CFC buyer's sec. 338 election deprives seller of FTCs.

• Author: Zarzar, Robert
• Position: Controlled foreign corporations; foreign tax credits

When a U.S. person sells stock in a controlled foreign corporation (CFC) and recognizes gain, Sec. 1248 may apply to treat all or a portion of the gain as dividend income, to the extent of the shareholder's proportionate share of the CFC's historical earnings. If the seller is a U.S. corporation, it might be able to claim foreign tax credits (FTCs) under Sec. 902 for the deemed dividend. The amount of FTCs available will depend on whether the buyer makes a, Sec. 338 election.

Sec. 338, in general, allows a corporation making a qualified stock purchase (QSP) to elect to treat the stock purchase as an asset acquisition. The target corporation is considered to sell all of its assets to a "new" target corporation as of the close of the acquisition date, and must recognize gain or loss on its assets.

When a U.S. corporation makes a QSP of a foreign target corporation (FT), it generally is advantageous for the purchaser to make a Sec. 338 election to treat the purchase of the FT stock as an asset purchase. For U.S. tax purposes, the Sec. 338 election provides for a basis step-up in the FT's assets and eliminates the FT's pre-acquisition earnings and profits (E&P) and tax pools. The basis step-up in the FT's assets should provide for an increased effective tax rate (ETR) for the FT's E&P in future years. The increased ETR should assist the new U.S. shareholder in claiming additional FTCs on future dividends received from the FT, and perhaps assist the new U.S. shareholder in avoiding future taxable income inclusions for the FT's activities under the subpart F rules.

If the buyer makes a Sec. 338 election for the CFC, the gain from the deemed-asset sale increases the CFC'S E&P to the extent of the net inside gain of the CFC's assets. The gain from the deemed sale of assets would increase the Sec. 1248 deemed dividend (limited by the recognized gain on the stock sold), thereby recharacterizing an additional portion of the seller's gain as dividend income (typically general-basket foreign-source income) that carries FTCs--a beneficial result for the seller.

To prevent taxpayers from receiving an FTC benefit from this increased dividend, Congress enacted Sec. 338(h)(16), which provides that the deemed-sale provisions of Sec. 338 do not apply for purposes of determining the source or character of any item for FTC purposes (i.e., Secs. 901-908). Sec. 338(h)(16), however, does not apply to any gain, to the extent such gain is includible in gross income...