An old friend reconsidered: Post-TCJA Sec. 338(g) elections for foreign targets

By Rob Hallman, CPA, MSA, Minneapolis

Editor: Mark Heroux, J.D.

The election under Sec. 338(g) has long been a staple of cross-border acquisition planning. However, this planning merits renewed analysis in light of the passage of P.L. 115-97, the law known as the Tax Cuts and Jobs Act of 2017 (TCJA). Specifically, the TCJA's implementation of a hybrid territorial international tax regime under Sec. 245A and Sec. 1248(j) mitigates the benefit of the Sec. 338(g) election and may induce taxpayers to not make the election to avoid additional tax liability on the eventual sale of foreign target shares.

Sec. 338(g) generally provides taxpayers the ability to step up the basis of a foreign target's assets to fair market value (FMV) and eliminate the historic tax attributes (such as earnings and profits, or E&P) of the foreign target by causing the foreign target to form a new corporation that acquires its assets and assumes its liabilities for consideration equal to the foreign target's purchase price (Regs. Sec. 1.338-1(a)(1)). Under the pre-TCJA worldwide tax regime, this proved beneficial in the following ways:

  • Removing the need for the cumbersome computation of accounting adjustments required to convert beginning statutory retained earnings of the foreign target to U.S. GAAP as required by Regs. Sec. 1.964-1(b)(1) and tax adjustments to convert U.S. GAAP retained earnings to accumulated E&P.
  • "Hyping" the effective tax rate of the foreign target by creating a mismatch between E&P for U.S. tax purposes, which takes into account favorable E&P adjustments from additional write-offs of stepped-up assets and local taxable income. Importantly, however, this foreign tax credit benefit was eliminated with the enactment of Sec. 901(m), which applies to transactions occurring after 2010.
  • Facilitating post-acquisition restructuring by, for example, stepping up basis in a foreign target's subsidiary stock. One relevant fact pattern involves the foreign target's ownership of a domestic corporation, the stock of which is stepped up to FMV by virtue of the Sec. 338(g) election made for the foreign target. This, in turn, enables the foreign target to sell stock of the domestic subsidiary up the ownership chain free of gain that would otherwise apply under Rev. Rul. 74-605 (see Yoder, "Section 338(g) Election for a Foreign Target Continues to Provide Benefits to Buyer After New §901(m)," 33 Tax Mgmt. Int'l J. 375 (June 10, 2011)).
  • Perhaps, most importantly, minimizing the foreign target's E&P via additional write-offs of stepped-up assets, thereby lessening taxable dividend inclusions on distributions to the U.S. parent (see Secs. 301(c)(1) and 316).

In the context of a C corporation U.S. parent, the TCJA eliminated perhaps the largest of these benefits by formalizing a hybrid territorial tax regime. The TCJA enacted Sec. 245A, which provides for a 100% dividends-received deduction for dividends received from greater-than-10%-owned foreign corporations. So where the pre-TCJA worldwide tax regime had previously incentivized Sec. 338(g) elections by taxing foreign target E&P when distributed, the new regime may actually favor additional E&P at the foreign target as a defense against capital gain distributions under Sec. 301(c)(3). Put simply, the new hybrid territorial regime under Sec. 245A equalizes the tax treatment of foreign target dividend and return-of-basis distributions and, in so doing, removes a significant motivating factor behind the Sec. 338(g) election.

In addition, the new hybrid territorial regime implemented by the TCJA may actually favor the presence of additional E&P at the foreign target in the event of its sale. Sec. 1248(j), which was enacted by the TCJA, provides that amounts recharacterized under Sec. 1248(a) as dividend income on the sale or exchange by a domestic corporation of stock in a foreign corporation held for one year or more be treated as dividends for purposes of Sec. 245A. Because any portion of the gain on the sale of foreign target stock not recharacterized under Sec. 1248(a) will be taxable as capital gain, there is a clear preference to maximize foreign target E&P.

Consider the following examples:

Example 1: USP, a domestic C corporation, acquired 100% of the stock of FT, a foreign corporation, in 2X18 for $100. No Sec. 338(g) election was made for the acquisition, and FT had $50 of accumulated E&P at the acquisition date. In 2X21, USP sells 100% of its stock in FT for $200. FT had accumulated E&P of $100 at the sale date. USP therefore realizes gain of $100 on the sale of FT, which will be recharacterized as dividend income under Sec. 1248(a) to the extent of its accumulated E&P, or $100. Sec. 1248(j) is then applied to treat the full $100 Sec. 1248(a) amount as eligible for the 100% dividends-received deduction of Sec. 245A. Therefore, USP's entire $100 gain on the sale of FT shares is tax-free.

Example 2: Assume the same facts as in Example 1, except that in 2X18 USP makes a Sec. 338(g) election for FT. In this case, USP still realizes $100 of gain on the sale of FT, but the Sec. 1248(a) amount is $50 rather than $100 because FT's $50 of accumulated E&P at the acquisition date is eliminated through the Sec. 338(g) election. Therefore, only $50 of the $100 gain is eligible for Sec. 245A under Sec. 1248(j), and the remaining $50 of gain is fully taxable toUSP.

Note that the preceding examples involve the sale of foreign target stock by a domestic C corporation. Where the foreign target is a lower-tier subsidiary, i.e., is owned by another foreign subsidiary of a domestic C corporation, Sec. 964(e) applies Sec. 1248(a) to characterize any gain on the sale as dividend income to the extent of the target's E&P. Dividend income thus recharacterized is protected against Subpart F treatment under the lookthrough rule of Sec. 954(c)(6) where both the seller and the target are greater-than-50%-owned foreign corporations, known as controlled foreign corporations (CFCs). However, any gain in excess of the foreign target's E&P that a CFC realized on the sale of foreign target stock will be taxable under Subpart F (see Regs. Sec. 1.954-2(e)(2)(i)). In practice, however, the Subpart F implications of such a sale have been historically managed through "check-and-sell" transactions, whereby the lower-tier CFC liquidates into its CFC parent via an election to be treated as an entity disregarded from its parent, followed by the deemed sale of the lower-tier CFC's assets by the CFC parent. The courts have viewed this transaction as a tax-free Sec. 332 liquidation followed by an asset sale (Dover Corp., 122 T.C. 324 (2004)).

While Sec. 338(g) elections for foreign targets should never be dismissed before careful analysis, the TCJA has expanded the universe of scenarios in which those elections could prove detrimental, on balance, to taxpayers.


Mark Heroux, J.D., is a principal with the National Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.

For additional information about these items, contact Mr. Heroux at 312-729-8005 or

Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.

Tax Insider Articles


Business meal deductions after the TCJA

This article discusses the history of the deduction of business meal expenses and the new rules under the TCJA and the regulations and provides a framework for documenting and substantiating the deduction.


Quirks spurred by COVID-19 tax relief

This article discusses some procedural and administrative quirks that have emerged with the new tax legislative, regulatory, and procedural guidance related to COVID-19.