Final Consistency Rules for Qualified Stock Purchases

 [4830-01-u]

 ACTION: Final and temporary regulations.

 SUMMARY: This document contains final regulations that replace the stock and asset consistency rules of the temporary Income Tax Regulations. The final regulations substantially revise and simplify the stock and asset consistency rules. The final regulations also restate, simplify, and substantially shorten most of the other regulations under section 338.

 DATES: These regulations are effective January 20, 1994.

 For applicability of these regulations, see "Effective Dates" under the "SUPPLEMENTARY INFORMATION" portion of the preamble.

 FOR FURTHER INFORMATION CONTACT: Don Leatherman at telephone (202) 622-7520 (not a toll-free number) for domestic issues and Kenneth D. Allison at telephone (202) 622-3860 (not a toll-free number) for international issues.

SUPPLEMENTARY INFORMATION:

A. PAPERWORK REDUCTION ACT.

The collection of information contained in this final regulation has been reviewed and approved by the Office of Management and Budget in accordance with the requirements of the Paperwork Reduction Act (44 U.S.C. 3504(h)) under control number 1545-1295. The estimated annual burden per respondent varies from .2 hours to 1 hour, depending on individual circumstances, with an estimated average of .56 hours.

 These estimates are an approximation of the average time expected to be necessary for a collection of information. They are based on such information as is available to the Internal Revenue Service. Individual respondents or recordkeepers may require more or less time, depending on their particular circumstances.

 Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington, D.C. 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, D.C. 20503.

B. BACKGROUND.

 On January 14, 1992, a notice of proposed rulemaking (CO-111-90) under section 338 of the Internal Revenue Code was published in the Federal Register (57 FR 1409). See 1992-1 C.B. 1000. The notice proposed to restate most of the existing temporary regulations by (1) replacing the asset and stock consistency rules of sections 1.338-4T and 1.338-5T of the temporary regulations, (2) revising the temporary regulations regarding the international aspects of section 338, and (3) generally restating the remainder of the temporary regulations under section 338. Comments on the notice were received and a public hearing was held on March 26, 1992. After considering the comments and statements made at the hearing, the proposed regulations are adopted as revised by this Treasury decision, and the corresponding temporary regulations are removed.

C. THE CONSISTENCY RULES.

 The final regulations adopt the consistency rules of the proposed regulations with several minor modifications.

 1. CARRYOVER BASIS RULE. Several commentors argued that the carryover basis rule should be modified if the gain of a target (T) on the sale of an asset does not result in an equivalent reduction in the gain of the selling group (S or the S group) from the sale of the T stock. For example, they argued that the carryover basis rule should be modified if S recognized a loss on the sale of T stock that was disallowed under section 1.1502-20, if T sold gain and loss assets to the purchasing corporation (P), or if T had separate return limitation year losses. Similarly, they suggested that the rule be modified if the gain on the asset sale is not fully reflected in the basis of T's stock because, for example, the asset is sold by a subsidiary or conduit that is not wholly owned by T.

 For purposes of simplification and administrative convenience, the consistency rules in the final regulations apply in a more limited set of circumstances than in the temporary regulations. Adopting the suggested modifications, however, would substantially complicate the regulations. In addition, the carryover basis rule generally will apply only when the stock sale is contemplated at the time of the asset sale. For these reasons, the suggestions have not been adopted.

 2. AFFILIATED GROUPS. The final regulations apply the consistency rules in certain cases where dividends qualifying for a 100 percent dividends received deduction may be used in conjunction with asset dispositions to achieve a result similar to that available under the consolidated return investment adjustment rules. This provision applies only to amounts treated as dividends under general tax principles. The substance-over-form, step-transaction, and similar principles continue to apply to treat certain amounts that are dividends in form as payments by P for the T stock. See, e.g., Commissioner v. Waterman Steamship Corp., 430 F.2d 1185 (5th Cir. 1970), cert. denied, 401 U.S. 939 (1971).

 As discussed in more detail below, these regulations also permit section 338(h)(10) elections to be made for certain targets that are members of affiliated, non-consolidated groups.

 3. CONTROLLED FOREIGN CORPORATIONS. Consistency rules for controlled foreign corporations generally are not included in the final regulations. Instead, rules for controlled foreign corporations are contained in temporary regulations that may be found elsewhere in this issue of the Federal Register.

 4. ANTI-ABUSE RULES. Some commentors requested that the anti- abuse rules of section 1.338-4(j) be narrowed and that these rules and the indirect acquisition rule of section 1.338-4(f) be stated as general principles. The Treasury Department and the Service believe that the anti-abuse and indirect acquisition rules are necessary to protect the final consistency rules. Further, no statement of general principle has been identified that provides adequate guidance to distinguish the cases described in the proposed regulations from those not described. Accordingly, these rules have been retained with minor modifications.

D. INTERNATIONAL ASPECTS

 The final regulations under sections 1.338-1(g), 1.338-3(c)(3) through (6) and (8), and 1.338-5 are substantially as proposed. The preamble to the proposed regulations contains a discussion of the provisions. The differences from the proposed regulations are noted below.

 1. SECTION 338(h)(16). In the notice of proposed rulemaking, the Service sought comments on the proper application of section 338(h)(16), including its application where the deemed sale of assets results in subpart F income under section 952. The comments received will be considered in separate proposed regulations.

 2. GOOD FAITH EFFORT TO NOTIFY. A commentor suggested that the Service provide examples of a good faith effort, under section 1.338-1(g)(4)(v) of the proposed regulations, to notify affected U.S. shareholders of targets that are controlled foreign corporations, passive foreign investment companies or foreign personal holding companies. The regulations require that the Commissioner determine, under all the facts and circumstances, whether the taxpayer has vigorously attempted the notification. The suggestion has not been adopted because the determination depends on the facts and circumstances in each case.

 3. ALLOCATION OF FOREIGN INCOME TAXES. One commentor pointed out that the allocation of foreign income taxes between the pre- and post-acquisition U.S. taxable years of a target in section 1.338-5(d) of the proposed regulations is to be made under the principles of section 1.1502-76(b)(4) of the consolidated return regulations. That provision has been interpreted to require taxes to be allocated in proportion to U.S. taxable income. Because foreign income taxes are paid with respect to foreign taxable income, an allocation with respect to U.S. taxable income may incorrectly allocate the foreign income taxes between taxable years. The final regulations require foreign income taxes to be allocated in proportion to foreign taxable income.

E. OTHER CHANGES TO THE REGULATIONS.

 Several commentors argued that, if a section 338(h)(10) election is made for T, new T should not be severally liable under section 1.1502-6 for federal income tax liability of the S group, as provided in the proposed and the existing temporary regulations. They reasoned that a section 338(h)(10) election is intended to be equivalent to an asset sale and that this liability does not continue in an asset sale. However, one other commentor noted that, although the transaction is treated as an asset sale for purposes of income recognition, it continues to be treated as a stock sale for purposes of determining the rights of T's creditors. The final regulations provide that new T remains liable for the tax liabilities of old T (including tax liabilities resulting from the deemed sale of assets and any liability of old T under section 1.1502-6).

 Commentors requested that the formula price at which T is deemed to sell its assets be modified to reflect buying and selling costs, as appropriate. These suggestions have been adopted in the final regulations.

 Commentors asked that the availability of section 338(h)(10) treatment be extended to situations in which T is not a member of a consolidated group. The final regulations provide that a section 338(h)(10) election may be made for a non-consolidated T if a corporation (the selling affiliate) sells an amount of T stock to P on the acquisition date that satisfies the requirements of section 1504(a)(2). The election must be made jointly by P and the selling affiliate. The instructions to the revised Form 8023 will provide more guidance on making the election.

 The final regulations also provide that a section 338(h)(10) election may be made if T is an S corporation immediately before the acquisition date. The deemed sale gain is reported on T's final S corporation return and therefore is taken into account under section 1366 and 1367 in determining a T shareholder's basis in the T stock and resulting gain or loss on the deemed liquidation of T. The section 338(h)(10) election must be made jointly by P and the T shareholders. The instructions to the revised Form 8023 will provide more guidance on making the election.

 If a section 338(h)(10) election is made for T, for purposes of subtitle A of the Internal Revenue Code, T is treated as selling all of its assets and liquidating. Thus, as appropriate, the old T shareholders recognize income, gain, or loss under sections 331 and 332.

 Several other modifications to the proposed regulations have been included in the final regulations. Minor editorial changes and clarifications have been made. For example, the final regulations clarify the amount of liabilities to be taken into account in calculating deemed sale gain or loss and basis following a section 338 election. Further, the final regulations provide that the adjusted deemed sale price (ADSP) must be calculated under a formula method. (The temporary and proposed regulations referred to the formula method as the elective ADSP formula.) Under the temporary regulations, the ADSP could be calculated using the formula method or by separately valuing each asset. Mandating the formula method is consistent with the treatment under section 338(h)(10) and makes the regulations simpler and easier to apply. The final regulations also simplify the ADSP examples.

 In addition, the final regulations contain a provision clarifying that a target S corporation for which a section 338 election (other than a section 338(h)(10) election) is made must file a deemed sale return reporting the deemed asset sale as a C corporation. See H.R. Rep. No. 432, Part 2, 98th Cong., 2d Sess., 1642 (March 5, 1984). No implication is intended by that provision as to the status of an acquired S corporation in the absence of a section 338 election.

F. EFFECTIVE DATES.

 Commentors suggested that the final regulations be effective either as of January 14, 1992 (the date the proposed regulations were filed) or earlier (including as early as the effective date of the repeal of the General Utilities doctrine by the Tax Reform Act of 1986).

 The final regulations are generally effective for targets with acquisition dates on or after January 20, 1994. The final regulations also apply on an elective basis to targets with acquisition dates on or after January 14, 1992 and before January 20, 1994. If an election is made to apply the final regulations to targets with acquisition dates on or after January 14, 1992 and before January 20, 1994, the provisions for controlled foreign corporations that are issued as temporary regulations elsewhere in the Federal Register will also apply to such targets. Further, if that election is made, a protective carryover basis election or offset prohibition election made under the temporary regulations will have no effect.

 Section 1.338(h)(10)-1(f) (relating to mandatory use of the MADSP formula) is generally effective for targets with acquisition dates on or after November 10, 1986.

 Section 1.304-5 is effective January 20, 1994.

 Finally, the District Director's discretion to impose a section 338 election (other than with the taxpayer's consent) under section 338(e) and section 1.338-4T(f)(6)(i) is revoked for all open years.

 Although comments were requested regarding transition issues raised by the proposed effective date, no comments were received. Consequently, no special rules relating to transition issues have been provided.

G. SPECIAL ANALYSES.

 It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act 5 U.S.C. chapter 6) do not apply to these regulations, and therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on the impact of the rules on small business.

H. DRAFTING INFORMATION.

 The principal author of the international aspects of these regulations is Kenneth D. Allison of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service. However, other personnel from the IRS and Treasury Department participated in their development.

LIST OF SUBJECTS

26 CFR part 1

 Income taxes, Reporting and recordkeeping requirements.

26 CFR part 602

 Reporting and recording requirements.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1 -- INCOME TAXES

PARAGRAPH 1. The authority citation for part 1 is amended by removing the entry for "Section 1.338-6T" and adding entries in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.304-5 also issued under 26 U.S.C. 304. * * *

Section 1.338-1 also issued under 26 U.S.C. 337(d), 338, and 1502.

Section 1.338-2 also issued under 26 U.S.C. 337(d), 338, and 1502.

Section 1.338-3 also issued under 26 U.S.C. 337(d), 338, and 1502.

Section 1.338-4 also issued under 26 U.S.C. 337(d), 338, and 1502.

Section 1.338-5 also issued under 26 U.S.C. 337(d), 338, and 1502.

Section 1.338(b)-1 also issued under 26 U.S.C. 337(d), 338, and 1502. * * *

Section 1.338(h)(10)-1 also issued under 26 U.S.C. 337(d), 338, and 1502.

Section 1.338(i)-1 also issued under 26 U.S.C. 337(d), 338, and 1502. * * *

Section 1.1502-75 also issued under 26 U.S.C. 1502. * * *

PAR. 2. Section 1.304-5 is added to read as follows:

SECTION 1.304-5 CONTROL.

(a) CONTROL REQUIREMENT IN GENERAL. Section 304(c)(1) provides that, for purposes of section 304, control means the ownership of stock possessing at least 50 percent of the total combined voting power of all classes of stock entitled to vote or at least 50 percent of the total value of shares of all classes of stock. Section 304(c)(3) makes section 318(a) (relating to constructive ownership of stock), as modified by section 304(c)(3)(B), applicable to section 304 for purposes of determining control under section 304(c)(1).

(b) EFFECT OF SECTION 304(c)(2)(B) -- (1) IN GENERAL. In determining whether the control test with respect to both the issuing and acquiring corporations is satisfied, section 304(a)(1) considers only the person or persons that --

(i) Control the issuing corporation before the transaction;

(ii) Transfer issuing corporation stock to the acquiring corporation for property; and

(iii) Control the acquiring corporation thereafter.

(2) APPLICATION. Section 317 defines property to include money, securities, and any other property except stock (or stock rights) in the distributing corporation. However, section 304(c)(2)(B) provides a special rule to extend the relevant group of persons to be tested for control of both the issuing and acquiring corporations to include the person or persons that do not acquire property, but rather solely stock from the acquiring corporation in the transaction. Section 304(c)(2)(B) provides that if two or more persons in control of the issuing corporation transfer stock of such corporation to the acquiring corporation, and if the transferors are in control of the acquiring corporation after the transfer, the person or persons in control of each corporation include each of those transferors. Because the purpose of section 304(c)(2)(B) is to include in the relevant control group the person or persons that retain or acquire acquiring corporation stock in the transaction, only the person or persons transferring stock of the issuing corporation that retain or acquire any proprietary interest in the acquiring corporation are taken into account for purposes of applying section 304(c)(2)(B).

(3) EXAMPLE. This section may be illustrated by the following example.

EXAMPLE. (a) A, the owner of 20% of T's only class of stock, transfers that stock to P solely in exchange for all of the P stock. Pursuant to the same transaction, P, solely in exchange for cash, acquires the remaining 80% of the T stock from T's other shareholder, B, who is unrelated to A and P.

(b) Although A and B together were in control of T (the issuing corporation) before the transaction and A and B each transferred T stock to P (the acquiring corporation), sections 304(a)(1) and (c)(2)(B) do not apply to B because B did not retain or acquire any proprietary interest in P in the transaction. Section 304(a)(1) also does not apply to A because A (or any control group of which A was a member) did not control T before the transaction and P after the transaction.

(c) EFFECTIVE DATE. This section is effective [INSERT DATE THIS DOCUMENT IS PUBLISHED IN THE FEDERAL REGISTER (January 20, 1994)].

PAR. 3. The following sections or paragraphs are amended as follows:

(a) Sections 1.338-1T through 1.338-3T are removed.

(b) Sections 1.338-5T and 1.338-6T are removed.

(c) Section 1.338(b)-1T is removed.

(d) Section 1.338(b)-2T(a)(3) is removed.

(e) Section 1.338(b)-4T is removed.

(f) Section 1.338(h)(10)-1T is removed.

(g) Section 1.367(a)-4T(b)(4) is removed and reserved.

PAR. 4. Sections 1.338-0 through 1.338-5 and section 1.338(b)-1 are added to read as follows:

SECTION 1.338-0 OUTLINE OF TOPICS.

This section lists the captions contained in the regulations under section 338.

 SECTION 1.338-1 ELECTIONS UNDER SECTION 338.

(a) SCOPE. This section prescribes rules relating to elections under section 338. Paragraphs (c)(6), (e), and (g) of this section do not apply to a target for which a section 338(h)(10) election is made.

(b) NOMENCLATURE. For purposes of the regulations under section 338 (except as otherwise provided):

(1) T is a domestic corporation that has only one class of stock outstanding.

(2) P is a domestic corporation that purchases stock of T in a qualified stock purchase.

(3) The P group is an affiliated group of which P is a member.

(4) P1, P2, etc., are domestic corporations that are members of the P group.

(5) T1, T2, etc., are domestic corporations that are target affiliates of T. These corporations (T1, T2, etc.) have only one class of stock outstanding and may also be targets.

(6) S is a domestic corporation (unrelated to P and B) that owns T prior to the purchase of T by P. (S is referred to in cases in which it is appropriate to consider the effects of having all of the outstanding stock of T owned by a domestic corporation.)

(7) A, a U.S. resident or citizen, is an individual (unrelated to P and B) who owns T prior to the purchase of T by P. (A is referred to in cases in which it is appropriate to consider the effects of having all of the outstanding stock of T owned by an individual who is a U.S. resident or citizen. Ownership of T by A and ownership of T by S are mutually exclusive circumstances.)

(8) B, a U.S. resident or citizen, is an individual (unrelated to T, S, and A) who owns the stock of P.

(9) F, used as a prefix with the other terms in this paragraph (b), connotes foreign, rather than domestic, status. For example, FT is a foreign corporation (as defined in section 7701(a)(5)) and FA is an individual other than a U.S. citizen or resident.

(10) CFC, used as a prefix with the other terms in this paragraph (b) referring to a corporation, connotes a controlled foreign corporation (as defined in section 957, taking into account section 953(c)). A corporation identified with the prefix F may be a controlled foreign corporation. The prefix CFC is used when the corporation's status as a controlled foreign corporation is significant.

(c) DEFINITIONS. For purposes of the regulations under section 338 (except as otherwise provided):

(1) ACQUISITION DATE. The term acquisition date has the same meaning as in section 338(h)(2).

(2) AFFILIATED GROUP. The term affiliated group has the same meaning as in section 338(h)(5). Corporations are affiliated on any day they are members of the same affiliated group with each other.

(3) COMMON PARENT. The term COMMON PARENT has the same meaning as in section 1504.

(4) CONSISTENCY PERIOD. The CONSISTENCY PERIOD is the period described in section 338(h)(4)(A) unless extended pursuant to section 1.338-4(j)(1).

(5) DOMESTIC CORPORATION. A DOMESTIC corporation is a corporation --

(i) That is domestic within the meaning of section 7701(a)(4) or that is treated as domestic for purposes of subtitle A of the Internal Revenue Code (e.g., to which an election under section 953(d) or 1504(d) applies); and

(ii) That is not a DISC, a corporation described in section 1248(e), or a corporation to which an election under section 936 applies.

(6) OLD TARGET'S FINAL RETURN. OLD TARGET'S FINAL RETURN is the income tax return of old target for the taxable year ending at the close of the acquisition date that includes the deemed sale of assets under section 338. If the disaffiliation rule of paragraph (e)(2)(i) of this section applies, target's DEEMED SALE RETURN is considered old target's final return.

(7) PURCHASING CORPORATION. The term PURCHASING CORPORATION has the same meaning as in section 338(d)(1). Unless otherwise provided, any reference to the purchasing corporation is a reference to all members of the affiliated group of which the purchasing corporation is a member. See sections 338(h)(5) and (8).

(8) QUALIFIED STOCK PURCHASE. The term QUALIFIED STOCK PURCHASE has the same meaning as in section 338(d)(3).

(9) RELATED PERSONS. Two persons are related if stock in a corporation owned by one of the persons would be attributed under section 318(a) (other than section 318(a)(4)) to the other.

(10) SECTION 338 ELECTION. A SECTION 338 ELECTION is an election to apply section 338(a) to target. A section 338 election may be made by filing a statement of section 338 election pursuant to section 1.338-1(d). The form on which this statement is filed is referred to in the regulations under section 338 as the FORM 8023.

(11) SECTION 338(h)(10) ELECTION. A SECTION 338(h)(10) ELECTION is an election to apply section 338(h)(10) to target. A section 338(h)(10) election may be made by making a joint election for target under section 1.338(h)(10)-1.

(12) SELLING GROUP. The SELLING GROUP is the affiliated group (as defined in section 1504) that is eligible to file a consolidated return that includes target for the target's taxable period that includes the acquisition date and that does not have a target as common parent for the taxable year including the acquisition date.

(13) TARGET; OLD TARGET; NEW TARGET. TARGET is the target corporation as defined in section 338(d)(2). Old target refers to target for periods ending as of the close of the date of target's deemed sale of assets. NEW TARGET refers to target for subsequent periods.

