United States: Section 338

Originally published June 2003

TABLE OF CONTENTS

I. INTRODUCTION

Part I of this Outline discusses the background of section 338 and how section 338 applies, in a broad sense, to leveraged buy-out transactions. Parts II through V analyze in detail section 338 (as amended by P.L. 99-514 ("TRA 86")) and all regulations issued thereunder. Parts VI through XIV discuss leveraged buy-out transactions involving domestic corporations. The international tax aspects of section 338 are not specifically covered.

Final regulations, T.D. 8940 (February 12, 2001) (the "final regulations"), replaced temporary regulations issued January 5, 2000, T.D. 8858 (January 5, 2000) (the "temporary regulations"). 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 pre-January 5, 2000 regulations (the "old regulations") continue to apply. Both the final and temporary regulations revise all the regulations under section 338 (other than those dealing with international matters and stock consistency). See T.D. 8858 (January 5, 2000).

The final regulations, which are discussed throughout this Outline and are summarized in Part I.C.3., 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"). 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. 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.

A. Basic Structures for Leveraged Buy-Out Transactions

1. Taxable Acquisitions

There are numerous structures and combinations of structures for effecting a leveraged buy-out, including redemptions, stock purchases by negotiation or tender offer, forward and reverse mergers and purchases of assets.

a. Generally, if a transaction does not qualify for reorganization or section 351 treatment, it will be treated as a taxable transaction. As a result, the shareholders of the target corporation (or the target corporation itself if the transaction is a taxable purchase of assets) will recognize gain or loss for tax purposes.

b. If purchase money debt is used, such gain generally can be deferred by the use of the installment reporting rules of section 453.

c. If structured as a taxable asset acquisition (including a forward cash merger under Rev. Rul. 69-6, 1969-1 C.B. 104), the purchasing corporation receives a cost basis in any assets acquired.

d. If structured as a taxable stock acquisition (including one accomplished by a reverse subsidiary merger under Rev. Rul. 73-427, 1973-2 C.B. 301), all of the tax attributes and basis of the target assets generally carryover after the acquisition.

2. Stock Purchases

a. In general, under section 382 once a change (however effected) of 50 percentage points in the ownership of stock of the target occurs during a three-year testing period, the use of the target's NOLs, credits and certain other tax attributes will be limited to a prescribed amount based on the value of the target corporation and the long-term tax-exempt bond rate.

b. Sections 269 and 384, as well as the consolidated return SRLY and CRCO rules, also limit utilization of NOLs and tax attributes.

c. Where the target is a subsidiary of a selling consolidated return group, a stock purchase creates concern because of several liability for the selling group's tax liabilities. See Treas. Reg. § 1.1502-6(a) and (c). Cf. Treas. Reg. § 1.1502-6(b). In addition, if the target has NOLs or other tax attributes, these may be absorbed by income of other members of the selling group even after the sale.

d. Also, where the target is a subsidiary in a consolidated group, the common parent (who may or may not be the selling member) may, under certain circumstances, make an irrevocable election to retain all or a portion of the target's net operating loss carryovers and net capital loss carryovers. See Treas. Reg. § 1.1502-20(g)(1); Temp. Treas. Reg. § 1.1502-20(i)(3). Such election can only be made if the disposition occurs before May 7, 2002 (or pursuant to a binding agreement entered into before that date) and the taxpayer does not elect (under Temp. Treas. Reg. § 1.1502-20(i)(2)(ii)) to apply the rules of Temp. Treas. Reg. § 1.337(d)- 2T. Temp. Treas. Reg. § 1.1502-20(i)(3). The election cannot be made if Temp. Treas. Reg. § 1.337(d)-2T applies to the disposition. Temp. Treas. Reg. § 1.1502-20(i)(3)(ii).

