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Foreign M&A: The Taxable Deals

Posted on Apr. 26, 2021
[Editor's Note:

This article originally appeared in the April 26, 2021, issue of Tax Notes Federal.

]
Jasper L. Cummings, Jr.
Jasper L. Cummings, Jr.

Jasper L. Cummings, Jr., is of counsel with Alston & Bird LLP in Raleigh, North Carolina.

In this report, Cummings examines the tax consequences of buying and selling foreign corporations or dealing with foreign buyers and sellers of corporations. The Tax Cuts and Jobs Act made these common transactions exponentially harder to plan, and he reviews the new regulations that add to the confusion.

I. The World Republicans Remade

A. What Would Kennedy Think?

Subpart F was a project of the Kennedy administration, after it first proposed something vaguely similar to taxing global intangible low-taxed income. In contrast, the 2017 tax act is a wholly Republican project that vastly reordered the taxation of foreign income for very different political purposes. It may be the only comprehensive federal income tax legislation ever that didn’t change the bones of the subchapter C rules underlying corporate mergers and acquisitions. Nevertheless, the 2017 act wholly upset the tax analysis for most taxable acquisitions of foreign corporations or acquisitions by or from foreign corporations.1

For starters, it invested most controlled foreign corporations with tons of previously taxed income, needlessly renamed previously taxed earnings and profits (PTEP).2 And it needlessly turned into CFCs many foreign subsidiaries of foreign parent corporations that are not themselves CFCs.3 Treasury has supplied a torrent of regulations to fill in many uncertainties, but the regulations have also created vast complexity. Even three years out, some of the international tax treatises have not quite integrated the 2017 changes into useful commentary.

This report undertakes to update the discussion of the basic moving parts for a tax analysis of international corporate acquisitions. It does not address corporate reorganizations or internal group restructurings; it focuses primarily on buyers, sellers, and targets that are corporations. The most important takeaway is this: Do nothing in haste because the consequences can be counterintuitive. You can’t reason your way to the right result in this area; you just have to follow the rules, assuming you can find them.

First, Section II reviews the 2017 act’s new rules and how they can affect foreign M&A generally, and then sections III and IV apply the old and new rules to common transactions involving foreign corporations or foreign buyers and sellers. But even before that, let’s reimagine what CFCs look like.

B. The CFC X-Ray

Readers may intuitively understand the tranches of value inside CFCs, which can be generally reflected in the value of the stock. Each tranche has an important tax effect, which can be relevant in M&A planning, particularly the choice of whether to make a section 338(g) election (the third tranche). Table 1 may help readers keep the tranches in mind.

Table 1. CFC Value Components

Tranches of Value of CFC

Potential Tax Effects on M&A

PTEP

Stock basis increase

Untaxed E&P

Section 1248/964(e)/245A dividend

Built-in asset gain

Stock gain or subpart F income and GILTI

Adjusted tax basis of assets

Qualified business asset investment

II. The Act’s M&A Provisions

A. Expensing

Neither section 179 expensing nor section 168(k) bonus depreciation applies to foreign persons and thus will not be relevant to acquisitions of foreign corporations.4 That generally means CFCs will have more asset basis because they determine the adjusted basis of property under the alternative depreciation system, which precludes bonus depreciation.5 Anyway, the basis of foreign tangible property is useful as qualified business asset investment, which can reduce the section 951A GILTI inclusion, but the deduction can create a tranche of what is called untaxed earnings or QBAI E&P (similarly, earnings that are not taxed as GILTI because of loss netting produce untaxed earnings).

B. Interest Deduction

1. Relevant foreign corporations.

Although this report doesn’t address acquisition financing, section 163(j) can be relevant for other reasons, including its ability to create suspended excess business interest expense that can be an attribute of a target foreign corporation.6 For tax years beginning on or after November 13, 2020, relevant foreign corporations will be subject to section 163(j), limiting their interest deduction to their business interest income plus 30 percent of adjusted taxable income.7 A relevant foreign corporation is any foreign corporation whose classification is relevant under reg. section 301.7701-3(d)(1) for a tax year, other than solely under section 881 or 882.8 Although most of the regulation is reserved, it does exclude from ATI any dividend included in gross income that is received from a related person.9

A companion proposed regulation fills in details.10 It creates rules for applicable CFCs — meaning foreign corporations described in section 957 — but only if the foreign corporation has at least one U.S. shareholder that owns, within the meaning of section 958(a), stock of the foreign corporation.11 So once again, the “CFC lite” created by the repeal of section 958(b)(4) had to be backstopped with a reference to a CFC that actually has a U.S. shareholder that will include subpart F income.12 We will see another example of problems caused by the odd definition of CFC in connection with the interaction of sections 1248 and 245A, discussed below.

A specified group will be able to make a CFC group election to apply section 163(j) on a group basis.13 A specified group is one or more chains of applicable CFCs connected through stock ownership with a specified group parent, which may be (1) an applicable CFC, (2) a domestic corporation (including members of a consolidated group), or (3) a U.S. individual citizen or resident.14 The group uses the consolidated group definition of section 1504, but based solely on 80 percent of value.15 The CFC group then applies the limitation on a CFC group basis and allocates a portion of the limitation to each CFC group member.16

2. Considerations for locating debt.

Should debt incurred to acquire an applicable CFC be located in the U.S. shareholder or in the stand-alone applicable CFC or applicable CFC group? The competing considerations include:

  • The interest deduction limit might be applied differently within the two groups.

  • If the U.S. shareholder is a partnership, it may have a more constricted ATI calculation than a U.S. corporation.

  • The U.S. parent corporation may borrow commercially and re-lend to its CFCs with dual benefits: (1) it creates interest income against which the parent may deduct its interest expense; and (2) the CFCs’ interest deductions may save foreign taxes and reduce GILTI, although the CFCs will be subject to section 163(j), too.

  • While foreign interest deductions can reduce GILTI, they also reduce the deemed 10 percent return on the CFC’s QBAI,17 which can increase GILTI. It may be desirable to place acquisition debt in a purchased CFC and to liquidate it into the purchasing parent CFC to expand the ATI base, although that should not be needed when the CFC group election is available.