(14) TARGET AFFILIATE. The term TARGET AFFILIATE has the same meaning as in section 338(h)(6) (applied without section 338(h)(6)(B)(i)). Thus, a corporation described in section 338(h)(6)(B)(i) is considered a target affiliate for all purposes of section 338. If a target affiliate is acquired in a qualified stock purchase, it is also a target.

(15) 12-MONTH ACQUISITION PERIOD. The 12-MONTH ACQUISITION PERIOD is the period described in section 338(h)(1), unless extended pursuant to section 1.338-4(j)(2).

(d) TIME AND MANNER OF MAKING ELECTION. The purchasing corporation makes a section 338 election for target by filing a statement of section 338 election on Form 8023 in accordance with the instructions to the form. The section 338 election must be made not later than the 15th day of the 9th month beginning after the month in which the acquisition date occurs. A section 338 election is irrevocable.

(e) RETURNS INCLUDING TAX LIABILITY FROM DEEMED SALE -- (1) IN GENERAL. Except as provided in paragraphs (e)(2) and (3) of this section, any tax liability resulting from the deemed sale of assets under section 338 is included in the final return of old target filed for old target's taxable year that ends at the close of the acquisition date. If old target is the common parent of an affiliated group, the final return may be a consolidated return (any such consolidated return must also include any tax liability from any deemed sales under section 338 by subsidiaries in the consolidated group that have the same acquisition date as old target and that are acquired by the purchasing corporation).

(2) OLD TARGET'S FINAL TAXABLE YEAR OTHERWISE INCLUDED IN CONSOLIDATED RETURN OF SELLING GROUP -- (i) GENERAL RULE. If the selling group files a consolidated return for the period that includes the acquisition date, old target is disaffiliated from that group immediately before its deemed sale of assets under section 338 and must file a separate final return that includes only the items resulting from the deemed sale and the carryover items specified in paragraph (e)(2)(iii) of this section (deemed sale return). The deemed sale occurs at the close of the acquisition date and is the last transaction of old target. Any transactions of old target occurring on the acquisition date other than the deemed sale are included in the selling group's consolidated return. A deemed sale return includes a COMBINED RETURN as defined in paragraph (e)(4) of this section.

(ii) SEPARATE TAXABLE YEAR. The deemed sale included in the deemed sale return under this paragraph (e)(2) occurs in a separate taxable year, except that old target's taxable year of the sale and the consolidated year of the selling group that includes the acquisition date are treated as the same year for purposes of determining the number of years in a carryover or carryback period.

(iii) CARRYOVER AND CARRYBACK OF TAX ATTRIBUTES. Target's attributes may be carried over to, and carried back from, the deemed sale return under the rules applicable to a corporation that ceases to be a member of a consolidated group.

(iv) OLD TARGET IS A COMPONENT MEMBER OF PURCHASING CORPORATION'S CONTROLLED GROUP. For purposes of its deemed sale return, target is a component member of the controlled group of corporations including the purchasing corporation unless target is treated as an excluded member under section 1563(b)(2).

(3) OLD TARGET AN S CORPORATION. If target is an S corporation for the period that ends on the day before the acquisition date, old target must file a deemed sale return as a C corporation. For this purpose, the principles of paragraph (e)(2) of this section apply.

(4) COMBINED DEEMED SALE RETURN -- (i) GENERAL RULE. Under section 338(h)(15), a combined deemed sale return (combined return) may be filed for all targets from a single selling consolidated group (as defined in section 1.338(h)(10)-1(c)(3)) that are acquired by the purchasing corporation on the same acquisition date and that otherwise would be required to file separate deemed sale returns. The combined return must include all such targets. For example, T and T1 may be included in a combined return if --

(A) T and T1 are directly owned subsidiaries of S;

(B) S is the common parent of a consolidated group; and

(C) P makes qualified stock purchases of T and T1 on the same acquisition date.

(ii) GAIN AND LOSS OFFSETS. Gains and losses recognized on the deemed sale of assets by targets included in a combined return are treated as the gains and losses of a single target. In addition, loss carryovers of a target that were not subject to the separate return limitation year restrictions (SRLY restrictions) of the consolidated return regulations while that target was a member of the selling consolidated group may be applied without limitation to the gains of other targets included in the combined return. If, however, a target has loss carryovers that were subject to the SRLY restrictions while that target was a member of the selling consolidated group, the use of those losses in the combined return continues to be subject to those restrictions, applied in the same manner as if the combined return were a consolidated return. A similar rule applies, when appropriate, to other tax attributes.

(iii) PROCEDURE FOR FILING A COMBINED RETURN. A combined return is made by filing a single corporation income tax return in lieu of separate deemed sale returns for all targets required to be included in the combined return. The combined return reflects the deemed sales of all targets required to be included in the combined return. If the targets included in the combined return constitute a single affiliated group within the meaning of section 1504(a), the income tax return is signed by an officer of the common parent of that group. Otherwise, the return must be signed by an officer of each target included in the combined return. Rules similar to the rules in section 1.1502-75(j) apply for purposes of preparing the combined return. The combined return must include an attachment prominently identified as an "ELECTION TO FILE A COMBINED RETURN UNDER SECTION 338(h)(15)." The attachment must --

(A) Contain the name, address, and employer identification number of each target required to be included in the combined return;

(B) Contain the following declaration (or a substantially similar declaration): "EACH TARGET IDENTIFIED IN THIS ELECTION TO FILE A COMBINED RETURN CONSENTS TO THE FILING OF A COMBINED RETURN"; and

(C) For each target, be signed by a person who states under penalties of perjury that he or she is authorized to act on behalf of such target.

(iv) CONSEQUENCES OF FILING A COMBINED RETURN. Each target included in a combined return is severally liable for any tax associated with the combined return. See section 1.338-2(d)(1).

(5) DEEMED SALE EXCLUDED FROM PURCHASING CORPORATION'S CONSOLIDATED RETURN. Old target may not be considered a member of any affiliated group that includes the purchasing corporation with respect to the deemed sale of target assets under section 338.

(6) DUE DATE FOR OLD TARGET'S FINAL RETURN -- (i) GENERAL RULE. Old target's final return is generally due on the 15th day of the third calendar month following the month in which the acquisition date occurs. See section 6072 (time for filing income tax returns).

(ii) APPLICATION OF SECTION 1.1502-76(c) -- (A) IN GENERAL. Section 1.1502-76(c) applies to old target's final return if old target was a member of a selling group that did not file consolidated returns for the taxable year of the common parent that precedes the year that includes old target's acquisition date. If the selling group has not filed a consolidated return that includes old target's taxable period that ends on the acquisition date, target may, on or before the final return due date (including extensions), either --

(1) File a deemed sale return on the assumption that the selling group will file the consolidated return; or

(2) File a return for so much of old target's taxable period as ends at the close of the acquisition date on the assumption that the consolidated return will not be filed.

(B) DEEMED EXTENSION. For purposes of applying section 1.1502-76(c)(2), an extension of time to file old target's final return is considered to be in effect until the last date for making the election under section 338.

(C) ERRONEOUS FILING OF DEEMED SALE RETURN. If, pursuant to this paragraph (e)(6)(ii), target files a deemed sale return but the selling group does not file a consolidated return, target must file a substituted return for old target not later than the due date (including extensions) for the return of the common parent with which old target would have been included in the consolidated return. The substituted return is for so much of old target's taxable year as ends at the close of the acquisition date. Under section 1.1502-76(c)(2), the deemed sale return is not considered a return for purposes of section 6011 (relating to the general requirement of filing a return) if a substituted return must be filed.

(D) ERRONEOUS FILING OF RETURN FOR REGULAR TAX YEAR. If, pursuant to this paragraph (e)(6)(ii), target files a return for so much of old target's regular taxable year as ends at the close of the acquisition date but the selling group files a consolidated return, target must file an amended return for old target not later than the due date (including extensions) for the selling group's consolidated return. (The amended return is a deemed sale return.)

(E) LAST DATE FOR PAYMENT OF TAX. If either a substituted or amended final return of old target is filed pursuant to this paragraph (e)(6)(ii), the last date prescribed for payment of tax is the final return due date (as defined in paragraph (e)(6)(i) of this section).

(7) EXAMPLES. This paragraph (e) may be illustrated by the following examples:

EXAMPLE 1. (a) S is the common parent of a consolidated group that includes T. The S group files calendar year consolidated returns. At the close of June 30 of Year 1, P makes a qualified stock purchase of T from S. P makes a section 338 election for T, and the deemed sale of T's assets occurs as of the close of T's acquisition date (June 30).

(b) T is considered disaffiliated for purposes of reporting the deemed sale. Accordingly, T is included in the S group's consolidated return through T's acquisition date except than the tax liability resulting from the deemed sale of assets is reported in a separate deemed sale return of T. Provided that T is not treated as an excluded member under section 1563(b)(2), T is a component member of P's controlled group for the taxable year represented by the deemed sale, and the taxable income bracket amounts available in calculating tax on the deemed sale return must be limited accordingly.

(c) If P purchased the stock of T at 10 a.m. on June 30 of Year 1, the results would be the same. See paragraph (e)(2)(i) of this section.

EXAMPLE 2. The facts are the same as in EXAMPLE 1, except that the S group does not file consolidated returns. T must file a separate return for its taxable year ending on June 30 of Year 1, which includes the deemed sale.

(f) WAIVER -- (1) CERTAIN ADDITIONS TO TAX. An addition to tax or additional amount (addition) under subchapter A of chapter 68 of the Internal Revenue Code arising on or before the last day for making the election under section 338, by reason of circumstances that would not exist but for an election under section 338, is waived if --

(i) Under the particular statute the addition is excusable upon a showing of reasonable cause; and

(ii) Corrective action is taken on or before the last day.

(2) NOTIFICATION. The Service should be notified at the time of correction (e.g., by attaching a statement to a return that constitutes corrective action) that the waiver rule of this paragraph (f) is being asserted.

(3) ELECTIONS OR OTHER ACTIONS REQUIRED TO BE SPECIFIED ON A TIMELY FILED RETURN -- (i) IN GENERAL. If paragraph (f)(1) of this section applies or would apply if there was an underpayment, any election or other action that must be specified on a timely filed return for the taxable period covered by the late filed return described in paragraph (f)(1) of this section is considered timely if specified on a late-filed return filed on or before the last day for making the election under section 338.

(ii) NEW TARGET IN PURCHASING CORPORATION'S CONSOLIDATED RETURN. If new target is includible for its first taxable year in a consolidated return filed by the affiliated group of which the purchasing corporation is a member on or before the last day for making the election under section 338, any election or other action that must be specified in a timely filed return for new target's first taxable year (but which is not specified in the consolidated return) is considered timely if specified in an amended return filed on or before such last day, at the place where the consolidated return was filed.

(4) EXAMPLES. This paragraph (f) may be illustrated by the following examples:

EXAMPLE 1. T is an unaffiliated corporation with a tax year ending March 31. At the close of September 20 of Year 1, P makes a qualified stock purchase of T. P does not join in filing a consolidated return. P makes a section 338 election for T on or before June 15 of Year 2, which causes T's taxable year to end as of the close of September 20 of Year 1. An income tax return for T's taxable period ending on September 20 of Year 1 was due on December l5 of Year 1. Additions to tax for failure to file a return and to pay tax shown on a return will not be imposed if T's return is filed and the tax paid on or before June 15 of Year 2. (This waiver applies even if the acquisition date coincides with the last day of T's former taxable year, i.e., March 31 of Year 2.) Interest on any underpayment of tax for old T's short taxable year ending September 20 of Year 1 runs from December 15 of Year 1. A statement indicating that the waiver rule of section 1.338-1(f) is being asserted should be attached to T's return.

EXAMPLE 2. Assume the same facts as in EXAMPLE 1. Assume further that new T adopts the calendar year by filing, on or before June 15 of Year 2, its first return (for the period beginning on September 21 of Year 1 and ending on December 31 of Year 1) indicating that a calendar year is chosen. See section 1.338-2(d)(8). Any additions to tax or amounts described in this paragraph (f) which arise by reason of the late filing of a return for the period ending on December 31 of Year 1 are waived, because they are based on circumstances that would not exist but for the section 338 election. Notwithstanding this waiver, however, the return is still considered due March 15 of Year 2, and interest on any underpayment runs from that date.

EXAMPLE 3. Assume the same facts as in EXAMPLE 2, except that T's former taxable year ends on October 31. Although prior to the election old T had a return due on January 15 of Year 2 for its year ending October 31 of Year 1, that return need not be filed because a timely election under section 338 was made. Instead, old T must file a final return for the period ending on September 20 of Year 1, which is due on December 15 of Year 1.

(g) SPECIAL RULES FOR FOREIGN CORPORATIONS OR DISCs -- (1) ELECTIONS BY CERTAIN FOREIGN PURCHASING CORPORATIONS -- (i) GENERAL RULE. A qualifying foreign purchasing corporation is not required to file a statement of section 338 election for a qualifying foreign target before the earlier of 3 years after the acquisition date and the 180th day after the close of the purchasing corporation's taxable year within which a triggering event occurs.

(ii) QUALIFYING FOREIGN PURCHASING CORPORATION. A purchasing corporation is a QUALIFYING FOREIGN PURCHASING CORPORATION only if, during the acquisition period of a qualifying foreign target, all the corporations in the purchasing corporation's affiliated group are foreign corporations that are not subject to United States tax.

(iii) QUALIFYING FOREIGN TARGET. A target is a QUALIFYING FOREIGN TARGET only if target and its target affiliates are foreign corporations that, during target's acquisition period, are not subject to United States tax (and will not become subject to United States tax during such period by reason of a section 338 election). A target affiliate is taken into account for purposes of the preceding sentence only if, during target's 12-month acquisition period, it is or becomes a member of the affiliated group that includes the purchasing corporation.

(iv) TRIGGERING EVENT. A triggering event occurs in the taxable year of the qualifying foreign purchasing corporation in which either that corporation or any corporation in its affiliated group becomes subject to United States tax.

(v) SUBJECT TO UNITED STATES TAX. For purposes of this paragraph (g)(1), a foreign corporation is considered SUBJECT TO UNITED STATES TAX --

(A) For the taxable year for which that corporation is required under section 1.6012-2(g) (other than section 1.6012-2(g)(2)(i)(b)(2)) to file a United States income tax return; or

(B) For the period during which that corporation is a controlled foreign corporation, a passive foreign investment company for which an election under section 1295 is in effect, a foreign investment company, or a foreign corporation the stock ownership of which is described in section 552(a)(2).

(2) ACQUISITION PERIOD. For purposes of this paragraph (g), the term ACQUISITION PERIOD means the period beginning on the first day of the 12-month acquisition period and ending on the acquisition date.

(3) STATEMENT OF SECTION 338 ELECTION MAY BE FILED BY UNITED STATES SHAREHOLDERS IN CERTAIN CASES. The United States shareholders (as defined in section 951(b)) of a foreign purchasing corporation that is a controlled foreign corporation (as defined in section 957 (taking into account section 953(c))) may file a statement of section 338 election on behalf of the purchasing corporation if the purchasing corporation is not required under section 1.6012-2(g) (other than section 1.6012-2(g)(2)(i)(b)(2)) to file a United States income tax return for its taxable year that includes the acquisition date. Form 8023 must be filed as described in the form and its instructions and also must be attached to the Form 547l (information return with respect to a foreign corporation) filed with respect to the purchasing corporation by each United States shareholder for the purchasing corporation's taxable year that includes the acquisition date (or, if paragraph (g)(1)(i) of this section applies to the election, for the purchasing corporation's taxable year within which it becomes a controlled foreign corporation). The provisions of section 1.964-1(c) (including section 1.964-1(c)(7)) do not apply to an election made by the United States shareholders.

(4) NOTICE REQUIREMENT FOR U.S. PERSONS HOLDING STOCK IN FOREIGN TARGET -- (i) GENERAL RULE. If a target subject to a section 338 election was a controlled foreign corporation, a passive foreign investment company, or a foreign personal holding company at any time during the portion of its taxable year that ends on its acquisition date, the purchasing corporation must deliver written notice of the election (and a copy of Form 8023, its attachments and instructions) to --

(A) Each U.S. person (other than a member of the affiliated group of which the purchasing corporation is a member (the purchasing group member)) that, on the acquisition date of the foreign target, holds stock in the foreign target; and

(B) Each U.S person (other than a purchasing group member) that sells stock in the foreign target to a purchasing group member during the foreign target's 12-month acquisition period.

(ii) LIMITATION. The notice requirement of this paragraph (g)(4) applies only where the section 338 election for the foreign target affects income, gain, loss, deduction, or credit of the U.S. person described in paragraph (g)(4)(i) of this section under section 551, 951, 1248, or 1293.

(iii) FORM OF NOTICE. The notice to U.S. persons must be identified prominently as a notice of section 338 election and must --

(A) Contain the name, address, and employer identification number (if any) of, and the country (and, if relevant, the lesser political subdivision) under the laws of which is organized, the purchasing corporation and the relevant target (i.e., target the stock of which the particular U.S. person held or sold under the circumstances described in paragraph (g)(4)(i) of this section);

(B) Identify those corporations as the purchasing corporation and the foreign target, respectively; and

(C) Contain the following declaration (or a substantially similar declaration): "THIS DOCUMENT SERVES AS NOTICE OF AN ELECTION UNDER SECTION 338 FOR THE ABOVE CITED FOREIGN TARGET THE STOCK OF WHICH YOU EITHER HELD OR SOLD UNDER THE CIRCUMSTANCES DESCRIBED IN TREASURY REGULATIONS SECTION 1.338-1(g)(4). FOR POSSIBLE UNITED STATES FEDERAL INCOME TAX CONSEQUENCES UNDER SECTION 551, 951, 1248, OR 1293 OF THE INTERNAL REVENUE CODE OF 1986 THAT MAY APPLY TO YOU, SEE TREASURY REGULATIONS SECTION 1.338-5(b). YOU MAY BE REQUIRED TO ATTACH THE INFORMATION ATTACHED TO THIS NOTICE TO CERTAIN RETURNS".

(iv) TIMING OF NOTICE. The notice required by this paragraph (g) (4) must be delivered to the U.S person on or before the later of the 120th day after the acquisition date of the particular target or the day on which Form 8023 is filed. If notice is delivered by United States mail, the date of the United States postmark is deemed to be the date of delivery.

(v) CONSEQUENCE OF FAILURE TO COMPLY. A statement of section 338 election is not valid if timely notice is not given to one or more U.S. persons described in this paragraph (g)(4). If the form of notice fails to comply with all requirements of this paragraph (g)(4), the section 338 election is valid, but the waiver rule of paragraph (f)(1) of this section does not apply.

(vi) GOOD FAITH EFFORT TO COMPLY. The purchasing corporation will be considered to have complied with this paragraph (g)(4), even though it failed to provide notice or provide timely notice to each person described in this paragraph (g)(4), if the Commissioner determines that the purchasing corporation made a good faith effort to identify and provide timely notice to those U.S. persons.

SECTION 1.338-2 MISCELLANEOUS ISSUES UNDER SECTION 338.

(a) SCOPE. This section provides guidance on miscellaneous issues under section 338.

(b) RULES RELATING TO QUALIFIED STOCK PURCHASES -- (1) PURCHASING CORPORATION REQUIREMENT. An individual cannot make a qualified stock purchase of target. Section 338(d)(3) requires, as a condition of a qualified stock purchase, that a corporation purchase the stock of target. If an individual forms a corporation (new P) to acquire target stock, new P can make a qualified stock purchase of target if new P is considered for tax purposes to purchase the target stock. Facts that may indicate that new P does not purchase the target stock include that new P merges downstream into target, liquidates, or otherwise disposes of the target stock following the purported qualified stock purchase.

(2) PURCHASE -- (i) DEFINITION. The term PURCHASE has the same meaning as in section 338(h)(3).

(ii) EXAMPLES. This paragraph (b)(2) may be illustrated by the following examples:

EXAMPLE 1. A, who owns all of the stock of P and T, sells the T stock to P for cash. A is treated under section 304(a)(1) as receiving a distribution in redemption of the P stock to which section 301 applies. P is treated as receiving the T stock as a contribution to its capital. Under section 362(a) and section 1.304-2(a), P's basis in the T stock is determined by reference to A's adjusted basis in the stock. Further, stock owned by A would be attributed to P under section 318(a)(3)(C). Thus, P is not considered to have acquired the T stock by purchase. See sections 338(h)(3)(A)(i) and (iii).

