United States: Section 338(h)(10)

I. INTRODUCTION

Generally, the result of a section 338(h)(10) election is to treat the purchase and sale of the stock of a target corporation as the purchase and sale of the assets of the target corporation, followed by a distribution of the proceeds of the deemed asset sale to the selling shareholders, after which the target corporation ceases to exist. Part I of this outline provides a brief overview of section 338 and section 338(h)(10) and discusses the final regulations under section 338. Part II provides an example of a typical acquisition in which a section 338(h)(10) election might be made, and analyzes the results. Parts III-VII provide a more detailed analysis of the operation and effect of section 338(h)(10).

Except as otherwise noted, in this outline "T" or "target" will represent the target corporation, "P", the "purchasing corporation" or the "purchaser" is the corporation that makes a qualified stock purchase of T, and "S" or the "seller" is a domestic corporation (unrelated to P) that owns T before the purchase of T by P.

A. Overview of Section 338

A general overview of section 338 is helpful to understand section 338(h)(10).

1. Operation of section 338

In general, section 338 operates as follows:

a. Purchase and election

(1) In one or more transactions occurring within a 12-month period (the "acquisition period"), the purchasing corporation ("P") must "purchase" at least 80 percent of the stock of a target corporation ("T"). The first date on which P has "purchased" at least 80 percent of T's stock is the "acquisition date."

(2) P must then make an election to have section 338 apply within 8½ months after the month in which the acquisition date occurs. (This period corresponds to the time period for filing a corporate income tax return for "Old T," including extensions.) See sections 6072(b), 6081(a).

b. Deemed sale of assets

(1) If a qualifying purchase and election occur, T is treated as if it sold all of its assets in a single, fully taxable transaction. See Section 338(a).

(2) In this hypothetical sale, which takes place at the close of the acquisition date, T is both the seller and the purchaser.

(a) As the seller, T is characterized as "Old T", a corporation whose existence for tax purposes terminates on the acquisition date.

(b) As the purchaser, T is "New T," a corporation whose existence for tax purposes begins on the day after the acquisition date.

(3) The hypothetical selling price of all of the T assets is the "grossed-up" amount realized on the sale of the T stock plus the liabilities of Old T. The hypothetical purchase price is equal to P's basis in its "recently purchased" T stock, "grossed up" to reflect the value of any T stock not held by P on the acquisition date, plus P's basis in any "nonrecently purchased" stock, plus the liabilities of New T.

2. Consequences of the sale

a. As a result of the deemed asset sale, Old T (now owned by P) incurs all appropriate tax liabilities, and its tax attributes disappear.

b. As a result of the deemed asset purchase, New T holds the assets with a FMV cost basis if FMV was paid for the T stock.

c. The deemed asset sale by T does not affect the tax treatment of the actual sale of T stock by its shareholders. The selling shareholders of T recognize any gain or loss on the actual sale of the T stock.

d. Similarly, minority shareholders who retain their T stock are not deemed to engage in a sale of their Old T shares for New T shares even though they become shareholders in New T.

3. Liquidation of T

a. In contrast to prior law, there is no need to liquidate T in order to obtain a FMV cost basis for T's assets under section 338. The treatment described above obtains regardless of whether T is actually liquidated.

b. Indeed, an actual liquidation in the absence of a section 338 election will result in a carryover basis to P under section 334(b)(1). See Rev. Rul. 90-95, 1990-2 C.B. 67.

(1) Section 338 preempts the non-statutory rule of Kimbell-Diamond Milling Co. v. Commissioner, 14 T.C. 74 (1950), aff'd, 187 F.2d 718 (5th Cir. 1951) (stock purchase followed by a previously planned liquidation treated by court as a purchase of assets, with the result that the purchaser took a basis in the acquired assets equal to the cost of the stock).

(2) The combination of nonelection under section 338 and liquidation pursuant to a plan adopted within two years of the acquisition date, however, may trigger section 269(b), which allows the Treasury Secretary to disallow certain tax benefits if the principal purpose of the liquidation is the evasion or avoidance of Federal income taxes. See CCA 200238025 (June 14, 2002) (discussing the application of section 269(b)).

4. Consistency provisions

a. In accordance with the legislative purpose to prevent P from selectively stepping up the basis of acquired assets, the regulations under section 338 contain consistency rules.

b. The old temporary regulations contained a complex set of consistency rules. In general, these rules required P (and its affiliates) to treat all acquisitions from T or T's affiliates consistently as either stock purchases or asset purchases.

c. Following the Tax Reform Act of 1986, P.L. 99-514 ("TRA 86") and the repeal of the so-called General Utilities doctrine, the opportunity for abusive transactions was considerably narrowed. The final regulations (previously Treas. Reg. §§ 1.338-4, and -5, now renumbered as -8 and -9) reflect this by greatly simplifying the consistency rules and limiting their scope.