C. FDII

1. General.

Analysis of public company reporting shows substantial tax reduction through foreign-derived intangible income for multinational technology businesses as well as consumer product manufacturers, wholesalers, and retailers.18 Perhaps that explains the Biden proposal to eliminate FDII. The FDII regime allows a deduction computed as a percentage of FDII, which reduces the effective tax rate on some foreign-derived income,19 limited to domestic C corporations, which can claim the deduction through partnerships.20

FDII is deemed intangible income, which is deduction-eligible income (DEI, a net amount)21 minus deemed tangible income (10 percent return on tangible property that is QBAI).22 That base is then multiplied by the foreign-derived ratio, which is foreign-derived deduction-eligible income over DEI.23 Many nonbusiness income items are removed from gross DEI (subpart F income, GILTI, dividends from a CFC, and branch income).24

Deductions are allocated under section 861 methods based on the adjusted tax basis of assets used to produce the two types of income.25 Expensing and bonus depreciation will reduce DEI. Export sales are good.26 Services provided to persons and property not located in the United States are good.27 Leases and licenses count.28 Sales to related persons can count if for resale to unrelated foreign persons.29 The FDII deduction percentage will drop by about 42 percent after 2025.

2. Effects.

FDII is supposed to motivate domestic acquisitions of exporting businesses, as opposed to buying another plant abroad in a CFC that could incur GILTI. In theory, the same intangible property that can produce FDII when held in the United States can produce GILTI when held in the CFC. However, having domestic QBAI to produce deemed tangible income return30 can decrease FDII, so domestic sellers might try to sell their plants to contract manufacturers, reduce the tangible income offset to their FDII, and retain the same export sales. But sales to related parties can be caught by an antiavoidance regulation.31

What about the sale of a foreign branch to a foreign buyer? The income generated by the sale might be qualifying income because it could be a sale of general property.32 The foreign buyer might even be the seller’s CFC upon the incorporation of a foreign branch,33 but there would have to be a use of “general property” in an unrelated-party sale.34 A U.S. corporation might sell stock of a CFC to a foreign buyer that makes a section 338(g) election. The deemed asset sale gain would not, however, produce FDII because it would be income of a foreign corporation taxable to the U.S. seller only under section 951 or 951A, which is excluded from DEI.

3. 2020 losses.

FDII and GILTI (addressed next) share section 250, which allows the deductions used in each regime, subject to a shared cap. Therefore, a domestic corporation can encounter the limit when it both owns CFCs that can generate GILTI and it hopes to enjoy FDII. The losses sustained in 2020 by many multinationals can cause the cap to limit the deduction. One planning technique may be to move the ownership of the CFC out of the U.S. consolidated group that has the losses.

D. GILTI

1. General.

GILTI makes CFCs the lowest-taxed places to make and sell stuff (a perverse result).35 So now much tax planning involves turning subpart F income into GILTI, which is included by U.S. shareholders (10 percent of vote or value), but only U.S. C corporation shareholders can claim the deduction in section 250(a)(1)(B).

The U.S. shareholder computes GILTI for all CFCs on a net basis. Credits attributable to GILTI are in a separate basket, and they cannot be carried over if not used in the year generated. The reduction of GILTI by a deemed 10 percent return on QBAI will be reduced by specified interest expense of the CFCs. The high-tax exclusion was made particularly useful by a Treasury decision to extend it to all relatively high-tax jurisdictions.36

GILTI gross income increases the basis of the stock in the CFC under section 961(a) just like subpart F gross income, despite the section 250 deduction, which makes the basis increase less costly to the shareholder.37

2. Effects.

Asset sales by CFCs, including section 338(g) asset sales, can produce GILTI, whereas a CFC’s sale of CFC stock produces subpart F income, which may be converted in part into a section 964(e)/1248/245A deductible dividend to the U.S. shareholder by way of a special set of deeming rules in section 964(e). That dichotomy drives many acquisition choices, as shown in the examples below. Moreover, foreign asset purchase and section 338(g) elections can produce more tangible asset basis for the buyer, which can produce more QBAI that can help the CFC reduce GILTI and subpart F income in the future for the buyer or its U.S. shareholder. But the buyer may not want debt in the CFC because interest paid usually reduces QBAI.38 An antiabuse rule addresses short-term acquisitions of QBAI but can be managed.39

The section 338(g) planning for CFC sales, which can produce GILTI, requires careful attention to when the CFC’s tax year closes and when the entity ceases to be a CFC in the year. The CFC’s tax year will close upon the qualified stock purchase and section 338(g) election, but not otherwise (absent an election, discussed below).40 Without a section 338(g) election, if a U.S. shareholder sells a target CFC to a foreign buyer with a U.S. subsidiary, the target’s status as a CFC will not end, and the U.S. seller will not take the GILTI and subpart F inclusions at year-end, although section 1248 will apply to the seller, with a complicated result discussed below.

The netting of CFC tested income and tested loss at the U.S. shareholder level may influence acquisitions of CFCs to manage the GILTI profile of the shareholder. However, the QBAI of tested loss CFCs doesn’t count.41 The solution may be to liquidate a tested-loss-purchased CFC with lots of inside asset basis.

Financing foreign acquisitions by purchase now presents different consideration for identifying the lender, which can affect GILTI. The deemed 10 percent return on QBAI that reduces GILTI will itself be reduced by allocable interest expense paid by a profitable CFC, unless paid to a related CFC that produced tested income.42 Generally, the interest offset to the 10 percent return on QBAI punishes debt-financing equipment specifically and CFC borrowing in general.

