications.

The analysis differs dramatically depending on whether the U.S. parent owns the intellectual property (IP) (with the Israeli subsidiary serving as a contract R&D provider) or whether the Israeli subsidiary owns the IP. Each structure presents unique challenges under current law.

In general, NCTI is the aggregate of a U.S shareholder's pro rata share of tested income from CFC reduced by losses, which, for tax years beginning after December 31, 2025, are taxed as a current year inclusion in gross income.

I. SECTION 174: U.S. PARENT PAYMENTS TO ISRAELI SUBSIDIARY

A. The 15-Year Amortization Requirement for Foreign R&D

Section 174, as amended by the Tax Cuts and Jobs Act, requires mandatory capitalization and amortization of foreign research and experimental expenditures over 15 years using a mid-year convention. This requirement applies to all amounts paid or incurred in taxable years beginning after December 31, 2021. The One Big Beautiful Bill Act, enacted July 4, 2025, restored immediate expensing for domestic R&D effective for tax years beginning after December 31, 2024, but explicitly left the 15-year amortization requirement in place for foreign R&D.

When a U.S. parent company makes payments to its Israeli R&D subsidiary for research services, those payments constitute specified research or experimental expenditures under Section 174. The location where the research is physically conducted generally determines whether expenditures are domestic or foreign. Because the Israeli subsidiary conducts its research activities in Israel, the U.S. parent's reimbursement payments are foreign R&D expenditures subject to 15-year amortization regardless of the entity's classification or the contractual characterization of the payments.

The mechanics of the 15-year amortization create a severe timing mismatch. In Year one when a payment is made, only one-fifteenth of the amount (6.67%) can be deducted, multiplied by one-half under the mid-year convention, resulting in a first-year deduction of only 3.33% of the expenditure. The remaining 96.67% will be deducted ratably over the next 14.5 years. This means that when a U.S. parent pays $15,000,000 to its Israeli subsidiary in Year 1, the Year 1 deduction is only approximately $500,000. The remaining $14,500,000 provides no current tax benefit and will be recovered over the following years.

B. Application to Contract R&D Arrangements

In the typical structure where the U.S. parent retains IP ownership and the Israeli subsidiary operates as a contract R&D service provider, the subsidiary charges the parent on a cost-plus basis. The Israeli Tax Authority's guidance, including [Circular 8/2025], indicates that arm's-length markups for routine R&D services typically range from 8% to 15%. If the Israeli subsidiary has R&D costs of $10,000,000 and charges a 10% markup, the U.S. parent pays $11,000,000. Under Section 174, the full $11,000,000 payment must be capitalized and amortized over 15 years, even though economically the subsidiary is merely recovering its costs plus a service margin.

This creates a fundamental disconnect between economic reality and tax treatment. The U.S. parent is making a payment to compensate its subsidiary for conducting research on the parent's behalf. From a transfer pricing perspective, this is a service payment comparable to any other intercompany service arrangement. But Section 174 treats it as a capital expenditure to be recovered over 15 years, regardless of whether the underlying research succeeds, fails, becomes obsolete, or generates immediate commercial value.

The problem compounds when the research does generate value quickly. If the Israeli subsidiary completes development of a commercially viable product within two years, the U.S. parent may earn substantial revenue from that product while still amortizing the R&D costs over the full 15-year period. From a matching principle perspective, this makes no sense; the costs that generated the revenue are not being matched against that revenue for tax purposes.

C. Limited Planning Solutions Within Section 174

Taxpayers generally cannot avoid the Section 174 capitalization requirement by re-characterizing the costs as otherwise deductible expenditures paid to related parties. The regulations make clear that the requirement applies to payments made to related parties for contract research, regardless of how those payments are characterized. Attempting to characterize payments as something other than R&D expenditures (for example, as management fees or technical assistance fees) will generally fail if the economic substance of the arrangement is the performance of research activities.