5. Benefits of a section 338 election

In general, a section 338 election is of economic value to the purchasing corporation only if the present value of future tax savings resulting from the "step-up" in basis of the T's assets exceeds the current tax cost of such a step-up.

a. TRA 86 substantially amended the corporate tax provisions dealing with distributions and liquidating sales. Conforming amendments were made to section 338.

(1) The amendments greatly reduce the utility of section 338 as a mechanism to achieve a basis step-up in acquired assets.

(2) To achieve a basis step-up under section 338, T must recognize the full gain or loss inherent in its assets. Previously, under old section 338, the cost of basis step-up was limited to recapture and similar items.

(3) As a result, the present value of future tax savings (e.g., increased depreciation deductions) will rarely be greater than the current tax cost of the step-up. An election under section 338 will make economic sense only in limited situations, such as in the case of a foreign target or where the target corporation has sufficient loss carryovers to offset the section 338 gain.

b. However, section 338 has continued vitality under section 338(h)(10) inasmuch as this section provides for an asset basis step-up with only a single level of corporate tax.

B. Overview of Section 338(h)(10)

1. Basics of section 338(h)(10)

In the context of certain qualified stock purchases of a target corporation ("T"), the purchasing corporation ("P") and the seller (selling consolidated group, selling affiliate or S corporation shareholders) ("S") may make a joint election under section 338(h)(10) to treat the sale of T stock as if T sold all of its assets in a single transaction.

2. Consequences of a section 338(h)(10) election to S

Generally, for a T that is a member of a consolidated group:

a. No gain or loss will be recognized by members of the selling group on their sale of T stock (except as provided by regulations), but T will recognize gain or loss as if it had actually sold all its assets while included as a member of the selling group.

b. As a result, the tax on T's gain resulting from a section 338(h)(10) election is generally paid by the selling consolidated group. Such gain can be offset by the losses, if any, of the selling group but not the purchasing group. As discussed in more detail below, any losses in excess of the gain remain with the selling consolidated group.

See Part V.B.1., below for consequences if T is a member of an affiliated nonconsolidated group or an S corporation.

3. Consequences of a section 338(h)(10) election to P 

T's basis in its assets will be revalued to reflect the purchase price paid by P for the T stock.

4. Scope of section 338(h)(10)

a. As originally enacted, section 338(h)(10) was limited to the sale of stock of a target corporation that was a member of an affiliated group of corporations filing a consolidated return. 

b. Regulations have expanded the scope of section 338(h)(10) to include the sale of stock of a target: (1) that is a member of an affiliated group of corporations filing separate returns, or (2) that is an S corporation. See Treas. Reg. § 1.338(h)(10)-1(b), (c) and old Treas. Reg. § 1.338(h)(10)-1(a),(c).

C. The Final Regulations

1. In general

a. Final regulations, T.D. 8940 (February 12, 2001) (the "final regulations" or "new regulations") replaced temporary regulations issued January 5, 2000, T.D. 8858 (January 5, 2000) (the "temporary regulations"). The temporary regulations replaced Treas. Reg. §§ 1.338-0 through 1.338-3; 1.338(b)-1, -2T and -3T; 1.338(h)(10)-1; and 1.338(i)-1 (the "old regulations"). Treas. Reg. §1.338-4 and -5 (relating to asset and stock consistency and international aspects of section 338) were retained, but were renumbered as -8 and -9. The final regulations also replace Temp. Treas. Reg. § 1.1060-1T.

b. The final regulations are generally effective for qualified stock purchases occurring on or after March 16, 2001. Treas. Reg. § 1.338(i)-1. The temporary regulations are generally effective for qualified stock purchases occurring after January 5, 2000 but before March 16, 2001. Temp. Treas. Reg. § 1.338(i)-1T. For qualified stock purchases on or before January 5, 2000, the old regulations continue to apply.

c. The final regulations are substantially the same as the temporary regulations and proposed regulations that were published on August 10, 1999. Notice of Proposed Rulemaking REG-107069-97, 64 Fed. Reg. 43461 (August 10, 1999) (the "proposed regulations").

d. To the extent that the same result would be reached under the temporary regulations and the final regulations, this outline refers, and cites to, the final regulations. When appropriate, this outline highlights differences between the final regulations and the temporary regulations.

e. In addition, this outline refers to the preamble to the Notice of Proposed Rulemaking (the "preamble to the proposed regulations"), in order to explain certain provisions in the final regulations or the temporary regulations.