E. The BEAT

1. General.

The base erosion and antiabuse tax at section 59A has been managed by most multinationals.43 The main ways out have been substituting inventory purchases for royalties;44 using the services cost method exception from the definition of base erosion payment (which doesn’t extend to the mark-up);45 and, because of the BEAT’s cliff effect, waiving enough deductions to get out of it, although the waiver applies for all deduction purposes.46

2. Effects.

The effects of the BEAT on acquisitions are more indirect. Basis acquired in inbound nonrecognition transactions can be treated as base erosion payments if the basis (as for intangible property) was artificially stepped up in anticipation of the transaction.47 Net operating loss carryforwards are reduced by the current-year base erosion percentage,48 so acquired NOLs may be limited by both section 382 and the BEAT. The aggregate group gross receipts and base erosion percentage will include a corporation only while it is in the group, so taxable dispositions and acquisitions cannot be used to beef up the base, although section 381 acquisitions can.49

F. Foreign DRD

1. General.

Section 245A provides a deduction to domestic C corporation shareholders (section 245A shareholders)50 of a specified 10-percent-owned foreign corporation (specified foreign corporation, not necessarily a CFC) for foreign-source dividends. The definition requires a 10 percent U.S. shareholder, which can be determined by vote or value.51 But the major limiter on the dividends received deduction (DRD) will be the two 365-day stock holding period requirements;52 the nominal holding period can be suspended by options and other risk reducers. And use of the deduction can have a nasty interaction with stock basis under section 1059(b)(2)(B) if the stock holding period is shorter than two years.53 In the M&A context, the principal applications of section 245A are for sections 1248 and 964(e).

a. Sale of CFC.

Section 1248 can treat gain recognized by a U.S. shareholder on the sale of stock of a directly owned CFC as a dividend, and that dividend can be eligible for the DRD.54 Section 1248 has odd applicability rules, which should not affect its application to sales of all the stock of a CFC by a domestic corporate parent.55 For purposes of section 1248, the term “dividend” has a special meaning that excludes undistributed PTEP.56 So PTEP previously included by a CFC stock seller has two effects on the sale: (1) it usually will reduce the stock sale gain realized, by increasing the stock basis;57 and (2) it reduces the untaxed E&P of the CFC available to convert the stock sale gain to a dividend for section 1248/245A purposes.

These effects also arise when the PTEP is created by earnings recognized by the stock seller for the CFC’s year in which it sells the CFC stock. That is why section 338(g) elections for sold CFCs are so important. The election will cause the U.S. shareholder to include subpart F income and GILTI recognized on the deemed asset sale by the CFC, because the stock seller will be the U.S. shareholder that owns the CFC stock on the last day of the CFC’s short year. Those inclusions usually will be taxed at a lower rate as to GILTI, and most importantly, will increase the stock basis instantaneously and thus decrease the stock seller’s gain that may be taxed at a higher effective rate. In effect, the deemed QBAI return may be untaxed in the section 338(g) election and thus left to possibly be reflected as stock sale gain. That stock sale gain can be eligible for the section 1248/245A DRD. Any part of the CFC stock sale gain that exceeds the taxed and untaxed earnings of the CFC can still produce capital gain to the selling U.S. corporate shareholder, but section 961(d) limits the creation of a loss.

If that wasn’t enough complication, there is more confusion because the sale of all the stock of a CFC inevitably will be an “extraordinary reduction” of the selling shareholder’s stock interest, which can make the extraordinary reduction amount ineligible for the section 245A DRD.58 The prototypical case that concerned Treasury is the sale of all the stock of a CFC by one U.S. shareholder to another U.S. shareholder.59 The buyer will be the shareholder on the last day of the CFC’s tax year when it is still a CFC and so will include the section 951 and 951A amounts, less the reduction for the part thereof deemed allocated to the selling shareholder under section 951(a)(1)(A) and (2)(B). To the extent the reduction of the seller’s stock interest produces a section 1248 gain/dividend that enjoys the section 245A DRD, Treasury will have been shortchanged. The regulation’s solution is to define an amount of the section 1248 dividend that is ineligible for the section 245A DRD and sort of restore the status quo pre-2018.60

Conceptually, the problem can arise only when the selling shareholder doesn’t include its part of the section 951 and 951A amounts for the year. It will include them when the CFC’s tax year ends with the stock sale (for example, if a section 338(g) election is made) and when the buyer is of a sort that causes the CFC’s status as a CFC to end upon the sale (section 951(a)(1) will cause the seller to take the inclusions for the first part of the year). The regulation takes account of the case of the CFC year ending by excepting that from the extraordinary reduction rule.61 And it allows all of the U.S. shareholders (not just seller) to elect into that case by electing to close the year.62 But it curiously doesn’t provide for the case of the CFC status ending without the year closing; the exception applies only “if the taxable year of the CFC ends immediately after the transfer.”63 Therefore, the election should be made in that case as well.

But the CFC status will not end if the buyer is a direct U.S. shareholder or if the CFC stock is deemed owned by a U.S. shareholder indirectly, as when the buyer is the foreign corporation with the U.S. subsidiary. In either case, the election should be made.

Finally, is the section 1248/245A dividend PTEP? It should be.64

b. Sale by CFC.

M&A often means a CFC selling its subsidiary CFC to an unrelated buyer, which could produce capital gain that could be subpart F income. Because subpart F income is taxed more heavily than GILTI, those sales often are subject to a section 338(g) election,65 which replaces the subpart F gain with inside gain on assets whose sale may not produce foreign personal holding company income.66 Instead, that inside gain can be GILTI taxed to the U.S. shareholder at a lower effective rate.

But without a section 338(g) election, the CFC’s stock sale gain can be treated as a dividend received to the extent section 1248 would have created a deemed dividend if the stock seller were a U.S. person.67 Section 954(c)(6) might apply to recharacterize an actual dividend in whole or part as active income and not subpart F income on a look-through basis.68 But instead, section 964(e) in effect extends section 1248 treatment to the sale of a CFC by a CFC and makes the deemed dividend at the shareholder level eligible for the section 245A DRD.69 The sale of a CFC by a CFC is an indirect sale by the U.S. shareholder and thus an extraordinary reduction, so the DRD can be limited unless a closing-of-the-books election is made (without a section 338(g) election), as discussed earlier.70

These rules can produce a fantastic menu of results: stock sale gain that is part capital gain, part subpart F income, part GILTI, and part dividend at the U.S. shareholder level that is eligible for the DRD and part ineligible.