Similarly, cost-sharing arrangements under Treasury Regulation Section 1.482-7 generally do not avoid Section 174 capitalization. In a cost-sharing arrangement, each party shares the costs of R&D and obtains rights to developed intangibles in its respective territory. However, each party's share of the costs must still be treated under Section 174. If a U.S. parent and Israeli subsidiary enter a cost-sharing arrangement where the parent bears 70% of costs and the subsidiary bears 30%, the parent's 70% share is still subject to 15-year amortization as foreign R&D (because the research is conducted in Israel).

The only way to avoid 15-year amortization is to conduct R&D in the United States. But for companies that have established R&D operations in Israel to access specialized talent, proximity to markets, or Israeli government incentives, relocating operations is generally not commercially viable. Section 174 effectively penalizes foreign R&D by requiring far longer cost recovery than domestic R&D (immediate expensing versus 15 years).

II. NCTI CALCULATION: MUST THE ISRAELI CFC APPLY U.S. TAX PRINCIPLES?

A. The Fundamental Question: Whose Tax Rules Apply to Calculate NCTI?

A critical and often misunderstood aspect of the NCTI regime concerns the accounting principles used to calculate tested income. When a U.S. parent must determine its NCTI inclusion from its Israeli CFC, a threshold question arises: Does the Israeli CFC calculate its income and deductions using Israeli tax law, or must it apply U.S. tax principles?

This question has enormous practical consequences. Israeli tax law and U.S. tax law differ in numerous respects, including depreciation methods, inventory accounting, recognition of revenue and expenses, treatment of reserves and accruals, and, most critically for these purposes, the treatment of R&D expenditures. If the Israeli CFC applies Israeli tax law to calculate its income, then its tested income would reflect whatever treatment Israeli law provides for R&D costs (which may allow immediate expensing or shorter amortization). If the Israeli CFC must apply U.S. tax principles, then Section 174 capitalization would apply to the CFC's own R&D expenditures, potentially creating very different results.

B. The Regulatory Answer: U.S. Tax Principles Control

The regulations under Section 951A provide that: tested income is calculated using U.S. federal income tax principles. Treasury Regulation Section 1.951A-2(b)(1) states that "tested income is determined under the rules of sections 952(c), 954, 955(a)(2), 956(b), and 961, and the regulations under those sections, which require that such amounts be determined under U.S. federal income tax principles." This regulatory language has been consistently applied since the GILTI regime was enacted in 2017 and continues to apply under the NCTI provisions following the One Big Beautiful Bill Act.

The requirement to use U.S. tax principles means that when calculating the Israeli CFC's tested income, taxpayers must apply all relevant Code provisions, including Section 174. This has profound implications. If the Israeli subsidiary incurs its own R&D expenditures (distinct from the reimbursement payments from the U.S. parent), those expenditures must be capitalized and amortized under Section 174 for purposes of calculating tested income, even if Israeli tax law allows immediate expensing.

This creates a layered Section 174 problem. At the U.S. parent level, the parent must capitalize its reimbursement payments to the Israeli CFC over 15 years. At the CFC level, the CFC must capitalize its own R&D expenditures over 15 years for purposes of calculating tested income that flows through to the parent as NCTI. The same underlying research costs are being capitalized twice—once at the parent level and once at the CFC level for different purposes.

C. Practical Implications: The CFC Must Maintain Dual Books

The requirement to calculate tested income using U.S. tax principles creates significant compliance burdens. The Israeli CFC must maintain its regular financial statements under Israeli GAAP or IFRS for Israeli reporting purposes. It must also prepare Israeli tax returns reflecting Israeli tax law. But for U.S. purposes, the CFC must prepare a separate calculation of its income and deductions applying U.S. tax principles, including all relevant Code sections and regulations.

This dual-books requirement is particularly burdensome for Section 174 purposes. The CFC must identify all expenditures that qualify as specified research or experimental expenditures under U.S. tax law, even though these may not be separately tracked under Israeli accounting or tax law. The CFC must then apply the 15-year amortization requirement to these expenditures, maintaining amortization schedules that track basis, placed-in-service dates, and remaining recovery periods. All of this must be done solely for U.S. tax purposes, creating information that has no relevance to the CFC's Israeli tax filings or financial reporting.