2. Overview

a. The preamble to the proposed regulations states that the proposed (now final) regulations were intended to clarify the treatment of, and provide consistent rules (where possible) for, both deemed and actual asset acquisitions under sections 338 and 1060. The changes made by the final regulations have four major components: (i) organization of the regulations; (ii) clarification and modification of the accounting rules applicable to deemed and actual asset acquisitions; (iii) modifications to the residual method mandated for allocating consideration and basis; and (iv) miscellaneous revisions to the old regulations.

b. A brief summary of some of the more significant provisions of the final regulations follows. These provisions are discussed in the order in which they appear in the final regulations. Many of these provisions are also discussed in more detail in other parts of this outline.

3. Organization of the regulations

The preamble to the proposed regulations states that the proposed (now final) regulations change the organization of the regulations in order to make the rules for all asset acquisitions more administrable and provide consistent treatment, when appropriate, for deemed and actual asset acquisitions. 

4. Treas. Reg. § 1.338-1 -- General principles; status of old target and new target

a. The final regulations provide that if a section 338 election is made, Old T is treated as transferring all of its assets to an unrelated person in exchange for consideration that includes the discharge of its liabilities, and New T is treated as acquiring all of its assets from an unrelated person in exchange for consideration that includes the assumption of, or taking subject to, liabilities. If a section 338(h)(10) election is made, Old T is also deemed to liquidate following the deemed asset sale. Treas. Reg. § 1.338-1(a).

b. The final regulations provide that other rules of law apply to determine the tax consequences to the parties as if they had actually engaged in the transactions deemed to occur under section 338 and the regulations thereunder except to the extent otherwise provided in the regulations. For example, if T is an insurance company for which a section 338 election is made, the deemed asset sale would be characterized and taxed as an assumption-reinsurance transaction under applicable Federal income tax law. See Treas. Reg. § 1.338- 1(a)(2).

c. The final regulations include an anti-abuse rule. Under the final regulations, the Commissioner, for purposes of calculating and allocating the sales price and purchase price, has the authority under certain circumstances (a) to treat as not being part of T's assets those assets added to the pool of T's assets before the deemed asset sale and (b) to treat as being part of T's assets those assets removed from the pool of T's assets before the deemed asset sale. Treas. Reg. § 1.338-1(c).

d. The final regulations include a next day rule to section 338 transactions. Treas. Reg. § 1.338-1(d). The next day rule is intended to ensure that all tax liability stemming from a post acquisition sale of acquired assets falls on the acquiring corporation by providing that the target and all persons related thereto must treat a post acquisition sale of assets as occurring at the beginning of the day following the transaction and after the deemed purchase of new target. NOTE – No such rule exists under the temporary regulations applicable to qualified stock purchases before March 16, 2001 and after January 5, 2000.

5. Treas. Reg. § 1.338-2 -- Nomenclature and definitions: mechanics of the section 338 election.

a. Four definitions of terms that were already used in the old regulations have been added to the final regulations. These terms are acquisition date asset, deemed asset sale, deemed sale gain, and deemed sale return. The scope of some of these terms has been expanded from their usage in the old regulations.

b. Additionally, the definitions of certain terms have been modified.

c. In particular, the final regulations modify the definition of selling group to provide that a section 338(h)(10) election may be made for target notwithstanding that it was at some time during the year in which the acquisition date occurs the common parent of its affiliated or consolidated group, so long as it is not the common parent on the acquisition date. See Treas. Reg. § 1.338-2(c)(16).

6. Treas. Reg. § 1.338-3 -- Qualification for the section 338 election

A section 338 election may be made only with respect to a transaction that qualifies as a purchase within the meaning of section 338(h)(3).

a. The proposed regulations provided that a purchase of T stock occurs so long as more than a nominal amount is paid for the stock. Old Prop. Treas. Reg. § 1.338-3(b)(2)(ii). In response to comments received on this provision, the temporary regulations removed this provision and reserved this issue pending further consideration of the comments. Temp. Treas. Reg. § 1.338-3T(b)(2)(ii).

b. The final regulations do not adopt the definition of purchase from the proposed regulations. Rather, the final regulations include a single definition of purchase applicable to both targets and target affiliates. This definition generally conforms to the definition of purchase of target affiliate in the temporary regulations. Under this definition, stock in a target (or target affiliate) may be considered purchased if, under general principles of tax law, the purchasing corporation is considered to own the stock of the target (or the target affiliate) meeting the requirements of section 1504(a)(2), notwithstanding that no amount may be paid for (or allocated to) the stock. See Treas. Reg. § 1.338-3(b)(2).

c. Under section 338(h)(3)(A)(iii), the parties to a section 338 transaction must be unrelated in order for the transaction to qualify as a purchase. The statute is unclear as to when the relationship between the parties is tested. The final regulations provide that the relationship between the purchaser and seller is tested immediately after the transaction. See Treas. Reg. § 1.338-3(b)(3)(ii).

