Hybrid Transactions

By James J. Tobin, Esq.  

Ernst & Young LLP New York, NY1

I had occasion to read through the recently issued final regulations under §336(e) in the last few weeks.  Not an international tax provision as such but interesting nonetheless.

Section 336(e) was added to the Code in 1986 and provides an election to treat the sale, exchange, or distribution of at least 80% of the vote and value of stock of a corporation as a sale of the underlying assets of the corporation (target company).  By its terms §336(e) required enabling regulations from Treasury; now, 27 years later, we finally have the regulations that give the provision effect.

The election under §336(e) is similar in effect to the already familiar deemed-sale election under §338(g) or §338(h)(10). The main significance of §336(e) is the broader application of the election provision. Unlike with respect to a §338(g) election, there is no requirement for a single qualifying purchaser of 80% of the stock of the target company. Thus, a "qualified stock disposition" for purposes of §336(e) can occur as a result of creeping dispositions of 80% or more of the target shares over a 12-month period to multiple buyers, including by reason of one or more taxable distributions of the shares of the target company.  Thus, if a seller sells 50% of a target subsidiary to an unrelated buyer and within 12 months distributes the other 50% to its public shareholders, the transaction would qualify for a §336(e) election.  So we can expect lots more situations where deemed asset sales will occur.

Unfortunately, in some respects the eligibility for a §336(e) election is also narrower than §338, at least narrower than §338(g). Most important to me is that, similar to §338(h)(10), the §336(e) election is limited by the regulations to a disposition of domestic target stock held by domestic corporate sellers. So if either the sellers or target are foreign corporations, the election will not be available - for now. The Preamble states that the Treasury and IRS will continue to study the potential application in the foreign context. Someone more cynical than I might question whether the studying will take another 27 years, but, as I have said before, I am an optimistic guy.

So for now, the international application of the election is somewhat limited, but not entirely non-existent.  A U.S. target for which a §336(e) election is made could well have foreign branch assets or assets producing foreign-source income.  Also, if the U.S. target owns over 80% of a controlled foreign corporation (CFC), it would seem that a §336(e) deemed-sale election would enable the buyer to make a §338(g) election with respect to the CFC. That's not explicit in the regulations, but it seems to be the logical result. Thus, there could be international tax consequences to a §336(e) election, which could potentially impact the analysis of making an election or not and the overall consequences thereof.  Rather than a thorough analysis of all the technical rules of the regulations, in this commentary I'd like to focus a bit on the international aspects of the election.

I find the various elective asset sale provisions to be interesting from a policy perspective. As elective provisions, they would be chosen only when there's a net tax benefit in doing so. The §336(e) election must be agreed to by the seller and the target. Interesting that the joint agreement is with the seller and the target rather than the seller and the buyer. But this is necessitated by reason of the fact that there could be multiple purchasers or, in the case of a distribution, even a public shareholder group that is considered the "buyers" of target. Thus, target's agreement to the election is essentially the agreement/consent of the new ownership group of target. (No doubt a section on the potential application of §336(e) will be a required feature in purchase/sale and distribution documentation going forward.) Agreement to the election would presumably be premised on there being a net tax benefit to both seller and target or an overall benefit to one or the other which effectively gets shared in the deal pricing. The benefits could relate to the amount of the gain or loss due to inside/outside basis differences, the step-up benefit with respect to the underlying assets, the use of tax attributes, etc. These types of domestic tax benefits are all considered acceptable tax consequences enabled by the election under §336(e) or by the election under §338, which produces similar outcomes. However, any tax benefit that could result from these elections in the international tax context is still out of bounds and apparently considered an inappropriate outcome (or at least one which requires further study).

Recall that for §338 elections, when it comes to the foreign tax credit implications, §338(h)(16) ensures that asset gain in a §338(h)(10) election is not treated as foreign-source income, which avoids enabling greater use of credits. Likewise, the regulations under §336(e) specifically incorporate the principles of §338(h)(16) to ensure the same foreign tax credit consequences.  Since a §336(e) election cannot be made with respect to a CFC, the §338(h)(16) principles just apply to foreign branch assets of a U.S. target and essentially treat what would be foreign-source income (if the sale occurred "long-hand") as U.S.-source income (from the sale of U.S. stock). I have never fully understood why the domestic tax benefits of a deemed-sale election were acceptable policy but the international consequences were not. But obviously Treasury and the IRS haven't changed their mind on that point and so provided for consistency between §338 and §336(e).