On top of all that, the sold CFC may have paid actual dividends in the year of sale. To the extent there are section 954(c)(6) dividends, they are subject to a special extraordinary reduction rule in the regulation.71

2. Effects.

The seller will compare the consequences of a section 338(g) election with the consequences of using the section 245A DRD plus a closing-of-the-books election for purposes of the extraordinary reduction rule. Generally, as to unrecognized CFC gain, the choice involves trading GILTI for income taxed at regular rates in connection with the untaxed appreciation in the sold CFC. When the CFC’s year closes on the sale, the seller will want to contract with the buyer not to cause abnormal recognition of subpart F income or GILTI in the last part of the year.72

The buyer will consider the effect of the section 338(g) election on the inside asset basis of the CFC and also the loss of its attributes, but the buyer will care only if it has U.S. shareholders. The primary attribute will be PTEP, and if the buyer is not a U.S. shareholder or owned by one, it won’t care about the ability to access previously taxed earnings of the CFC tax free.73

G. The Transition Tax

1. General.

Deferred foreign income corporations that had at least one corporate U.S. shareholder and were specified foreign corporations caused their U.S. shareholders to include as subpart F income their share of post-1986 earnings, subject to a special deduction.74 The inclusion created PTEP, with the attendant section 961 stock basis increases. Most shareholders that could elected to pay their section 965/951 tax in installments over eight years. The sale of the CFC can be an acceleration event for those installments.75

2. Effects.

The two effects of the transition tax will be the large PTEP amounts that a seller may want to extract in a pre-sale distribution, and the acceleration of the deferred tax upon the sale of a CFC. In many cases, the CFC will be sold out of a consolidated group and will not trigger the installment tax because it will not be substantially all the assets of the person, which for this purpose is the consolidated group.76

H. The Subpart F Rules

1. General.

The primary effect of the subpart F rules on M&A is that the definition of a CFC was indirectly changed by the repeal of section 958(b)(4), which can result in a foreign corporation owned by a foreign corporation being a CFC if the parent has a U.S. subsidiary.77 Further, CFCs not subject to a section 338(g) election may have PTEP, for which Treasury has proposed in a notice a massive new regime for categorizing types of PTEP, which indirectly then affects the associated foreign tax credits.78

2. Effects.

Identifying unexpected CFCs will be the primary effect. Second, checking the bookkeeping on PTEP, if it will survive the acquisition, will be a chore.

I. NOLs

The seller may have NOLs and current-year losses, and the sale of the target may produce a loss that will be capital, which is generally disliked because of the limit on the ability to offset capital gains. If the sale of a CFC produces loss, section 1248 cannot apply. A section 338(g) election is not likely unless the deemed sale of the assets will produce tested loss that can reduce the seller’s group GILTI inclusion.

III. Section 338: The Three Elections

A. Overview

The 2017 act didn’t change section 338, but the changes it did make will substantially affect the consequences of section 338 and section 336(e) elections for qualified stock purchases and qualified stock dispositions.79 It is important to keep firmly in mind the participant requirements for the three elections that can turn a stock purchase (generally at least 80 percent of vote and value in a year) into an asset purchase, as summarized in Table 2.

Table 2. Section 338 Cheatsheet

Election

Seller

Target

Buyer

Who Makes Election?

Foreign Application

Section 338(g)

Any person

Domestic C or S corporation, or foreign corporation

Domestic C or S corporation, foreign corporation, or foreign or domestic affiliated group

Buyer

Outbound, inbound, or foreign-to-foreign sale

Section 338(h)(10)

Domestic C or S corporation, S corporation shareholders, or a consolidated or affiliated group

Domestic C or S corporation

Domestic C or S corporation, a foreign C corporation, or a foreign or domestic affiliated group

Joint election

Foreign buyer

Section 336(e)

Domestic C or S corporation, S corporation shareholders, or a consolidated or affiliated group

Domestic C or S corporation

Any person other than a domestic C or S corporation or a foreign C corporation, or a foreign affiliated group for which a section 338(h)(10) election could be made for the sale

Seller, but target must be a party to a written agreement to elect

Foreign non-corporate buyer

B. Effects for CFCs

Reg. section 1.338-9(b)(2) is highly important. It states that the person that transfers the foreign target stock on the acquisition date owns it as of the end of that day (even though it really does not). Therefore, that transferor is the one that counts to identify the U.S. shareholder on the last day the target foreign corporation is a CFC. The transferor can be the U.S. shareholder itself, a CFC with U.S. shareholders, or a foreign corporation with no U.S. shareholders. In all cases, the CFC-level consequences of the deemed sale for purposes of subpart F and GILTI inclusions will always fall on the seller side, which may or may not implicate U.S. shareholders.

Historically, the normal case in which the section 338(g) election was made for a foreign target was limited to a foreign seller, and the target could not be a CFC (unless the foreign seller was a subsidiary of a U.S. corporation), so no one had to worry about the inclusion, which then was limited to subpart F income. Now there can be “fake CFCs.” Also, U.S. shareholders of real CFCs may want the section 338(g) election to convert stock sale gain into lower-taxed GILTI. Putting the deemed sale on the seller side is the reverse of the domestic section 338(g) election whose effects fall on the buyer side.

The section 338(g) election can increase the QBAI of a CFC, which can reduce future GILTI. It can wipe the CFC’s slate clean and relieve the buyer from concern about identifying asset basis, PTEP, and other tranches of E&P, as well as FTCs. When the seller is a U.S. shareholder, the subpart F and GILTI inclusions will fall on its return.80 They will increase stock basis under section 961 and reduce gain recognized so that section 1248 will be less important and possibly might create a capital loss for the seller. But that is subject to section 961(d), which prevents a section 245A dividend from creating a stock loss. The election has such drastic consequences that every CFC purchase agreement must address and control it.81

Section 901(m) contains one downside for the election82: It calls the section 338(g) election a covered asset acquisition,83 which disqualifies from the CFC’s FTCs a portion of foreign taxes paid after the basis step-up for relevant foreign assets, proportional to the amount of the step-up.84 The limit was thought to require a careful rethinking of the wisdom of the section 338(g) election for purchased foreign corporations, which had been routine.85 However, section 901(m) will have less impact because the 2017 act reduced the importance of FTCs by eliminating the section 902 indirect credit for dividends received. Section 245A will provide protection against taxation of post-2017 E&P after the PTEP of the CFC has been exhausted.