Specifically:

(1) In the case of a single transaction, immediately after the purchase of the T stock;

(2) In the case of a series of acquisitions otherwise constituting a qualified stock purchase, immediately after the last acquisition in such series;

(3) In the case of a series of transactions effected pursuant to an integrated plan to dispose of T stock, immediately after the last transaction in such series.

7. Treas. Reg. §§ 1.338-4, 1.338-5, 1.338-6 and 1.338-7 -- Aggregate deemed sale price; various aspects of taxation of the deemed asset sale; adjusted grossed-up basis; allocation of aggregate deemed sale price and adjusted grossed-up basis

The final regulations make several changes to the definition, calculation, allocation and other aspects of aggregate deemed sale price and adjusted grossed-up basis. A few of these provisions are discussed below.

a. The final regulations change the number and content of the asset classes. Treas. Reg. § 1.338-6(b) provides that basis is allocated to seven asset classes as opposed to five asset classes under the old regulations. The new asset classes are designed to put certain "fast pay" assets into more senior classes than currently provided.

b. The final regulations remove the link in the old regulations between the calculation of the first element of ADSP and the purchaser's basis in recently purchased T stock. This change, combined with changes to the timing rules, results in the elimination of "open-transaction" treatment that was provided in the old regulations.

c. Regarding the timing of taking liabilities into account, the final regulations provide that general principles of tax law apply in determining the timing and amount of the elements of ADSP and AGUB. Accordingly, the rule in the old regulations that liabilities are taken into account in calculating ADSP and AGUB, only when such liability becomes fixed and determinable was removed in the final regulations. See Treas. Reg. §§ 1.338-4(b)(2) and 1.338-5(b)(2).

d. The "other relevant items" that were included in the calculation of MADSP under the old regulations are not included in the calculation of ADSP under the final regulations.

e. The final regulations provide that, for New T, the definition of AGUB is changed, such that when the P's basis in recently purchased stock is grossed-up, acquisition costs are no longer also grossed-up.

8. Treas. Reg. § 1.338(h)(10)-1 --Deemed asset sale and liquidation

a. Treas. Reg. § 1.338(h)(10)-1 describes the model on which taxation of the section 338(h)(10) election is based. Under the model in the final regulations:

(1) Old T is treated as transferring all of its assets by sale to an unrelated person.

(2) Old T recognizes the deemed sale gain while a member of the selling consolidated group, or owned by the selling affiliate, or owned by the S corporation shareholders (both those who actually sell their shares and any who do not).

(3) Old T is then treated as transferring all of its assets to members of the selling consolidated group, the selling affiliate, or S corporation shareholders and ceasing to exist.

(4) If T is an S corporation, the deemed asset sale and deemed liquidation are considered as occurring while it is still an S corporation.

b. The preamble to the proposed regulations states that the proposed (now final) regulations treat all parties concerned as if the transactions that are deemed to occur under section 338(h)(10) actually did occur, or as closely thereto as possible.

c. Old T generally may not obtain any tax benefit from the section 338(h)(10) election that it could not obtain if it actually sold its assets and liquidated. Treas. Reg. § 1.338(h)(10)-1(d)(9).

d. The old regulations provided that as a result of a section 338(h)(10) election Old T was deemed to sell all of its assets and distribute the proceeds in complete liquidation. The final regulations do not mention the term "complete liquidation" but instead provide that Old T is treated as if it transferred all of its assets to members of the selling consolidated group, the selling affiliate, or S corporation shareholders and then ceased to exist. Treas. Reg. § 1.338(h)(10)-1( d)(4).

e. The final regulations provide that when T is an S corporation, any direct or indirect subsidiaries of T which T has elected to treat as qualified subchapter S subsidiaries under section 1361(b)(3) remain qualified subchapter S subsidiaries through the close of the acquisition date. However, the final regulations provide that no similar rule applies when a qualified subchapter S subsidiary, as opposed to the S corporation that is its owner, is the target the stock of which is actually purchased. See Treas. Reg. § 1.338(h)(10)-1( d)(3).

f. The final regulations make the section 453 installment method available to Old T in its deemed asset sale, as long as the deemed asset sale would otherwise qualify for installment sale reporting. For purposes of section 453, New T is considered to be the obligor on  the installment obligation the purchasing corporation actually issued. Treas. Reg. § 1.338(h)(10)-1(d)(8).

g. The final regulations provide that, in the case of parent-subsidiary chains of corporations making section 338(h)(10) elections, the deemed asset sale at the parent level is considered to precede that at the subsidiary level. Treas. Reg. § 1.338(h)(10)-1(d)(3)(ii). The final regulations then provide, however, that the deemed liquidation of the subsidiary is considered to precede the deemed liquidation of the parent. Treas. Reg. § 1.338(h)(10)-1(d)(4)(ii). 

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