Internal Revenue Code Section 338 provides that if a purchasing corporation (“P”) purposes 80 percent or more of the stock of a target corporation (“T”) within 12 months or less, it may elect within a specified time period to treat the target as having sold all of its assets for their fair market value in a single transaction. T thus must recognize gain or loss on the hypothetical asset sale, after which it returns as a new corporation (“new T”) with a cost basis in its assets and none of its former tax attributes. The Section 338 election is available only to a “purchasing corporation,” which is defined as “any corporation which makes a qualified purchase of stock of another corporation.” IRC Section 338(d)(1). A “qualified stock purchase” is a transaction or series of transactions in which one corporation acquires by “purchase” an 80 percent controlling interest in another corporation during a 12-month “acquisition period.”
If P makes a valid Section 338 election, T is treated as having sold all of its assets at the close of the acquisition date for their fair market value in a single transaction to a new corporation (“new T”). The deemed sale has tax consequences to both “old T” and “new T.”
Old T recognizes gain or loss on the deemed sale, just as if it actually had sold its assets. Old T is deemed to have sold all its assets even if P acquires less than 100% of the T stock. Although Section 338(a)(1) suggests that this gain is determined by reference to the fair market value of T’s assets and provides in Section 338(h)(11) for an “elective” formula to determine value, the regulations under Section 338 require use of a formula. They treat T as selling its assets for their “aggregate deemed sales price” (“ADSP”). Which is the sum of the grossed-up basis of P’s recently purchased stock (including acquisition coasts) plus new T’s liabilities, including any tax liabilities resulting from the deemed sale. Treas. Reg. Section 1.338-3(d)(1). The grossed-up basis of P’s recently purchased stock is its basis in that stock multiplied by the following fraction:
100% – of Nonrecently Purchased Stock
% of Recently Purchased Stock
In the simple case where P purchased and held 100% of T’s stock during the 12-month acquisition period, the ADSP is P’s cost for the stock plus liabilities of new T. The income from the deemed Section 338 sale is reported in an old T’s tax return and may not be included in any consolidated return filed by P and its other subsidiaries.
The consequences to new T are treated as having purchased old T’s assets as of the beginning of the day after the “acquisition date.” New T’s basis in the acquired assets is the “adjusted grossed-up basis” (“AGUB”), which is defined as “the grossed-up basis” of P’s recently purchased stock plus the basis of P’s nonrecently purchased stock, adjusted for liabilities (including income tax liabilities resulting from the deemed sale) and other relevant items.
The Section 338(g) Election and Effect of the Election
If a corporation makes a qualified stock purchase and wishes to make a Section 338(g) election, it must do so no later than the 15th day of the 9th month beginning after the month in which the acquisition occurs. (9100 relief is available) IRC Section 338(g)(1).
If P makes a Section 338 election, T is treated as having sold all of its assets at the close of the acquisition for the “fair market value” in a single transaction and is treated as a new corporation which purchased all of its assets on the day after the acquisition. A Section 338 election is irrevocable. A Section 338(g) election may be made for lower-tier subsidiaries of T.
As discussed above, Section 338(g) permits a buyer of stock to elect unilaterally to reclassify a taxable stock acquisition as a deemed asset acquisition. The main advantage to the buyer is that the tax basis of the assets of T are “stepped up” to the fair market value of the assets on the date of the purchase. The mechanics of making a Section 338(g) election (typically a Section 338(g) election is made with an acquisition of a foreign controlled foreign corporation (“CFC”) are different from a Section 338 election typically made in the context of the acquisition of a domestic corporation. However, the timing of such an election is the same.
Making a Section 338(g) election to step-up basis of a CFC may be of enhanced value because, in addition to permitting increased depreciation and amortization deductions, this increased asset basis generally has the effect of reducing future Global Intangible Low Income (“GILTI”)/Net CFC Tested Income (“NCTI”) inclusions by reducing “tested income.”
When a Section 338(g) election is made, the target CFC is deemed to sell its assets and must recognize any gain resulting from the deemed asset sale. If the seller is a domestic corporation that holds a CFC, the CFC target’s gain on non-trade or business assets typically is classified as Subpart F income, and the remaining gain instead is Net Tested Income. The CFC’s tax year closes, and its Subpart F income and Net Tested Income through the date of sale is included in the gross income of the domestic seller.