IV. Application to M&A Transactions

Assume that the buyer and seller are C corporations and are U.S. corporations in a consolidated group, unless otherwise stated. Further assume that a foreign buyer or seller is not a CFC and doesn’t have U.S. shareholders, except as stated.

A. U.S. Buyer and Foreign Seller

1. Target is U.S. corporation.

a. Section 338(g) election.

The foreign seller will not be taxed unless section 897 applies. The buyer will be responsible for tax on the target’s deemed sale gain and therefore may choose to make a section 338(g) election in two situations. First, if the target has substantial NOLs, it can use them to offset its deemed sale gain without any section 382 limit;86 any remaining NOLs disappear.87 The deemed asset sale occurs on the last day of the short year of the target before the new target joins the buyer’s consolidated group.88 Therefore, the buyer will have practical responsibility for the target’s final short-year return, including not only the deemed sale gain but also other income incurred before the acquisition.89 The next day, the new target is deemed to purchase its assets.90

That brings up the second case for the election even without NOLs in the target: when the target can enjoy a substantial amount of bonus depreciation on tangible property called qualified property.91 On the day of the deemed asset purchase, the target will be a member of the buyer’s consolidated group, and the target can deduct its bonus depreciation on tangible property.92 If the buyer group will generate enough income in the year of the deemed asset purchase to absorb the entire bonus depreciation, the election will not create a net federal tax cost to the buyer to the extent of the target’s qualified property.

b. Target has CFC.

If the target owns a CFC and a section 338(g) election is made for the target, it will be deemed to sell the stock of the CFC, and an extraordinary reduction will occur. Therefore, unless the target elects to close the year of the CFC, the section 245A DRD can be limited as to the section 1248 deemed dividend. It is easy enough to elect to close the year, but what if the buyer wants a section 338(g) election for the CFC?93 This looks like a case in which the buyer buys a foreign subsidiary of a foreign corporation, but here, the subsidiary not only is clearly a CFC, but the buyer will acquire its U.S. shareholder, which will be responsible for inclusions. Therefore, it is important to know that the deemed asset sale gain can produce subpart F and GILTI inclusions for the U.S. corporation.94

It might seem that the election normally would not be made for the CFC unless the target has substantial NOLs. However, the target’s basis for the CFC stock will be increased by the PTEP created by the deemed CFC asset sale, so the target’s gain on its deemed sale of CFC stock will be reduced. As a result, the target’s deemed sale gain on its CFC stock that reflected the inside gain in the CFC’s assets might be converted into GILTI, taxed at a lower rate.

Section 956 may be relevant here and in other cases of U.S. buyer purchases. The buyer may need credit support from a CFC and can get it without a section 956 inclusion when a section 245A DRD otherwise could apply.95

2. Target is foreign, not a CFC.

a. Section 338 election.

This is the classic, easy case for the section 338(g) election because it will hurt no one. The deemed asset sale cannot produce subpart F income and GILTI; nevertheless, reg. section 1.338-9 shows that the election can be made for these foreign corporations.96

b. No section 338 election.

This will be a rare case. The buyer will get a CFC with perhaps unknown amounts of E&P, basis, etc. The target will be a CFC for the year, and its income for the entire year will be included in the computation of its section 951 and section 951A inclusions, although prorated to the portion of the year the buyer owned the stock.

B. CFC Sells CFC

1. Fake CFCs.

First, let’s get out of the way the cases in which the CFC seller is a fake CFC. For example, the public foreign parent owns the seller, which is a CFC because the parent has a U.S. subsidiary, but the CFC has no U.S. shareholders. Because the seller is technically a CFC, so is the target, and its status will continue for the whole year. The results will differ from those discussed below, mostly on the seller side, because there will be no U.S. taxpayer on the seller side to care about deemed asset sale inclusions.

2. CFC sells CFC to foreign buyer.

a. No section 338 election.

The stock sale gain will be treated as subpart F income and as a section 964(e)(1)/1248 dividend to the extent of the target’s untaxed E&P, which section 964(e)(4) treats as subpart F income includable by the U.S. shareholder of the seller CFC. The shareholder can claim the section 245A DRD for that dividend, which DRD should not be reduced if the election to close the year for purposes of the extraordinary reduction rule is made.97 There should not be room for GILTI to be generated for the selling CFC. If the sale date is the last day in the target’s year when it is a CFC, the seller’s U.S. shareholder will take its pro rata part of the target’s subpart F income and GILTI inclusions for the target’s entire year.98 Because the year doesn’t close without the election, the seller will want to contract against post-closing recognition of includable income by either (1) contracting to limit the buyer’s and CFC’s actions, or (2) obligating the buyer to make the section 338(g) election (which also will change the sale taxation to the seller, as discussed later).

b. Section 338 election.

If the buyer makes a section 338(g) election, the U.S. shareholder of the seller CFC will include subpart F income and GILTI generated by the target CFC’s deemed asset sale because the year closes. Both inclusions will increase the U.S. shareholder’s basis in the seller, and they will also increase the basis to the selling CFC, which will reduce any subpart F income it generates from the stock sale itself.99

3. To U.S. buyer.

Same as above, except the status as a CFC will not close, so the buyer will be responsible for the inclusions for the year, reduced under section 951(a)(2)(B). The buyer can enjoy the stepped-up asset basis of the target to reduce future GILTI inclusions, make post-acquisition restructuring such as by sales to affiliates easier, and avoid the target’s subpart F income for the closed year. But if there are favorable attributes in the target, they will be lost. Section 901(m) can apply to a section 338(g) election.