EXAMPLE 2. P exchanges cash for all of the stock of N, a newly formed corporation. N was formed for the sole purpose of acquiring all of the T stock by means of a reverse subsidiary cash merger. Prior to the merger, N conducted no activities other than those required for the merger. Pursuant to the plan, N merges into T, and the T shareholders receive cash for their T stock. No T shareholder is related to P, and no group of T shareholders controls P within the meaning of section 304(c). The existence of N is disregarded, and P is considered to acquire the T stock directly from the T shareholders for cash. Thus, P is considered to have acquired the T stock by purchase.

(3) DATE OF PURCHASE FROM RELATED CORPORATIONS -- (i) IN GENERAL. Stock acquired by a purchasing corporation from a related corporation (R) is generally not considered acquired by purchase. See section 338(h)(3)(A)(iii). However, if section 338(h)(3)(C) applies and the purchasing corporation is treated as acquiring stock by purchase from R, solely for purposes of determining when the stock is considered acquired --

(A) Target stock acquired from R is considered to have been acquired by the purchasing corporation on the day on which the purchasing corporation is first considered to own that stock under section 318(a) (other than section 318(a)(4)); and

(B) If such stock first may be considered owned by the purchasing corporation on more than one date, such stock is deemed acquired on the earliest date first to the extent thereof, then on the next earliest date, and so on.

(ii) EXAMPLES. This paragraph (b)(3) may be illustrated by the following examples:

EXAMPLE 1. (a) On January 1 of Year 1, P purchases 75% in value of the R stock. On that date, R owns 4 of the 100 shares of T stock. On June 1 of Year 1, R acquires an additional 16 shares of T stock. On December 1 of Year 1, P purchases 70 shares of T stock from an unrelated person and 12 of the 20 shares of T stock held by R.

(b) Of the 12 shares of T stock purchased by P from R on December 1 of Year 1, 3 of those shares are deemed to have been acquired by P on January 1 of Year 1, the date on which 3 of the 4 shares of T stock held by R on that date were first considered owned by P under section 318(a)(2)(C) (i.e., 4 x .75). The remaining 9 shares of T stock purchased by P from R on December 1 of Year 1, are deemed to have been acquired by P on June 1 of Year 1, the date on which an additional 12 of the 20 shares of T stock owned by R on that date were first considered owned by P under section 318(a)(2)(C) (i.e., (20 x .75) - 3). Because stock acquisitions by P sufficient for a qualified stock purchase of T occur within a 12-month period (i.e., 3 shares constructively on January 1 of Year 1, 9 shares constructively on June 1 of Year 1, and 70 shares actually on December 1 of Year 1), a qualified stock purchase is made on December 1 of Year 1.

EXAMPLE 2. (a) On February 1 of Year 1, P acquires 25% in value of the R stock from B (the sole shareholder of P). That R stock is not acquired by purchase. See section 338(h)(3)(A)(iii). On that date, R owns 4 of the 100 shares of T stock. On June 1 of Year 1, P purchases an additional 25% in value of the R stock, and on January 1 of Year 2, P purchases another 25% in value of the R stock. On June 1 of Year 2, R acquires an additional 16 shares of the T stock. On December 1 of Year 2, P purchases 68 shares of the T stock from an unrelated person and 12 of the 20 shares of the T stock held by R.

(b) Of the 12 shares of the T stock purchased by P from R on December 1 of Year 2, 2 of those shares are deemed to have been acquired by P on June 1 of Year 1, the date on which 2 of the 4 shares of the T stock held by R on that date were first considered owned by P under section 318(a)(2)(C) (i.e., 4 x .5). For purposes of this attribution, the R stock need not be acquired by P by purchase. See section 338(h)(1). (By contrast, the acquisition of the T stock by P from R does not qualify as a purchase unless P has acquired at least 50% in value of the R stock by purchase. Section 338(h)(3)(C)(i).) Of the remaining 10 shares of the T stock purchased by P from R on December 1 of Year 2, 1 of those shares is deemed to have been acquired by P on January 1 of Year 2, the date on which an additional 1 share of the 4 shares of the T stock held by R on that date was first considered owned by P under section 318(a)(2)(C) (i.e., (4 x .75) - 2). The remaining 9 shares of the T stock purchased by P from R on December 1 of Year 2, are deemed to have been acquired by P on June 1 of Year 2, the date on which an additional l2 shares of the T stock held by R on that date were first considered owned by P under section 3l8(a)(2)(C) (i.e., (20 x .75) - 3). Because a qualified stock purchase of T by P is made on December 1 of Year 2, only if all 12 shares of the T stock purchased by P from R on that date are considered acquired during a 12-month period ending on that date (so that, in conjunction with the 68 shares of the T stock P purchased on that date from the unrelated person, 80 of T's 100 shares are acquired by P during a 12-month period) and because 2 of those 12 shares are considered to have been acquired by P more than 12 months before December 1 of Year 2 (i.e., on June 1 of Year 1), a qualified stock purchase is not made. (under section 1.338-4(j)(2), for purposes of applying the consistency rules, P is treated as making a qualified stock purchase of T if, pursuant to an arrangement, P purchases T stock satisfying the requirements of section 1504(a)(2) over a period of more than 12 months.)

EXAMPLE 3. Assume the same facts as in Example 2, except that on February 1 of Year 1, P acquires 25% in value of the R stock by purchase. The result is the same as in Example 2.

(4) ACQUISITION DATE FOR TIERED TARGETS -- (i) STOCK SOLD IN DEEMED ASSET SALE. If an election under section 338 is made for target, old target is deemed to sell target's assets and new target is deemed to acquire those assets. Under section 338(h)(3)(B), new target's deemed purchase of stock of another corporation is a purchase for purposes of section 338(d)(3) on the acquisition date of target. If new target's deemed purchase causes a qualified stock purchase of the other corporation and if a section 338 election is made for the other corporation, the acquisition date for the other corporation is the same as the acquisition date of target. However, the deemed sale and purchase of the other corporation's assets is considered to take place after the deemed sale and purchase of target's assets.

(ii) EXAMPLES. This paragraph (b)(4) may be illustrated by the following examples:

EXAMPLE 1. A owns all of the T stock. T owns 50 of the 100 shares of X stock. The other 50 shares of X stock are owned by corporation Y, which is unrelated to A, T, or P. On January 1 of Year 1, P makes a qualified stock purchase of T from A and makes a section 338 election for T. On December 1 of Year 1, P purchases the 50 shares of X stock held by Y. A qualified stock purchase of X is made on December 1 of Year 1, because the deemed purchase of 50 shares of X stock by new T by reason of the section 338 election for T and the actual purchase of 50 shares of X stock by P are treated as purchases made by one corporation. Section 338(h)(8). For purposes of determining whether those purchases occur within a 12-month acquisition period as required by section 338(d)(3), T is deemed to purchase its X stock on T's acquisition date, i.e., January 1 of Year 1.

EXAMPLE 2. On January 1 of Year 1, P makes a qualified stock purchase of T and makes a section 338 election for T. On that day, T sells all of the stock of T1 to A. Although T held all of the T1 stock on T's acquisition date, T is not considered to have purchased the T1 stock by reason of the section 338 election for T. In order for T to be treated as purchasing the T1 stock, T must hold the T1 stock when T's deemed sale of assets occurs pursuant to section 338(a). The deemed sale of assets is considered the last transaction of old T at the close of T's acquisition date. Accordingly, the T1 stock actually disposed of by T on the acquisition date is not included in the deemed sale of assets. Thus, T does not make a qualified stock purchase of T1.

(5) EFFECT OF REDEMPTIONS -- (i) GENERAL RULE. Except as provided in this paragraph (b)(5), a qualified stock purchase is made on the first day on which the percentage ownership requirements of section 338(d)(3) are satisfied by reference to target stock that is both --

(A) Held on that day by the purchasing corporation; and

(B) Purchased by the purchasing corporation during the 12-month period ending on that day.

(ii) REDEMPTIONS FROM PERSONS UNRELATED TO THE PURCHASING CORPORATION. Target stock redemptions from persons unrelated to the purchasing corporation that occur during the 12-month acquisition period are taken into account as reductions in target's outstanding stock for purposes of determining whether target stock purchased by the purchasing corporation in the 12-month acquisition period satisfies the percentage ownership requirements of section 338(d)(3).

(iii) REDEMPTIONS FROM THE PURCHASING CORPORATION OR RELATED PERSONS DURING 12-MONTH ACQUISITION PERIOD -- (A) GENERAL RULE. For purposes of the percentage ownership requirements of section 338(d)(3), a redemption of target stock during the 12-month acquisition period from the purchasing corporation or from any person related to the purchasing corporation is not taken into account as a reduction in target's outstanding stock.

(B) EXCEPTION FOR CERTAIN REDEMPTIONS FROM RELATED CORPORATIONS. A redemption of target stock during the 12-month acquisition period from a corporation related to the purchasing corporation is taken into account as a reduction in target's outstanding stock to the extent that the redeemed stock would have been considered purchased by the purchasing corporation (by reason of section 338(h)(3)(C)) during the 12-month acquisition period if the redeemed stock had been acquired by the purchasing corporation from the related corporation on the day of the redemption. See paragraph (b)(3) of this section.

(iv) EXAMPLES. This paragraph (b)(5) may be illustrated by the following examples:

EXAMPLE 1. QSP ON STOCK PURCHASE DATE; REDEMPTION FROM UNRELATED PERSON DURING 12-MONTH PERIOD. A owns all 100 shares of T stock. On January 1 of Year 1, P purchases 40 shares of the T stock from A. On July 1 of Year 1, T redeems 25 shares from A. On December 1 of Year 1, P purchases 20 shares of the T stock from A. P makes a qualified stock purchase of T on December 1 of Year 1, because the 60 shares of T stock purchased by P within the 12-month period ending on that date satisfy the 80-percent ownership requirements of section 338(d)(3) (i.e., 60/75 shares), determined by taking into account the redemption of 25 shares.

EXAMPLE 2. QSP ON STOCK REDEMPTION DATE; REDEMPTION FROM UNRELATED PERSON DURING 12-MONTH PERIOD. The facts are the same as in Example 1, except that P purchases 60 shares of T stock on January 1 of Year 1 and none on December 1 of Year 1. P makes a qualified stock purchase of T on July l of Year 1, because that is the first day on which the T stock purchased by P within the preceding 12-month period satisfies the 80-percent ownership requirements of section 338(d)(3) (i.e., 60/75 shares), determined by taking into account the redemption of 25 shares.

EXAMPLE 3. REDEMPTION FROM UNRELATED PERSON MORE THAN 12 MONTHS BEFORE STOCK PURCHASE. A owns all 100 shares of T stock. On January 1 of Year 1, T redeems 25 of its shares. On January 15 of Year 2, P purchases 60 shares of T stock from A. P makes a qualified stock purchase of T on January 15 of Year 2. The 60 shares of T stock purchased by P within the 12-month period ending on that date satisfy the 80-percent ownership requirements of section 338(d)(3) (i.e., 60/75 shares), determined by taking into account the redemption of 25 shares. It is irrelevant that the redemption occurred before the 12-month acquisition period.

EXAMPLE 4. REDEMPTION FROM UNRELATED PERSON MORE THAN 12 MONTHS AFTER STOCK PURCHASE. The facts are the same as in Example 3, except that the redemption occurs on April 1 of Year 3. P does not make a qualified stock purchase of T on April 1 of Year 3, because 80% of the T stock, as of April 1 of Year 3 had not been purchased in the preceding l2 months. (Under section 1.338-A(j)(2) for purposes of applying the consistency rules, P is treated as making a qualified stock purchase of T if, pursuant to an arrangement, P purchases T stock satisfying the requirements of section 1504(a)(2) over a period of more than 12 months.)

EXAMPLE 5. REDEMPTION FROM PURCHASING CORPORATION NOT TAKEN INTO ACCOUNT. On December IS of Year 1, T redeems 30% of its stock from P. The redeemed stock was held by P for several years and constituted P's total interest in T. On December 1 of Year 2, P purchases the remaining T stock from A. P does not make a qualified stock purchase of T on December 1 of Year 2. For purposes of the 80-percent ownership requirements of section 338(d)(3), the redemption of P's T stock on December 15 of Year 1 is not taken into account as a reduction in T's outstanding stock.

EXAMPLE 6. REDEMPTION FROM RELATED PERSON TAKEN INTO ACCOUNT. On January 1 of Year 1, P purchases 60 of the 100 shares of X stock. On that date, X owns 40 of the 100 shares of T stock. On April 1 of Year 1, T redeems X's T stock and P purchases the remaining 60 shares of T stock from an unrelated person. For purposes of the 80-percent ownership requirements of section 338(d)(3), the redemption of the T stock from X (a person related to P) is taken into account as a reduction in T's outstanding stock. If P had purchased the 40 redeemed shares from X on April 1 of Year 1, all 40 of the shares would have been considered purchased (by reason of section 338(h)(3)(C)(i)) during the 12-month period ending on April [1] of Year 1 (24 of the 40 shares would have been considered purchased by P on January 1 of Year 1 and the remaining 16 shares would have been considered purchased by P on April 1 of Year 1). See paragraph (b)(3) of this section. Accordingly, P makes a qualified stock purchase of T on April 1 of Year 1, because the 60 shares of T stock purchased by P on that date satisfy the 80-percent ownership requirements of section 338(d)(3) (i.e., 60/60 shares), determined by taking into account the redemption of 40 shares.

(c) EFFECT OF POST-ACQUISITION EVENTS ON ELIGIBILITY FOR SECTION 338 ELECTION -- (1) POST-ACQUISITION ELIMINATION OF TARGET. (i) The purchasing corporation may make an election under section 338 for target even though target is liquidated on or after the acquisition date. If target liquidates on the acquisition date, the liquidation is considered to occur on the following day and immediately after new target's deemed purchase of assets. The purchasing corporation may also make an election under section 338 for target even though target is merged into another corporation, or otherwise disposed of by the purchasing corporation provided that, under the facts and circumstances, the purchasing corporation is considered for tax purposes as the purchaser of the target stock.

(ii) This paragraph (c)(1) may be illustrated by the following examples:

EXAMPLE 1. On January 1 of Year 1, P makes a qualified stock purchase of T. On June 1 of Year 1, P sells the T stock to an unrelated person. Assuming that P is considered for tax purposes as the purchaser of the T stock, P remains eligible, after June 1 of Year 1, to make a section 338 election for T that results in a deemed sale of T's assets on January 1 of Year 1.

EXAMPLE 2. On January 1 of Year 1, P makes a qualified stock purchase of T. On that date, T owns the stock of T1. On March 1 of Year 1, T sells the T1 stock to an unrelated person. On April 1 of Year 1, P makes a section 338 election for T. Notwithstanding that the T1 stock was sold on March 1 of Year 1, the section 338 election for T on April 1 of Year 1, results in a qualified stock purchase by T of T1 on January 1 of Year 1. See paragraph (b)(4)(i) of this section.

(2) POST-ACQUISITION ELIMINATION OF THE PURCHASING CORPORATION. An election under section 338 may be made for target after the acquisition of assets of the purchasing corporation by another corporation in a transaction described in section 381(a), provided that the purchasing corporation is considered for tax purposes as the purchaser of the target stock. The acquiring corporation in the section 381(a) transaction may make an election under section 338 for target.

(d) MISCELLANEOUS MATTERS AFFECTING NEW TARGET -- (1) GENERAL RULE FOR SUBTITLE A. Except as provided in this paragraph (d), new target is treated as a new corporation that is unrelated to old target for purposes of subtitle A of the Internal Revenue Code. Thus, in the section 338(a)(1) deemed sale, new target is treated as purchasing assets from an unrelated person, and --

(i) New target is not considered related to old target for purposes of section 168 and may make new elections under section 168 without taking into account the elections made by old target; and

(ii) New target may adopt, without obtaining prior approval from the Commissioner, any taxable year that meets the requirements of section 441 and any method of accounting that meets the requirements of section 446.

(2) EXCEPTIONS FOR SUBTITLE A. New target and old target are treated as the same corporation for purposes of --

(i) The rules applicable to employee benefit plans (including those plans described in sections 79, 104, 105, 120, 125, 127, and 129), qualified pension, profit-sharing, stock bonus and annuity plans (sections 40l(a) and 403(a)), simplified employee pensions (section 408(k)), and tax qualified stock option plans (sections 422 and 423);

(ii) Sections 1311-1314 (relating to the mitigation of the effect of limitations) if a section 338(h)(10) election is not made for target; and

(iii) Any other provision identified by the Commissioner.

(3) TAXABLE YEAR OF NEW TARGET. Notwithstanding section 1.441-1b(b)(2), a new target may adopt a taxable year on or before the last day for making the election under section 338 by filing its first return for the desired taxable year on or before that date.

(4) GENERAL RULE FOR OTHER PROVISIONS OF THE INTERNAL REVENUE CODE. Except as provided in the regulations under section 338 or by the Commissioner, new target is treated as a continuation of old target for purposes other than subtitle A. For example --

(i) New target is liable for old target's federal income tax liabilities, including tax liabilities resulting from the deemed asset sale and those tax liabilities of the other members of any consolidated group that included old target that are attributable to taxable years in which those corporations and old target joined in the same consolidated return (see section 1.1502-6(a));

(ii) Wages earned by the employees of old target are considered wages earned by such employees from new target for purposes of sections 3101 and 3111 (Federal Insurance Contributions Act) and section 3301 (Federal Unemployment Tax Act); and

(iii) Old target and new target must use the same employer identification number.

SECTION 1.338-3 DEEMED SALE AND AGGREGATE DEEMED SALE PRICE.

(a) SCOPE. This section provides guidance regarding the recognition of gain or loss on the deemed sale of target affiliate stock. This section also provides guidance regarding the determination of the price (the aggregate price) at which old target is treated as selling its assets in the section 338(a)(1) deemed sale for purposes of determining the gain or loss recognized by target in the deemed sale. Notwithstanding section 338(h)(6)(B)(ii), stock held by a target affiliate in a foreign corporation or in a corporation that is a DISC or that is described in section 1248(e) is not excluded from the operation of section 338.

(b) DEFINITIONS. For purposes of the regulations under section 338:

(1) ADSP. The ADSP is the aggregate deemed sale price, i.e., the price at which target is deemed to have sold all of its assets in the deemed sale under section 338(a)(1). See paragraph (d) of this section for the determination of the ADSP.

(2) ALLOCABLE ADSP AMOUNT. The ALLOCABLE ADSP AMOUNT is the portion of the ADSP that is allocable to a particular target asset. Deemed sale gain on a target asset is computed by reference to the allocable ADSP amount for that asset. Except as provided in section 7701(g) (relating to fair market value in the case of nonrecourse indebtedness), the ADSP is allocated among target assets for this purpose under the principles of section 1.338(b)-2T (without taking into account section 1.338(b)-2T(c)(2)). Appropriate adjustments to reflect accurately the fair market value of assets must be made if stock of a target affiliate is purchased in the section 338(a)(1) deemed sale, a section 338 election is made for the target affiliate, and target recognizes no gain or loss on the deemed sale of the target affiliate stock under paragraph (c) of this section. See Example 4 of paragraph (d)(8) of this section.

(3) DEEMED SALE GAIN. DEEMED SALE GAIN is gain (or loss) that is recognized in the section 338(a)(1) deemed sale. For purposes of subtitle A of the Internal Revenue Code, deemed sale gain is taken into account by treating the old target as if, on the acquisition date, it sold all of its assets to an unrelated person in the deemed sale. See section 1.338-2(d)(1). For example, section 267 does not apply to loss recognized on the deemed sale.

(4) CLASSES OF ASSETS. The four classes of assets are defined in section 1.338(b)-2T(b).

(c) DEEMED SALE OF TARGET AFFILIATE STOCK -- (1) IN GENERAL. This paragraph (c) prescribes rules relating to the treatment of gain or loss realized on the deemed sale of stock of a target affiliate where a section 338 election (but not a section 338(h)(10) election) is made for the target affiliate. For purposes of this paragraph (c), the definition of domestic corporation in section 1.338-1(c)(5) is applied without the exclusion therein for DISCs, corporations described in section 1248(e), and corporations to which an election under section 936 applies.

(2) GENERAL RULE. Except as otherwise provided in this paragraph (c), if a section, 338 election is made for target, no gain or loss is recognized by target on the deemed sale of stock of a target affiliate having the same acquisition date and for which a section 338 election is made if --

(i) Target directly owns stock in the target affiliate satisfying the requirements of section 1504(a)(2);

(ii) Target and the target affiliate are members of a consolidated group filing a final consolidated return described in section 1.338-1(e)(1); or

(iii) Target and the target affiliate file a combined return under section 1.338-1(e)(4).