The practical difficulty is compounded by differences in how Israeli and U.S. tax law define R&D expenditures. IRS Notice 2023-63 provides detailed guidance on what constitutes specified research or experimental expenditures under Section 174, including software development costs, materials consumed in research, depreciation of equipment used in research, and overhead allocable to research activities. Israeli tax law may define qualifying R&D costs differently. The CFC must apply the U.S. definitions and standards, not the Israeli standards, when preparing the tested income calculation.

D. Example: Israeli CFC That Owns IP and Conducts Its Own R&D

To illustrate the problem concretely, consider an Israeli CFC that owns intellectual property and conducts ongoing R&D to enhance and develop that IP. The CFC has operating revenue of $20,000,000 from licensing its IP to third parties. The CFC incurs $8,000,000 in R&D costs during the year to improve and expand its IP portfolio.

Under Israeli tax law, assume the CFC qualifies for preferential treatment under the Encouragement of Capital Investments Law and is entitled to immediate expensing of qualifying R&D costs. The CFC's Israeli taxable income would be $12,000,000 ($20,000,000 revenue minus $8,000,000 R&D expense). At a preferential Israeli tax rate of 7.5%, the CFC pays Israeli tax of $900,000.

For U.S. purposes, however, the calculation is entirely different. The CFC's tested income must be calculated under U.S. tax principles. The $8,000,000 in R&D costs must be capitalized and amortized over 15 years under Section 174. In the first year, only approximately $267,000 can be deducted (one-fifteenth of $8,000,000, multiplied by one-half for the mid-year convention). The CFC's tested income for NCTI purposes is approximately $19,733,000 ($20,000,000 revenue minus $267,000 Section 174 amortization).

This creates a massive discrepancy. For Israeli tax purposes, the CFC has taxable income of $12,000,000 and pays tax of $900,000. For U.S. tax purposes, the CFC has tested income of $19,733,000 that is subject to NCTI inclusion at the parent level. The effective Israeli tax rate on the tested income is only 4.56% ($900,000 divided by $19,733,000), well below the 18.9% threshold for the high-tax exception. The U.S. parent will have an NCTI inclusion of $19,733,000, subject to U.S. tax at the 12.6% effective rate, resulting in U.S. tax of approximately $2,486,000 before foreign tax credits. The foreign tax credits will be limited to 90% of the $900,000 Israeli taxes, or $810,000, leaving a residual U.S. tax of approximately $1,676,000.

The result is problematic. The same $8,000,000 in R&D expenditures that the Israeli government intended to incentivize through immediate expensing and preferential tax rates becomes the source of substantial U.S. taxation because Section 174 capitalization inflates the CFC's tested income to levels far exceeding its Israeli taxable income.

III. NOL TREATMENT AT THE CFC LEVEL AND THE HIGH-TAX EXCEPTION

A. Can a CFC Use NOL Carryforwards to Reduce Its Tested Income?

A related question concerns the treatment of the Israeli CFC's net operating loss carryforwards under Israeli tax law. If the CFC generated losses in prior years that are carried forward under Israeli law, can those NOL carryforwards reduce the CFC's tested income for NCTI purposes?

The answer is generally no, with important nuances. Tested income is calculated on a current-year basis using U.S. tax principles. Under U.S. tax law, NOL carryforwards from prior years do not reduce current-year gross income or current-year deductions. Rather, they are applied after taxable income is determined to reduce the tax liability based on the NOL amount multiplied by the applicable tax rate. Because tested income is analogous to gross income minus deductions, not taxable income after NOL application, CFC NOL carryforwards available under foreign law do not reduce tested income.

This creates another significant problem. The Israeli CFC may have accumulated NOL carryforwards under Israeli tax law from prior loss years (potentially generated during R&D development phases). When the CFC becomes profitable, these Israeli NOLs reduce the CFC's Israeli taxable income and Israeli tax liability. But for U.S. purposes, the tested income reflects the CFC's current-year income and deductions without regard to the Israeli NOLs. The result is that the CFC pays little or no Israeli tax (due to Israeli NOL utilization) but generates substantial tested income subject to NCTI inclusion.