C. U.S. Seller — Foreign Buyer

1. Target is U.S. subsidiary.

The parties can agree to make a section 338(h)(10) election, which has less downside than a section 338(g) election for a domestic target.100 The bonus depreciation will have to be absorbed by the target’s own future income. If the target owns a CFC, a section 338(g) election can be made, and the same considerations as in Section IV.A.1.b apply.

2. Target is CFC.

a. No section 338(g) election, and CFC status ends on sale, but tax year doesn’t end.

The seller will include its pro rata portion of the subpart F income and GILTI for the entire tax year of the CFC.101 Because the year doesn’t close, the seller will want to contract against post-closing recognition of includable income by either (1) contracting to limit the buyer’s and CFC’s actions, or (2) obligating the buyer to make the section 338(g) election (which also will change the sale taxation to the seller, as discussed below). Section 1248 can recharacterize stock sale gain as a dividend, and the section 245A DRD can be claimed. The extraordinary reduction limitation should not apply because the CFC status ends on the sale date,102 but a closing-of-the-books election might be made just in case.

b. No section 338(g) election; CFC status doesn’t end upon sale; and tax year doesn’t end.

If the buyer foreign corporation has a U.S. subsidiary or is itself a CFC, the CFC will remain a CFC after the sale as a result of the repeal of section 958(b)(4).103 If no direct shareholder of the buyer is a U.S. shareholder, no taxpayer will include the subpart F income and GILTI at the CFC’s year-end.104 However, section 1248(a) can recharacterize the seller’s gain as a dividend to the extent of E&P of the CFC not previously taxed.105 That dividend is eligible for the section 245A DRD if the seller held the stock for at least a year.106 However, to avoid nontaxation of both the current-year subpart F income and GILTI and the stock sale gain through that use of the DRD, the regulation denies the DRD upon that extraordinary reduction in the seller’s ownership of the CFC stock.107 To that extent, the seller will recognize ordinary dividend income from the CFC, and FTCs are not available. Alternately, the parties may elect to close the CFC’s year, turning off the extraordinary reduction rule and converting the section 1248 dividend into dividend eligible for the section 245A DRD.108

c. Section 338(g) election.

The buyer can make a section 338(g) election, which closes the CFC’s year.109 The deemed sale gain of the CFC in the short year may convert the seller’s stock sale gain that reflected untaxed appreciation in the CFC into taxed GILTI and increase its stock basis under section 961(c). To the extent the deemed asset sale might generate subpart F income, that also will cause a stock basis increase. To the extent it generates non-GILTI E&P that is not subpart F income, that doesn’t increase stock basis but generates more E&P, which can recharacterize more of the seller’s gain as a section 1248 dividend eligible for the section 245A DRD.

D. U.S. Seller Sells CFC to U.S. Buyer

1. Section 338(g) election.

The election closes the CFC’s year, and the seller includes the short-year subpart F income and GILTI generated by the deemed asset sale. The seller’s stock basis increases under section 961 for the PTEP. Its stock sale gain decreases, and to any extent that the gain reflects the seller’s share of the CFC’s E&P not previously taxed, it includes a section 1248 dividend and can claim the section 245A DRD. Any residual gain is capital and can be U.S.- or foreign-source (if the CFC has had an active foreign business, under section 865(f)).

The CFC in the buyer’s hands has a new basis for its assets, and no attributes and FTCs will be subject to section 901(m). The basis step-up will help reduce subpart F income and GILTI.110 In the odd case in which the buyer becomes a U.S. shareholder before the acquisition date (for example, by buying 10 percent or more, but not 80 percent), the buyer can be a sale-date U.S. shareholder and will take its share of a section 951 inclusion.111

2. No section 338 election.

If the buyer doesn’t make the section 338(g) election, the CFC’s status as a CFC will not end, and its year will not end. Therefore, the buyer will take the subpart F income and GILTI inclusion as the U.S. shareholder on the last day of the CFC’s year. But section 951(a)(2)(B) would reduce the buyer’s year-end inclusion by the deemed dividend the seller will receive under section 1248 — a dividend to which the seller cannot apply the section 245A DRD because the sale is an extraordinary reduction.112 But if the parties agree to close the CFC’s year, the seller will qualify for the section 245A DRD to the extent of the target’s untaxed E&P.

E. CFC Asset Sales and Liquidations

1. Top-tier asset sale and inbound liquidation.

A CFC may sell its foreign business and liquidate inbound. Its asset sale can produce a combination of subpart F income, GILTI, and untaxed E&P, and it will likely incur foreign taxes and create FTCs. A section 960 credit may be available to the U.S. shareholder for the deemed income inclusions. Upon a section 332 liquidation, a controlling U.S. corporation will include all E&P amounts not previously taxed, which will be treated as a dividend for all purposes.113 Therefore, the shareholder can claim the section 245A DRD.

2. Lower-tier CFC asset sales.

If a CFC sells the stock of another CFC without a section 338(g) election, the stock sale can produce subpart F income to the extent of asset appreciation inside the target. To avoid that, the target CFC can check the box, called a Dover transaction.114 The parent CFC will be treated as selling the target’s active business assets and creating GILTI, rather than creating subpart F income by selling its stock.

3. Public sells foreign target.

If a U.S. buyer buys a public foreign target in a qualified stock purchase, the buyer can make a section 338(g) election.115 But if the acquisition is by a tender plus a squeeze-out merger, and the tender makes the target a CFC for the period preceding the merger, then the deemed sale gain can produce subpart F income and GILTI that will be included by the buyer.116

V. Conclusion

The interaction of section 1248 with the section 245A DRD has turned out to be the cause of the most complexity in these cases. Only last summer was it addressed by reg. section 1.245A-5, which substantially changed the calculus of M&A deals. Put that together with reg. section 1.338-9, section 951(a)(2)(B), and the repeal of section 958(b)(4), and you have a fine mess.