Elections under both provisions are also §901(m) covered asset transactions for foreign tax credit purposes. So if a domestic target for which a §336(e) election is made has foreign branch assets that are stepped up for U.S. tax purposes, but obviously not for foreign purposes since the foreign country sees a stock sale of the U.S. target, a part of the future foreign tax attributable to lower depreciation deductions for foreign tax purposes (as a result of lower asset bases) will be disallowed as foreign tax credits.  I've previously written (okay, complained) about this potential application of §901(m), which seems to me totally inappropriate. For foreign branch assets where a §336(e) or §338 election is made the situation seems pretty bleak: asset gain is fully recognized and taxed in the United States, all at once and in advance of annual operating earnings; further, the gain is considered U.S.-source income to the seller by reason of §338(h)(10) and future foreign tax paid by target after the sale could be disallowed under §901(m) even though the step-up gain for U.S. tax purposes was fully taxed in the United States. Hopefully, when we finally get guidance under §901(m), it's not this punitive. But again it seems ironic to me that domestic tax advantages from the election are acceptable policy - indeed they are essentially the purpose behind the Code provision - but international tax advantages are eliminated or, potentially under §901(m), the results are more onerous than not making the election in the first place. Well - good that it's an election!

It's interesting to note that the elective provisions of §336(e) and §338 are not the only ways of achieving asset sale treatment. Obviously, the parties could actually have the target company sell its assets and liquidate rather than selling shares.  That's typically a more cumbersome transaction from a legal standpoint.  The domestic tax results would be expected to be largely the same as for an elective sale. However, the international tax results would be quite different and potentially more beneficial from a U.S. tax standpoint. This is particularly troublesome, in that one of the purposes of §338 was to simplify the process of effecting an asset disposition for U.S. tax purposes. It's turning §338 on its head.

In an actual asset sale, the principles of §338(h)(16) would not apply and the sourcing of the gains and losses would follow the general principles of §§861-865. For foreign branch assets, it is likely that at least a portion of the gain would be considered foreign-source. Likewise, §901(m) would clearly not apply.  However, the sale of assets of the foreign branch could well be subject to immediate foreign tax. As long as that foreign tax could be credited against U.S. tax on the sale, there would be no net cost to the seller for the foreign tax and the purchaser would expect a potential future foreign tax benefit from the step-up. Encouraging U.S. sellers to plan into subjecting themselves to an acceleration of foreign tax is not a winning result for the U.S. fisc, which again calls the tax policy here into question.

To avoid the legal hassles of a true asset sale and also avoid the foreign tax effects of §338(h)(16), another alternative would be to convert the target company to a disregarded LLC before the sale. In this case it would be considered an actual sale of assets for U.S. tax purposes. If properly structured, a portion of any gain would likely be foreign-source for foreign tax credit purposes. Hopefully, the conversion from an Inc. to an LLC would not be considered a recognition event in the foreign branch country so potentially no local foreign tax on the conversion or the sale.  But assuming the LLC was considered a corporation in the foreign branch country, the LLC sale would still likely be a §901(m) transaction with the potential effect of disallowance of future foreign tax credits. Which means maybe better to have the transaction treated as a taxable sale overseas as well, if possible.

So there are a lot of alternatives to making a §336(e) or §338 election when selling a target with foreign operations. Ironically, there has been much noise recently (e.g., in the OECD report on base erosion and profit shifting, on the political front, and in the press) about hybrid transactions, entities, and instruments. Here we see a new (or newly activated) elective hybrid transaction which is viewed as good domestic tax policy but which is specifically made unavailable for international application and which even has the potential for negative tax arbitrage if the full possible effects of §901(m) are applied. This treatment in the international context seems to me inappropriate and out of balance.  I am heartened that making the §336(e) election available for international application is under further study by the government.  But I'm not sure I can wait another 27 years…

This commentary also will appear in the August 2013 issue of the  Tax Management International Journal.  For more information, in the Tax Management Portfolios, see Chudy, Early-Hubelbank & Reddy, 788 T.M., Stock Purchases Treated as Asset Acquisitions - Section 338, and DuPuy and Dolan, 901 T.M., The Creditability of Foreign Taxes - General Issues and in Tax Practice Series, see ¶7150, U.S. Persons - Worldwide Taxation.

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  1 The views expressed herein are those of the author and do not necessarily reflect those of Ernst & Young LLP.