B. Application of Section 338

1. Cost or Carryover Election

If a purchasing corporation acquires 80 percent or more of the stock of the target corporation in a qualified stock purchase ("QSP"), a section 338 election may be made to treat the stock purchase as an asset purchase. This election must be made no later than the fifteenth day of the ninth month (i.e., within 8½ months) after the month in which the acquisition date occurs. If the purchasing corporation fails to make such an election, it will ordinarily take a carryover basis in the target's assets.

2. Benefit 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 target's assets exceeds the current tax cost of such a step-up.

a. The Tax Reform Act of 1986, P.L. 99-514 ("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 current section 338, the target corporation 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 that the current tax cost of the step-up. An election under current 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.

c. The key to determining the present value of future tax savings is the allocation of basis among the target's assets.

d. Section 338(b)(5) states that the deemed purchase price "shall be allocated among the assets of the target corporation under regulations prescribed by the Secretary."

(1) In January 1986, Treasury issued temporary and proposed regulations governing basis allocation under section 338(b). Treas. Reg. §§ 1.338(b) -1t, -2t, -3t. These regulations were amended in February 1997. See T.D. 8711 (January 9, 1997). The 1997 amendments are generally effective for asset acquisitions completed on or after February 14, 1997. Temporary regulations were issued on January 5, 2000 and apply to qualified stock purchases occurring after January 5, 2000 and before March 16, 2001. Final regulations were issued on February 12, 2001 and apply to qualified stock purchases occurring on or after March 16, 2001.

(2) For asset acquisitions on or after March 16, 2001, Treas. Reg. § 1.338- 6(b) provides that basis is allocated to seven asset classes in the following order:

(a) Class I -- cash and general deposit accounts (including savings and checking accounts) other than certificates of deposit held in banks, savings and loan associations, and other depository institutions. If the amount of Class I assets exceeds AGUB, New T will immediately realize ordinary income in an amount equal to such excess.

(b) Class II -- actively traded personal property within the meaning of section 1092(d)(1) and Treas. Reg. § 1.1092(d)-1 (determined without regard to 1092(d)(3)). In addition, Class II assets include certificates of deposit and foreign currency even if they are not actively traded personal property. Class II assets do not include stock of target affiliates, whether or not of a class that is actively traded, other than actively traded stock described in section 1504(a)(4). Examples of Class II assets include U.S. government securities and publicly traded stock.

(c) Class III -- assets that the taxpayer marks to market at least annually for Federal income tax purposes and debt instruments (including accounts receivable). However, Class III assets do not include --

(i) Debt instruments issued by persons related at the beginning of the day following the acquisition date to the target under section 267(b) or 707;

(ii) Contingent debt instruments subject to Treas. Reg. § 1.1275-4, Treas. Reg. § 1.483-4, or section 988, unless the instrument is subject to the non-contingent bond method of Treas. Reg. § 1.1275-4(b) or is described in Treas. Reg. § 1.988- 2(b)(2)(i)(B)(2); and

(iii) Debt instruments convertible into the stock of the issuer or other property.

(d) Class IV -- stock in the trade of the taxpayer or other property of a kind which would properly be included in the inventory of taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business.

(e) Class V -- all assets other than Class I, II, III, IV, VI, and VII assets.

(f) Class VI -- all section 197 intangibles, as defined in section 197, except goodwill and going concern value.

(g) Class VII -- goodwill and going concern value (whether or not the goodwill and going concern value qualifies as a section 197 intangible).

(3) For asset acquisitions completed after January 5, 2000, and before March 16, 2001, basis is allocated to the seven asset classes in the same manner as described above, except Class II and Class III assets are defined as follows under the temporary regulations:

(a) Class II -- actively traded personal property within the meaning of section 1092(d)(1) and Treas. Reg. § 1.1092(d)-1. In addition, Class II assets include certificates of deposit and foreign currency even if they are not actively traded personal property. Examples of Class II assets include U.S. government securities and publicly traded stock.

