Section 338(g) Election for a Foreign Target Continues to Provide Benefits to Buyer After New §901(m)

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By Lowell D. Yoder, Esq.

McDermott Will & Emery LLP, Chicago, IL


U.S. acquirers have generally found it beneficial to make a §338(g) election for a foreign target. However, beginning in 2011, new §901(m) substantially reduces the foreign tax credit benefits of such an election. Nevertheless, the remaining foreign tax credit benefits and other important advantages will likely cause buyers in many situations to continue to make §338(g) elections for foreign targets.1  

A §338(g) election can be made for a foreign target when a U.S. corporation (or one of its subsidiaries) acquires 80% or more of the stock of the foreign target in a taxable transaction within a one-year period.2 In addition, a §338(g) election can be made for a foreign subsidiary owned by a domestic target for which a §338(h)(10) election is made.3  

A §338(g) election also can be separately made for one or more subsidiaries of the foreign target. An election for a lower-tier target subsidiary requires that such election be made for the immediate parent of the subsidiary. It is not necessary to make the election for every subsidiary of the foreign target, e.g., a U.S. subsidiary.4

If a §338(g) election is made for a foreign target, the acquirer is considered as forming a new foreign corporation that acquires the assets, and assumes the liabilities, of the foreign target. As a result, the basis of the assets of the foreign target are stepped-up to fair market value, all historic tax attributes are eliminated, and the foreign target begins a new taxable year. If the election is made for subsidiaries of the foreign target, separate new companies are considered as formed and are treated as acquiring the assets and assuming the liabilities of each respective target subsidiary.5 The buyer generally does not bear any U.S. tax costs as a result of the election.6

Prior to 2011, a §338(g) election for a foreign target generally resulted in a post-1986 earnings pool with a "hyped" foreign tax credit rate. This occurred because the target's assets are stepped up to fair market value only for U.S. tax purposes, resulting in amortization and depreciation deductions that are not recognized for foreign purposes.

Example. CFC purchases the stock in foreign target (FT) for $100 and makes a §338(g) election.  The inside asset basis is $50, which is stepped up to $100. Assume that the additional $50 of basis is amortized over a 10-year period for U.S. tax purposes (i.e., $5 annually). Assume FT has $15 of income (before the additional amortization) subject to a 40% foreign tax rate, resulting in $6 of foreign taxes. FT's earnings pool would be $4 ($15 - $5 - $6). Prior to §901(m), the effective tax rate of the pool of earnings would be 60% [$6 ÷ ($4 + $6)]. If the $4 of earnings were distributed to the United States, the excess foreign tax credits would be $2.50 ($6 – $3.50 (i.e., ($6 + $4) × 35%)).

New §901(m) provides that a portion of foreign income tax determined with respect to income or gain attributable to foreign assets acquired in a "covered asset acquisition" is not creditable. Covered asset acquisitions include a purchase of stock in a target for which a §338 election is made or transactions treated as asset acquisitions for U.S. purposes but as acquisitions of stock or that are disregarded for foreign tax purposes (e.g., the purchase of interests in an entity disregarded for U.S. tax purposes).  The disqualified portion equals the aggregate basis difference allocable to such taxable year with respect to all relevant foreign assets divided by income on which the foreign income tax is determined. In other words, §901(m) denies a credit for foreign income taxes paid on foreign income that is not recognized for U.S. purposes because of the covered asset acquisition. Depreciation and amortization deductions resulting from a covered asset acquisition remain deductible for purposes of calculating U.S. income and earnings and profits, as do the non-creditable taxes.7

Applying §901(m) to the above example, the calculation of FT's income and earnings is the same (i.e., $4). Nevertheless, the amount of foreign taxes eligible for credit is reduced by $2 [($5 ÷ $15) x $6], from $6 to $4. This results in an effective tax rate on FT's earnings of 50% [$4 ÷ ($4 + $4)], with excess foreign tax credits of $1.20.8

If a §338(g) election was not made for FT, there would be no step-up in the basis of FT's assets for U.S. tax purposes and accordingly §901(m) would not apply. In the above example, the effective tax rate on FT's earnings generally would be 40%, which would provide excess foreign tax credits of $.75. From an effective foreign tax rate perspective, this is a less favorable result than making a §338(g) election with the application of §901(m).

In addition to foreign tax credit benefits, there are significant other advantages of making a §338(g) election for a foreign target. One important benefit is the elimination of the foreign target's tax attribute history, including earnings and profits and basis in assets. This is especially valuable when the target was foreign-owned because U.S. tax principles would not have been used to compute the tax attributes of the target, and conversion to U.S. tax rules would be difficult and uncertain. It should be pointed out, however, that beginning in 2011 taxpayers are required to calculate the historic bases of assets for purposes of applying §901(m), but not for other purposes.