With a Section 338(g) election, the domestic seller will also be taxed on the gain from the sale of the CFC stock, with the basis of such stock being increased to account for any inclusions under Subpart F and Net Tested Income for the year. Subject to holding period requirements, the stock gain will be recharacterized as a deemed dividend under Section 1248(a) of the Internal Revenue Code. A Section 1248(a) deemed dividend recharacterizes a U.S. shareholder’s stock sale in a CFC into dividend income and enables a 100% dividends-received deduction (“DRD”) for eligible domestic corporations. Thus, if the U.S. shareholder is a domestic C corporation, the deemed dividend can qualify for a 100% deduction under Section 245A, reducing the federal tax rate on that portion to 0%.
On the seller’s side, because the dividend received deduction under Section 1245A, there could be a preference among U.S. corporate sellers of CFCs toward dividend characterization under Section 1248, which may be exempt from U.S. tax under Section 245A, as compared to taxable gain under either Net CFC Tested Income of Subpart F income which could be taxed as high as 21%. If sufficient E&P exists, such corporate sellers may prefer a stock sale over an asset sale.
On the other hand, in cases involving U.S. individual sellers of CFC’s, no deduction would be permitted under Section 245A for any gain recognition as a dividend under Section 1248 of the Internal Revenue Code. Instead, dividends are taxable either at qualified dividend rates of 20% under Section 1(h)(11) of the Internal Revenue Code or as ordinary income at a maximum rate of 37%, depending upon whether the CFC is resident in a treaty country. Any excess gain in excess of relevant earnings and profits generally would be taxable at the 20% long-term capital gains rate if the individual has held the shares more than one year. Gain from a deemed asset sale due to an Section 338(g) election in such a situation would produce Net CFC Tested Income or Subpart F income which is taxable at ordinary income rates assuming no Section 962 election is made. Thus, in most cases, individual U.S. sellers of CFCs will prefer a buyer not make a Section 338(g) election. If the individual seller does not want a Section 338(g) election made, the written contract for the acquisition of the CFC shares needs to specifically prevent the buyer from making a Section 338(g) election.
Impact of Section 901(m) on a Section 338(g) Election
The EMJF Act added Section 901(m) to the Internal Revenue Code. Section 901(m) partially denies a foreign tax credit for the “disqualified portion” of any foreign income tax paid or accrued in connection with a “covered asset acquisition.” The disqualified portion for any particular tax year is the ratio (expressed as a percentage) of (i) the aggregate basis difference allocable to such tax year of all relevant foreign assets divided by (ii) the income on which the foreign income tax is determined (as calculated for foreign tax purposes).
The basis difference of any relevant foreign asset is the excess of (i) the U.S. tax basis immediately after the covered asset acquisition over (ii) the U.S. tax basis immediately before the covered asset acquisition. To determine the foreign tax credit amount denied under Section 901(m), it will be necessary to multiply the disqualified portion for the particular year by the foreign taxes allocable to such year that is paid or accrued with respect to the relevant foreign assets. Expressed formulaically:
Amount of Disqualified Foreign Taxes
Foreign Tax Credit Denied = Portion Paid/Accrued
To the extent a foreign tax credit is disallowed, the disqualified portion may be deducted to the extent it is otherwise deductible.
If there is a disposition (for both U.S. and foreign tax purposes) of a foreign asset subject to Section 901(m) prior to full cost recovery, any remaining tax basis difference is captured in the year of disposition.
Anytime a Section 338(g) election is made, a careful determination must be made how Section 901(m) may reduce the credibility of foreign taxes.Under Section 901(m), a Section 338(g) elect ion result in trapped foreign tax credits that cannot be carried out of T under Section 960.
Conclusion
Making a Section 338(g) election in connection with the acquisition of a CFC permits the buyer to treat a stock purchase as an asset sale. The benefits of making a Section 338(g) election includes an asset basis step-up and potentially reduced future income inclusions. There are however a number of notable potential disadvantages to making a Section 338(g) election that should be considered. Which include possible step-down in basis of CFC assets, trapped foreign tax credits, elimination of pre-acquisition foreign tax credits, and the elimination of pre-acquisition previously taxed income under Section 959(a) of the Internal Revenue Code. The advantages and disadvantages of making a Section 338(g) election must carefully be considered prior to the acquisition of the CFC.
Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony has advised various Fortune 500 companies and large privately held businesses in their cross-border tax planning.
Anthony is a frequent author and speaker on international tax topics.
Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.
Written By Anthony Diosdi
Anthony Diosdi focuses his practice on international inbound and outbound tax planning for high net worth individuals, multinational companies, and a number of Fortune 500 companies.