(b) Class III -- accounts receivable, mortgages, and credit card receivables from customers which arise in the ordinary course of business.

(4) For asset acquisitions completed on or after February 14, 1997 and on or before January 5, 2000, Former Temp. Treas. Reg. § 1.338(b)-2T provides for basis allocation in the following order:

(a) Class I -- cash, demand deposits and similar accounts in banks and savings and loan associations, and other items designated by the Service.

(b) Class II -- certificates of deposit, U.S. government securities, readily marketable stock or securities, foreign currency, and other items designated by the Service.

(c) Class III -- all assets of the target, other than Class I, II, IV, and V assets.

(d) Class IV -- all section 197 intangibles, as defined in section 197, except those in the nature of goodwill and going concern value.

(e) Class V -- section 197 intangibles in the nature of goodwill and going concern value.

(5) The allocation regulations prior to the 1997 amendments were identical to the old temporary regulations except that Classes IV and V were combined into a single class, Class IV. The 1997 amendments were made in response to the enactment of section 197 in OBRA93. The purpose of the amendments were to provide that goodwill and going concern value be assigned to a true residual class.

(6) For asset acquisitions completed before February 14, 1997, the transition rules for the old regulations provide that the taxpayer may choose whether to apply:

(a) the allocation method applicable to asset acquisitions completed on or after February 14, 1997 and on or before January 5,2000;

(b) the allocation method in place before the 1997 amendment; or

(c) the allocation method in place before the 1997 amendment, but treat all amortizable section 197 intangibles as Class IV assets

(7) The allocation to assets within a class of assets is made based on the relative FMV of such assets. The FMV of an asset is the gross fair market value of the asset (i.e., fair market value determined without regard to mortgages, liens, pledges, or other liabilities). Treas. Reg. § 1.338-6(a)(2). The final regulations provide that the Service may challenge a taxpayer's determination of the fair market value of any asset by any appropriate method and take into account all factors, including any lack of adverse tax interests between the parties. Treas. Reg. § 1.338-6(a)(2)(iii).

(8) All of the allocations are subject to the limitation that the basis allocated to each asset cannot exceed its FMV and any other limitation imposed on an acquisition of assets from an unrelated person (e.g., section 1056, relating to basis limitation on player contracts transferred in connection with a sale of a franchise). Treas. Reg. § 1.338- 6(c).

(9) Any excess over FMV is allocated to the next seriatim class of assets, with any residual excess allocated to "intangible assets in the nature of goodwill and going concern value." Treas. Reg. § 1.338-6(b)(2).

3. Section 338(h)(10)

a. In certain situations, a section 338(h)(10) election to treat the sale of the target stock as a direct sale of the target's assets may make sense. The reasons are as follows.

(1) Generally, for a target that is a member of a consolidated group, under section 338(h)(10), the selling group will not recognize gain on the disposition of the target stock. Only the deemed asset sale triggers gain recognition. Thus, while the buyer receives a cost basis in both the stock and assets of the target, only one level of corporate tax is imposed.

(2) TRA 86 eliminated the favorable corporate capital gains rate. Pursuant to the rate changes, all corporate income generally is taxed at a maximum rate of 35 percent. Thus, ordinary income generated in an asset sale should not be taxed at a higher rate than capital gain income on a stock sale.

(3) An election under section 338(h)(10) may allow a group to use losses that would otherwise be disallowed under Treas. Reg. §§ 1.337-2T, 1.1502-20(a).

(4) A stock sale and purchase with a section 338(h)(10) election may also be preferable to an actual purchase and sale of assets for many non-tax reasons. For example, the target corporation may have licenses that are not transferable. In addition, the target corporation may have assets that require the consent of third parties before they can be transferred.

b. The disadvantages of a section 338(h)(10) election must also be considered.

(1) The amount of gain in a section 338(h)(10) transaction will exceed that in a straight stock sale if the aggregate inside asset basis is less than the outside stock basis. See Woods Investment Co. v. Commissioner, 85 T.C. 274 (1985).