Post-acquisition restructuring is accommodated by the elimination of the foreign target's earnings and profits and the step-up in the bases of its assets. For example, assume that a foreign target owns stock in a U.S. subsidiary. With a §338(g) election for the foreign target, the basis of the stock of the U.S. subsidiary would be stepped up to fair market value. As a result, the U.S. subsidiary stock could be sold to the U.S. parent without generating any gain which would have been Subpart F income.9 

Often a buyer desires to integrate with its own operations the foreign subsidiaries of a foreign target. For example, the foreign target may distribute the stock of a foreign operating subsidiary to a foreign holding company without triggering Subpart F gain or dividends as a result of the step-up in basis provided by the §338(g) election. The foreign holding company may thereafter sell the foreign subsidiary stock in a leveraged transaction to a local country holding company without U.S. taxation even if subject to §304, because of the stepped-up stock basis and elimination of historic earnings and profits. Similarly, a cross-chain cash "D" reorganization may be utilized to integrate foreign target subsidiaries without triggering Subpart F income.10 

A §338(g) election also can provide Subpart F benefits. Closing the foreign target's taxable year eliminates pre-acquisition Subpart F income for the buyer. For example, assume a calendar year foreign target is acquired on July 1, 2011, from a foreign seller. During the first six months the foreign target has $500 of Subpart F income (even if it is not a controlled foreign corporation, "CFC"), but derives no Subpart F income after the acquisition. Absent the election, the buyer would have $250 of Subpart F income under a rule that allocates the Subpart F income pro rata to the pre- and post-acquisition ownership periods.11 With a §338(g) election, the buyer would have no Subpart F income, because the target's taxable year would close on the acquisition date.

Furthermore, the additional U.S. deductions for amortization and depreciation would reduce the foreign target's Subpart F income to the extent allocated or apportioned to such income.12 In addition, the target's higher effective tax rate pool of earnings can increase the likelihood of the availability of the Subpart F high-tax exception.13 The additional deductions reduce earnings and profits which may cause the current year earnings and profits limitation to apply, and possibly result in a qualified deficit that may be carried forward or used by another CFC in the chain of ownership.14 

The application of §338(g) to a foreign target affects a U.S. seller's tax consequences (but not a foreign seller's tax consequences). As a result, a U.S. seller generally will require its approval for a buyer to make the election and request indemnification for any additional tax costs.15  

Under §1248, gain on the sale of stock in a CFC is treated as ordinary dividend income to the extent of the CFC's earnings and profits attributed to the shares sold. Any earnings and profits resulting from the gain on the deemed §338 sale of the foreign target's assets would increase the amount of any otherwise capital gain that would be treated as ordinary income. Also, any Subpart F income resulting from the deemed asset sale would be taxable to the U.S. seller (e.g., gain on the sale of stock in a joint venture), and the basis in the stock of the foreign target would correspondingly be increased for purposes of calculating the seller's gain.16 A §338 election may be a disadvantage to a seller if it has capital losses that it is prevented from using as a result of the increased amount of gain recharacterized as ordinary income.

A §338 election can also result in adverse foreign tax credit consequences to a U.S. seller. The amount of the seller's gain treated as ordinary dividend income under §1248 generally is foreign-source, general basket income, bringing deemed paid foreign tax credits. Under §338(h)(16), the seller's additional §1248 amount resulting from the foreign target's gain on the deemed sale of its assets cannot be treated as general basket foreign-source income, but must be sourced based on the source of the capital gain on the sale of the stock (i.e., U.S.-source or passive basket foreign-source income).17 In addition, if the foreign target recognizes passive Subpart F income that replaces a portion of the seller's §1248 amount, the amount of the seller's general basket foreign-source income would correspondingly be reduced. Furthermore, if the earnings resulting from the §338 election cause a CFC target's total §1248 earnings and profits to exceed the seller's gain on the sale of the foreign target's stock, the amount of the seller's deemed paid tax credits can be reduced.18  

Finally, under certain circumstances it may be desirable for a buyer to not make a §338(g) election for a foreign target. Without an election, the foreign target retains all of its historic tax attributes. One important attribute is previously taxed income (PTI).19 A foreign target can have PTI as a result of Subpart F inclusions in the income of an ultimate U.S. parent, and the amount of the earnings taxable to a U.S. seller under §1248 upon the sale of the foreign target stock also gives rise to PTI.  A distribution by a foreign target of its earnings to the buyer is considered as made out of PTI first and to that extent is not treated as a taxable dividend,20 which can be a significant benefit for U.S. multinationals with domestic net operating losses or overall foreign losses.21

If a foreign-owned foreign target holds U.S. property, as a general rule such property investment is not subject to the Subpart F inclusion rule to the extent of the earnings of the target on the date of the acquisition.22If a §338(g) election is made, the grandfather rule does not apply. In addition, the basis in the property is stepped up to fair market value. With an election, the U.S. shareholder would include in its income under Subpart F an amount equal to the stepped-up basis of the property, limited to the earnings and profits of the target. On the other hand, if a §338(g) election is not made, the grandfather rule and lower basis in the property would be available to minimize any Subpart F inclusion.