(3) DEEMED SALE OF FOREIGN TARGET AFFILIATE BY A DOMESTIC TARGET. Gain or loss is recognized by a domestic target on the deemed sale of stock of a foreign target affiliate. For the proper treatment of such gain or loss, see, e.g., sections 1246, 1248, 1291 et seq., and 338(h)(16) and section 1.338-5.

(4) DEEMED SALE PRODUCING EFFECTIVELY CONNECTED INCOME. Gain or loss is recognized by a foreign target on the deemed sale of stock of a foreign target affiliate to the extent that such gain or loss is effectively connected (or treated as effectively connected) with the conduct of a trade or business in the United States.

(5) DEEMED SALE OF INSURANCE COMPANY TARGET AFFILIATE ELECTING UNDER SECTION 953(d). Gain (but not loss) is recognized by a domestic target on the deemed sale of stock of a target affiliate that has in effect an election under section 953(d) in an amount equal to the lesser of the gain realized or the earnings and profits described in section 953(d)(4)(B).

(6) DEEMED SALE OF DISC TARGET AFFILIATE. Gain (but not loss) is recognized by a foreign or domestic target on the deemed sale of stock of a target affiliate that is a DISC or a former DISC (as defined in section 992(a)) in an amount equal to the lesser of the gain realized or the amount of accumulated DISC income determined with respect to such stock under section 995(c). Such gain is included in gross income as a dividend as provided in sections 995(c)(2) and 996(g).

(7) ANTI-STUFFING RULE. If an asset the adjusted basis of which exceeds its fair market value is contributed or transferred to a target affiliate as transferred basis property (within the meaning of section 7701(a)(43)) and a purpose of such transaction is to reduce the gain (or increase the loss) recognized on the deemed sale of such target affiliate's stock, the gain or loss recognized by target on the deemed sale of stock of the target affiliate is determined as if such asset had not been contributed or transferred.

(8) EXAMPLES. This paragraph (c) may be illustrated by the following examples:

EXAMPLE 1. (a) P makes a qualified stock purchase of T and makes a section 338 election for T. T's sole asset, all of the T1 stock, has a basis of $50 and a fair market value of $150. T's deemed purchase of the T1 stock results in a qualified stock purchase of T1 and a section 338 election is made for T1. T1's assets have a basis of $50 and a fair market value of $150.

(b) T realizes $100 of gain on the deemed sale of the T1 stock, but the gain is not recognized because T directly owns stock in T1 satisfying the requirements of section 1504(a)(2) and a section 338 election is made for T1.

(c) T1 recognizes gain of $100 on the deemed sale of its assets.

EXAMPLE 2. The facts are the same as in Example 1, except that P does not make a section 338 election for T1. Because a section 338 election is not made for T1, the $100 gain realized by T on the deemed sale of the T1 stock is recognized.

EXAMPLE 3. (a) P makes a qualified stock purchase of T and makes a section 338 election for T. T owns all of the stock of T1 and T2. T's deemed purchase of the T1 and T2 stock results in a qualified stock purchase of T1 and T2 and a section 338 election is made for T1 and T2. T1 and T2 each own 50% of the vote and value of T3 stock. The deemed purchases by T1 and T2 of the T3 stock result in a qualified stock purchase of T3 and a section 338 election is made for T3. T is the common parent of a consolidated group and all of the deemed sales are reported on the T group's final consolidated return. See section 1.338-1(e)(1).

(b) Because T, T1, T2 and T3 are members of a consolidated group filing a final consolidated return, no gain or loss is recognized by T, T1 or T2 on their respective deemed sales of target affiliate stock.

EXAMPLE 4. (a) T's sole asset, all of the FT1 stock, has a basis of $25 and a fair market value of $150. FT1's sole asset, all of the FT2 stock, has a basis of $75 and a fair market value of $150. FT1 and FT2 each have $50 of accumulated earnings and profits for purposes of section 1248(c) and (d). FT2's assets have a basis of $125 and a fair market value of $150, and their sale would not generate subpart F income under section 951. The sale of the FT2 stock or assets would not generate income effectively connected with the conduct of a trade or business within the United States. FT1 does not have an election in effect under section 953(d) and neither FT1 nor FT2 is a passive foreign investment company.

(b) P makes a qualified stock purchase of T and makes a section 338 election for T. T's deemed purchase of the FT1 stock results in a qualified stock purchase of FT1 and a section 338 election is made for FT1. Similarly, FT1's deemed purchase of the FT2 stock results in a qualified stock purchase of FT2 and a section 338 election is made for FT2.

(c) T recognizes $125 of gain on the deemed sale of the FT1 stock under paragraph (c)(3) of this section. FT1's $75 of gain on the deemed sale of the FT2 stock is not recognized under paragraph (c)(2) of this section. FT2 recognizes $25 of gain on the deemed sale of its assets. The $125 gain T recognizes on the deemed sale of the FT1 stock is included in T's income as a dividend under section 1248, because FT1 and FT2 have sufficient earnings and profits for full recharacterization ($50 of accumulated earnings and profits in FT1, $50 or accumulated earnings and profits in FT2, and $25 of deemed sale earnings and profits in FT2). Section 1.338-5(b). For purposes of sections 901 through 908, the source and foreign tax credit limitation basket of $25 of the recharacterized gain on the deemed sale of the FT1 stock is determined under section 338(h)(16).

(d) DETERMINATION OF ADSP -- (1) GENERAL rule. The ADSP is the sum of--

(i) The grossed-up basis of the purchasing corporation's recently purchased target stock (as defined in section 338(b)(6)(A));

(ii) The liabilities of new target (including any tax liabilities resulting from the deemed sale); and

(iii) Other relevant items.

(2) GROSSED-UP BASIS OF THE PURCHASING CORPORATION'S RECENTLY PURCHASED TARGET STOCK. The grossed-up basis of the purchasing corporation's recently purchased target stock is an amount equal to the purchasing corporation's basis in recently purchased target stock, divided by the percentage of target stock (by value) attributable to that recently purchased target stock. If target has a single class of outstanding stock, the grossed-up basis of the purchasing corporation's recently purchased target stock reflects the total price the purchasing corporation would have paid for all outstanding target stock had it purchased all such stock for a price per share equal to the average price per share that it paid for the recently purchased target stock.

(3) LIABILITIES. Liabilities taken into account are the liabilities of new target described in section 1.338(b)-1(f). The amount of the liabilities of new target taken into account to calculate ADSP is determined as if old target had sold its assets to an unrelated person for consideration that included the liabilities. Thus, the ADSP takes into account both tax credit recapture liability arising by reason of the deemed sale and the tax liability on deemed sale gain. The ADSP reflects the fact that deemed sale gain (loss) both increases (decreases) the ADSP by creating (reducing) a tax liability and is computed by reference to the ADSP.

(4) OTHER RELEVANT ITEMS. Other relevant items include reductions for acquisition costs of the purchasing corporation incurred in connection with the qualified stock purchase that are capitalized in the basis of recently purchased target stock (e.g., brokerage commissions and any similar costs paid by the purchasing corporation to acquire target stock).

(5) CALCULATION OF DEEMED SALE GAIN AND LOSS. Deemed sale gain on each asset is computed by reference to the ADSP. In certain cases, the determination of the tax liability resulting from the deemed sale and therefore the determination of the ADSP may require trial and error computations.

(6) OTHER RULES APPLY IN DETERMINING ADSP. The ADSP may not be applied in such a way as to contravene other applicable rules. For example, a capital loss cannot be applied to reduce ordinary income in calculating the tax liability on the deemed sale for purposes of determining the ADSP.

(7) CROSS-REFERENCE. See section 1.338(b)-3T(h) for adjustments to ADSP because of events occurring after the acquisition date and section 1.338(h)(10)-1(f) for the determination of modified ADSP.

(8) EXAMPLES. (i) For purposes of the examples in this paragraph (d)(8), unless otherwise stated, T is a calendar year taxpayer that files separate returns and that has no loss, tax credit, or other carryovers to Year 1. Depreciation for Year 1 is not taken into account. T has no liabilities other than a federal income tax liability resulting from the deemed sale of assets, and T has no other relevant items. Assume that T's tax rate for any ordinary income or net capital gain resulting from the deemed sale of assets is 34 percent and that any capital loss is offset by capital gain. On July 1 of Year 1, P purchases all of the stock of T and makes a section 338 election for T.

(ii) This paragraph (d) may be illustrated by the following examples:

EXAMPLE 1. ONE CLASS. (a) On July 1 of Year 1, T's only asset is an item of section 1245 property with an adjusted basis to T of $50,400, a recomputed basis of $80,000, and a fair market value of $100,000. P purchases all of the T stock for $75,000.

(b) The ADSP may be determined as follows. (In the formula below, G is the grossed-up basis in P's recently purchased T stock, L is T's liabilities other than T's tax liabilities for deemed sale gain determined by reference to the ADSP, TR is the applicable tax rate, and B is the adjusted basis of the asset deemed sold.)

ADSP = G + L + TR x (ADSP - B)

ADSP = ($75,000/1) + $0 + .34 x (ADSP - $50,400)

ADSP = $75,000 + .34ADSP - $17,136

.66ADSP = $57,864

ADSP = $87,672.72

(c) Because the ADSP for T ($87,672.72) does not exceed the fair market value of T's asset ($100,000), a Class III asset, T's entire ADSP is allocated to that asset. Thus, T has deemed sale gain of $37,272.72 (consisting of $29,600 of ordinary income and $7,672.72 of capital gain).

(d) The facts are the same as in paragraph (a) of this EXAMPLE 1, except that on July 1 of Year 1, P purchases only 80 of the 100 shares of T stock for $60,000. The grossed-up basis in P's recently purchased T stock (G) is $75,000 ($60,0001/.8). Consequently, the ADSP and deemed sale gain are the same as in paragraphs (b) and (c) of this EXAMPLE 1.

(e) The facts are the same as in paragraph (a) of this EXAMPLE 1, except that T also has goodwill (a Class IV asset) with an appraised value of $10,000. The results are the same as in paragraphs (b) and (c) of this EXAMPLE 1. Because the ADSP does not exceed the fair market value of the Class III asset, no amount is allocated to goodwill.

EXAMPLE 2. MORE THAN ONE CLASS. (a) P purchases all of the T stock for $140,000. On July 1 of Year 1, T has liabilities (not including the tax liability for deemed sale gain on its assets) of $50,000, cash (a Class I asset) of $10,000, readily marketable securities (a Class II asset) with a basis of $4,000 and fair market value of $10,000, goodwill (a Class IV asset) with a basis of $3,000, and the following Class III assets:

    Asset                 Basis                 FMV            Ratio

(c) The portion of the ADSP allocable to the Class III assets is preliminarily determined as follows. (In the formula, the amount allocated to the Class I assets is referred to as I and the amount allocated to the Class II assets as II.)

ADSP(sub III) = (G - (I + II)) + L + T(sub R) x [(II - BII) + (ADSPIII - BIII)

ADSPIII = ($140,000 - ($10,000 + $10,000)) + $50,000 + .34 x [($10,000 - $4,000) + (ADSPIII - ($5,000 + $10,000 + $5,000 + $10,000))]

ADSPIII = $161,840 + .34ADSPIII

.66ADSPIII = $161,840

ADSPIII = $245,212.12

(d) Because, under the preliminary calculation of the ADSP, the amount to be allocated to Class I, II, and III assets does not exceed their aggregate fair market value, no ADSP amount is allocated to the goodwill. Accordingly, the deemed sale of the goodwill results in a capital loss of $3,000. The portion of the ADSP allocable to the Class III assets is finally determined by taking into account this loss as follows:

ADSPIII = (G - (I + II)) + L + TR x [(II - BII) + (ADSPIII - BIII) + (ADSPIV - BIV)

ADSPIII = ($140,000 - ($10,000 + $10,000)) + $50,000 + .34 x [($10,000 - $4,000) + (ADSPIII - $30,000) + (0 - $3,000)]

ADSPIII = $160,820 + .34ADSPIII

.66ADSPIII = $160,820

ADSPIII = $243,666.67

(e) The allocation of ADSPIII among the Class III assets is in proportion to their fair market values, as follows:

    Asset                 ADSP                Gain

(b) As in EXAMPLE 2, the ADSP exceeds $20,000. Thus, $10,000 of the ADSP is allocated to the cash and $10,000 to the marketable securities.

(c) The portion of the ADSP allocable to the Class III assets as preliminarily determined under the formula set forth in paragraph (c) of EXAMPLE 2 is $260,363.64. The amount allocated to the Class III assets cannot exceed their aggregate fair market value ($250,000). Thus, preliminarily, the ADSP amount allocated to Class III assets is $250,000.

(d)(1) Based on this preliminary allocation, the ADSP is determined as follows. (In the formula, the amount allocated to the Class I assets is referred to as I, the amount allocated to the Class II assets as II, and the amount allocated to the Class III assets as III.)

ADSP = G + L + TR X [(II - BII) + (III - BIII) + (ADSP - (I + II + III + BIV)))]

ADSP = $150,000 + $50,000 + .34 x [($10,000 - $4,000) + ($250,000 - $30,000) + (ADSP - ($10,000 + $10,000 + $250,000 + $3,000))]

ADSP = $200,000 + .34ADSP - $15,980

.66ADSP = $184,020

ADSP = $278,818.18

(2) Because the ADSP as determined exceeds the aggregate fair market value of the Class I, II, and III assets, the $250,000 amount preliminarily allocated to Class III assets is appropriate. Thus, the amount of the ADSP allocated to Class III assets equals their aggregate fair market value ($250,000), and the allocated ADSP amount for each Class III asset is its fair market value. Further, the allocable ADSP amount for the Class IV asset (goodwill) is $8,818.18 (the excess of the ADSP over the aggregate allocable ADSP amounts for the Class I, II, and III assets).

EXAMPLE 4. AMOUNT ALLOCATED TO T1 STOCK. (a) The facts are the same as in EXAMPLE 2, except that T owns all of the T1 stock (instead of the inventory), and T1's only asset is the inventory. The T1 stock and inventory each have a fair market value of $50,000, and the inventory has a basis of $10,000. A section 338 election is made for T1 (as well as T), and T1 has no liabilities other than a tax liability resulting from the deemed sale gain. Under paragraph (c) of this section, T recognizes no gain or loss on its deemed sale of T1 stock.

(b) The ADSP exceeds $20,000. Thus, $10,000 of the ADSP is allocated to the cash and $10,000 to the marketable securities.

(c) T1 stock is purchased in the deemed sale of T assets, T does not recognize any gain on the deemed sale of the T1 stock under paragraph (c) of this section, and a section 338 election is made for T1. Thus, under paragraph (b)(2) of this section, in determining the allocation of ADSP among T's Class III assets, including the T1 stock, appropriate adjustments must be made to reflect accurately the fair market value of the T and T1 assets. In preliminarily calculating ADSPIII in this case, the T1 stock can be disregarded and, because T owns all of the T1 stock, the T1 asset can be treated as a T asset. Under this assumption, ADSPIII is $243,666.67. See paragraph (d) of EXAMPLE 2.

(d) Because the portion of the preliminary ADSP allocable to Class III assets ($243,666.67) does not exceed their aggregate fair market value ($250,000), no amount is allocated to Class IV assets for T. Further, this amount is allocated among T's Class III assets in proportion to their fair market values. See paragraph (e) of EXAMPLE 2. Tentatively, $48,733.34 of this amount is allocated to the T1 stock.

(e) The amount tentatively allocated to the T1 stock, however, reflects the tax incurred on the deemed sale of the T1 asset equal to $13,169.34 (.34 x ($48,733.34 - $10,000)). Thus, the ADSP allocable to the Class III assets of T, and the allocable ADSP amount for the T1 stock, as preliminarily calculated, each must be reduced by $13,169.34. Consequently, these amounts, respectively, are $230,497.33 and $35,564.00. In determining the ADSP for T1, the grossed-up basis of T's recently purchased T1 stock is $35,564.00.

(f) The facts are the same as in paragraph (a) of this EXAMPLE 5, except that the T1 inventory has a $12,500 basis and $62,500 value, the T1 stock has a $62,500 value, and T owns 80% of the T1 stock. In preliminarily calculating ADSPIII, the T1 stock can be disregarded but, because T owns only 80% of the T1 stock, only 80% of T1 asset basis and value should be taken into account in calculating T's ADSP. By taking into account 80% of these amounts, the remaining calculations and results are the same as in paragraphs (b), (c), (d), and (e) of this EXAMPLE 5, except that the grossed-up basis in T's recently purchased T1 stock is $44,455.00 ($35,564.00/0.8).

SECTION 1.338-4 ASSET AND STOCK CONSISTENCY.

(a) INTRODUCTION -- (1) OVERVIEW. This section implements the consistency rules of sections 338(e) and (f). Under this section, no election under section 338 is deemed made or required with respect to target or any target affiliate. Instead, the person acquiring an asset may have a carryover basis in the asset.

(2) GENERAL APPLICATION. The consistency rules generally apply if the purchasing corporation acquires an asset directly from target during the target consistency period and target is a subsidiary in a consolidated group. In such a case, gain from the sale of the asset is reflected under the investment adjustment provisions of the consolidated return regulations in the basis of target stock and may reduce gain from the sale of the stock. See section 1.1502-32 (investment adjustment provisions). Under the consistency rules, the purchasing corporation generally takes a carryover basis in the asset, unless a section 338 election is made for target. Similar rules apply if the purchasing corporation acquires an asset directly from a lower-tier target affiliate if gain from the sale is reflected under the investment adjustment provisions in the basis of target stock.

(3) EXTENSIONS OF THE GENERAL RULES. If an arrangement exists, paragraph (f) of this section generally extends the carryover basis rule to certain cases in which the purchasing corporation acquires assets indirectly from target (or a lower-tier target affiliate). To prevent avoidance of the consistency rules, paragraph (j) of this section also may extend the consistency period or the 12-month acquisition period and may disregard the presence of conduits.

(4) APPLICATION WHERE CERTAIN DIVIDENDS ARE PAID. Paragraph (g) of this section extends the carryover basis rule to certain cases in which dividends are paid to a corporation that is not a member of the same consolidated group as the distributing corporation. Generally, this rule applies where a 100 percent dividends received deduction is used in conjunction with asset dispositions to achieve an effect similar to that available under the investment adjustment provisions of the consolidated return regulations.

(5) APPLICATION TO FOREIGN TARGET AFFILIATES. Section 1.338-4T(h) extends the carryover basis rule to certain cases involving target affiliates that are controlled foreign corporations.

(6) STOCK CONSISTENCY. This section limits the application of the stock consistency rules to cases in which the rules are necessary to prevent avoidance of the asset consistency rules. Following the general treatment of a section 338(h)(10) election, a sale of a corporation's stock is treated as a sale of the corporation's assets if a section 338(h)(10) election is made. Because gain from this asset sale may be reflected in the basis of the stock of a higher- tier target, the carryover basis rule may apply to the assets.

(b) CONSISTENCY FOR DIRECT ACQUISITIONS -- (1) GENERAL RULE. The basis rules of paragraph (d) of this section apply to an asset if --

(i) The asset is disposed of during the target consistency period;

(ii) The basis of target stock, as of the target acquisition date, reflects gain from the disposition of the asset (see paragraph (c) of this section); and

(iii) The asset is owned, immediately after its acquisition and on the target acquisition date, by a corporation that acquires stock of target in the qualified stock purchase (or by an affiliate of an acquiring corporation).

(2) SECTION 338(h)(10) ELECTIONS. For purposes of this section, if a section 338(h)(10) election is made for a corporation acquired in a qualified stock purchase --

(i) The acquisition is treated as an acquisition of the corporation's assets (see section 1.338(h)(10)-1); and

(ii) The corporation is not treated as target.

(c) GAIN FROM DISPOSITION REFLECTED IN BASIS OF TARGET STOCK. For purposes of this section:

(1) GENERAL RULE. Gain from the disposition of an asset is reflected in the basis of a corporation's stock if the gain is taken into account under section 1.1502-32, directly or indirectly, in determining the basis of the stock, after applying section 1503(e) and other provisions of the Internal Revenue Code.