(2) However, with the enactment of section 1503(e) (the "anti-Woods Investment" legislation) and the issuance of revised Treas. Reg. § 1.1502-32, a corporation's inside basis is more likely to match the outside stock basis.

C. Background of Section 338

1. Legislative History

a. Section 338 was originally enacted in 1982 as part of the Tax Equity and Fiscal Responsibility Act, P.L. 97-248 ("TEFRA"). Minor amendments were made shortly thereafter in the Technical Corrections Act of 1982, P.L. 97-448 ("1982 TCA"). In 1984, Congress made extensive and significant changes in section 338 as part of the Tax Reform Act of 1984, P.L. 98-369 ("TRA 84").

b. In 1986, Congress made conforming changes to section 338 to reflect the repeal of the so- called General Utilities doctrine. See TRA 86, § 631(b)(1). The Technical and Miscellaneous Revenue Act of 1988, P.L. 100- 647 ("TAMRA"), made certain conforming changes to section 338 and added new section 338(h)(16). The Omnibus Budget Reconciliation Act of 1990 ("OBRA 90") added a new information reporting requirement in section 338(h)(10)(C).

2. Issuance of Regulations

a. In February 2001, Treasury issued final regulations under section 338. T.D. 8940 (February 12, 2001) (the "final regulations"). The final regulations replace temporary regulations issued January 5, 2000, T.D. 8858 (January 5, 2000) (the "temporary regulations"). The final regulations, which are substantially the same as the temporary regulations, revise all the regulations under section 338 (other than those dealing with international matters and stock consistency).

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 and before March 16, 2001. Temp. Treas. Reg. § 1.338(i)-1T.

c. 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.

d. The final regulations are discussed in detail in Part I.C.3., below. This Part I.C.2. of the Outline discusses the series of regulations issued under section 338 prior to the new temporary regulations.

e. In February 1984, Treasury issued Temp. Treas. Reg. §§ 5f.338-1, -2, -3, describing general rules for making elections under section 338. See T.D. 7942, 1984-1 C.B. 93. Those regulations were amended and redesignated as Temp. Treas. Reg. §§ 1.338- 1T, -2T, -3T in September 1984. See T.D. 7975, 1984-2 C.B. 81.

f. In April 1985, Treasury issued temporary regulations amending Temp. Treas. Reg. §§ 1.338-1T and -2T, and added Temp. Treas Reg. § 1.338-4T. See T.D. 8021, 1985-1 C.B. 96. These regulations provided guidance in a question and answer format, most notably in the areas of asset and stock consistency. In addition, these regulations covered the following subjects:

(1) The definition of a QSP (Temp. Treas. Reg. § 1.338-4T(c)).

(2) The effect of post-acquisition events on eligibility to make an election (Temp. Treas. Reg. § 1.338-4T(d)).

(3) The determination of the deemed sale price, including the elective formula under section 338(h)(11) (Temp. Treas. Reg. § 1.338-4T(h)).

(4) The determination of the basis for the assets of "new target" (Temp. Treas. Reg. § 1.338-4T(j)).

g. In January, 1986, Treasury issued temporary regulations amending Temp. Treas. Reg. §§ 1.338-1T and -4T, and adding Temp. Treas. Reg. § 1.338(h)(10)-1T implementing section 338(h)(10). See T.D. 8068, 1986-1 C.B. 165.

h. Later in January 1986, Treasury issued temporary regulations again amending Temp. Treas. Reg. §§ 1.338-1T and -4T, amending Temp. Treas. Reg. § 1.338(h)(10)-1T, and adding Temp. Treas. Reg. §§ 1.338(b)-1T, - 2T, and -3T. See T.D. 8072, 1986-1 C.B. 111. These regulations required the selling price and basis allocated to each asset to be determined using a four class residual method.