In addition, a buyer may not wish to make a §338(g) election for a foreign target if the target has a high-taxed earnings pool or has deficits. These attributes can provide opportunities for repatriating foreign earnings with an effective foreign tax rate in excess of the U.S. tax rate.23 The target also may have qualified deficits that could offset post-acquisition Subpart F income.24

In summary, there continue to be significant U.S. tax benefits of making a §338(g) election for a foreign target even with new §901(m). Nevertheless, the foreign tax credit benefits have been reduced (but not eliminated) and the requirement to determine historic bases in assets continues for foreign tax credit purposes. Each acquisition will need to be carefully analyzed to determine whether the best course is to make a §338(g) election, taking into account the advantages and disadvantages of such election under the particular facts, and any required indemnification payments to the seller.

This commentary also will appear in the June 2011 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, DuPuy and Dolan, 901 T.M., The Creditability of Foreign Taxes — General Issues, and Carr and Moetell, 902 T.M., Indirect Foreign Tax Credits,  and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation.


1 See Yoder, "CFC Target: To Make or Not to Make a Code Sec. 338 Election," 3 J. of Tax'n of Global Trans. 3 (Winter 2004); Yoder, "Code Sec. 338(g) Election Applied to Foreign Targets: Permissible Tax Arbitrage," 33 Int'l Tax J. 3 (May-June 2007).


2 §338(d)(3); Regs. §1.338-5(a).


3 §338(h)(3)(B); Regs. §§1.338-9(b)(2), -2(c)(18).


4 A §338(g) election for a domestic target subsidiary would cause the net gain on the deemed sale of the subsidiary's assets to be subject to U.S. taxation. An election might be made if the domestic subsidiary has net operating losses that would offset the gain.


5 If a §338(g) election is made for a foreign subsidiary of the foreign target, then the deemed sale of its stock would be ignored. Regs. §1.338-4(h)(2).


6 There can be U.S. tax costs if the foreign target has assets or transactions that would be subject to U.S. taxation on the deemed sale, or where the buyer acquires the foreign target's stock in a series of transactions over the 12-month period and the deemed sale results in Subpart F income (i.e., a "creeping acquisition"). See Regs. §1.338-9(f)(2), Ex. 4.


7 §901(m)(6); see Regs. §1.902-1(a)(9)(i).


8 $4 – $2.80 (i.e., ($4 + $4) × 35%). SeeRegs. §§1.338-5(d), 1.1502-76(b)(4) (allocation of foreign income taxes for the year of acquisition between the pre- and post-acquisition periods).


9 §954(c)(2). Stock in subsidiaries often can be sold without foreign taxation.


10 With a §304 transaction, the amount of earnings derived during the current year after the acquisition would be treated as a deemed dividend, although higher depreciation and amortization deductions should reduce this amount. (Such deemed dividend should qualify for the temporary Subpart F exception provided in §954(c)(6).) A cash "D" reorganization, under current law, should not take into account post-acquisition earnings because the basis in the stock of the foreign target subsidiary is stepped up to fair market value (the boot-within-gain limitation under §356).  SeeYoder, "CFC Purchase of Stock in a Related CFC: Code Sec. 304 vs. D Reorganization Treatment," 34 Int'l Tax J. 3 (March-April 2008); Yoder, "New Code Sec. 367(a) Regulations Apply to International Code Sec. 304(a)(1) Transactions," 35 Int'l Tax J. 3 (May-June 2009).


11 §951(a)(2)(A); Regs. §1.951-1(a). A buyer can also have Subpart F income if the target was U.S.-owned and therefore a CFC. The U.S. shareholder that holds the CFC's stock on the last day of the CFC's taxable year must include in its gross income the §951(a) amounts for the entire year. See also §951(a)(2)(B) (the amount taxable to the buyer may be reduced by a portion of the §1248 amount taxable to the seller).


12 Regs. §1.954-1(c).


13 See Yoder, "Subpart F High-Tax Exception: Impact of Recent Foreign Tax Credit Legislation," 40 Tax Mgmt. Int'l J. 113 (2/11/11).


14 §952(c).


15 An acquirer can unilaterally make a §338(g) election without obtaining consent of the seller (absent a provision in the contract), although it must provide the seller with notice after the acquisition. Regs. §1.338-1(e)(4).  See Yoder & Kahn, "Buyers Electing Section 338 for CFC Targets: Sellers Beware," 28 Tax Mgmt. Int'l J. 531 (9/10/99).


16 Regs. §1.338-9.


17 §865(a), (f).


18 This is the position of the IRS. See Yoder, "CCA 200103031: Does §338(h)(16) Apply to Deemed-Paid Credits?," 30 Tax Mgmt. Int'l J. 443 (10/12/01); see also Yoder, "Selling CFC Stock with a §338 Election: §1248 and Foreign Tax Credit Consequences," 33 Tax Mgmt. Int'l J. 375 (6/11/04).


19 §959.


20 Regs. §1.959-1(d) (successor in interest provisions).


21 §904(f).


22 §956(b)(2).


23 If the foreign target was not a CFC (e.g., it was foreign-owned), its earnings and profits are maintained in accordance with the pre-1987 layering rules, but may be afforded look-through treatment. See §902(b); Regs. §§1.902-1(a)(4)(ii), 1.904-5, -7.


24 §952(c).


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