The Impact of a Section 338 Election to CFC Shareholders

Congress enacted Section 338 of the Internal Revenue Code to allow taxpayers to treat certain stock purchases as asset acquisitions for federal income tax purposes. A Section 338 election can be made under Section 338(h)(1)) and 338(g). A Section 338 election typically benefits the buyer of a corporation. For tax purposes, a buyer is not entitled to a step-up in the tax basis of the acquired corporation. Instead, the buyer receives a carryover basis of the seller. However, if a Section 338 election is made in connection with a taxable stock sale, the transaction is treated as a hypothetical asset deal for tax purposes, and the buyer’s basis is revalued to reflect the acquisition price. The depreciation and amortization and amortization of all assets and intangibles, including goodwill, identified in the purchase price allocation then becomes tax-deductible expenses.

There are significant disadvantages to the selling shareholders of a corporation. This is particularly the case when a buyer makes a Section 338 election in the acquisition of a controlled foreign corporation. This article discusses the impact of a Section 338 election when a controlled foreign corporation is acquired.

Section 338(h)(1)

There are two types of Section 338 elections: Section 338(h)(1) and 338(g). A Section 338(h)(1) applies to acquisitions of corporate subsidiaries or S corporations. The election is made jointly on Form 8023. In a Section 338(h)(10) election, one level of tax is typically imposed on the deemed asset sale and the stock sale is ignored for tax purposes. As a result of this “deemed” asset purchase, the assets held by the selling corporation get stepped up to their fair market value (as determined by reference to the consideration paid by the purchaser), and the taxable gain that the selling corporation realizes from the asset purchase gets “passed-through” up to the selling corporation. One important requirement for the Section 338(h)(10) election here is that the selling corporation must either be a corporate subsidiary or S corporation. If the seller is a S corporation, it must indeed be a valid S corporation — i.e., it must not have inadvertently lost its status as an S corporation at any time prior to the election.

Section 338(g)

A Section 338(g) election permits a buyer of stock to elect unilaterally to recharacterize a taxable stock acquisition as a deemed asset acquisition. As with a Section 338(h)(1) election, the main advantage to the buyer is the step-up on the basis of the assets deemed acquired to the fair market value on the date of the purchase. Since Section 338(g) may trigger double tax in domestic acquisitions, Section 338(g) elections are rarely made in the domestic context. Section 338(g) elections are typically made in cross-border acquisitions. Several conditions must be satisfied to make a Section 338(g) election. First, the purchaser and target must be corporations. Second, the purchasing corporation must typically acquire at least 80 percent of the target within a 12 month period in a series of transactions.

When a Section 338(g) election is made, the target corporation is treated as if it sold all its assets and the target corporation must recognize any gain resulting from the deemed asset sale. Care should be taken if either the acquiring or target corporation can be classified as a controlled foreign corporation (“CFC”). A foreign corporation is a CFC if, on any day during the foreign corporation’s taxable year, U.S. shareholders own more than 50 percent of the combined voting power of all classes of stock, or more than 50 percent of the total value, of the foreign corporation. Only U.S. shareholders are considered in applying for the 50 percent test. All forms of ownership, including direct, indirect (ownership through intervening entities), and constructive (attribution of ownership from one related party to another), are considered in applying the 50 percent test.

If the seller is CFC, the CFC gain on non-trade or business assets typically is classified as Subpart F income, and the remaining gain (with respect to trade or business assets) will be classified as tested income for “global intangible low-taxed income (“GILTI”) purposes. With a Section 338(g) election, the CFC also will be taxed on the gain from the sale of its stock, with the basis of such stock being increased to account for any inclusions under GILTI and Subpart F income for the year (including the Subpart F and GILTI income generated by the deemed asset sale). GILTI and Subpart F income is typically taxed at rates between 10.5% and 21% at the corporate level. Subject to holding period requirements, the stock gain will be recharacterized as a dividend under Section 1248. Under Internal Revenue Code Section 1248(a), gain recognized on a U.S. shareholder’s disposition of stock in a CFC is treated as dividend income to the extent of the relevant earnings and profits accumulated in which such person held the stock of the foreign corporation.

The 2017 Tax Cuts and Jobs Act implemented Section 245A. Section 245A allows an exemption for certain foreign income of a domestic corporation that is a U.S. shareholder. After the enactment of the 2017 Tax Cuts and Jobs Act, Section 1248(a) gain generally is exempt from tax for U.S. corporate shareholders under Section 245A and generally will be deductible under Section 245A to the extent of the CFC’s prior year untaxed earnings and current year earnings that are not Subpart F income or tested income, as well as earnings arising from gain on the deemed sale of assets that are not subject to Subpart F or GILTI.

Because of the dividends received deduction under Section 245A, there may be a preference among U.S. corporate sellers that are CFCs toward dividend characterization under Section 1248 (i.e., a stock sale), which may be exempt from U.S. tax under Section 245A, as compared to gain that may be classified as either GILTI or Subpart F income (i.e., an asset sale). If sufficient E&P exists, such corporate sellers may thus generally be expected to prefer stock sales over asset sales. In the absence of sufficient E&P, though, utilizing a Section 338(g) election to convert Subpart F income or gain taxable at 21% to GILTI taxable at 10.5% may be preferable.

The situation is different for individual shareholders of CFCs. U.S. individual shareholders held CFC stock for more than 12 months, its sale usually generates long-term capital gain of 20% for the shareholder. The situation becomes complicated if a Section 338(g) election is made by a buyer. This is because U.S. individual shareholders are not entitled to an exemption under Section 245A. As a result, U.S. shareholders of a CFC recognize gain on the disposition of stock in a CFC that is treated as dividend income. CFC gain will typically be taxed as either GILTI or Subpart F income. U.S. shareholders must typically include GILTI or Subpart F income as ordinary income on their individual income tax returns. The current highest federal tax rate applicable to an individual is 37% rather than favorable capital gains rates. As a result of the punitive impact of GILTI and Subpart F tax regimes, individual U.S. shareholders of a CFC typically are negatively impacted from a U.S. federal income tax perspective when a buyer makes a Section 338(g) election.

For the reasons discussed above, whenever Section 338(g) under consideration in connection with the acquisition of a CFC, careful modeling should be done to determine the potential U.S. income tax consequences associated with a Section 338(g) election compared to a stock sale, to determine which may produce the optimal tax results.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.