The 2017 Tax Act significantly increased the benefits of a section 338(g) election for a domestic corporate purchaser of stock in a controlled foreign corporation (CFC). If an election is made, the Buyer is treated as organizing a “new” CFC that purchases the assets of the “old” target CFC for the amount paid for the CFC stock. The primary benefit for the Buyer is a stepped-up basis in the CFC’s assets, which can facilitate tax efficient post-acquisition integration and which results in a reduction of future global intangible low-taxed income (GILTI).
When the Buyer makes a section 338(g) election, the tax year of the target CFC closes on the date of the sale of the stock and all of the CFC’s prior tax attributes are eliminated. The Seller reports the tax consequences of the CFC’s gain on the deemed sale of its assets under section 338, including any Subpart F income and GILTI [see Insight]. The Seller also includes in its income any other Subpart F income or GILTI arising during the year of sale prior to the transaction date. Without a section 338(g) election, a US Buyer generally would be taxable on the target CFC’s Subpart F income and GILTI for the entire year of sale (albeit reduced by the amount of current year earnings included in the Seller’s income as a deemed dividend under section 1248).
The step up in basis in the target CFC’s assets provides additional amortization and depreciation deductions for the target CFC, which are generally available to reduce future Subpart F income and tested income for purposes of GILTI. In addition, the step up in basis of tangible property can increase the Buyer’s “qualified business asset investment” and thus further reduce the amount of the Buyer’s GILTI inclusion. The fair market value basis in the target CFC’s assets also generally eliminates gain on post-acquisition integration transactions involving further transfers of the CFC’s assets that otherwise might give rise to Subpart F income or GILTI. The closing of the target CFC’s tax year prevents the Buyer from having a Subpart F income or GILTI inclusion by reason of actions taken by the Seller during the year of the sale. Finally, the elimination of the CFC’s historical earnings and profits avoids complications that may arise regarding the application of section 245A and the Subpart F and GILTI rules for the Buyer going forward.
While favorable tax attributes of the “old” target CFC (such as foreign tax credits and previously taxed income) do not carry over to the “new” CFC following a section 338(g) election, such attributes generally are less important following the 2017 Tax Act. For example, pre-acquisition foreign taxes of the target CFC are more difficult to access following the 2017 Tax Act (given the repeal of section 902 and modifications of section 960), and distributions of future non-GILTI/non-Subpart F earnings of the target CFC will frequently be eligible for a 100 percent dividends received deduction under section 245A.
For foreign tax credit purposes, the section 338(g) election is treated as a covered asset acquisition under section 901(m). As a result, a credit is not permitted for foreign taxes paid on amortization and depreciation deductions that are not taken into account for purposes of calculating foreign income taxes. The disallowed foreign tax credits are still deductible by the CFC, however, to determine tested income and earnings and profits.
Subject to a notice requirement to the Seller, a corporate purchaser of CFC stock may unilaterally make a section 338(g) election. Nevertheless, the Seller will likely ask that the sales agreement set forth whether the Buyer is permitted contractually to make a section 338(g) election, and may require that the Buyer make the Seller whole if the Seller incurs additional tax costs as a result of such election (or, alternatively, the Seller may request an increase in the purchase price at the time of the sale so that the Seller can effectively share a portion of the Buyer’s tax benefits). As discussed in a prior Insight, a Seller under certain situations can actually benefit from a Buyer’s section 338 election.
In summary, a section 338(g) election generally is beneficial for a domestic corporate purchaser of CFC stock because the stepped-up basis results in a reduction of the amounts of future Subpart F income and GILTI inclusions. The election also facilitates tax-efficient integration into the Buyer’s foreign operations. Although a Seller may require that it be made whole for any additional tax costs resulting from a section 338(g) election, under certain circumstances the Seller’s tax result will be more favorable.