Cross-Border M&A: Section 338(g) Elections After TCJA

338(g) Elections at a glance

• The main takeaway: Subject to certain requirements, U.S. corporate taxpayers who acquire stock of a foreign corporation often make a section 338(g) election for advantageous U.S. federal income tax outcomes.
• Impact on your business: A section 338(g) election has different implications for buyers and sellers after the Tax Cuts and Jobs Act (TCJA).
• Next steps: Contact Aprio’s International Tax Services team for expert assistance with navigating the complex tax implications associated with international M&A transactions.

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338(g) election – the full story:

When exploring avenues to grow their business, a U.S. corporate taxpayer may expand offshore by purchasing a foreign business. Similar to a domestic acquisition, an initial structuring question the taxpayer must address is whether to purchase stock or assets of the foreign target.

Often, a buyer and seller may have adverse interests when structuring an acquisition. The negotiation and ultimate structural choice will be derived by the parties through the analysis of alternatives with which they can weigh competing tax and nontax considerations.

For a domestic corporate buyer of the stock of a foreign corporation, an election under section 338(g) has been a longstanding tax planning tool that permits the buyer to treat the transaction as an asset purchase for U.S. federal income tax purposes.

If an actual asset acquisition is not possible, corporate domestic acquirers of a foreign corporation can make a section 338(g) election to create the same U.S. federal income tax effect. The section 338(g) election has not changed after the TCJA, but the buyer and seller implications have changed, which can alter the considerations and structuring of cross-border transactions.

In this article, we highlight the impacts of a section 338(g) election for domestic corporate buyers and domestic corporate sellers, with respect to a foreign target characterized as a controlled foreign corporation (CFC) — generally, a foreign corporation owned more than 50% by U.S. persons who each own at least 10%.

How domestic corporate buyers are affected by 338(g) elections

When a purchaser makes a section 338(g) election, the foreign target entity (the “old target”) is treated as if it sold its assets at the close of the acquisition date. The old target is then deemed the “new target,” which purchases the old target’s assets as of the beginning of the day after the acquisition. This hypothetical asset sale typically causes corporate-level gain and tax.

By making a section 338(g) election, a domestic corporate purchaser typically enjoys a step-up in basis in foreign target assets, eliminates historic U.S. federal income tax attributes (e.g., earnings and profits and foreign tax pool) and closes the foreign target’s tax year. Additionally, in the case of a CFC sale, the consequence of a section 338(g) election can result in subpart F and/or global intangible low-taxed income (GILTI) to the seller. Subpart F and GILTI both require the domestic corporate seller to include foreign income of a CFC in their gross income, subjecting it to current U.S. income tax.

The GILTI regime was introduced with the TCJA and will generally encourage domestic corporate acquirers to structure purchases of CFCs as taxable asset transactions to reduce the amount of their GILTI inclusions going forward. A section 338(g) election may reduce a domestic buyer’s post-acquisition GILTI inclusion amount, because asset basis step-up can be written off in computing the amount of the GILTI inclusion for post-acquisition years as well as increase the qualified business asset investment amount.

Notwithstanding, going forward, it is generally desirable to make a section 338(g) election, despite the loss of the foreign tax credits under section 901(m).

How domestic corporate sellers are affected by 338(g) elections

From a domestic corporate seller perspective, a gain on the sale of CFC stock is recharacterized as a dividend under section 1248 if the CFC has any untaxed earnings and profits (E&P). That dividend amount should qualify for the 100% dividend received deduction under section 245A subject to a one-year holding period requirement; under current rates, the remaining capital gain is taxed at 21%.

Because a buyer’s section 338(g) election results in a CFC tax-year closure as of the transaction, a gain from the hypothetical asset sale will either be subpart F income or GILTI and included in the gross income of the domestic seller rather than the buyer. Generally, GILTI income will normally be included in the domestic corporate seller’s gross income and be subject to an effective tax rate of 10.5% (notwithstanding any foreign tax credits). The domestic seller is also taxed on the sale of CFC stock, but its basis in the CFC stock is increased by the amount of subpart F or GILTI inclusion caused by the hypothetical asset sale, reducing the amount of the stock sale gain.

Despite the fact that section 1248 and 245A may cause any stock gain recharacterized as a dividend to not be subject to tax, any remaining capital gain is subject to tax at 21%. Because a buyer’s section 338(g) election may cause the domestic corporate seller to pay GILTI tax at 10.5% rather than 21%, the election can produce a more favorable tax result for the seller.

For example, consider a domestic corporation that sells stock in a CFC for $1,000 and holds such stock at a $500 basis. The seller has held the stock for longer than one year and the sale results in a $500 gain. If the untaxed E&P of the CFC from prior years attributable to the seller is $200 and no section 338(g) election is made, $200 of the gain is characterized as a dividend and with an offsetting $200 deduction, not subject to tax. The remaining $300 of the gain is subject to tax at 21% ($63 of tax).

Alternatively, consider that the buyer makes a section 338(g) election, and the CFC recognizes $100 of asset gain subject to GILTI and has another $50 of operational income through the date of sale, which is also subject to GILTI. Because the CFC tax year closes, the seller is generally taxed on $150 of GILTI income at 10.5% ($15.75 of tax). The seller’s basis in the CFC would increase by $150. After the basis increase, the seller would have $350 of gain on the stock sale and $200 (i.e., the prior untaxed E&P above) would be characterized as a dividend eligible for a corresponding $200 deduction. The remaining gain of $150 would be subject to tax at 21% ($31.50 of tax). The seller’s overall tax cost would be reduced by $15.75 of tax ($63 minus $47.25).

The bottom line

As noted, while a section 338(g) election can have favorable U.S. federal income tax consequences for a buyer, it can also materially reduce the seller’s tax cost under certain circumstances. In particular, a seller should model the U.S. federal tax impact prior to a CFC disposition and potentially address any section 338(g) elections in its transaction agreements.

Aprio’s International Tax Services team can help you navigate section 338(g) elections and the other complex tax implications associated with international M&A transactions. Schedule a consultation with us today.