B. Impact on the High-Tax Exception Calculation

The high-tax exception under Section 954(b)(4) and Treasury Regulation Section 1.954-1(d) allows taxpayers to exclude from tested income any income that is subject to foreign tax at an effective rate exceeding 18.9% (90% of the 21% U.S. corporate rate). The exception is determined by comparing the foreign income taxes paid or accrued with respect to the income to the income itself.

The critical question for the high-tax exception is: what is the denominator? Is it the CFC's foreign taxable income (after foreign NOL utilization), or is it the tested income calculated under U.S. principles (without foreign NOL utilization)?

The regulations answer this question clearly but unfavorably for taxpayers. The high-tax exception determination compares foreign taxes to the tested income calculated under U.S. tax principles. Treasury Regulation Section 1.954-1(d)(1)(ii) provides that an item of income meets the high-tax test if the foreign income taxes paid or accrued with respect to the item exceed 90% of the product of the item's net tested income multiplied by the highest corporate tax rate. The term "net tested income" refers to the item as calculated under U.S. tax principles, not the foreign taxable income.

This means that when an Israeli CFC utilizes Israeli NOL carryforwards to reduce its Israeli taxable income, those NOLs do not reduce the tested income used for the high-tax exception calculation. The foreign taxes paid are compared to the tested income (calculated under U.S. principles without the benefit of Israeli NOLs), resulting in a low effective tax rate that fails the high-tax exception test.

C. Combined Impact: Section 174 and NOLs Create High-Tax Exception Failures

The combined impact of Section 174 capitalization and NOL disallowance creates situations where the high-tax exception is unavailable even though the Israeli CFC appears to be paying substantial foreign taxes relative to its economic income.

Return to our earlier example of the Israeli CFC with $20,000,000 of revenue and $8,000,000 of R&D costs. Assume further that the CFC has $10,000,000 of Israeli NOL carryforwards from prior years. For Israeli tax purposes, the CFC's taxable income is $2,000,000 ($20,000,000 revenue minus $8,000,000 R&D expense minus $10,000,000 NOL utilization). At the 7.5% preferential rate, Israeli tax is $150,000.

For U.S. purposes, the tested income is $19,733,000 (as calculated above, applying Section 174 capitalization). The Israeli NOL carryforward is disregarded—it does not reduce tested income. The effective foreign tax rate is $150,000 divided by $19,733,000, or approximately 0.76%. This is far below the 18.9% threshold, so the high-tax exception is unavailable.

The harsh result is that the CFC pays only $150,000 in Israeli taxes due to the combination of immediate R&D expensing, preferential tax rates, and NOL utilization, but generates $19,733,000 of tested income that is subject to NCTI inclusion. The U.S. parent has an NCTI inclusion of $19,733,000, U.S. tax at 12.6% of approximately $2,486,000, foreign tax credits of 90% of $150,000 or $135,000, and residual U.S. tax of approximately $2,351,000. The combined Israeli and U.S. tax burden is $2,501,000, representing an effective tax rate of approximately 12.7% on the tested income, even though the Israeli effective rate on economic income was only 0.76%.

D. Planning Implication: Israeli Tax Benefits Create U.S. Tax Liabilities

The interaction between Section 174, the disallowance of foreign NOLs in calculating tested income, and the high-tax exception creates a perverse incentive structure. The more successful a taxpayer is in obtaining Israeli tax benefits (preferential rates, R&D incentives, NOL utilization), the more likely the taxpayer is to fail the high-tax exception and face substantial residual U.S. tax. Israeli tax benefits that reduce the CFC's Israeli tax liability simultaneously increase the U.S. parent's NCTI inclusion and residual U.S. tax.

This is precisely the opposite of how tax incentives are supposed to work. When the Israeli government provides R&D incentives or preferential tax rates, the intent is to make Israel more attractive for R&D investment by reducing the overall tax burden. But for U.S. parent companies, these Israeli incentives merely shift the tax burden from Israel to the United States without reducing the overall tax cost. In some cases, the overall tax burden actually increases due to the interaction of the various rules.