(2) GAIN NOT REFLECTED IF SECTION 338 ELECTION MADE FOR TARGET. Gain from the disposition of an asset that is otherwise reflected in the basis of target stock as of the target acquisition date is not considered reflected in the basis of target stock if a section 338 election is made for target.

(3) GAIN REFLECTED BY REASON OF DISTRIBUTIONS. Gain from the disposition of an asset is not considered reflected in the basis of target stock merely by reason of the receipt of a distribution from a target affiliate that is not a member of the same consolidated group as the distributee. See paragraph (g) of this section for the treatment of dividends eligible for a 100 percent dividends received deduction.

(4) CONTROLLED FOREIGN CORPORATIONS. For a limitation applicable to gain of a target affiliate that is a controlled foreign corporation, see section 1.338-4T(h)(2).

(5) GAIN RECOGNIZED OUTSIDE THE CONSOLIDATED GROUP. Gain from the disposition of an asset by a person other than target or a target affiliate is not reflected in the basis of a corporation's stock unless the person is a conduit, as defined in paragraph (j)(4) of this section.

(d) BASIS OF ACQUIRED ASSETS -- (1) CARRYOVER BASIS RULE. If this paragraph (d) applies to an asset, the asset's basis immediately after its acquisition is, for all purposes of the Internal Revenue Code, its adjusted basis immediately before its disposition.

(2) EXCEPTIONS TO CARRYOVER BASIS RULE FOR CERTAIN ASSETS. The carryover basis rule of paragraph (d)(1) of this section does not apply to the following assets --

(i) Any asset disposed of in the ordinary course of a trade or business (see section 338(e)(2)(A));

(ii) Any asset the basis of which is determined wholly by reference to the adjusted basis of the asset in the hands of the person that disposed of the asset (see section 338(e)(2)(B));

(iii) Any debt or equity instrument issued by target or a target affiliate (see section 1.338-4T(h)(3) for an exception relating to the stock of a target affiliate that is a controlled foreign corporation);

(iv) Any asset the basis of which immediately after its acquisition would otherwise be less than its adjusted basis immediately before its disposition; and

(v) Any asset identified by the Internal Revenue Service in a revenue ruling or revenue procedure.

(3) EXCEPTION TO CARRYOVER BASIS RULE FOR DE MINIMIS ASSETS. The carryover basis rules of this section do not apply to an asset if the asset is not disposed of as part of the same arrangement as the acquisition of target and the aggregate amount realized for all assets otherwise subject to the carryover basis rules of this section does not exceed $250,000.

(4) MITIGATION RULE -- (i) GENERAL RULE. If the carryover basis rules of this section apply to an asset and the asset is transferred to a domestic corporation in a transaction to which section 351 applies or as a contribution to capital and no gain is recognized, the transferor's basis in the stock of the transferee (but not the transferee's basis in the asset) is determined without taking into account the carryover basis rules of this section.

(ii) TIME FOR TRANSFER. This paragraph (d)(4) applies only if the asset is transferred before the due date (including extensions) for the transferor's income tax return for the year that includes the last date for which a section 338 election may be made for target.

(e) EXAMPLES -- (1) IN GENERAL. For purposes of the examples in this section, unless otherwise stated, the basis of each asset is the same for determining earnings and profits and taxable income, the exceptions to paragraph (d)(1) of this section do not apply, the taxable year of all persons is the calendar year, and the following facts apply: S is the common parent of a consolidated group that includes T, T1, T2, and T3; S owns all of the stock of T and T3; and T owns all of the stock of T1, which owns all of the stock of T2. B is unrelated to the S group and owns all of the stock of P, which owns all of the stock of P1. Y and Y1 are partnerships that are unrelated to the S group but may be related to the P group. Z is a corporation that is not related to any of the other parties.

[graph omitted]

(2) DIRECT ACQUISITIONS. Paragraphs (b), (c), and (d) of this section may be illustrated by the following examples:

EXAMPLE 1. ASSET ACQUIRED FROM TARGET BY PURCHASING CORPORATION. (a) On February 1 of Year 1, T sells an asset to P1 and recognizes gain. T's gain from the disposition of the asset is taken into account under section 1.1502-32 in determining S's basis in the T stock. On January 1 of Year 2, P1 makes a qualified stock purchase of T from S. No section 338 election is made for T.

(b) T disposed of the asset during its consistency period, gain from the asset disposition is reflected in the basis of the T stock as of T's acquisition date (January 1 of Year 2), and the asset is owned both immediately after the asset disposition (February 1 of Year 1) and on T's acquisition date by P1, the corporation that acquired T stock in the qualified stock purchase. Consequently, under paragraph (b) of this section, paragraph (d)(1) of this section applies to the asset and P1's basis in the asset is T's adjusted basis in the asset immediately before the sale to P1.

EXAMPLE 2. GAIN FROM SECTION 338(H)(10) ELECTION REFLECTED IN STOCK BASIS. (a) On February 1 of Year 1, P1 makes a qualified stock purchase of T2 from T1. A section 338(h)(10) election is made for T2 and T2 recognizes gain on each of its assets. T2's gain is taken into account under section 1.1502-32 in determining S's basis in the T stock. On January 1 of Year 2, P1 makes a qualified stock purchase of T from S. No section 338 election is made for T.

(b) Under paragraph (b)(2) of this section, the acquisition of the T2 stock is treated as an acquisition of T2's assets on February 1 of Year 1, because a section 338(h)(10) election is made for T2. The gain recognized by T2 under section 338(h)(10) is reflected in S's basis in the T stock as of T's acquisition date. Because the other requirements of paragraph (b) of this section are satisfied, paragraph (d)(1) of this section applies to the assets and new T2's basis in its assets is old T2's adjusted basis in the assets immediately before the disposition.

EXAMPLE 3. CORPORATION OWNING ASSET CEASES AFFILIATION WITH CORPORATION PURCHASING TARGET BEFORE TARGET ACQUISITION DATE. (a) On February 1 of Year 1; T sells an asset to P1 and recognizes gain. On December 1 of Year 1, P disposes of all of the P1 stock while P1 still owns the asset. On January 1 of Year 2, P makes a qualified stock purchase of T from S. No section 338 election is made for T.

(b) Immediately after T's disposition of the asset, the asset is owned by P1 which is affiliated on that date with P, the corporation that acquired T stock in the qualified stock purchase. However, the asset is owned by a corporation (P1) that is no longer affiliated with P on T's acquisition date. Although the other requirements of paragraph (b) of this section are satisfied, the requirements of paragraph (b)(1)(iii) of this section are not satisfied. Consequently, the basis rules of paragraph (d) of this section do not apply to the asset by reason of P1's acquisition.

(c) If P acquires all of the Z stock and P1 transfers the asset to Z on or before T's acquisition date (January 1 of Year 2), the asset is owned by an affiliate of P both on February 1 of Year 1 (P1) and on January 1 of Year 2 (Z). Consequently, all of the requirements of paragraph (b) of this section are satisfied and paragraph (d)(1) of this section applies to the asset and P1's basis in the asset is T's adjusted basis in the asset immediately before the sale to P1.

EXAMPLE 4. GAIN REFLECTED IN STOCK BASIS NOTWITHSTANDING OFFSETTING LOSS OR DISTRIBUTION. (a) On April 1 of Year 1, T sells an asset to P1 and recognizes gain. In Year 1, T distributes an amount equal to the gain. On March 1 of Year 2, P makes a qualified stock purchase of T from S. No section 338 election is made for T.

(b) Although, as a result of the distribution, there is no adjustment with respect to the T stock under section 1.1502-32 for Year 1, T's gain from the disposition of the asset is considered reflected in S's basis in the T stock. The gain is considered to have been taken into account under section 1.1502-32 in determining the adjustments to S's basis in the T stock because S's basis in the T stock is different from what it would have been had there been no gain.

(c) If T distributes an amount equal to the gain on February 1 of Year 2, rather than in Year 1, the results would be the same because S's basis in the T stock is different from what it would have been had there been no gain. If the distribution in Year 2 is by reason of an election under section 1.1502-32(f)(2), the results would be the same.

(d) If, in Year 1, T does not make a distribution and the S group does not file a consolidated return, but, in Year 2, the S group does file a consolidated return and makes an election under section 1.1502-32(f)(2) for T, the results would be the same. S's basis in the T stock is different from what it would have been had there been no gain. Paragraph (c)(3) of this section (gain not considered reflected by reason of distributions) does not apply to the deemed distribution under the election because S and T are members of the same consolidated group. If T distributes an amount equal to the gain in Year 2 and no election is made under section 1.1502-32(f)(2), the results would be the same.

(e) If, in Year 1, T incurs an unrelated loss in an amount equal to the gain, rather than distributing an amount equal to the gain, the results would be the same because the gain is taken into account under section 1.1502-32 in determining S's basis in the T stock.

EXAMPLE 5. GAIN OF A TARGET AFFILIATE REFLECTED IN STOCK BASIS AFTER CORPORATE REORGANIZATION. (a) On February 1 of Year 1, T3 sells an asset to P1 and recognizes gain. On March 1 of Year 1, S contributes the T3 stock to T in a transaction qualifying under section 351. On January 15 of Year 2, P1 makes a qualified stock purchase of T from S. No section 338 election is made for T.

(b) T3's gain from the asset sale is taken into account under section 1.1502-32 in determining S's basis in the T3 stock. Under section 358, the gain that is taken into account under section 1.1502-32 in determining S's basis in the T3 stock is also taken into account in determining S's basis in the T stock following S's contribution of the T3 stock to T. Consequently, under paragraph (b) of this section, paragraph (d)(1) of this section applies to the asset and P1's basis in the asset is T3's adjusted basis in the asset immediately before the sale to P1.

(c) If on March 1 of Year 1, rather than S contributing the T3 stock to T, S causes T3 to merge into T in a transaction qualifying under section 368(a)(1)(D), the results would be the same.

EXAMPLE 6. GAIN NOT REFLECTED IF ELECTION UNDER SECTION 338 MADE. (a) On February 1 of Year 1, T1 sells an asset to P1 and recognizes gain. On January 1 of Year 2, P1 makes a qualified stock purchase of T1 from T. A section 338 election (but not a section 338(h)(10) election) is made for T1.

(b) Under paragraph (c)(2) of this section, because a section 338 election is made for T1, T's basis in the T1 stock is considered not to reflect gain from the disposition. Consequently, the requirement of paragraph (b)(1)(ii) of this section is not satisfied. Thus, P1's basis in the asset is not determined under paragraph (d) of this section. Although the section 338 election for T1 results in a qualified stock purchase of T2, the requirement of paragraph (b)(1)(ii) of this section is not satisfied with respect to T2, whether or not a section 338 election is made for T2.

(c) If, on January 1 of Year 2, P1 makes a qualified stock purchase of T from S and a section 338 election for T, rather than T1, S's basis in the T stock is considered not to reflect gain from T1's disposition of the asset. However, the section 338 election for T results in a qualified stock purchase of T1. Because the gain is reflected in T's basis in the T1 stock, the requirements of paragraph (b) of this section are satisfied. Consequently, P1's basis in the asset is determined under paragraph (d)(1) of this section unless a section 338 election is also made for T1.

(f) EXTENSION OF CONSISTENCY TO INDIRECT ACQUISITIONS -- (1) INTRODUCTION. If an arrangement exists (see paragraph (j)(5) of this section), this paragraph (f) generally extends the consistency rules to indirect acquisitions that have the same effect as direct acquisitions. For example, this paragraph (f) applies if, pursuant to an arrangement, target sells an asset to an unrelated person who then sells the asset to the purchasing corporation.

(2) GENERAL RULE. This paragraph (f) applies to an asset if, pursuant to an arrangement --

(i) The asset is disposed of during the target consistency period;

(ii) The basis of target stock as of, or at any time before, the target acquisition date reflects gain from the disposition of the asset; and

(iii) The asset ownership requirements of paragraph (b)(1)(iii) of this section are not satisfied, but the asset is owned, at any time during the portion of the target consistency period following the target acquisition date, by --

(A) A corporation --

(1) The basis of whose stock, as of, or at any time before, the target acquisition date, reflects gain from the disposition of the asset; and

(2) That is affiliated, at any time during the target consistency period, with a corporation that acquires stock of target in the qualified stock purchase; or

(B) A corporation that at the time it owns the asset is affiliated with a corporation described in paragraph (f)(2)(iii)(A) of this section.

(3) BASIS OF ACQUIRED ASSETS. If this paragraph (f) applies to an asset, the principles of the basis rules of paragraph (d) of this section apply to the asset as of the date, following the disposition with respect to which gain is reflected in the basis of target's stock, that the asset is first owned by a corporation described in paragraph (f)(2)(iii) of this section. If the principles of the carryover basis rule of paragraph (d)(1) of this section apply to an asset, the asset's basis also is reduced (but not below zero) by the amount of any reduction in its basis occurring after the disposition with respect to which gain is reflected in the basis of target's stock.

(4) EXAMPLES. This paragraph (f) may be illustrated by the following examples:

EXAMPLE 1. ACQUISITION OF ASSET FROM UNRELATED PARTY BY PURCHASING CORPORATION. (a) On February 1 of Year 1, T sells an asset to Z and recognizes gain. On February 15 of Year 1, P1 makes a qualified stock purchase of T from S. No section 338 election is made for T. P1 buys the asset from Z on March 1 of Year 1, before Z has reduced the basis of the asset through depreciation or otherwise.

(b) Paragraph (b) of this section does not apply to the asset because the asset ownership requirements of paragraph (b)(1)(iii) of this section are not satisfied. However, the asset ownership requirements of paragraph (f)(2)(iii) of this section are satisfied because, during the portion of T's consistency period following T's acquisition date, the asset is owned by P1 while it is affiliated with T. Consequently, paragraph (f) of this section applies to the asset if there is an arrangement for T to dispose of the asset during T's consistency period, for the gain to be reflected in S's basis in the T stock as of T's acquisition date, and for P1 to own the asset during the portion of T's consistency period following T's acquisition date. If the arrangement exists, under paragraph (f)(3) of this section, P1's basis in the asset is determined as of March 1 of Year 1, under the principles of paragraph (d) of this section. Consequently, P1's basis in the asset is T's adjusted basis in the asset immediately before the sale to Z.

(c) If P1 acquires the asset from Z on January 15 of Year 2 (rather than on March 1 of Year 1), and Z's basis in the asset has been reduced through depreciation at the time of the acquisition, P1's basis in the asset as of January 15 of Year 2 would be T's adjusted basis in the asset immediately before the sale to Z, reduced (but not below zero) by the amount of the depreciation. Z's basis and depreciation are determined without taking into account the basis rules of paragraph (d) of this section.

(d) If P, rather than P1, acquires the asset from Z, the results would be the same.

(e) If, on March 1 of Year 1, P1 acquires the Z stock, rather than acquiring the asset from Z, paragraph (f) of this section would apply to the asset if an arrangement exists. However, under paragraph (f)(3) of this section, Z's basis in the asset would be determined as of February 1 of Year 1, the date the asset is first owned by a corporation (Z) described in paragraph (f)(2)(iii) of this section. Consequently, Z's basis in the asset as of February 1 of Year 1, determined under the principles of paragraph (d) of this section, would be T's adjusted basis in the asset immediately before the sale to Z.

EXAMPLE 2. ACQUISITION OF ASSET FROM TARGET BY TARGET AFFILIATE. (a) On February 1 of Year 1, T contributes an asset to T1 in a transaction qualifying under section 351 and in which T recognizes gain under section 351(b) that is deferred under section 1.1502-13. On March 1 of Year 1, P1 makes a qualified stock purchase of T from S and, pursuant to section 1.1502-13(f), the deferred gain is taken into account by T immediately before T ceases to be a member of the S group. No section 338 election is made for T.

(b) Paragraph (b) of this section does not apply to the asset because the asset ownership requirements of paragraph (b)(1)(iii) of this section are not satisfied.

(c) T1 is not described in paragraph (f)(2)(iii)(A) of this section because the basis of the T1 stock does not reflect gain from the disposition of the asset. Although, under section 358(a)(1)(B)(ii), T's basis in the T1 stock is increased by the amount of the gain, the gain is not taken into account directly or indirectly under section 1.1502-32 in determining T's basis in the T1 stock.

(d) T1 is described in paragraph (f)(2)(iii)(B) of this section because, during the portion of T's consistency period following T's acquisition date, T1 owns the asset while it is affiliated with T, a corporation described in paragraph (f)(2)(iii)(A) of this section. Consequently, paragraph (f) of this section applies to the asset if there is an arrangement. Under paragraph (j)(5) of this section, the fact that, at the time T1 acquires the asset from T, T1 is related (within the meaning of section 267(b)) to T indicates that an arrangement exists.

EXAMPLE 3. ACQUISITION OF ASSET FROM TARGET AND INDIRECT ACQUISITION OF TARGET STOCK. (a) On February 1 of Year 1, T sells an asset to P1 and recognizes gain. On March 1 of Year 1, Z makes a qualified stock purchase of T from S. No section 338 election is made for T. On January 1 of Year 2, P1 acquires the T stock from Z other than in a qualified stock purchase.

(b) The asset ownership requirements of paragraph (b)(1)(iii) of this section are not satisfied because the asset was never owned by Z, the corporation that acquired T stock in the qualified stock purchase (or by a corporation that was affiliated with Z at the time it owned the asset). However, because the asset is owned by P1 while it is affiliated with T during the portion of T's consistency period following T's acquisition date, paragraph (f) of this section applies to the asset if there is an arrangement. If there is an arrangement, the principles of the carryover basis rule of paragraph (d)(1) of this section apply to determine P1's basis in the asset unless Z makes a section 338 election for T. See paragraph (c)(2) of this section.

(c) If P1 also makes a qualified stock purchase of T from Z, the results would be the same. If there is an arrangement, the principles of the carryover basis rule of paragraph (d)(1) of this section apply to determine P1's basis in the asset unless Z makes a section 338 election for T. However, these principles apply to determine P1's basis in the asset if P1, but not Z, makes a section 338 election for T. The basis of the T stock no longer reflects, as of T's acquisition date by P1, the gain from the disposition of the asset.

(d) Assume Z purchases the T stock other than in a qualified stock purchase and P1 makes a qualified stock purchase of T from Z. Paragraph (b) of this section does not apply to the asset because gain from the disposition of the asset is not reflected in the basis of T's stock as of T's acquisition date (January 1 of Year 2). However, because the gain is reflected in S's basis in the T stock before T's acquisition date and the asset is owned by P1 while it is affiliated with T during the portion of T's consistency period following T's acquisition date, paragraph (f) of this section applies to the asset if there is an arrangement. If there is an arrangement, the principles of the carryover basis rule of paragraph (d)(1) of this section apply to determine P1's basis in the asset even if P1 makes a section 338 election for T. The basis of the T stock no longer reflects, as of T's acquisition date, the gain from the disposition of the asset.

EXAMPLE 4. ASSET ACQUIRED FROM TARGET AFFILIATE BY CORPORATION THAT BECOMES ITS AFFILIATE. (a) On February 1 of Year 1, T1 sells an asset to P1 and recognizes gain. On February 15 of Year 1, Z makes a qualified stock purchase of T from S. No section 338 election is made for T. On June 1 of Year 1, P1 acquires the T1 stock from T, other than in a qualified stock purchase.

(b) The asset ownership requirements of paragraph (b)(1)(iii) of this section are not satisfied because the asset was never owned by Z, the corporation that acquired T stock in the qualified stock purchase (or by a corporation that was affiliated with Z at the time it owned the asset).

(c) P1 is not described in paragraph (f)(2)(iii)(A) of this section because gain from the disposition of the asset is not reflected in the basis of the P1 stock.

(d) P1 is described in paragraph (f)(2)(iii)(B) of this section because the asset is owned by P1 while P1 is affiliated with T1 during the portion of T's consistency period following T's acquisition date. T1 becomes affiliated with Z, the corporation that acquired T stock in the qualified stock purchase, during T's consistency period, and, as of T's acquisition date, the basis of T1's stock reflects gain from the disposition of the asset. Consequently, paragraph (f) of this section applies to the asset if there is an arrangement.

EXAMPLE 5. DE MINIMIS RULES. (a) On February 1 of Year 1, T sells an asset to P and recognizes gain. On February 15 of Year 1, T1 sells an asset to Z and recognizes gain. The aggregate amount realized by T and T1 on their respective sales of assets is not more than $250,000. On March 1 of Year 1, T3 sells an asset to P and recognizes gain. On April 1 of Year 1, P makes a qualified stock purchase of T from S. No section 338 election is made for T. On June 1 of Year 1, P1 buys from Z the asset sold by T1.