FOOTNOTES

1 See, e.g., Scott Levine and Christopher S. Hanfling, “M&A Structures Post-Tax Reform,” BNA Int’l J., May 11, 2018; Sarah-Jane Morin, “Mergers, Acquisitions, and Integration in Light of Tax Reform,” Tax Notes, June 4, 2018, p. 1469; David Mattingly, “Blocker Alchemy,” Tax Notes Federal, Aug. 31, 2020, p. 1585; and Mattingly, “Blocker Alchemy, Part 2,” Tax Notes Federal, Sept. 7, 2020, p. 1771.

2 Section 965 attempted to tax the E&P of specified foreign corporations, which are CFCs and foreign corporations with at least one corporate U.S. shareholder. See Jasper L. Cummings, Jr., “Previously Taxed Income,” Tax Notes, Apr. 22, 2019, p. 531; Cummings, “Transition Tax Regulations,” Tax Notes, Nov. 5, 2018, p. 687; and Cummings, “The Territorial Transition Tax,” Tax Notes, Feb. 12, 2018, p. 857.

3 The fake CFCs are created when the parent has a U.S. subsidiary. See Cummings, “Selective Tax Act Analysis: Subpart F and Foreign Tax Credits,” Tax Notes, Jan. 29, 2018, p. 653.

4 Section 179(d)(1) cross-reference to section 50(b); section 168(k)(2)(D) and (g)(1)(A).

5 Sections 250(b)(2)(B) and 951A(d)(3)(A); and reg. section 1.250(b)-2(e).

6 Cummings, “The Interest Deduction Limitation,” Tax Notes, May 21, 2018, p. 1105.

7 Reg. section 1.163(j)-7(b).

8 Reg. section 1.163(j)-1(b)(33).

9 Reg. section 1.163(j)-7(g)(2).

11 Reg. section 1.163(j)-1(b)(2).

12 Section 951(a)(2)(a).

13 Prop. reg. section 1.163(j)-7(e)(5).

14 Prop. reg. section 1.163(j)-7(d)(2)(i).

15 Prop. reg. section 1.163(j)-7(d)(2)(i)(B).

16 Prop. reg. section 1.163(j)-7(c).

17 Section 951A(b)(2)(B) (the 10 percent deemed return on QBAI is netted down by business interest expense deducted and not otherwise included as tested income because the lender was an affiliated CFC).

18 Martin A. Sullivan, “S&P 500 Companies Report $3.8 Billion in FDII Benefits,” Tax Notes Federal, Nov. 9, 2020, p. 889.

19 Section 250(b). See Cummings, “Foreign-Derived Intangible Income Deduction,” Tax Notes, May 7, 2018, p. 853; Cummings, “FDII Regulations Are Like Macy’s Parade Balloons,” Tax Notes, June 3, 2019, p. 1483; and Michael DiFronzo, Oren P. Margulies, and Nick Zemil, “FDII: The Carrot Stick in the Tax Reform Crudités,” Tax Notes Federal, July 20, 2020, p. 365.

20 Reg. section 1.250(b)-1(e).

21 Reg. section 1.250(b)-1(c)(2).

22 QBAI is defined in reg. section 1.250(b)-2(b).

23 Reg. section 1.250(b)-1(c)(12).

24 Reg. section 1.250(b)-1(c)(15).

25 Reg. section 1.250(b)-1(d)(2).

26 Reg. section 1.250(b)-4.

27 Reg. section 1.250(b)-5.

28 Reg. section 1.250(b)-4(d)(2).

29 Reg. section 1.250(b)-6(c).

30 Reg. section 1.250(b)-1(c)(4).

31 Reg. section 1.250(b)-2(h).

32 Reg. section 1.250(b)-3(b)(10) and -4(b). Section 250(b)(3)(i)(VI) removes foreign branch income from DEI. The gain from the sale of the branch should not be foreign branch income. Reg. section 1.250(b)-1(c)(11) and reg. section 1.904-4(f)(2) and (f)(4)(ii), Example 2.

33 After the repeal of section 367(a)(3), the incorporation of a foreign branch is a taxable outbound transfer.

34 Reg. section 1.250(b)-6(b)(1) and (c)(1)(ii).

35 See Cummings, “GILTI Puts Territoriality in Doubt,” Tax Notes, Apr. 9, 2018, p. 161.

36 Cummings, “Not GILTI ‘by Reason of’ the High-Tax Exclusion,” Tax Notes Federal, Oct. 5, 2020, p. 89.

37 The deducted GILTI is treated as tax-exempt income in consolidation. Reg. section 1.1502-32(b)(3)(ii)(B) and -50(d).

38 Section 951A(b)(2)(B).

39 Reg. section 1.951A-3(h)(1)(iv)(A).

40 Reg. section 1.338-9.

41 Reg. section 1.951A-3(b).

42 Section 951A(b)(2)(B).

43 See Cummings, “Selective Analysis: The BEAT,” Tax Notes, Mar. 26, 2018, p. 1757; and James P. Fuller and Larissa Neumann, “U.S. Tax Review,” Tax Notes Int’l, Oct. 5, 2020, p. 33.

44 Reg. section 1.59A-3(b)(2)(viii).

45 Reg. section 1.59A-3(b)(3)(i).

46 Reg. section 1.59A-3(c)(6).

47 Reg. section 1.59A-3(b)(3)(viii).

48 Reg. section 1.59A-4(b)(2)(ii).

49 Reg. section 1.59A-2(c)(6).

50 Reg. section 1.245A-5(i)(21). See Cummings, “The Foreign Dividends Received Deduction,” Tax Notes, Mar. 12, 2018, p. 1487.

51 Section 951(b).

52 Sections 246(c)(5), 1248(j).

53 Also, the 2017 tax act added section 961(d) to reduce stock basis because of the section 245A DRD, solely to prevent the shareholder from recognizing a loss on the stock. But Treasury didn’t adopt the proposed regulation that would have reduced the basis of stock of a CFC that produced tested loss. Reg. section 1.951A-6. See T.D. 9866.

54 Section 1248(j) will make the gain that section 1248 already characterizes as a dividend a section 245A dividend. Reg. section 1.245A-5(g)(1).

55 It applies only to a U.S. person owning 10 percent of the vote at any time during the five preceding years. Section 1248 requires 10 percent of the vote, whereas a U.S. shareholder can own 10 percent of either vote or value.