i. In February, 1986, Treasury issued temporary regulations amending Temp. Treas. Reg. §§ 1.338-1T, -4T, and Temp. Treas. Reg. § 1.338(h)(10)-1T. See T.D. 8074, 1986-1 C.B. 126. These regulations provided guidance on international aspects of section 338.

j. In May 1986, Treasury issued temporary regulations amending Temp. Treas. Reg. §§ 1.338-1T, -2T, -4T, -5T, and Temp. Treas. Reg. § 1.338(h)(10)-1T. See T.D. 8088, 1986-1 C.B. 103. These regulations were issued to provide procedures for filing and perfecting certain statements of election under section 338(g).

k. In July 1986, Treasury issued temporary regulations again amending Temp. Treas. Reg. §§ 1.338-1T, -2T, -4T, -5T, and Temp. Treas. Reg. § 1.338(h)(10)-1T, and adding Temp. Treas. Reg. § 1.338(b)-4T. See T.D. 8092, 1986-2 C.B. 49. These regulations made miscellaneous conforming changes and transitional rules relating to making and filing section 338 elections.

l. In July 1988, Treasury issued Temp. Treas. Reg. § 1.1060-1T to implement the basis allocation rules of section 1060. See T.D. 8215, 1988-2 C.B. 304. These regulations included direction on the scope of section 1060 and reiterated the four class residual method found in the section 338 regulations.

m. In March 1991, Treasury issued Temp. Treas. Reg. § 1.338-6T, which prevented the double taxation that could occur when the target owning stock of an affected target made an election under section 338(g) without a corresponding election under section 338(h)(10). See T.D. 8339, 1991-1 C.B. 52.

n. In January 1992, Treasury published proposed regulations that replaced the asset and stock consistency rules contained in Treas. Reg. §§ 1.338-4T and 1.338-5T, and revised and simplified other aspects of the section 338 regulations. These regulations were made final in January 1994 in substantially the same form. See T.D. 8515, 199401 C.B. 89. The final regulations greatly narrow the scope of consistency rules in light of the repeal of the General Utilities doctrine.

(1) The final regulations revised the rules regarding the international aspects of Code section 338, primarily contained in Treas. Reg. § 1.338-5T.

(2) The final regulations restate the remainder of the temporary regulations under section 338, with minor conforming changes made to Treas. Reg. §§ 1.338(b)-2T and 1.338(b)-3T.

(3) The requirements for making an election under Code section 338 were removed from the regulations and are now contained in Form 8023.

(4) The regulations were reorganized in a more logical order to place related rules together. Also, the question and answer format of the temporary 338 regulations was no longer used.

(5) In addition to the above editorial changes, several substantive changes were made. For example, the final regulations reflect the repeal of old sections 336 and 337.

(6) The final regulations under section 338 are generally effective for targets with acquisition dates on or after January 12, 1994. In addition, taxpayers may apply the final regulations retroactively to acquisitions occurring on or after January 14, 1992 (the date the final regulations were first proposed).

(7) As noted, the final regulations replaced temporary regulations that had been issued in patch-work 1984 through 1991.

o. In October 1995, Treasury issued Treas. Reg. § 1.338-2 providing rules governing the treatment of an intragroup merger following a QSP of target stock when a section 338 election is not made for the target. See T.D. 8626, 199502 C.B. 34.

p. In January 1997, Treasury issued final regulations that amended Treas. Reg. § 1.338-4 and removed Temp. Treas. Reg. § 1.338-4T. See T.D. 8710, 1997-1 C.B. 82.

q. Also in January 1997, Treasury issued temporary regulations that amended Temp. Treas. Reg. §§ 1.338-2T, 1.338-3T, and 1.1060-1T. See T.D. 8711, 1997-1 C.B. 85. The January 16, 1997, changes to the regulations adapted the residual method to section 197 by adding a fifth class to the residual method prescribed for deemed and actual asset acquisitions.

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