(b) Under paragraph (b) of this section, the basis rules of paragraph (d) of this section apply to the asset sold by T. Under paragraph (f) of this section, the principles of the basis rules of paragraph (d) of this section apply to the asset sold by T1 if there is an arrangement. Because T3's gain is not reflected in the basis of the T stock, the basis rules of this section do not apply to the asset sold by T3.

(c) The de minimis rule of paragraph (d)(3) of this section applies to an asset if the asset is not disposed of as part of the same arrangement as the acquisition of T and the aggregate amount realized for all assets otherwise subject to the carryover basis rules does not exceed $250,000. The aggregate amount realized by T and T1 does not exceed $250,000. (The asset sold by T3 is not taken into account for purposes of the de minimis rule.) Thus, the de minimis rule applies to the asset sold by T if the asset is not disposed of as part of the same arrangement as the acquisition of T.

(d) If, under paragraph (f) of this section, the principles of the carryover basis rules of paragraph (d)(1) of this section otherwise apply to the asset sold by T1 because of an arrangement, the de minimis rules of this section do not apply to the asset because of the arrangement.

(e) Assume on June 1 of Year 1, Z acquires the T1 stock from T, other than in a qualified stock purchase, rather than P1 buying the T1 asset, and paragraph (f) of this section applies because there is an arrangement. Because the asset was disposed of and the T1 stock was acquired as part of the arrangement, the de minimis rules of this section do not apply to the asset.

(g) EXTENSION OF CONSISTENCY IF DIVIDENDS QUALIFYING FOR 100 PERCENT DIVIDENDS RECEIVED DEDUCTION ARE PAID -- (1) GENERAL RULE FOR DIRECT ACQUISITIONS FROM TARGET. Unless a section 338 election is made for target, the basis rules of paragraph (d) of this section apply to an asset if --

(i) Target recognizes gain (whether or not deferred) on disposition of the asset during the portion of the target consistency period that ends on the target acquisition date;

(ii) The asset is owned, immediately after the asset disposition and on the target acquisition date, by a corporation that acquires stock of target in the qualified stock purchase (or by an affiliate of an acquiring corporation); and

(iii) During the portion of the target consistency period that ends on the target acquisition date, the aggregate amount of dividends paid by target, to which section 243(a)(3) applies, exceeds the greater of --

(A) $250,000; or

(B) 125 percent of the yearly average amount of dividends paid by target, to which section 243(a)(3) applies, during the three calendar years immediately preceding the year in which the target consistency period begins (or, if shorter, the period target was in existence).

(2) OTHER DIRECT ACQUISITIONS HAVING SAME EFFECT. The basis rules of paragraph (d) of this section also apply to an asset if the effect of a transaction described in paragraph (g)(1) of this section is achieved through any combination of disposition of assets and payment of dividends to which section 243(a)(3) applies (or any other dividends eligible for a 100 percent dividends received deduction). See section 1.338-4T(h)(4) for additional rules relating to target affiliates that are controlled foreign corporations.

(3) INDIRECT ACQUISITIONS. The principles of paragraph (f) of this section also apply for purposes of this paragraph (g).

(4) EXAMPLES. This paragraph (g) may be illustrated by the following examples:

EXAMPLE 1. ASSET ACQUIRED FROM TARGET PAYING DIVIDENDS TO WHICH SECTION 243(a)(3) APPLIES. (a) The S group does not file a consolidated return. In Year 1, Year 2, and Year 3, T pays dividends to S to which section 243(a)(3) applies of $200,000, $250,000, and $300,000, respectively. On February 1 of Year 4, T sells an asset to P and recognizes gain. On January 1 of Year 5, P makes a qualified stock purchase of T from S. No section 338 election is made for T. During the portion of T's consistency period that ends on T's acquisition date, T pays S dividends to which section 243(a)(3) applies of $1,000,000.

(b) Under paragraph (g)(1) of this section, paragraph (d) of this section applies to the asset. T recognizes gain on disposition of the asset during the portion of T's consistency period that ends on T's acquisition date, the asset is owned by P immediately after the disposition and on T's acquisition date, and T pays dividends described in paragraph (g)(1)(iii) of this section. Consequently, under paragraph (d)(1) of this section, P's basis in the asset is T's adjusted basis in the asset immediately before the sale to P.

(c) If T is a controlled foreign corporation, the results would be the same if T pays dividends in the amount described in paragraph (g)(1)(iii) of this section that qualify for a 100 percent dividends received deduction. See sections 243(e) and 245.

(d) If S and T3 file a consolidated return in which T, T1, and T2 do not join, the results would be the same because the dividends paid by T are still described in paragraph (g)(1)(iii) of this section.

(e) If T, T1, and T2 file a consolidated return in which S and T3 do not join, the results would be the same because the dividends paid by T are still described in paragraph (g)(1)(iii) of this section.

EXAMPLE 2. ASSET DISPOSITION BY TARGET AFFILIATE ACHIEVING SAME EFFECT. (a) The S group does not file a consolidated return. On February 1 of Year 1, T2 sells an asset to P and recognizes gain. T pays dividends to S described in paragraph (g)(1)(iii) of this section. On January 1 of Year 2, P makes a qualified stock purchase of T from S. No section 338 election is made for T.

(b) Paragraph (g)(1) of this section does not apply to the asset because T did not recognize gain on the disposition of the asset. However, under paragraph (g)(2) of this section, because the asset disposition by T2 and the dividends paid by T achieve the effect of a transaction described in paragraph (g)(l) of this section, the carryover basis rule of paragraph (d)(1) of this section applies to the asset. The effect was achieved because T2 is a lower-tier affiliate of T and the dividends paid by T to S reduce the value to S of T and its lower-tier affiliates.

(c) If T2 is a controlled foreign corporation, the results would be the same because T2 is a lower-tier affiliate of T and the dividends paid by T to S reduce the value to S of T and its lower-tier affiliates.

(d) If P buys an asset from T3, rather than T2, the asset disposition and the dividends do not achieve the effect of a transaction described in paragraph (g)(1) of this section because T3 is not a lower-tier affiliate of T. Thus, the basis rules of paragraph (d) of this section do not apply to the asset. The results would be the same whether or not P also acquires the T3 stock (whether or not in a qualified stock purchase).

EXAMPLE 3. DIVIDENDS BY TARGET AFFILIATE ACHIEVING SAME EFFECT. (a) The S group does not file a consolidated return. On February 1 of Year 1, T1 sells an asset to P and recognizes gain. On January 1 of Year 2, P makes a qualified stock purchase of T from S. No section 338 election is made for T. T does not pay dividends to S described in paragraph (g)(1)(iii) of this section. However, T1 pays dividends to T that would be described in paragraph (g)(1)(iii) of this section if T1 were a target.

(b) Paragraph (g)(1) of this section does not apply to the asset because T did not recognize gain on the disposition of the asset and did not pay dividends described in paragraph (g)(1)(iii) of this section. Further, paragraph (g)(2) of this section does not apply because the dividends paid by T1 to T do not reduce the value to S of T and its lower-tier affiliates.

(c) If both S and T own T1 stock and T1 pays dividends to S that would be described in paragraph (g)(1)(iii) of this section if T1 were a target, paragraph (g)(2) of this section would apply because the dividends paid by T1 to S reduce the value to S of T and its lower-tier affiliates. If T, rather than T1, sold the asset to P, the results would be the same. Further, if T and T1 pay dividends to S that, only when aggregated, would be described in paragraph (g)(1)(iii) of this section (if they were all paid by T), the results would be the same.

EXAMPLE 4. GAIN REFLECTED BY REASON OF DIVIDENDS. (a) S and T file a consolidated return in which T1 and T2 do not join. On February 1 of Year 1, T1 sells an asset to P and recognizes gain. On January 1 of Year 2, P makes a qualified stock purchase of T from S. No section 338 election is made for T. T1 pays dividends to T that would be described in paragraph (g)(1)(iii) of this section if T1 were a target.

(b) The requirements of paragraph (b) of this section are not satisfied because, under paragraph (c)(3) of this section, gain from T1's sale is not reflected in S's basis in the T stock by reason of the dividends paid by T1 to T.

(c) Although the dividends paid by T1 to T do not reduce the value to S of T and its lower-tier affiliates, paragraph (g)(2) of this section applies because the dividends paid by T1 to T are taken into account under section 1.1502-32 in determining S's basis in the T stock. Consequently, the carryover basis rule of paragraph (d)(1) of this section applies to the asset.

(h) SPECIAL RULES FOR CONTROLLED FOREIGN CORPORATIONS. [Reserved]

(i) [Reserved]

(j) ANTI-AVOIDANCE RULES. For purposes of this section --

(1) EXTENSION OF CONSISTENCY PERIOD. The target consistency period is extended to include any continuous period that ends on, or begins on, any day of the consistency period during which a purchasing corporation, or any person related, within the meaning of section 267(b) or 707(b)(1), to a purchasing corporation, has an arrangement--

(i) To purchase stock of target; or

(ii) To own an asset to which the carryover basis rules of this section apply, taking into account the extension.

(2) QUALIFIED STOCK PURCHASE AND 12-MONTH ACQUISITION PERIOD. The 12-month acquisition period is extended if, pursuant to an arrangement, a corporation acquires by purchase stock of another corporation satisfying the requirements of section 1504(a)(2) over a period of more than 12 months.

(3) ACQUISITIONS BY CONDUITS -- (i) ASSET OWNERSHIP -- (A) GENERAL RULE. A corporation is treated as owning any portion of an asset attributed to the corporation from a conduit under section 318(a) (treating any asset as stock for this purpose, for purposes of --

(1) The asset airship requirements of this section; and

(2) Determining whether a controlled foreign corporation is a target affiliate for purposes of 51.338-4T(h).

(B) APPLICATION OF CARRYOVER BASIS RULE. If the basis rules of this section apply to the asset, the basis rules of this section apply to the entire asset (not just the portion for which ownership is attributed).

(ii) STOCK ACQUISITIONS -- (A) PURCHASE BY CONDUIT. A corporation is treated as purchasing stock of another corporation attributed to the corporation from a conduit under section 318(a) on the day the stock is purchased by the conduit. The corporation is not treated as purchasing the stock, however, if the conduit purchased the stock more than two years before the date the stock is first attributed to the corporation.

(B) PURCHASE OF CONDUIT BY CORPORATION. If a corporation purchases an interest in a conduit (treating the interest as stock for this purpose), the corporation is treated as purchasing on that date any stock owned by a conduit on that date and attributed to the corporation under section 318(a) with respect to the interest in the conduit that was purchased.

(C) PURCHASE OF CONDUIT BY CONDUIT. If a conduit (the first conduit) purchases an interest in a second conduit (treating the interest as stock for this purpose), the first conduit is treated as purchasing on that date any stock owned by a conduit on that date and attributed to the first conduit under section 318(a) with respect to the interest in the second conduit that was purchased.

(4) CONDUIT. A person (other than a corporation) is a conduit as to a corporation if --

(i) The corporation would be treated under section 318(a)(2)(A) and (B)(attribution from partnerships, estates, and trusts) as owning any stock owned by the person; and

(ii) The corporation, together with its affiliates, would be treated as owning an aggregate of at least 50 percent of the stock owned by the person.

(5) EXISTENCE OF ARRANGEMENT. The existence of an arrangement is determined under all the facts and circumstances. For an arrangement to exist, there need not be an enforceable, written, or unconditional agreement, and all the parties to the transaction need not have participated in each step of the transaction. One factor indicating the existence of an arrangement is the participation of a related party. For this purpose, persons are related if they are related within the meaning of section 267(b) or 707(b)(1).

(6) PREDECESSOR AND SUCCESSOR -- (i) PERSONS. A reference to a person (including target, target affiliate, and purchasing corporation) includes, as the context may require, a reference to a predecessor or successor. For this purpose, a predecessor is a transferor or distributor of assets to a person (the successor) in a transaction --

(A) To which section 381(a) applies; or

(B) In which the successor's basis for the assets is determined, directly or indirectly, in whole or in part, by reference to the basis of the transferor or distributor.

(ii) ASSETS. A reference to an asset (the first asset) includes, as the context may require, a reference to any asset the basis of which is determined, directly or indirectly, in whole or in part, by reference to the first asset.

(7) EXAMPLES. This paragraph (j) may be illustrated by the following examples:

EXAMPLE 1. ASSET OWNED BY CONDUIT TREATED AS OWNED BY PURCHASER OF TARGET STOCK. (a) P owns a 60-percent interest in Y. On March 1 of Year 1, T sells an asset to Y and recognizes gain. On January 1 of Year 2, P makes a qualified stock purchase of T from S. No section 338 election is made for T.

(b) Under paragraph (j)(4) of this section, Y is a conduit with respect to P. Consequently, under paragraph (j)(3)(i)(A) of this section, P is treated as owning 60% of the asset on March 1 of Year 1 and January 1 of Year 2. Because P is treated as owning part or all of the asset both immediately after the asset disposition and on T's acquisition date, paragraph (b) of this section applies to the asset. Consequently, paragraph (d)(1) of this section applies to the asset and Y's basis in the asset is T's adjusted basis in the asset immediately before the sale to Y.

EXAMPLE 2. CORPORATION WHOSE STOCK IS OWNED BY CONDUIT TREATED AS AFFILIATE. (a) P owns an 80-percent interest in Y. Y owns all of the stock of Z. On March 1 of Year 1, T sells an asset to Z and recognizes gain. On January 1 of Year 2, P makes a qualified stock purchase of T from S. No section 338 election is made for T.

(b) Under paragraph (j)(4) of this section, Y is a conduit with respect to P. Consequently, under paragraph (j)(3)(i)(A) of this section, P is treated as owning 80% of the Z stock and Z is therefore treated as an affiliate of P for purposes of applying the asset ownership requirements of paragraph (b)(1)(iii) of this section. Because Z, an affiliate of P, owns the asset both immediately after the asset disposition and on T's acquisition date, paragraph (b) of this section applies to the asset, and the asset's basis is determined under paragraph (d) of this section.

(c) If, instead of owning an 80-percent interest in Y, P owned a 79-percent interest in Y, Z would not be treated as an affiliate of P and paragraph (b) of this section would not apply to the asset.

EXAMPLE 3. QUALIFIED STOCK PURCHASE BY REASON OF STOCK PURCHASE BY CONDUIT. (a) P owns a 90-percent interest in Y. Y owns a 60-percent interest in Y1. On February 1 of Year 2, T sells an asset to P and recognizes gain. On January 1 of Year 3, P purchases 70% of the T stock from S and Y1 purchases the remaining 30% of the T stock from S.

(b) Under paragraph (j)(3)(ii)(A) of this section, P is treated as purchasing on January 1 of Year 3, the 16.2% of the T stock that is attributed to P from Y and Y1 under section 318(a). Thus, for purposes of this section, P is treated as making a qualified stock purchase of T on January 1 of Year 3, paragraph (b) of this section applies to the asset, and the asset's basis is determined under paragraph (d) of this section. However, because P is not treated as having made a qualified stock purchase of T for purposes of making an election under section 338, no election can be made for T.

(c) If Y1 purchases 20% of the T stock from S on December 1 of Year 1, rather than 30% on January 1 of Year 3, P would be treated as purchasing 10.8% of the T stock on December 1 of Year 1. Thus, if paragraph (j)(2) of this section (relating to extension of the 12-month acquisition period) does not apply, P would not be treated as making a qualified stock purchase of T, because P is not treated as purchasing T stock satisfying the requirements of section 1504(a)(2) within a 12-month period.

EXAMPLE 4. SUCCESSOR ASSET. (a) On February 1 of Year 1, T sells stock of X to P1 and recognizes gain. On December 1 of Year 1, P1 exchanges its X stock for stock in new X in a reorganization qualifying under section 368(a)(1)(F). On January 1 of Year 2, P1 makes a qualified stock purchase of T from S. No section 338 election is made for T.

(b) The asset ownership requirements of paragraph (b)(1)(iii) of this section are satisfied because, under paragraph (j)(6)(ii) of this section, P1 is treated as owning the X stock on T's acquisition date. P1 is treated as owning the X stock on that date because P1 owns the new X stock and P1's basis in the new X stock is determined by reference to P1's basis in the X stock. Consequently, under paragraph (d)(1) of this section, P1's basis in the X stock on February 1 of Year 1 is T's adjusted basis in the X stock immediately before the sale to P1.

SECTION 1.338-5 INTERNATIONAL ASPECTS OF SECTION 338.

(a) SCOPE. This section provides guidance regarding international aspects of section 338. As provided in section 1.338-1(c)(14), a foreign corporation, a DISC, or a corporation for which a section 936 election has been made is considered a target affiliate for all purposes of section 338. In addition, stock described in section 338(h)(6)(B)(ii) held by a target affiliate is not excluded from the operation of section 338.

(b) APPLICATION OF SECTION 338 TO FOREIGN TARGETS -- (1) IN GENERAL. For purposes of subtitle A, the deemed sale gain, as defined in section 1.338-3(b)(4), of a foreign target for which a section 338 election is made (FT), and the corresponding earnings and profits, are taken into account in determining the taxation of FT and FT's direct and indirect shareholders. See, however, section 338(h)(16). For example, the income and earnings and profits of FT are determined, for purposes of sections 551, 951, 1248, and 1293, by taking into account the deemed sale gain.

(2) OWNERSHIP OF FT STOCK ON THE ACQUISITION DATE. A person who transfers FT stock to the purchasing corporation on FT's acquisition date is considered to own the transferred stock at the close of FT's acquisition date. See, e.g., section 1.951-1(f) (relating to determination of holding period for purposes of sections 951 through 964). If on the acquisition date the purchasing corporation owns a block of FT stock that was acquired before FT's acquisition date, the purchasing corporation is considered to own such block of stock at the close of the acquisition date.

(3) CARRYOVER FT STOCK -- (i) DEFINITION. FT stock is carryover FT stock if --

(A) FT was a controlled foreign corporation within the meaning of section 957 (taking into account section 953(c)) at any time during the portion of the 12-month acquisition period that ends on the acquisition date; and

(B) Such stock is owned as of the beginning of the day after FT's acquisition date by a person other than a purchasing corporation, or by a purchasing corporation if the stock is nonrecently purchased and is not subject to a gain recognition election under section 1.338(b)-1(e)(2).

(ii) CARRYOVER OF EARNINGS AND PROFITS. The earnings and profits of old FT (and associated foreign taxes) attributable to the carryover FT stock (adjusted to reflect deemed sale gain) carry over to new FT solely for purposes of --

(A) Characterizing an actual distribution with respect to a share of carryover FT stock as a dividend;

(B) Characterizing gain on a post-acquisition date transfer of a share of carryover FT stock as a dividend under section 1248 (if such section is otherwise applicable);

(C) Characterizing an investment of earnings in United States property as income under sections 951(a)(1)(B) and 956 (if such sections are otherwise applicable); and

(D) Determining foreign taxes deemed paid under sections 902 and 960 with respect to the amount treated as a dividend or income by virtue of this paragraph (b)(3)(ii) (subject to the operation of section 338(h)(16)).

(iii) CAP ON CARRYOVER OF EARNINGS AND PROFITS. The amount of earnings and profits of old FT taken into account with respect to a share of carryover FT stock is limited to the amount that would have been included in gross income of the owner of such stock as a dividend under section 1248 if --

(A) The shareholder transferred that share to the purchasing corporation on FT's acquisition date for a consideration equal to the fair market value of that share on that date; or

(B) In the case of nonrecently purchased FT stock treated as carryover FT stock, a gain recognition election under section 338(b)(3)(A) applied to that share. For purposes of the preceding sentence, a shareholder that is a controlled foreign corporation is considered to be a United States person, and the principle of section 1248(c)(2)(D)(ii) (concerning a United States person's indirect ownership of stock in a foreign corporation) applies in determining the correct holding period.

(iv) POST-ACQUISITION DATE DISTRIBUTION OF OLD FT EARNINGS AND PROFITS. A post-acquisition date distribution with respect to a share of carryover FT stock is considered to be derived first from earnings and profits derived after FT's acquisition date and then from earnings and profits derived on or before FT's acquisition date.

