Following the 2017 Tax Act, a domestic corporate purchaser of stock in a controlled foreign corporation (CFC) generally will desire to make a section 338(g) election. A section 338(g) election provides a stepped-up basis in the assets of the CFC, and thereby results in increased deductions for amortization and depreciation that will reduce the buyer’s future global intangible low-taxed income (GILTI) by both reducing “tested income” and increasing “qualified business asset investment.” A section 338(g) election also can be beneficial for a domestic corporate seller of CFC stock, although not in all cases and the analysis can be complex.
As discussed in a prior Insight, gain recognized by a domestic corporation on the sale of CFC stock is recharacterized as a dividend under section 1248 to the extent of the previously untaxed earnings and profits of the CFC and its subsidiaries. The amount treated as a dividend generally qualifies for a 100 percent dividends received deduction. Any remaining capital gain is subject to a 21 percent tax rate. A domestic purchaser (rather than the seller) generally is subject to tax on any Subpart F income and GILTI of the CFC for the entire year of sale, reduced by the amount of current year earnings treated as a dividend distributed to the seller, including any amount recharacterized as a dividend under section 1248.
With a section 338(g) election, the target CFC is deemed to sell its assets and recognize any gain resulting from the deemed asset sale. If the seller is a domestic corporation, the CFC target’s gain on non-trade or business assets would generally be Subpart F income and the remaining amount (gain on the trade or business assets) would be tested income for GILTI purposes. The CFC’s tax year closes, and its Subpart F income and GILTI through the date of sale would be included in the gross income of the domestic seller (rather than the buyer).
When a section 338(g) election is made, the domestic seller will also be taxed on the gain on the sale of the CFC stock, with the basis of such stock increased for the amount of any inclusions under Subpart F and GILTI for the year (including the Subpart F and GILTI income generated by the deemed asset sale). Subject to holding period requirements, the stock gain will be recharacterized as a deductible dividend under sections 1248 and 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.
To illustrate the effect of a section 338(g) election on a selling US shareholder, consider a domestic corporation that sells stock in a CFC for $700. The basis in the CFC stock is $400, and thus the seller has $300 of gain. Assume the untaxed earnings and profits of the CFC from prior years attributable to the seller is $100. If no section 338(g) election is made, $100 of the seller’s gain would be recharacterized as a dividend, and the seller would receive an offsetting $100 deduction under sections 1248 and 245A. The seller would pay a 21 percent tax rate on the remaining $200 of capital gain ($42 of tax).
Now assume the same facts except that the buyer makes a section 338(g) election for the CFC, and the CFC recognizes $90 of deemed gain. Assume the gain is not Subpart F income but is tested income for GILTI purposes. Assume further that the CFC has $10 of additional tested income for the current year through the date of sale. Because the CFC’s tax year closes, the seller would generally be taxed under the GILTI regime on $100 at a 10.5 percent tax rate ($10.50 of tax), and the seller’s stock basis would be increased by $100. After taking into account the stock basis increase, the seller would have $200 of gain on the sale of the stock, $100 of which would be a deemed dividend and eligible for a $100 deduction. The remaining $100 of gain recognized would be capital gain taxed at 21 percent ($21 of tax). Thus, the seller’s total tax costs would be reduced to $31.50 (rather than $42) by converting a portion of the gain to GILTI.
Under certain circumstances, a seller’s tax costs can increase with a section 338(g) election. For example, the GILTI inclusion resulting from the deemed asset sale and closing of the CFC tax year can sometimes cause a material reduction of the amount of gain that would have been recharacterized as a deductible dividend under section 245A if the election had not been made. In addition, the seller could have higher tax costs if the additional Subpart F or GILTI inclusions resulted in taxable income greater than the amount of gain on the sale of the stock, and the seller does not have capital gains to absorb the resulting capital loss.
In summary, a section 338(g) election, in addition to generally being beneficial to a buyer, can also reduce a domestic corporate seller’s US tax costs on the sale of stock in a CFC. Under certain circumstances, however, the election can result in an increase in a seller’s tax costs. Therefore, a domestic seller should ensure that the stock sale agreement addresses the seller’s tax consequences resulting from a buyer making a section 338(g) election.