The U.S. tax code already contains tools designed to prevent adversarial nations from benefiting financially through American taxpayers, but gaps in enforcement and scope continue to draw criticism from lawmakers on both sides of the aisle. The tension between maintaining a globally competitive tax system and ensuring that hostile regimes cannot exploit deductions or credits sits at the center of an unresolved policy fight. This article walks through the existing legal architecture, where it falls short, and what Congress could do to tighten the screws.
How Section 901(j) Blocks Credits for Sanctioned Nations
The primary statutory mechanism for denying tax benefits tied to hostile governments lives in Section 901 of the Internal Revenue Code, specifically subsection (j). That provision expressly denies foreign tax credits for income taxes paid or accrued to countries designated under U.S. sanctions during what the statute calls a “sanction period.” The law also includes a presidential waiver framework that requires congressional reporting, meaning any relaxation of the denial must be transparent. In practical terms, if a U.S. taxpayer or multinational earns income in a sanctioned country and pays local taxes there, they cannot offset their U.S. tax bill with those payments the way they normally would under the foreign tax credit system.
The IRS operationalizes this rule through its taxpayer-facing guidance. Publication 514, which explains the foreign tax credit for individuals, includes a dedicated section on taxes imposed by sanctioned countries. It states plainly that taxpayers “cannot claim a foreign tax credit for income taxes paid or accrued to sanctioned countries during the sanction period” and lists the specific nations that meet that description for the current tax year. The implementing regulation at Treasury Regulation 1.901(j)-1 goes further by establishing sourcing rules for payments and income routed through entities, an anti-avoidance measure meant to prevent taxpayers from indirectly claiming credits for sanctioned-country income by layering transactions through intermediary structures.
Deduction Denials for Fines Tied to Law Violations
The credit denial under Section 901(j) addresses one side of the problem: taxes paid to hostile governments. But there is a parallel rule targeting the other side, which involves penalties that U.S. persons incur for violating sanctions, export controls, or other laws connected to adversarial conduct. Under IRC Section 162(f), the tax code denies deductions for amounts paid to or at the direction of a government in relation to a violation of law. The final regulations implementing this rule were published as Treasury Decision 9946 in Internal Revenue Bulletin 2021‑06, which also describes how government entities must report certain payments under IRC Section 6050X. Together, these provisions are designed to ensure that penalties retain their full deterrent effect rather than being diluted through tax planning.
The regulatory text at Regulation 1.162‑21 spells out when deductions are disallowed and carves out limited exceptions for restitution, remediation, and amounts paid to come into compliance with the law. This matters because without the deduction denial, a company that violated sanctions could theoretically write off the resulting fine as a cost of doing business, reducing its effective penalty. The rule ensures that if a taxpayer breaks export controls or funnels money through sanctioned channels, the IRS will not let them soften the blow on their tax return. For ordinary taxpayers, this is the equivalent of making sure a burglar cannot deduct the cost of a lockpick set: the tax system should not subsidize unlawful conduct, especially when it implicates national security.
Congressional Pressure to Close Terrorism Loopholes
Even with these statutory tools in place, some members of Congress argue the tax code still has blind spots that benefit terrorist organizations. Rep. David Kustoff, a Republican from Tennessee, has urged the Senate to act on legislation targeting those gaps, arguing that existing law does not go far enough to cut off the financial oxygen available to designated groups. In a statement highlighted on his official website, he wrote that “the U.S. Senate must pass this important legislation to significantly diminish the ability of Hamas and other terrorist groups to fund their operations and carry out future attacks,” according to a press release. His argument reflects a broader concern that the existing patchwork of credit denials, deduction limits, and sanctions enforcement does not fully anticipate the creative financing structures used by terrorist networks.
The challenge Kustoff identifies is real, even if the precise fiscal impact remains difficult to quantify. Public audit data from the IRS on how often taxpayers attempt to claim foreign tax credits routed through sanctioned-country entities is not readily available, and there are no widely cited Government Accountability Office tallies that isolate how much revenue is protected specifically by Section 162(f) in the sanctions context. That absence of granular enforcement data makes it harder for lawmakers to build a precise case, but it also means the problem could be larger than current estimates suggest. Without transparent reporting on how many credit claims the IRS rejects under Section 901(j) each year, or how often deduction denials are triggered by sanctions-related fines, Congress is legislating partly in the dark and must rely on anecdotal enforcement stories and classified briefings rather than comprehensive statistics.
Broader Tax Policy, Foreign Earnings, and National Security
The debate over tax benefits flowing to adversaries intersects with a wider argument about how the U.S. taxes multinational corporate earnings abroad. Policymakers who favor higher taxes on foreign income often frame their proposals as a way to discourage offshoring and profit shifting, but they also sometimes invoke national security concerns. If companies can lower their effective tax rates by booking income in jurisdictions that are politically aligned with U.S. adversaries, critics argue that the tax code may be indirectly rewarding behavior that undermines strategic interests. Proposals to raise minimum taxes on foreign earnings, tighten anti-abuse rules, or restrict the use of low-tax jurisdictions are therefore increasingly evaluated not just through an economic lens but also through a security-focused one.
Any significant change to the treatment of foreign income, however, has to be weighed against competitiveness and treaty obligations. The United States participates in a network of bilateral tax treaties and is part of ongoing global discussions about coordinated minimum taxes. Adjustments that go too far in singling out particular countries or transaction types could invite retaliation or create double-taxation problems for U.S. businesses. That is why many of the most consequential changes in this space are implemented through detailed regulations and notices published in venues like the Federal Register, where Treasury and the IRS can refine definitions, anti-avoidance rules, and compliance mechanisms without constantly reopening the statute itself. The balance between protecting the tax base, preserving national security, and maintaining a hospitable environment for cross-border investment is delicate, and incremental regulatory moves often do as much work as headline-grabbing legislation.
What Congress Could Do Next
Given the existing framework, the most plausible congressional next steps fall into three categories: expanding the scope of denial provisions, enhancing transparency, and harmonizing tax rules with other national security tools. Expanding scope could mean broadening Section 901(j) to cover not only formally sanctioned countries but also certain categories of entities or territories that are functionally controlled by adversarial regimes, or tightening the presidential waiver process to require more detailed reporting and shorter renewal periods. Lawmakers could likewise consider clarifying that particular types of payments to state-owned enterprises in designated jurisdictions are ineligible for credits or deductions, closing off potential gray areas that sophisticated taxpayers might otherwise exploit.
On transparency, Congress could mandate regular public reporting on the application of these rules, including aggregate statistics on foreign tax credits denied under Section 901(j) and deductions disallowed under Section 162(f) in cases involving sanctions or terrorism-related offenses. Such reporting would not need to disclose taxpayer identities but could provide enough detail to inform future legislative debates and oversight. Finally, harmonization would involve ensuring that tax provisions align with financial sanctions, export controls, and anti-money-laundering measures so that hostile actors cannot play one system against another. That might include closer coordination between the IRS and agencies responsible for sanctions enforcement, as well as statutory language that explicitly links tax consequences to designations made under other national security authorities. In combination, these steps could help ensure that the U.S. tax code supports, rather than undermines, broader efforts to constrain adversaries and terrorist organizations.
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*This article was researched with the help of AI, with human editors creating the final content.
Julian Harrow specializes in taxation, IRS rules, and compliance strategy. His work helps readers navigate complex tax codes, deadlines, and reporting requirements while identifying opportunities for efficiency and risk reduction. At The Daily Overview, Julian breaks down tax-related topics with precision and clarity, making a traditionally dense subject easier to understand.