(v) OLD FT EARNINGS AND PROFITS UNAFFECTED BY POST-ACQUISITION DATE DEFICITS. The carryover amount for a share of carryover FT stock is not reduced by deficits in earnings and profits incurred by new FT. This rule applies for purposes of determining the amount of foreign taxes deemed paid regardless of the fact that there are no accumulated earnings and profits. For example, a distribution by new FT with respect to a share of carryover FT stock is treated as a dividend by the distributee to the extent of the carryover amount for that share notwithstanding that new FT has no earnings and profits.

(vi) CHARACTER OF FT STOCK AS CARRYOVER FT STOCK ELIMINATED UPON DISPOSITION. A share of FT stock is not considered carryover FT stock after it is disposed of provided that all gain realized on the transfer is recognized at the time of the transfer, or that, if less than all of the realized gain is recognized, the recognized amount equals or exceeds the remaining carryover amount for that share.

(4) PASSIVE FOREIGN INVESTMENT COMPANY STOCK. Stock that is owned as of the beginning of the day after FT's acquisition date by a person other than a purchasing corporation, or by a purchasing corporation if the FT stock is nonrecently purchased stock not subject to a gain recognition election under section 1.338(b)- 1(e)(2), is treated as passive foreign investment company stock to the extent provided in section 1297(b)(1).

(c) DIVIDEND TREATMENT UNDER SECTION 1248(e). The principles of this paragraph (b) apply to shareholders of a domestic corporation subject to section 1248(e).

(d) ALLOCATION OF FOREIGN TAXES. If a section 338 election is made for target (whether foreign or domestic), and target's taxable year under foreign law (if any) does not close at the end of the acquisition date, foreign income taxes attributable to the foreign taxable income earned by target during such foreign taxable year are allocated to old target and new target. Such allocation is made under the principles of section 1.1502-76(b).

(e) OPERATION OF SECTION 338(h)(16). [Reserved]

(f) EXAMPLES. (1) Except as otherwise provided, all corporations use the calendar year as the taxable year, have no earnings and profits (or deficit) accumulated for any taxable year, and have only one class of outstanding stock.

(2) This section may be illustrated by the following examples:

EXAMPLE 1. GAIN RECOGNITION ELECTION FOR CARRYOVER FT STOCK. (a) A has owned 90 of the 100 shares of CFCT stock since CFCT was organized on March 13, 1989. P has owned the remaining 10 shares of CFCT stock since CFCT was organized. Those 10 shares constitute nonrecently purchased stock in P's hands within the meaning of section 338(b)(6)(B). On November 1, 1994, P purchases A's 90 shares of CFCT stock for $90,000 and makes a section 338 election for CFCT. P also makes a gain recognition election under section 338(b)(3)(A) and section 1.338(b)- 1(e)(2).

(b) CFCT's earnings and profits for its short taxable year ending on November 1, 1994, are $50,000, determined without taking into account the deemed asset sale. Assume A recognizes gain of $81,000 on the sale of the CFCT stock. Further, assume that CFCT recognizes gain of $40,000 by reason of its deemed sale of assets under section 338(a)(1).

(c) A's sale of CFCT stock to P is a transfer to which section 1248 and paragraphs (b)(1) and (2) of this section apply. For purposes of applying section 1248(a) to A, the earnings and profits of CFCT for its short taxable year ending on November 1, 1994, are $90,000 (the earnings and profits for that taxable year as determined under section 1.1248-2(e) ($50,000) plus earnings from the deemed sale ($40,000)). Thus, A's entire gain is characterized as a dividend under section 1248 (but see section 338(h)(16)).

(d) Assume that P recognizes a gain of $9,000 with respect to the 10 shares of nonrecently purchased CFCT stock by reason of the gain recognition election. Because P is treated as selling the nonrecently purchased stock for all purposes of the Internal Revenue Code, section 1248 applies. Thus, under section 1.1248-2(e), $9,000 of the $90,000 of earnings and profits for 1994 are attributable to the block of 10 shares of CFCT stock deemed sold by P at the close of November 1, 1994 ($90,000 X 10/100). Accordingly, P's entire gain on the deemed sale of 10 shares of CFCT stock is included under section 1248(a) in P's gross income as a dividend (but see section 338(h)(16)).

EXAMPLE 2. NO GAIN RECOGNITION ELECTION FOR CARRYOVER FT STOCK. (a) Assume the same facts as in EXAMPLE 1, except that P does not make a gain recognition election.

(b) The 10 shares of nonrecently purchased CFCT stock held by P is carryover FT stock under paragraph (b)(3) of this section. Accordingly, the earnings and profits (and attributable foreign taxes) of old CFCT carry over to new CFCT solely for purposes of that block of 10 shares. The amount of old CFCT's earnings and profits taken into account with respect to that block in the event, for example, of a distribution by new CFCT with respect to that block is the amount of the section 1248 dividend that P would have recognized with respect to that block had it made a gain recognition election under section 338(b)(3)(A). Under the facts of EXAMPLE 1, P would have recognized a gain of $9,000 with respect to that block, all of which would have been a section 1248 dividend ($90,000 X 10/100). Accordingly, the carryover amount for the block of 10 shares of nonrecently purchased CFCT stock is $9,000.

EXAMPLE 3. SALE OF CONTROLLED FOREIGN CORPORATION STOCK PRIOR TO AND ON THE ACQUISITION DATE. (a) X and Y, both U.S. corporations, have each owned 50% of the CFCT stock since 1986. Among CFCT's assets are assets the sale of which would generate subpart F income. On December 31, 1994, X sells its CFCT stock to P. On June 30, 1995, Y sells its CFCT stock to P. P makes a section 338 election for CFCT. In both 1994 and 1995, CFCT has subpart F income resulting from operations.

(b) For taxable year 1994, X and Y are United States shareholders on the last day of CFCT's taxable year, so pursuant to section 951(a)(1)(A) each must include in income its pro rata share of CFCT's subpart F income for 1994. Because P's holding period in the CFCT stock acquired from X does not begin until January 1, 1995, P is not a United States shareholder on the last day of 1994 for purposes of section 951(a)(1)(A) (see section 1.951-1(f)). X must then determine the extent to which section 1248 recharacterizes its gain on the sale of CFCT stock as a dividend.

(c) For the short taxable year ending June 30, 1995, Y is considered to own the CFCT stock sold to P at the close of CFCT's acquisition date. Because the acquisition date is the last day of CFCT's taxable year, Y and P are United States shareholders on the last day of CFCT's taxable year. Pursuant to section 951(a)(1)(A), each must include its pro rata share of CFCT's subpart F income for the short taxable year ending June 30, 1995. This includes any income generated on the deemed sale of CFCT's assets. Y must then determine the extent to which section 1248 recharacterizes its gain on the sale of the CFCT stock as a dividend, taking into account any increase in CFCT's earnings and profits due to the deemed sale of assets.

EXAMPLE 4. ACQUISITION OF CONTROL FOR PURPOSES OF SECTION 951 PRIOR TO THE ACQUISITION DATE. FS owns 100% of the FT stock. On July 1, 1994, P buys 60% of the FT stock. On December 31, 1994, P buys the remaining 40% of the FT stock and makes a section 338 election for FT. For tax year 1994, FT has earnings and profits of $1,000 (including earnings resulting from the deemed sale). The section 338 election results in $500 of subpart F income. As a result of the section 338 election, P must include in gross income the following amount under section 951(a)(1)(A) (see section 1.951-(b)(2)):

 FT's subpart F income for 1994 ....................$500.00

(b) T's deemed sale of assets under section 338 constitutes a sale for purposes of subtitle A of the Internal Revenue Code, including section 936(a)(1)(A)(ii). To the extent that the assets deemed sold are used in the conduct of an active trade or business in a possession for purposes of section 936(a)(1)(A)(i), and assuming all the other conditions of section 936 are satisfied, the income from the deemed sale qualifies for the credit granted by section 936(a). The source of income from the deemed sale is determined as if the assets had actually been sold and is not affected for purposes of section 936 by section 338(h)(16).

(c) Because new T is treated a new corporation for purposes of subtitle A of the Internal Revenue Code, the three year testing period in section 936(a)(2)(A) begins again for new T on the day following T's acquisition date. Thus, if the character or source of old T's gross income disqualified it for the credit under section 936, a fresh start is allowed by a section 338 election.

SECTION 1.338(b)-1 ADJUSTED GROSSED-UP BASIS.

(a) SCOPE. This section provides rules under section 338(b) to determine the adjusted grossed-up basis (AGUB) for target. The AGUB is the amount for which new target is deemed to have purchased all of its assets in the deemed purchase under section 338(a)(2). The AGUB is allocated among target's assets in accordance with section 1.338(b)-2T to determine the price at which the assets are deemed to have been purchased. Subsequent adjustments to AGUB and the allocation of such adjustments to target's assets may be made under section 1.338(b)-3T.

(b) ADJUSTMENT EVENTS. ADJUSTMENT EVENTS are increases (or decreases) in the consideration paid for recently or nonrecently purchased stock, reductions in target's liabilities included in AGUB as of the beginning of the day after the acquisition date, and old target liabilities that become fixed and determinable.

(c) AGUB -- (1) IN GENERAL. AGUB is the sum of --

(i) The grossed-up basis in the purchasing corporation's recently purchased target stock;

(ii) The purchasing corporation's basis in nonrecently purchased target stock;

(iii) The liabilities of new target; and

(iv) Other relevant items.

(2) TIME WHEN AGUB DETERMINED. AGUB is initially determined at the beginning of the day after the acquisition date of target. However, adjustment events that occur during new target's first taxable year are taken into account for purposes of determining AGUB and the basis of target's assets as if they had occurred at the beginning of the day after the acquisition date.

(d) GROSSED-UP BASIS OF RECENTLY PURCHASED STOCK -- (1) GENERAL RULE. The purchasing corporation's grossed-up basis of recently purchased target stock is the product of --

(i) The purchasing corporation's basis in recently purchased target stock (as defined in section 338(b)(6)(A)) at the beginning of the day after the acquisition date; multiplied by

(ii) A fraction the numerator of which is 100 percent minus the percentage of target stock (by value) attributable to the purchasing corporation's nonrecently purchased target stock and the denominator of which is the percentage of target stock (by value) attributable to the purchasing corporation's recently purchased target stock. See section 338(b)(4).

(2) APPLICATION. If target has a single class of outstanding stock, the grossed-up basis in the purchasing corporation's recently purchased target stock reflects the total price the purchasing corporation would have paid for all outstanding target stock (other than the purchasing corporation's nonrecently purchased target stock, as defined in section 338(b)(6)(B)) had the purchasing corporation purchased all such stock (other than the nonrecently purchased target stock) for a price per share equal to the average price per share that the purchasing corporation paid for the recently purchased target stock.

(e) BASIS OF NONRECENTLY PURCHASED STOCK -- (1) IN GENERAL. In the absence of an election under section 338(b)(3) (gain recognition election), the purchasing corporation retains its basis in the nonrecently purchased stock. A gain recognition election applies to nonrecently purchased stock of target (or a target affiliate) only if a section 338 election is made for target (or the target affiliate).

(2) EFFECT OF GAIN RECOGNITION ELECTION -- (i) IN GENERAL. If the purchasing corporation makes a gain recognition election, for all purposes of the Internal Revenue Code --

(A) The purchasing corporation is treated as if it sold on the acquisition date the nonrecently purchased target stock for the basis amount determined under paragraph (e)(2)(ii) of this section; and

(B) The purchasing corporation's basis on the acquisition date in nonrecently purchased target stock is the basis amount.

(ii) BASIS AMOUNT. The basis amount is equal to the purchasing corporation's grossed-up basis in recently purchased target stock multiplied by a fraction the numerator of which is the percentage of target stock (by value) attributable to the purchasing corporation's nonrecently purchased target stock and the denominator of which is 100 percent minus the numerator amount. Thus, if target has a single class of outstanding stock, the purchasing corporation's basis in each share of nonrecently purchased target stock after the gain recognition election is equal to the average price per share of the purchasing corporation's recently purchased target stock.

(iii) LOSSES NOT RECOGNIZED. Only gains (unreduced by losses) on the nonrecently purchased target stock are recognized.

(iv) STOCK SUBJECT TO ELECTION. The gain recognition election applies to --

(A) All nonrecently purchased target stock; and

(B) Any nonrecently purchased stock in a target affiliate having the same acquisition date as target if such target affiliate stock is held by the purchasing corporation on such date.

(3) PROCEDURE FOR MAKING GAIN RECOGNITION ELECTION -- (i) IN GENERAL. The gain recognition election is made by attaching a gain recognition statement to a timely filed Form 8023 for target. The gain recognition statement must contain the information specified in the form and its instructions. The gain recognition election is irrevocable.

(ii) SECTION 338(h)(10) ELECTION. If a section 338(h)(10) election is made for target, the purchasing corporation is deemed to have made a gain recognition election.

(4) COMPARISON WITH ADSP FORMULA. Whenever the purchasing corporation holds nonrecently purchased target stock at a basis that differs from the purchasing corporation's basis in recently purchased target stock, the grossed-up basis in the purchasing corporation's recently purchased target stock as calculated for purposes of the AGUB differs from the grossed-up basis of the purchasing corporation's recently purchased target stock as calculated in the ADSP formula. The ADSP formula treats the purchasing corporation's nonrecently purchased target stock in the same manner as target stock not held by the purchasing corporation. If a gain recognition election is made, the sum of the grossed-up basis in the purchasing corporation's recently purchased target stock and the purchasing corporation's basis in nonrecently purchased target stock equals the grossed-up basis of the purchasing corporation's recently purchased target stock as calculated in the ADSP formula.

(f) LIABILITIES OF NEW TARGET -- (1) IN GENERAL. The liabilities of new target are its liabilities (and the liabilities to which target's assets are subject) as of the beginning of the day after the acquisition date (other than liabilities that were neither liabilities of old target nor liabilities to which old target's assets were subject). The amount of the liabilities of new target taken into account to determine AGUB is determined as if new target had acquired old target's assets from an unrelated person and, as part of the transaction, had assumed or taken property subject to the liabilities.

(2) EXCLUDED OBLIGATIONS -- (i) IN GENERAL. In order to be included in AGUB at the beginning of the day after the acquisition date, an obligation must be a bona fide liability of target as of that date which is properly includible in basis under principles of tax law that would apply if new target had acquired old target's assets from an unrelated person and, as part of the transaction, had assumed or taken property subject to the obligation. For example, if, as of the beginning of the day after the acquisition date, the amount of a contingent or speculative obligation of target is not properly includible in basis under the preceding sentence, the obligation is not initially included in AGUB.

(ii) TIME WHEN EXCLUDED OBLIGATIONS TAKEN INTO ACCOUNT. Obligations that, under this paragraph (f)(2), are initially excluded from AGUB are taken into account in redetermining AGUB and the basis of target's assets under principles of tax law that would apply if new target had acquired old target's assets directly from an unrelated person and, as part of the transaction, had assumed or taken property subject to those obligations. For the application of these principles of tax law to certain contingent liabilities that are initially excluded from AGUB under this paragraph (f)(2), see section 1.338(b)-3T.

(3) LIABILITIES TAKEN INTO ACCOUNT IN DETERMINING AMOUNT REALIZED ON SUBSEQUENT DISPOSITION. In determining the amount realized on a subsequent sale or other disposition of property deemed purchased by new target, the entire amount of any liability included in AGUB is considered to be an amount taken into account in determining new target's basis in property which secures the liability for purposes of applying section 1.1001-2(a). Thus, if a liability is included in AGUB, section 1.1001-2(a)(3) does not prevent the amount of such liability from being treated as discharged within the meaning of section 1.1001-2(a)(4) as a result of new target's sale or disposition of the property which secures such liability.

(g) OTHER RELEVANT ITEMS -- (1) IN GENERAL. AGUB may be increased (or decreased) for OTHER RELEVANT ITEMS. For this purpose, other relevant items may only arise from adjustment events that occur after the close of new target's first taxable year and adjustments under paragraph (g)(3) of this section. See section 1.338(b)-3T (relating to the treatment of certain subsequent adjustments to AGUB). Unlike in the determination of ADSP or MADSP, other relevant items do not include reductions for acquisition costs incurred by the purchasing corporation in connection with the qualified stock purchase that are capitalized in the basis of recently purchased target stock

(2) FLOW-THROUGH OF RELEVANT ITEM ADJUSTMENT TO TARGET SUBSIDIARY. If the amount of AGUB of target (T) allocated to the stock of a target affiliate (T1) is subsequently increased (or decreased) by reason of an other relevant item under this paragraph (g), the grossed-up basis of the T1 stock (and, if a section 338 election is made for T1, T1's AGUB) is also increased (or decreased) as if the increase (or decrease) in the basis of the stock was an adjustment to the purchase price deemed paid by T for such stock. The resulting increase (or decrease) in AGUB of T1 is allocated among T1's assets in accordance with sections 1.338(b)-2T and 1.338(b)-3T.

(3) ADJUSTMENTS BY THE INTERNAL REVENUE SERVICE. In connection with the examination of a return, the District Director may increase (or decrease) AGUB for items other than those described in paragraphs (g)(1) and (2) of this section under the authority of section 338(b)(2) and allocate such amounts to target's assets under the authority of section 338(b)(5) so that AGUB and the basis of target's assets properly reflect the cost to the purchasing corporation of its interest in target's assets. Such items may include distributions from target to the purchasing corporation, capital contributions from the purchasing corporation to target during the 12-month acquisition period, or acquisitions of target stock by purchasing corporation after the acquisition date from minority shareholders.

(h) EXAMPLES. (1) For purposes of the examples in this paragraph (h), T has no liabilities other than a tax liability resulting from the deemed sale of assets.

(2) This section may be illustrated by the following examples:

EXAMPLE 1. (a) Before July 1 of Year 1, P purchases 10 of the 100 shares of T stock for $5,000. On July 1 of Year 2, P purchases 80 shares of T stock for $60,000 and makes a section 338 election for T. As of July 1 of Year 2, T's only asset is raw land with an adjusted basis to T of $50,400 and a fair market value of $100,000. T has no loss or tax credit carryovers to Year 2. T's marginal tax rate for any ordinary income or net capital gain resulting from the deemed sale of assets is 34%. The 10 shares purchased before July 1 of Year 1 constitute nonrecently purchased T stock with respect to P's qualified stock purchase of T stock on July 1 of Year 2.

(b) The ADSP formula as applied to these facts is the same as in EXAMPLE 2 of section 1.338-3(d)(9). Accordingly, the ADSP of T is $87,672.72. The existence of nonrecently purchased T stock is irrelevant for purposes of the ADSP formula, because that formula treats P's nonrecently purchased T stock in the same manner as T stock not held by P.

(c) The total tax liability resulting from T's deemed sale of assets, as calculated under the ADSP formula, is $12,672.72.

(d) If P does not make a gain recognition election, the AGUB of new T's assets is $85,172.72, determined as follows. (In the formula below, GRP is the grossed-up basis in P's recently purchased T stock, BNP is P's basis in nonrecently purchased T stock, L is T's liabilities, and X is other relevant items.)

 AGUB = GRP + BNP + L + X

 AGUB = $60,000 X [(1 - .1)/.8] + $60,000 X [(1 - .1)/.8] X [.1/(1 - .1)] + $12,672.72

 AGUB = $60,000/.8 + $12,672.72

EXAMPLE 2. On January 1 of Year 1, P purchases one-third of the T stock. On March 1 of Year 1, T distributes a dividend to all of its shareholders. On April 15 of Year 1, P purchases the remaining T stock and makes a section 338 election for T. In appropriate circumstances, the District Director may decrease the AGUB of T to take into account the payment of the dividend and properly reflect the fair market value of T's assets deemed purchased.

EXAMPLE 3. (a) T's sole asset is a building worth $100,000. On August 1 of Year 1, P purchases 10 of the 100 shares of T stock for $8,000. On June 1 of Year 2, P purchases 50 shares of T stock for $50,000. On June 15 of Year 2, P contributes a tract of land to the capital of T and receives 10 additional shares of T stock as a result of the contribution. Both the basis and fair market value of the land at that time are $10,800. On June 30 of Year 2, P purchases the remaining 40 shares of T stock for $40,000 and makes a section 338 election for T. The AGUB of T is $108,800.

(b) To prevent the shifting of basis from the contributed property to other assets of T, the District Director may allocate $10,800 of the AGUB to the land, leaving $98,000 to be allocated to the building.