The only way for a U.S. parent with an Israeli CFC to avoid this problem is to ensure the CFC pays Israeli tax at an effective rate exceeding 18.9% on the tested income (not the Israeli taxable income). This requires either declining Israeli tax benefits (defeating the purpose of investing in Israel) or structuring the CFC's operations to generate additional Israeli taxable income that offsets the tested income calculated under U.S. principles. Neither approach is commercially attractive.

IV. IP OWNERSHIP STRUCTURES: U.S. PARENT VS. ISRAELI SUBSIDIARY

A. Scenario 1: U.S. Parent Owns IP, Israeli Subsidiary Provides Contract R&D

In this structure, the U.S. parent retains ownership of all IP developed through the R&D activities. The Israeli subsidiary operates as a contract service provider, performing research on behalf of the parent under a services agreement. The subsidiary charges the parent on a cost-plus basis, typically with markups of 8% to 15% depending on the nature of the services and the risks assumed.

Section 174 Issues

From the U.S. parents' perspective, the payments to the Israeli subsidiary are foreign R&D expenditures subject to 15-year amortization. If the parent pays $11,000,000 annually (representing $10,000,000 of costs plus a 10% markup), only approximately $367,000 is deductible in the first year. The parent receives a lower current tax benefit from these payments.

From the Israeli CFC's perspective, the subsidiary has revenue of $11,000,000 and costs of $10,000,000, resulting in a profit of $1,000,000. For Israeli tax purposes, the $10,000,000 in costs may include R&D expenditures that are immediately deductible under Israeli law. For U.S. tested income purposes, any R&D costs incurred by the CFC must be capitalized under Section 174. If $8,000,000 of the $10,000,000 in costs represents R&D, only approximately $267,000 is deductible for tested income purposes in the first year. The CFC's tested income would be approximately $10,733,000 ($11,000,000 revenue minus $267,000 Section 174 amortization minus $2,000,000 for non-R&D costs), rather than the $1,000,000 profit reported under Israeli tax principles.

NCTI Implications

The CFC has a tested income of $10,733,000 that is subject to NCTI inclusion. If the CFC pays Israeli tax at the 23% standard rate on its $1,000,000 profit (Israeli taxable income), the Israeli taxes are $230,000. For high-tax exception purposes, the effective rate is $230,000 divided by $10,733,000, or 2.14%. This is far below 18.9%, so the high-tax exception is unavailable.

The U.S. parent has an NCTI inclusion of $10,733,000, U.S. tax at 12.6% of approximately $1,352,000, and foreign tax credits of 90% of $230,000 or $207,000, leaving residual U.S. tax of approximately $1,145,000. The combined Israeli and U.S. tax is $1,375,000 on tested income of $10,733,000, representing an effective rate of 12.8%.

Key Observation

Even though the Israeli subsidiary earns only a 10% markup on its costs ($1,000,000 of profit), the application of Section 174 at the CFC level inflates tested income to over $10,000,000, creating substantial NCTI inclusion and residual U.S. tax. The U.S. parent is essentially taxed on $10,000,000 of "phantom income" at the CFC level—income that exists for U.S. tax purposes but not for Israeli tax purposes due to the different treatment of R&D costs.

B. Scenario 2: Israeli Subsidiary Owns IP and Conducts R&D

In this structure, the Israeli subsidiary owns the IP and conducts R&D to develop, enhance, and commercialize that IP. The subsidiary might license the IP to the U.S. parent or to third parties, or it might directly commercialize products or services incorporating the IP. The subsidiary earns substantial profits from exploiting the IP, not merely a service markup.

Section 174 Issues

The Israeli subsidiary incurs significant R&D costs to develop and enhance its IP. Under Israeli tax law, these costs may be immediately deductible, particularly if the subsidiary qualifies for preferential treatment under the Encouragement Law. For U.S. tested income purposes, all R&D costs must be capitalized under Section 174 over 15 years.

