338 election analysis

FACTS
 
In November 1997, ABC COMPANY is planning to acquire XYZ COMPANY of Sweden by exchanging ABC COMPANYcommon shares for all of the outstanding shares in XYZ COMPANY. For accounting purposes, the acquisition will be treated as a pooling of interests.
 
None of the existing shareholders of XYZ COMPANY is a U.S. citizen or resident alien. XYZ COMPANY is not a controlled foreign corporation and has never operated a trade or business in the U.S.   
 
ISSUE
 
For U.S. tax purposes, should ABC COMPANY file a Section 338 election for XYZ COMPANY?  If so, how should the transaction be structured? 
 
CONCLUSION 
 
Yes, the election should be filed for two reasons: (1) It increases the tax basis in XYZ COMPANY's assets, which should benefit ABC COMPANY on future dividend repatriations; and (2) the election purges any existing earnings and profits or deficit thereof. 
 
The easiest method to structure a Section 338 election is to implement a stock-for-stock exchange that fails as a tax-free Type B reorganization, thereby converting the transaction to a qualified stock purchase under Section 338(d)(3). ABC COMPANY can trigger a failed Type B transaction by allowing a second tier U.S. subsidiary (FSA Combination Corp.) to exchange grandparent stock (ABC COMPANY common stock) for all of the XYZ COMPANY stock. 
 

DISCUSSION
 
1.  Mechanics of Sec. 338:  In a Section 338 election, the acquired company (old target) is first treated as having sold all of its assets at fair market value, recognizing gain or loss in the transaction. Then, the acquired company (new target) is treated as having repurchased the same assets at FMV on the next day, thereby giving it a cost basis in its assets.[1]  The election  has the effect of purging the target's prior tax history.[2] It does not affect the purchasing corporation's basis in the target stock. While a Section 338 election is normally a taxable event for a U.S. acquired company, it is not taxable if the acquired company is a foreign entity that is (1) not a controlled foreign corporation and (2) has not been carrying on a U.S. trade or business prior to the election. XYZ COMPANY and the shareholders of XYZ COMPANY meet both of these requirements and thus will not face any U.S. tax exposure from the Section 338 election.
 
2.  Benefits of a Sec. 338 election:  For a foreign acquisition, the benefits of a Section 338 election are twofold. First, the election increases the target's inside bases in its assets which is generally a benefit under the U.S. foreign tax credit rules. A step up in basis means that the target will have lower earnings and profits ("E&P") as a result of larger deductions for depreciation and amortization.[3]  Lower e&p means that ABC COMPANY should be able to recognize less dividend income on future distributions from XYZ COMPANY.
 
For example, assume XYZ COMPANY records after-tax earnings of $3 million over the next three years and for U.S. E&P purposes has depreciation and amortization deductions of $300,000.  On a full distribution of $3 million, ABC COMPANY will treat $2.7 million as a taxable dividend from XYZ COMPANY's E&P and the remaining $300,000 as a tax-free return of capital.[4]
 
A Section 338 election may have the effect of creating excess foreign tax credits ("FTC") if the effective foreign tax rate of XYZ COMPANY exceeds the U.S. statutory rate. However, this result should also be viewed as a benefit insofar as ABC COMPANY can utilize excess FTC on a carryback or carryfoward basis. Under the U.S. foreign tax credit rules, the effect of reducing E&P is to increase the effective tax rate on amounts distributed as a dividend. Because the Swedish statutory rate (28%) is less than the U.S. rate (35%), it would appear that ABC COMPANY's future distributions from XYZ COMPANY will not generate excess FTC.[5] However, if excess FTC is generated (i.e., due to other E&P deductions and expense allocations), then ABC COMPANY should be able to utilize these credits by coordinating its distributions from other low-tax sources and/or by taking the FTC benefit on a carryover basis. Thus, from an FTC perspective, a Section 338 election should generally be viewed as a net benefit regardless of whether the acquired entity is in a high tax or low tax jurisdiction.
 
The additional E&P deductions allowed under a Section 338 election will also affect such items as the high tax exception and the de minimus rule under Subpart F. In addition, XYZ COMPANY's step-up in basis will slightly increase the amount of interest expense that ABC COMPANY must allocate to foreign source income under the Section 904 FTC limit. The effect of these adjustments is not expected to be significant given ABC COMPANY's overall Subpart F exposure in Sweden and its consolidated interest expense amount.   
 
The second benefit is administrative. The Section 338 election allows ABC COMPANY to purge the prior tax history of XYZ COMPANY and avoids the need to recalculate XYZ COMPANY's starting e&p under U.S. rules.
 
3.  Structuring the QA acquisition:  The easiest method to structure the XYZ COMPANY acquisition is to utilize FSA Combination Corp. ("FSA Combo. Corp."), a 100% owned U.S. subsidiary of FSA Subsidiary Corporation.  FSA Subsidiary Corporation is a 100% owned U.S. subsidiary of ABC COMPANY. Because FSA Combo. Corp. is a second tier subsidiary of ABC COMPANY, its use of grandparent stock (ABC COMPANY stock) in a share-for-share exchange with XYZ COMPANY shareholders will not qualify as a tax-free "Type B" reorganization under Section 368(a)(1)(B).[6]  Using a "busted B" transaction to acquire XYZ COMPANY converts the transaction to a qualified stock purchase,[7] thereby allowing ABC COMPANY to make a Section 338 election for the acquired entity. At the end of the transaction, FSA Combo. Corp. owns all of the shares of XYZ COMPANY and its basis in these shares equals the value of the ABC COMPANY stock transferred to the former XYZ COMPANY shareholders.
 
