Section 338(g) Election for the Acquisition of a Foreign Target Corporation

A Section 338 election has the effect of recharacterizing a taxable stock acquisition as a deemed asset acquisition. The advantage to the buyer is the step up in the basis of the assets deemed acquired to the fair market value on the date of purchase. In the context of a cross-border acquisition, there are some advantages and disadvantages to making an I.R.C. Section 338(g) election when a US buyer acquires stock of a foreign corporation.

The main possible disadvantage of a Section 338(g) election for a foreign target corporation is the effect of a provision referred to as I.R.C. Section 901(m). This provision effectively reduces foreign tax credits available to a US corporate acquirer. The reduction occurs in order to account for increased foreign corporate taxes that are paid by the foreign target corporation. This happens because the stepped up basis in the foreign target’s assets from the Section 338(g) election may result in additional depreciation and amortization deductions which are allowable from the US tax perspective but not for foreign tax purposes. Section 901(m) effectively disallows a foreign tax credit for foreign taxes paid on the foreign target’s income which otherwise would not be recognized for US federal tax purposes.

Even with the impact of Section 901(m), the Section 338(g) election may prove to be more favorable in terms of the foreign target’s effective foreign tax rate as compared to not making the election. The Section 338(g) election may also provide other benefits, such as limiting the US acquirer’s Subpart F income in the year of acquisition. The election results in a closing of the foreign target’s taxable year, which effectively eliminates the US acquirer’s pre-acquisition Subpart F income. Other consequences of the election include a decrease in the foreign target’s earnings and profits by the depreciation and amortization deductions allowable for US tax purposes. Subpart F income also could be decreased if those deductions are properly allocated and apportioned to such income based on US federal tax principles.

It is important to quantify the impact of Section 901(m) and the differences in the foreign target’s effective foreign tax rate with and without a Section 338(g) election. Other possible disadvantages of a Section 338 election also should be considered for a US seller of a foreign corporation.

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