Assume the Israeli subsidiary has $30,000,000 of revenue from IP licensing and $12,000,000 of R&D costs. Under Israeli tax law with immediate expensing, Israeli taxable income is $18,000,000. At a 7.5% preferential rate, Israeli tax is $1,350,000. For U.S. tested income purposes, only approximately $400,000 of R&D costs can be deducted in the first year (one-fifteenth of $12,000,000, multiplied by one-half). Tested income is approximately $29,600,000 ($30,000,000 revenue minus $400,000 Section 174 amortization).

NCTI Implications

The CFC has a tested income of $29,600,000. The effective Israeli tax rate is $1,350,000 divided by $29,600,000, or 4.56%, well below 18.9%. The high-tax exception is unavailable. The U.S. parent has an NCTI inclusion of $29,600,000, U.S. tax at 12.6% of approximately $3,730,000, and foreign tax credits of 90% of $1,350,000 or $1,215,000, leaving residual U.S. tax of approximately $2,515,000.

The combined Israeli and U.S. tax burden is $3,865,000, representing an effective rate of 13.05% on the tested income. But more significantly, the U.S. parent is paying $2,515,000 in residual U.S. tax on what is fundamentally Israeli-source income generated by the Israeli subsidiary's IP. The Israeli government offered preferential rates to attract IP development in Israel, but the U.S. tax system effectively claws back those benefits through the NCTI regime and Section 174 capitalization.

Strategic Implications

When the Israeli subsidiary owns IP, the Section 174 problem is dramatically worse than in the contract R&D scenario. The subsidiary's tested income is inflated by the full amount of R&D capitalization, not just by the markup on services. This creates enormous NCTI inclusions and substantial residual U.S. tax even when the subsidiary pays reasonable Israeli taxes on its economic income.

Many U.S. companies that established Israeli IP-owning subsidiaries under prior law (when R&D costs were immediately deductible, and GILTI provided a qualified business asset investment ("QBAI") exclusion) are discovering that their structures are no longer tax-efficient under current law. The combination of Section 174 capitalization, elimination of the QBAI exclusion, and increased NCTI rates has fundamentally changed the economics of foreign IP ownership.

C. Transfer Pricing Considerations

The choice between U.S. IP ownership and Israeli IP ownership also implicates transfer pricing. When the U.S. parent owns IP, and the Israeli subsidiary provides contract R&D, the parent must pay the subsidiary an arm's-length service fee. This typically results in the subsidiary earning a modest markup (8% to 15%) and the parent retaining the bulk of profits associated with the IP.

When the Israeli subsidiary owns IP, the profit allocation is dramatically different. The subsidiary is entitled to the full economic return on the IP, which may be substantial. The U.S. parent or other group members that manufacture, distribute, or market products incorporating the IP must pay the Israeli subsidiary arm's-length royalties or transfer prices that reflect the value of the IP. From a transfer pricing perspective, more profits are allocated to the Israeli subsidiary.

Under prior U.S. tax law, this allocation might have been tax-efficient if the Israeli subsidiary paid relatively low foreign taxes and could defer U.S. taxation on those earnings. Under current law, however, the allocation merely increases NCTI inclusions and residual U.S. tax. The more profits allocated to the Israeli subsidiary, the larger the tested income, and the larger the U.S. tax burden (assuming the Israeli effective tax rate is below 18.9%).

This creates a tension between transfer pricing principles and U.S. tax efficiency. Transfer pricing rules require that profits be allocated based on where value is created and risks are borne. If the Israeli subsidiary is genuinely developing valuable IP and bearing development risks, transfer pricing principles require that substantial profits be allocated to the subsidiary. But doing so increases U.S. tax liabilities under the NCTI regime, potentially making the structure uneconomical.

V. CHECK-THE-BOX ELECTION: DOES DRE STATUS SOLVE THESE PROBLEMS?

A. The DRE Alternative and What It Changes

Given the problems created by CFC status, the NCTI regime, and Section 174 interactions, taxpayers often consider electing to treat the Israeli subsidiary as a disregarded entity  ("DRE') for U.S. federal income tax purposes under Treasury Regulation Section 301.7701-3. When an Israeli entity is treated as a DRE (essentially a branch of the U.S. parent), all income, deductions, and credits flow directly to the parent's tax return. The entity is not recognized as a separate corporation for U.S. tax purposes.

