CFC Buyer's Sec. 338 Election Deprives Seller of FTCs

When a U.S. person sells stock in a controlled foreign corporation (CFC) and recognizes gain, Sec. 1248 may apply to treat all or a portion of the gain as dividend income, to the extent of the shareholder's proportionate share of the CFC's historical earnings. If the seller is a U.S. corporation, it might be able to claim foreign tax credits (FTCs) under Sec. 902 for the deemed dividend. The amount of FTCs available will depend on whether the buyer makes a Sec. 338 election.

Sec. 338, in general, allows a corporation making a qualified stock purchase (QSP) to elect to treat the stock purchase as an asset acquisition. The target corporation is considered to sell all of its assets to a "new" target corporation as of the close of the acquisition date, and must recognize gain or loss on its assets.

When a U.S. corporation makes a QSP of a foreign target corporation (FT), it generally is advantageous for the purchaser to make a Sec. 338 election to treat the purchase of the FT stock as an asset purchase. For U.S. tax purposes, the Sec. 338 election provides for a basis step-up in the FT's assets and eliminates the FT's pre-acquisition earnings and profits (E&P) and tax pools. The basis step-up in the FT's assets should provide for an increased effective tax rate (ETR) for the FT's E&P in future years. The increased ETR should assist the new U.S. shareholder in claiming additional FTCs on future dividends received from the FT, and perhaps assist the new U.S. shareholder in avoiding future taxable income inclusions for the FT's activities under the subpart F rules.

If the buyer makes a Sec. 338 election for the CFC, the gain from the deemed-asset sale increases the CFC's E&P to the extent of the net inside gain of the CFC's assets. The gain from the deemed sale of assets would increase the Sec. 1248 deemed dividend (limited by the recognized gain on the stock sold), thereby recharacterizing an additional portion of the seller's gain as dividend income (typically general-basket foreign-source income) that carries FTCs—a beneficial result for the seller.

To prevent taxpayers from receiving an FTC benefit from this increased dividend, Congress enacted Sec. 338(h)(16), which provides that the deemed-sale provisions of Sec. 338 do not apply for purposes of determining the source or character of any item for FTC purposes (i.e., Secs. 901908). Sec. 338(h)(16), however, does not apply to any gain, to the extent such gain is includible in gross income as a dividend under Sec. 1248 (determined without regard to any deemed sale under Sec. 338 by a foreign corporation).

Congress believed that U.S. taxpayers should not receive FTC benefits from the E&P generated by a deemed-asset sale, because it is not taxed in the relevant foreign jurisdiction. To permit the deemed sale to flow through as general-basket foreign-source income (assuming that the deemed sale involves assets used in the active conduct of the CFC's trade or business) would be contrary to the policy reasons underlying the FTC rules (i.e., relief of double taxation.)

Recent CAA

In Chief Counsel Advice (CCA) 200103031, the IRS concluded that Sec. 338(h)(16) does not affect the computation of a selling shareholder's deemed-paid taxes under Secs. 902 and 1248. Put simply, the Service considers the increased E&P from the deemed-asset sale in determining the amount of foreign income taxes attributed to the Sec. 1248 deemed dividend.

The amount of deemed-paid taxes associated with a Sec. 1248 deemed dividend is computed by using the Sec. 902 fraction. The numerator of the fraction is the Sec. 1248 deemed dividend, which is the lesser of the gain recognized on the stock sold or the shareholder's proportionate share of the CFC's historical earnings, and the denominator is the CFC's post-1986 undistributed E&P (on a category-by-category basis).

Sec. 338(h)(16) ignores the deemed- asset provisions of Sec. 338 in determining the "source or character" of any item for FTC purposes. As noted in the CCA, "source" generally refers to whether income is derived within or without the U.S., and "character" generally is understood to refer to the separate Sec. 904(d) limitation categories (e.g., passive, general). The CCA states that Sec. 338(h)(16) does not disregard the deemed-asset sale provisions of Sec. 338 for other purposes (e.g., the determination of a Sec. 1248 deemed dividend).

Under the CCA's interpretation of Sec. 338(h)(16), a loss of FTCs might occur when the E&P generated by the Sec. 338 deemed sale, together with the FT's existing E&P, exceeds the gain recognized on the sale of the FT's stock. In this scenario, the seller would receive fewer FTCs with respect to the Sec. 1248 deemed dividend.

Example 1: USS, a domestic corporation, owns all the stock of FT, a CFC. USS has a basis of $0 in the FT stock. USS sells its FT stock for $400 to an unrelated domestic corporation, which elects under Sec. 338(g) to treat the stock purchase as an asset purchase for U.S. tax purposes. FT has general-limitation, post-1986 undistributed earnings of 50u, and has paid $10 in foreign income taxes on such earnings. The deemed sale of FT's assets results in additional general-limitation earnings of 450u (not assuming any subpart F income). USS recognizes a $400 gain on the sale of FT stock, all of which is recharacterized as a deemed dividend under Sec. 1248. The amount of foreign income taxes attributable to general-limitation income deemed paid by USS under Sec. 902 is computed as follows (FT's functional currency is u, with 1u = $1 at all times):

Deemed-Paid Tax = (400u / 500u) x $10 = $8

Because the Sec. 1248 deemed dividend is limited to the gain inherent in the stock sold, part of FT's E&P is not considered in computing the deemed-paid tax associated with such amount under Sec. 902. Accordingly, the U.S. shareholder (in Example 1, USS) does not receive the benefit of the foreign income taxes associated with such E&P (and neither will FT's new U.S. shareholder, because new-FT does not inherit old-FT's E&P and tax pools).

The CCA states that, under Sec. 338(h)(16), USS's $400 gain is comprised of $50 of foreign-source general-limitation income and $350 of foreign-source passive income (assuming the foreign-affiliate rule of Sec. 865(f) applies) for purposes of determining USS's Sec. 904 limit. Further, the recharacterization rule of Sec. 338(h)(16) (as illustrated) applies at the shareholder level.

On the other hand, if FT's existing E&P exceeds the inherent gain in its stock and FT's Sec. 338 deemed-asset sale results in a loss, FT's U.S. shareholder should receive additional FTCs because the deemed-sale loss is factored into the Sec. 902 equation.

Example 2: The facts are the same as in Example 1, except that FT's existing E&P is 500u and the deemed sale of FT's assets results in a general-limitation loss of 100u. The amount of foreign income taxes attributable to general-limitation income deemed paid by USS under Sec. 902 is computed as follows:

Deemed-Paid Tax = (400u / 400u) x $10 = $10

The primary advantage of the typical Sec. 338 election (i.e., basis step-up in the CFC's assets), however, would not exist under the facts of Example 2. Thus, the buyer is less likely to choose this scenario.

Conclusion

Sellers of CFC stock need to be aware that a buyer's Sec. 338 election may affect not only its reportable Sec. 1248 and subpart F income, resulting from the deemed sale, but that the Sec. 338 deemed sale may also affect the amount of available deemed-paid FTCs. Thus, the seller may want to undertake transactions—such as dividends or Sec. 956 investments—to clean out E&P and obtain all available FTCs before the sale, or obtain indemnification from the buyer as part of the transaction.

Commentators have called for regulations that would provide consistency between the treatment of the "source" or the "character" rule under Sec. 338(h)(16) and the deemed-paid FTC rules under Secs. 1248 and 902 for Sec. 338 elections. Such rules, if enacted or promulgated, likely would avoid the adverse impact of reduced FTCs that occurs under existing law.

From Martin J. Collins, J.D., CPA, Washington, DC