The steps of the proposed transaction are as follows. First, ABC COMPANY contributes the agreed upon number of shares to FSA Corporation, which in turn contributes these shares to FSA Combo. Corp. These transactions qualify for tax-free treatment as contributions of property to a controlled corporation under Section 351. FSA Combo. Corp. holds the ABC COMPANY stock.  Generally, the basis of the MacAfee stock held by FSA Combo. Corp. would be zero, because ABC COMPANY would have transferred the stock in a succession of transfers that would qualify for nonrecognition under section 351.  Second, FSA Combo. Corp. transfers the ABC COMPANY stock to the XYZ COMPANY shareholders in exchange for all of their XYZ COMPANY stock.[8] As noted above, this transfer does not qualify as a tax-free reorganization because FSA Combo. Corp. is transferring grandparent stock, rather than parent stock.
 
Normally, a transfer of ABC COMPANY stock by FSA Combo. Corp. in a taxable exchange would cause FSA Combo. Corp. to recognize gain equal to the fair market value of the stock (its basis in the stock being zero).  However, under the consolidated return regulations, FSA Combo. Corp. is not subject to tax.  Section 1.1502-13T(f)(6)(ii) provides that if a member of a consolidated group acquires stock of its common parent and disposes of the stock in a transaction (a "qualified disposition") in which certain conditions are satisfied, then the subsidiary is treated as purchasing the stock for an amount of cash equal to the fair market value of the parent stock.  A disposition is a "qualified disposition" if (i) the subsidiary acquires the parent stock directly from the parent as a contribution to capital or in a section 351 transaction (or a series of such transactions involving only members of the consolidated group), (ii) the subsidiary "immediately" transfers the stock outside the consolidated group to a person unrelated to any member of the group, (iii) the recipient of the parent stock does not take a substituted basis in the stock, (iv) the parent stock is not exchanged for other parent stock, (v) the parent does not become, or cease to be, the common parent of the group as a  result of the transaction, and (vi) the subsidiary does not become, or cease to be, a member of the group as a result of the transaction.   The present transaction appears to meet all of those requirements, so that FSA Combo. Corp.'s basis in the ABC COMPANY shares used to acquire XYZ COMPANY would equal the fair market value of the stock at the time MacAfee transferred the shares to FSA Combo. Corp.  Although the disposition of shares to the XYZ COMPANY shareholders would be a taxable exchange, there should be no gain recognized on the transaction.  The XYZ COMPANY shareholders would be subject to tax, but as foreign citizens and non-U.S. residents they are not within U.S. tax jurisdiction. After exchanging ABC COMPANY shares for the XYZ COMPANY shares, FSA Combo. Corp. ends up holding 100% of the shares in XYZ COMPANY and has a cost basis in these shares.[9] The basis amount equals the value of the transferred ABC COMPANY shares.   To ensure that the transaction meets the applicable criteria for a "qualified disposition," the transaction documents should provide that the transfers of ABC COMPANY stock used as consideration will be transferred to FSA Combo. Corp. as part of the overall acquisition plan, and ideally ABC COMPANY will transfer the shares to its subsidiary promptly before the acquisition of XYZ COMPANY.
 
The third step is for ABC COMPANY to file a Section 338 election for XYZ COMPANY, thereby increasing the basis in XYZ COMPANY's assets to fair market value. The steps required to file this election are detailed in Part 4 below.
 
4.  Reporting requirements: To make the Section 338 election, ABC COMPANY needs to file Form 8023-A with the IRS by the 15th day of the ninth month following the month of acquisition. Thus, if ABC COMPANY acquires XYZ COMPANY in November 1997, then Form 8023-A is due by August 15, 1998. ABC COMPANY also must attach Form 8023-A with its Form 5471 information return for the initial reporting year for XYZ COMPANY (i.e., tax year 1997). 
 
Regarding purchase price allocation, the FMV of XYZ COMPANY needs to be allocated among five classes of XYZ COMPANY assets in accordance with Reg. Sec. 1.338(b)-2T. It is prudent to obtain an outside purchase price allocation of the assets in order to withstand scrutiny from the IRS.
 
Below is a list of information needed to complete Form 8023-A and the requirement attachments:
 

Full name and address of XYZ COMPANY.
Tax year end date of XYZ COMPANY.
Acquisition date, percent of stock acquired, and type of stock acquired.
Total consideration paid by ABC COMPANY (description and amount).
XYZ COMPANY balance sheet (in local currency with USD conversion) on or near the acquisition date.
A list of XYZ COMPANY's assets, including any identifiable intangible assets and the FMV of such assets.
Confirmation that XYZ COMPANY did not have any income, gain, or loss from a U.S trade or business.
Confirmation that XYZ COMPANY has never filed a U.S. tax return and does not have a FEIN.
Confirmation that no XYZ COMPANY shareholders are U.S. citizens or U.S. resident aliens.
 
  
 
 
 


[1]Sec. 338(a)
[2]Sec. 338(a)(2).
[3]The calculation of E&P for a foreign corporation takes into account deductions for tax depreciation and amortization of Sec. 197 intangibles (i.e., goodwill and in-process technology). Sec. 312(k).
[4]Sec. 301(c).
[5]While the Swedish statutory rate is safely below the U.S. rate, XYZ COMPANY's future effective tax rate is difficult to predict given the interplay between foreign taxes, expense allocations and other e&p adjustments (i.e., stock option deductions).
[6]Sec. 368(a)(1)(B) (see parenthetical language, indicating that only parent stock may be used to qualify as a reorganization); Sec. 368(a)(2)(E). See Reg. 1.368-2(j)(7), Exs. (4) and (5) (use of parent stock to qualify broken Type A transactions as valid triangular B reorganizations).
[7]Sec. 338(d)(3).
[8]This outbound transfer of ABC COMPANY stock is not a Section 351 transfer, therefore it is not subject to the rules of Section 367.
[9]Sec. 1012.

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