DRE status eliminates the CFC rules entirely. There is no NCTI inclusion because there is no CFC. There is no Subpart F income and no Form 5471 filing requirement. The U.S. parent reports the branch's income and deductions directly on its corporate return and files Form 8858 to report the activities of the foreign disregarded entity.

At first glance, this appears to solve the NCTI problem. But careful analysis reveals that DRE status does not solve the Section 174 problem and creates new complications with foreign tax credits.

B. Section 174 Still Applies to DRE/Branch R&D

The critical point to understand is that electing DRE status does not change the treatment of R&D expenditures under Section 174. Section 174 applies based on where research is physically conducted, not on the classification of the entity conducting the research. When a U.S. parent has an Israeli DRE conducting R&D activities in Israel, that R&D is foreign R&D subject to mandatory 15-year amortization.

Therefore, if the Israeli DRE incurs $12,000,000 of R&D costs in a year, the U.S. parent must capitalize those costs and amortize them over 15 years. The first-year deduction is only approximately $400,000. The U.S. parent reports the DRE's operating income directly on its return, but the R&D costs provide minimal current deduction due to Section 174 capitalization.

In this sense, DRE status is no better than CFC status for Section 174 purposes. Whether the Israeli entity is a CFC or a DRE, the R&D costs incurred in Israel must be capitalized over 15 years. The only difference is that under CFC status, the Section 174 capitalization occurs at the CFC level for tested income purposes, while under DRE status, it occurs at the parent level for direct reporting purposes. Either way, the parent gets minimal current tax deductions for foreign R&D expenditures.

C. Foreign Tax Credit Complications Under DRE Status

While DRE status eliminates NCTI, it creates significant complications with foreign tax credits. When income is earned through a CFC, foreign taxes paid by the CFC generate deemed-paid foreign tax credits under Section 960 that are allocated to the NCTI basket. When income is earned through a foreign branch (DRE), foreign taxes paid by the branch are allocated to the foreign branch basket under Section 904(d)(1)(B).

The foreign branch basket is a separate foreign tax credit limitation category. Foreign tax credits must be calculated separately for each basket, and excess credits in one basket generally cannot offset U.S. tax on income in another basket. The branch basket rules are complex and require detailed attribution of income, deductions, and foreign taxes to the branch.

More problematically, the attribution rules may allocate some of the parent's deductions (including Section 174 amortization) to the branch basket, reducing the foreign-source income in that basket and thereby reducing the foreign tax credit limitation. Treasury Regulation Section 1.861-8 provides that expenses must be allocated and apportioned to the statutory and residual groupings of income. R&D expenses are subject to special allocation rules under Treasury Regulation Section 1.861-17.

Under the OBBBA changes effective for tax years beginning after December 31, 2025, R&D expenses are no longer apportioned to the NCTI basket for foreign tax credit limitation purposes. This is a favorable change for CFCs. However, for branches, the allocation rules continue to apply with full force. R&D expenses incurred by or allocable to a foreign branch must be allocated to the branch basket, reducing the foreign-source income and the foreign tax credit limitation for that basket.

D. Comparing CFC vs. DRE: Which Is Better?

The answer depends entirely on the specific facts. For an Israeli entity that is profitable and pays Israeli tax at the standard 23% rate, CFC status with the high-tax exception election is generally preferable. The high-tax exception (23% exceeds 18.9%) eliminates the NCTI.

With OBBBA's changes and as the rules and regulations related to R&D expenses and NCTI continue to evolve, taxpayers should carefully review any pre-existing arrangements and carefully analyze any future R&D projects.

To discuss any questions you have regarding the characterization of R&D expenses, the NCTI regime, or any other potential tax planning considerations, please contact Oz Halabi (ohalabi@cozen.com) at (212) 453-3895.

¹ Unless otherwise indicated, all references to Sections are Sections of the Code.