56 Section 1248(d)(1).

57 Sections 959, 961.

58 Reg. section 1.245A-5(b), (e). This rule applies only to a controlling U.S. shareholder, owning more than 50 percent by vote or value of the CFC.

59 Reg. section 1.245A-5(j)(2), Example 3.

60 Reg. section 1.245A-5(b)(2)(ii).

61 Reg. section 1.245A-5(e)(2)(i)(C).

62 Reg. section 1.245A-5(e)(3)(i). The agreement and election requirements are complex and must be addressed before the agreement to buy.

63 Reg. section 1.245A-5(e)(2)(i)(C).

64 Section 959(e).

65 Reg. section 1.338-9 applies to require the seller (rather than a domestic buyer) to take the subpart F and GILTI inclusions generated by the deemed sale (and otherwise for the CFC’s year up to the acquisition date).

66 Section 954(c)(1)(B).

67 Section 964(e)(1).

68 Notice 2007-9, 2007-1 C.B. 401; and reg. section 1.954(c)(6)-1.

69 Section 964(e)(4) (one-year holding period required). Reg. section 1.245A-5(g)(2) deems the shareholder to receive the dividend directly from the sold CFC.

70 Reg. section 1.245A-5(e)(2), (g)(2).

71 Reg. section 1.245A-5(f), (j)(7), Example 6.

72 Reg. section 1.951-1(e)(1) (earnings for entire tax year prorated to the period it is a CFC).

73 Reg. section 1.959-1.

74 See Cummings, “The Territorial Transition Tax,” Tax Notes, Feb. 12, 2018, p. 857.

75 Reg. section 1.965-7(b)(3)(ii).

76 Reg. section 1.965-7, -8(e)(1).

77 See Cummings, “Selective Tax Act Analysis,” supra note 3.

78 See Cummings, “Previously Taxed Income,” supra note 2.

79 See Cummings, “Final Regulations on Qualified Stock Dispositions,” Tax Notes, Aug. 19, 2013, p. 805.

80 Reg. section 1.338-9(b)(2). Reg. section 1.338-9(b)(1) states that the E&P for purposes of section 1248 reflect the section 338 deemed asset sale.

81 Reg. section 1.338-2(e) provides special rules for the filing of a section 338 election by foreign purchasers for a foreign target.

82 See Fuller and Neumann, “U.S. Tax Review,” Tax Notes Int’l, Apr. 6, 2020, p. 25.

83 Reg. section 1.901(m)-2(b).

84 Reg. section 1.901(m)-4.

85 See Robert Rizzi, “New Section 901(m) Guidance: Impact on Elections in Corporate Transactions,” Corp. Tax’n (2017).

86 Section 382(a) applies only to post-change years.

87 Section 338(a)(2) (a new corporation).

88 Reg. section 1.338-10(a)(1) and (5).

89 The result would be different if the seller were a domestic consolidated group, in which case the deemed sale would occur in a one-day year outside either group. Reg. section 1.338-10(a)(2).

90 Section 338(a)(2) (new corporation purchased assets the next day).

91 Reg. section 1.168(k)-2.

92 The related-person seller rule will not prevent the deduction. Reg. section 1.1502-68(b).

93 See generally Kevin Dolan et al., U.S. Taxation of International Mergers, Acquisitions and Joint Ventures, para. 2.02 (1995).

94 Section 338(a)(1) and reg. section 1.338-9(b)(2).

95 Reg. section 1.956-1(a)(2).

96 IRS auditors questioned the application of the section 338(g) election in these foreign situations. AM 2007-006 concluded that either a domestic or foreign purchasing corporation may make a section 338 election for a foreign target that was previously unconnected with the U.S. taxing jurisdiction, even though no U.S. or foreign tax is incurred on the old target’s deemed sale of assets to new target. The memo explained that Congress thought about the problem of step-up without U.S. tax and addressed it only by section 338(h)(16), intended to prevent increasing the foreign-source income resulting from the earnings generated by the deemed sale, and hence the FTC. It discusses the case in which the foreign target owns a U.S. subsidiary and says the election can be made for it, and the results would be as discussed above.

97 Reg. section 1.245A-5(e)(2).

98 Reg. section 1.951-1. Sections 951(a)(1) and 951A(e)(3) state that a foreign corporation shall be treated as a CFC for any tax year if the foreign corporation is a CFC at any time during that tax year. But the U.S. shareholder on the last day the corporation is a CFC is the taxpayer that includes a proportionate part of the income for the entire year.

99 Sections 961(c) and 951A(f)(1). But basis will not increase so as to produce a stock loss. Section 961(d).

100 Reg. section 1.338(h)(10)-1.

101 Reg. section 1.951-1.

102 Reg. section 1.245A-5(e)(2)(i)(C).

103 It will have a U.S. shareholder by virtue of section 958(b) that will not be a direct shareholder by virtue of section 958(a) and so will not include subpart F income or GILTI.

104 Section 951(a)(2)(B).

105 Section 1248(d).

106 Section 1248(j).

107 Reg. section 1.245A-5(b) and (e)(2)(i)(C) (the extraordinary reduction rule doesn’t apply if CFC status ends on the sale date).

108 Reg. section 1.245A-5(e)(3)(i).

109 Reg. section 1.338-2(b)(1). Reg. section 1.338-9(b) provides for apportioning the foreign taxes for the year to the two short years for FTC purposes. See LTR 8938036.

110 Basis step-up can reduce GILTI in two ways: (1) more depreciation; and (2) more QBAI, which is tax basis adjusted by the alternative depreciation method.

111 Reg. section 1.338-9(f)(2), Example 4.

112 Reg. section 1.245A-5(e).

113 Reg. section 1.367(b)-3(b)(3) and -2(e).

114 Dover Corp. v. Commissioner, 122 T.C. 324 (2004).

116 Elimination of the 30-day rule in section 951(a)(1) removed a way to avoid this result if the acquirer moved fast.

END FOOTNOTES

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