Par. 5. Section 1.338(b)-2T(a)(2) and (d) EXAMPLE (1)(i) are revised to read as follows:

SECTION 1.338(b)-2T ALLOCATION OF ADJUSTED GROSSED-UP BASIS AMONG TARGET ASSETS (TEMPORARY).

(a) * * *

(2) FAIR MARKET VALUE. The "fair market value" of an asset is the gross fair market value of that asset (i.e., fair market value determined without regard to mortgages, liens, pledges, or other liabilities).

* * * * *

(d) * * *

EXAMPLE (1). (i) T owns 90% of the outstanding T1 stock. P purchases 100% of the outstanding T stock for $2,000. A section 338 election is made for T and, as a result, T1 is considered acquired in a qualified stock purchase. A section 338 election is made for T1. The grossed-up basis of the T stock is $2,000 (i.e., $2,000 x 1/1).

* * * * *

Par. 5A. Section 1.338(b)-3T(b) is revised to read as follows:

SECTION 1.338(b)-3T SUBSEQUENT ADJUSTMENTS TO ADJUSTED GROSSED-UP BASIS (TEMPORARY).

* * * * *

(b) DEFINITIONS -- (1) CONTINGENT LIABILITY. A contingent liability is a liability of target at the beginning of the day after the acquisition date that is not fixed and determinable by the close of new target's first taxable year.

(2) CONTINGENT AMOUNT. The term CONTINGENT AMOUNT means the amount of the consideration to be paid for recently or nonrecently purchased stock that is not fixed or determinable by the close of new target's first taxable year, plus contingent liabilities of target.

(3) REDUCTION AMOUNT. The term REDUCTION AMOUNT means a reduction after the close of new target's first taxable year in either --

(i) The consideration paid for recently or nonrecently purchased stock; or

(ii) A liability of target (or a liability to which one or more of its assets are subject) that has been taken into account in determining AGUB.

(4) ACQUISITION DATE ASSET. The term ACQUISITION DATE asset means any asset held by new target at the beginning of the day after the acquisition date (other than Class I assets).

* * * * *

Par. 6. Sections 1.338(h)(10)-1 and 1.338(i)-1 are added to read as follows:

SECTION 1.338(b)(10)-1 DEEMED ASSET SALE AND LIQUIDATION.

(a) SCOPE. This section prescribes rules relating to section 338(h)(10) elections. If an election is made, target generally is deemed to sell all of its assets and distribute the proceeds in complete liquidation. Thus, the sale of target stock included in the qualified stock purchase generally is ignored. A section 338(h)(10) election may be made for target only if it is a member of a selling consolidated group, a member of a selling affiliated group filing separate returns, or an S corporation.

(b) NOMENCLATURE. For purposes of this section, the nomenclature in section 1.338-1(b) does not apply; instead:

(1) T is a section 338(h)(10) target. Old T refers to T for periods ending on or before the close of T's acquisition date; new T refers to T for subsequent periods.

(2) P is the purchasing corporation. Unless the context otherwise requires, any reference to P is a reference to all purchasing corporations. See sections 338(h)(5) and (8).

(c) DEFINITIONS -- (1) SECTION 338(h)(10) TARGET. A SECTION 338(h)(10) TARGET is a domestic corporation that is a target for which a section 338(h)(10) election is made.

(2) S CORPORATION SHAREHOLDERS. S CORPORATION SHAREHOLDERS are the T shareholders if T is an S corporation immediately before T's acquisition date. Thus, if T is an S corporation, for T to be a section 338(h)(10) target, P can purchase no T stock before the acquisition date.

(3) SELLING CONSOLIDATED GROUP. A SELLING CONSOLIDATED GROUP is a selling group that files a consolidated return for the period that includes T's acquisition date. Thus, T is a member of the selling consolidated group on the acquisition date.

(4) SELLING AFFILIATE. A SELLING AFFILIATE is a domestic corporation that is not a member of the selling consolidated group and from which, on the acquisition date, P purchases an amount of T stock that satisfies the requirements of section 1504(a)(2). Thus, on the acquisition date, the selling affiliate and T are affiliated (within the meaning of section 1504) but are not includible members of the same consolidated group.

(d) SECTION 338(h)(10) ELECTION -- (1) IN GENERAL. A section 338(h)(10) election may be made for T if P acquires T in a qualified stock purchase from --

(i) A selling consolidated group;

(ii) A selling affiliate; or

(iii) S corporation shareholders.

(2) SIMULTANEOUS JOINT ELECTION REQUIREMENT. A section 338(h)(10) election is made jointly by P and the selling consolidated group (or the selling affiliate or the S corporation shareholders) on Form 8023 in accordance with the instructions to the form. The section 338(h)(10) election must be made not later than the 15th day of the 9th month beginning after the month in which the acquisition date occurs.

(3) IRREVOCABILITY. A section 338(h)(10) election is irrevocable. If a section 338(h)(10) election is made for T, a section 338 election is deemed made for T.

(4) EFFECT OF INVALID ELECTION. If a section 338(h)(10) election for T is not valid, the section 338 election for T is also not valid.

(e) CERTAIN CONSEQUENCES OF SECTION 338(h)(10) ELECTION. This paragraph (e) applies if an election under section 338(h)(10) is made.

(1) OLD T. Old T recognizes gain or loss as if, while old T was a member of the selling consolidated group (or owned by the selling affiliate or S corporation shareholders), it sold all of its assets in a single transaction at the close of the acquisition date (but before the deemed liquidation). Old T's gain or loss on each asset is determined under paragraph (f) of this section. If P makes a qualified stock purchase from a selling affiliate or S corporation shareholders, the principles of sections 1.338-1(c)(6) and (e)(1), (5), and (6)(i) apply to the return filed by old T that includes the gain or loss and tax liability from the deemed sale.

(2) SELLING CONSOLIDATED GROUP, SELLING AFFILIATE, OR S CORPORATION SHAREHOLDERS -- (i) IN GENERAL. This paragraph (e)(2) describes the treatment of members of the selling consolidated group, the selling affiliate, and S corporation shareholders.

(ii) DEEMED LIQUIDATION FOR OLD T. For purposes of subtitle A of the Internal Revenue Code, old T is treated as if, while T is a member of the selling consolidated group (or owned by the selling affiliate or S corporation shareholders), it distributed all of its assets in complete liquidation. If T is an S corporation immediately before the acquisition date, nothing in this section prevents a holder of T stock from taking deemed sale gain into account under section 1366 and 1367. See section 331 or 332 for gain or loss recognized by the old T shareholders as a result of the deemed liquidation.

(iii) BASIS OF T STOCK NOT ACQUIRED. The basis of T stock retained by the selling consolidated group (or the selling affiliate or an S corporation shareholder) is its fair market value. For purposes of this paragraph, the fair market value of all of the T stock equals G less any reductions in determining MADSP for acquisition costs of P incurred in connection with the qualified stock purchase that are capitalized in the basis of recently purchased T stock. See paragraph (f) of this section for the definition of G and a description of MADSP.

(iv) T STOCK SALE. No gain or loss is recognized on the sale or exchange by the selling consolidated group (or the selling affiliate or an 5 corporation shareholder) of T stock included in the qualified stock purchase. If T is an S corporation immediately before T's acquisition date, the sale or exchange of old T stock to P on the acquisition date does not result in a termination of the section 1362(a) election for the S corporation.

(v) EXAMPLE. This paragraph (e)(2) may be illustrated by the following example.

EXAMPLE. (a) S1 owns all of the T stock and T owns all of the stock of T1 and T2. S1 is the common parent of a consolidated group that includes T, T1, and T2. P makes a qualified stock purchase of all of the T stock from S1. A section 338(h)(10) election is made for T. A section 338(h)(10) election also is made for the deemed purchase of T1. A section 338 election is not made for T2.

(b) S1 does not recognize gain or loss on the sale of the T stock and T does not recognize gain or loss on the sale of the T1 stock because T and T1 are section 338(h)(10) targets. Thus, for example, gain or loss realized on the sale of the T or T1 stock is not taken into account in earnings and profits. However, because a section 338 election is not made for T2, T must recognize any gain or loss realized on the deemed sale of the T2 stock. See section 1.338-3(c).

(c) The results would be the same if S1, T, T1, and T2 are not members of any consolidated group, because S1 and T are selling affiliates.

(3) CERTAIN MINORITY SHAREHOLDERS -- (i) IN GENERAL. This paragraph (e)(3) describes the treatment of shareholders of old T other than members of the selling consolidated group, the selling affiliate, S corporation shareholders, and P. A shareholder to which this paragraph (e)(3) applies is called a MINORITY SHAREHOLDER.

(ii) T STOCK SALE. Notwithstanding paragraph (e)(2)(iv) of this section, a minority shareholder recognizes gain or loss on the shareholder's sale or exchange of T stock included in the qualified stock purchase.

(iii) T STOCK NOT ACQUIRED. A minority shareholder does not recognize gain or loss under this section with respect to shares of T stock retained by the shareholder. The shareholders's basis and holding period for that T stock is not affected by the section 338(h)(10) election.

(4) P. P is treated as making a gain recognition election for its nonrecently purchased T stock. See section 1.338(b)-1(e)(2) (effect of a gain recognition election) and section 1.338(b)- 1(e)(3)(ii) (gain recognition election deemed made).

(5) NEW T. The adjusted grossed-up basis for new T's assets is determined in accordance with section 1.338(b)-1(c) and is allocated among the assets in accordance with sections 1.338(b)-2T and 1.338(b)-3T. Notwithstanding paragraph (e)(2)(ii) of this section, new T remains liable for the tax liabilities of old T (including tax liabilities resulting from the deemed sale of assets). For example, new T remains liable for the tax liabilities of the members of any consolidated group that are attributable to taxable years in which those corporations and old T joined in the same consolidated return. See section 1.1502-6(a).

(6) CONSOLIDATED RETURN OF SELLING CONSOLIDATED GROUP. If P acquires T in a qualified stock purchase from a selling consolidated group --

(i) The selling consolidated group must file a consolidated return for the taxable period that includes the acquisition date;

(ii) A consolidated return for the selling consolidated group for that period may not be withdrawn on or after the day that a section 338(h)(10) election is made for T; and

(iii) Permission to discontinue filing consolidated returns cannot be granted for, and shall not apply to, that period or any of the immediately preceding taxable periods during which consolidated returns continuously have been filed.

(f) DEEMED SALE PRICE -- (1) GENERAL RULE. The price at which each asset of old T is deemed to have been sold is calculated by --

(i) Determining the modified ADSP (MADSP); and

(ii) Then allocating MADSP among the assets of old T in accordance with section 1.338(b)-2T (without taking into account section 1.338(b)-2T(c)(2)).

(2) FORMULA. (i) The MADSP formula is as follows:

MADSP = G + L + X

(ii) For purposes of this formula --

(A) G is the grossed-up basis of P's recently purchased T stock determined under section 1.338-3(d)(2).

(B) L is new T's liabilities.

(C) X is other relevant items.

(3) LIABILITIES. Liabilities taken into account are the liabilities of new target described in section 1.338(b)-1(f). The amount of the liabilities of new T taken into account to determine ADSP is determined as if old T had sold its assets to an unrelated person for consideration that included the liabilities.

(4) OTHER RELEVANT ITEMS. Other relevant items include reductions for --

(i) Acquisition costs of P incurred in connection with the qualified stock purchase that are capitalized in the basis of recently purchased T stock (e.g., brokerage commissions and any similar costs incurred by P to acquire T stock); and

(ii) Selling costs of the selling consolidated group (or selling affiliate or S corporation shareholders) incurred in connection with the qualified stock purchase that reduce the amount realized on the sale of recently purchased T stock (e.g., brokerage commissions and any similar costs incurred by the selling group to sell T stock).

(5) CROSS-REFERENCE. For adjustments to MADSP because of events occurring after the acquisition date, see section 1.338(b)-3T(h).

(g) EXAMPLES. (1) For purposes of the examples in this paragraph (g), unless otherwise provided, T, a member of a selling consolidated group, has only one class of stock, all of which is owned by S1. As of the close of Year 1, old T had no items described in section 381(c) (including no accumulated earnings and profits nor deficit in earnings and profits). On March 1 of Year 2, S1 sells its T stock to P for $80,000, and a section 338(h)(10) election is made for T. As of the close of March 1 of Year 2, old T's current earnings and profits, other than those generated from the deemed sale of its assets, are $21,950.

(2) Paragraphs (e) and (f) of this section may be illustrated by the following examples:

EXAMPLE 1. (a) On March 1 of Year 2, T owns land with a $50,000 basis and $75,000 fair market value and equipment with a $30,000 adjusted basis, $70,000 recomputed basis, and $60,000 fair market value. T also has a $40,000 liability. S1 pays old T's allocable share of the selling group's consolidated tax liability for Year 2, which is $13,600 and attributable to the deemed sale of T's assets.

(b) The MADSP of $120,000 ($80,000 + $40,000 + 0) is allocated to each asset as follows:

 Allocable

(d) Under paragraph (e)(2) of this section, S1 does not recognize gain or loss upon its sale of the old T stock to P. See section 332. S1 takes into account old T's earnings and profits of $48,350, determined as of the close of the acquisition date but after the deemed sale.

(e) P's basis in new T stock is P's cost for the stock, $80,000. See section 1012.

(f) Under section 1.338(b)-1, the adjusted grossed-up basis for new T is $120,000, i.e., P's cost for the old T stock ($80,000) plus T's liability ($40,000). (Assume there are no other relevant items.) This adjusted grossed-up basis is allocated as basis among the new T assets under sections 1.338(b)-2T and 1.338(b)-3T.

EXAMPLE 2. (a) The facts are the same as in EXAMPLE 1, except that S1 sells 80% of the old T stock to P for $64,000, rather than 100% of the old T stock for $80,000.

(b) The consequences to P, T, and S1 are the same as in EXAMPLE 1, except that:

(i) P's basis for its 80-percent interest in the new T stock is P's $64,000 cost for the stock. See section 1012.

(ii) Under section 1.338(b)-1, the adjusted grossed-up basis for new T is $120,000 (i.e., $64,000/.8 + $40,000 + $0).

(iii) Under paragraph (e)(2) of this section, S1 does not recognize gain or loss with respect to the retained stock in T. See section 332.

(iv) Under paragraph (e)(2)(iii) of this section, the basis of the T stock retained by S1 is $16,000 (i.e., $120,000 - $40,000 (the MADSP amount for the old T assets over the sum of new T's liabilities immediately after the acquisition date) X .20 (the proportion of T stock retained by S1)).

EXAMPLE 3. (a) The facts are the same as in EXAMPLE 2, except that K, a shareholder unrelated to T or P, owns the 20% of the T stock that is not acquired by P in the qualified stock purchase. K's basis in its T stock is $5,000.

(b) The consequences to P, T, and S1 are the same as in EXAMPLE 3, except that S1 takes into account only $38,680 of T's earnings and profits (80% of $48,350).

(c) Under paragraph (e)(3) of this section, K recognizes no gain or loss, and K's basis in its T stock remains at $5,000.

EXAMPLE 4. (a) The facts are the same as in EXAMPLE 1, except that the equipment is held by T1, a wholly-owned subsidiary of T, and a section 338(h)(10) election is made for T1. The T1 stock has a fair market value of $60,000. T1 has no assets other than the equipment and no liabilities. S1 pays old T's and old T1's allocable shares of the selling group's consolidated tax liability for Year 2, which are $5,667 and $7,933, respectively, and attributable to the deemed asset sales by T and T1. As of the close of the acquisition date, but before the deemed sale of the equipment, old T1 has none of the attributes listed in section 381(c).

(b) The MADSP for T1 is $53,333 (i.e., $53,333 + $0 + $0). On the deemed sale, T1 recognizes ordinary income of $23,333. As of the close of the acquisition date, but after the deemed sale of the equipment, T1's earnings and profits are $15,400 ($0 plus $23,333 (T1's deemed sale gain) less $7,933 (T1's allocable share of the consolidated tax liability)).

(c) The MADSP for T is $120,000, allocated $66,667 to the land and $53,333 to the stock. Old T's deemed sale gain is $16,667 (the capital gain on its deemed sale of the land). Under paragraph (e)(2) of this section, old T does not recognize gain or loss on its deemed sale of the T1 stock. See section 332.

(d) Old T takes into account old T1's earnings and profits of $15,400, determined as of the close of the acquisition date but after the deemed sale by T1 of its asset. Thus, as of the close of the acquisition date, but after the deemed sale of old T's assets, old T's earnings and profits are $48,350, ($21,950 (its earnings and profits other than from the deemed sale) plus $15,400 (from T1) plus $16,667 (T's deemed sale gain) less $5,667 (T's allocable share of the consolidated tax liability)).

(e) Under paragraph (e)(2) of this section, S1 does not recognize gain or loss upon its sale of the old T stock to P and takes into account old T's earnings and profits of $48,350, determined as of the close of the acquisition date but after the deemed sale of old T's assets.

EXAMPLE 5. (a) The facts are the same as in EXAMPLE 4, except that P already owns 20% of the T stock, which is nonrecently purchased stock with a basis of $6,000, and that P purchases the remaining 80% of the T stock from S1 for $64,000.

(b) The results are the same as in EXAMPLE 4, except that:

(i) S1 takes into account only $38,680 of old T's earnings and profits.

(ii) Under paragraph (e)(4) of this section and section 1.338(b)-1(e)(2), P is deemed to have made a gain recognition election for its nonrecently purchased T stock. As a result, P recognizes gain of $10,000 and its basis in the nonrecently purchased T stock is increased from $6,000 to $16,000. P's basis in all the T stock is $80,000 (i.e., $64,000 + $16,000). The computations are as follows:

(A) P's grossed-up basis for the recently purchased T stock is $64,000 (i.e., $64,000 (the basis of the recently purchased T stock) X (1 - .2)/(.8) (the fraction in section 338(b)(4)).

(B) P's basis amount for the nonrecently purchased T stock is $16,000 (i.e., $64,000 (the grossed-up basis in the recently purchased T stock) X (.2)/(1.0 - .2) (the fraction in section 338(b)(3)(B)).

(C) The gain recognized on the nonrecently purchased stock is $10,000 (i.e., $16,000 - $6,000).

(h) INAPPLICABILITY OF PROVISIONS. The provisions of section 6043, section 1.331-1(d), and section 1.332-6 (relating to information returns and record keeping requirements for corporate liquidations) do not apply to the deemed liquidation of old T under paragraph (e)(2) of this section.

SECTION 1.338(i)-1 EFFECTIVE DATES.

(a) IN GENERAL. Sections 1.338-1 through 1.338-5, 1.338(b)-1, and 1.338(h)(10)-1 generally are effective for targets with acquisition dates on or after [INSERT DATE THIS DOCUMENT IS PUBLISHED IN THE FEDERAL REGISTER].

(b) ELECTIVE RETROACTIVE APPLICATION. A target with an acquisition date on or after January 14, 1992 and before [INSERT DATE THIS DOCUMENT IS PUBLISHED IN THE FEDERAL REGISTER] may apply sections 1.338-1 through 1.338-5, 1.338-4T(h), 1.338(b)-1, and 1.338(h)(10)-1 by including a statement with its return (including an amended return) for the period that includes the acquisition date to the effect that it is applying all of these sections pursuant to section 1.338(i)-1(b).

(c) MADSP. Section 1.338(h)(10)-1(f), which requires use of the MADSP formula to determine deemed sale price, is effective for qualified stock purchases for which the acquisition date is on or after November 10, 1986, unless the acquisition occurs pursuant to a binding contract entered into before that date.

(d) DEEMED ELECTION. The District Director's discretion to impose (without the taxpayer's consent) a deemed election under section 338(e)(1) and section 1.338-4T(f)(6)(i) (as contained in the CFR edition revised as of April 1, 1993) is revoked for all open tax years.

Par. 7. Section 1.1502-75(k) is added to read as follows:

SECTION 1.1502-75 FILING OF CONSOLIDATED RETURNS.

* * * * *

(k) CROSS-REFERENCE. See section 1.338(h)(10)-1(e)(6) for special rules regarding filing consolidated returns when a section 338(h)(10) election is made for a target acquired from a selling consolidated group.

PAR. 8. Section 1.1502-75T is removed.

PAR. 9. In the list below, for each section indicated in the left column, remove the wording indicated in the middle column from wherever it appears in that section, and add the wording indicated in the right column.

 Affected section              Remove                     Add

PAR. 10. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805

PAR. 11. Section 602.101(c) is amended --

a. by removing the following entries from the table:

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