Editor: Greg A. Fairbanks, J.D., LL.M.
Understanding and identifying tax consequences of complex mergers-and-acquisition (M&A) transactions has never been easy and has become even more fraught following the enactment of the law known as the Tax Cuts and Jobs Act (TCJA), P.L.115-97. The challenges confronting taxpayers entering into M&A transactions are further exacerbated when the transaction encompasses cross-border elements.
Many aspects of the TCJA supplant old paradigms for taxpayers planning or entering into cross-border transactions. Common tools like Sec. 338 elections have not changed in and of themselves, but the ramifications have. Beyond changes to the M&A toolbox, questions also linger following the law changes. The TCJA also added a few new traps that taxpayers must circumvent when navigating M&A transactions. These hazards can significantly affect the structuring of cross-border transactions.
Tax is a critical component of M&A. Beyond risk assessment, tax implications can influence valuation and return on investment. This item highlights three key considerations for a cross-border M&A transaction. It does not provide an exhaustive overview of all considerations but rather provides commentary on these three often overlooked or misunderstood factors potentially disrupting international transactions following the TCJA.
New twists to old Sec. 338(g) elections
A Sec. 338(g) election permits a purchasing corporation to treat a qualified stock purchase as an asset purchase, which allows the buyer to obtain a step-up in basis of the target's assets in what is otherwise treated as a sale of corporate stock. This potentially subjects the seller to two levels of tax. The seller recognizes gain or loss on the sale of target stock, and the target itself recognizes gain or loss on the deemed sale of its assets. For obvious reasons, the election and its two levels of tax have limited utility in the context of domestic entity acquisitions. However, the election is common when the acquisition is a foreign target where taxation at the foreign corporate level may not result in incremental U.S. tax (particularly, although not exclusively, when the seller is also a foreign person).
When a purchaser makes a Sec. 338(g) election, the target entity (Old Foreign Target) is treated as selling all of its assets at the close of the acquisition date. Old Foreign Target is then deemed to be a new corporation (New Foreign Target) that purchases all of Old Foreign Target's assets as of the beginning of the day after the acquisition date. This deemed sale of assets results in a corporate-level gain and corresponding corporate-level tax. Unlike a Sec. 338(h)(10) election, the Sec. 338(g) election is made unilaterally by the buyer and does not require the sellers' consent. An illustration of this deemed fiction is shown in the chart "Sec. 338(g) Elections."
A purchaser making a Sec. 338(g) election obtains numerous benefits in the international context. For federal income tax purposes, a Sec. 338(g) election made on a foreign target results in a step-up in the target's assets' bases, eliminates historic earnings and profits (E&P), and ends the target's tax year. The election also allows a buyer to obtain the benefits of an asset purchase for federal income tax purposes while respecting the form of the transaction as a stock sale for business, legal, and certain non-U.S. tax purposes. This produces several benefits unattainable in a true asset sale, such as the potential preservation of foreign tax attributes.
There are also several consequences. For example, in the case of a controlled foreign corporation (CFC), the election can result in Subpart F and/or global intangible low-taxed income (GILTI) inclusions to a U.S. seller.
The TCJA left the provisions governing the Sec. 338(g) election itself unchanged. However, the TCJA significantly overhauled the international tax system that dictates the outcome of such an election. As a result, taxpayers need to rethink where and when to use the election.
For example, if the seller is a U.S. shareholder in a target that is a CFC, U.S. shareholder-level consequences can result from the deemed asset sale occurring at the foreign target level. Prior to the TCJA, the main concern of a U.S. seller in a CFC was Subpart F income resulting from the deemed asset sale. However, following the TCJA, U.S. sellers are still potentially subject to Subpart F income, but now the election may also generate tested income. The excess of a U.S. shareholder's aggregated net tested income from CFCs over a routine return on certain qualified tangible assets is taxable as GILTI.
Whether a GILTI inclusion has negative or positive effects on the sale of stock depends on several factors. Inclusions under GILTI generally benefit from Sec. 250 deductions, thus often subjecting them to an effective tax rate of 10.5% (any tax liability could be further reduced by foreign tax credits). A GILTI inclusion also creates tax basis that potentially reduces the capital gain on the sale of New Foreign Target stock, which would in turn reduce the capital gain subject to tax at 21%. Any remaining untaxed E&P generated by the deemed sale of assets may be recharacterized as a dividend under Sec. 1248 and may be eligible for a 100% Sec. 245A dividends-received deduction (DRD), reducing the tax on the gain even further.
Still, U.S. sellers should proceed with caution. The outcome may not always be favorable. In instances when Old Foreign Target's inside asset basis is low, the incremental U.S. tax resulting from a GILTI inclusion could outweigh the potential benefit of any reduced capital gain. As a result, U.S. sellers must carefully model the outcome before agreeing to allow the buyer to make the Sec. 338(g) election.
Another aspect of the Sec. 338(g) election that must be considered post-TCJA is how the U.S. buyer intends to exit the investment in the foreign target. Pre-TCJA, the additional amortization and depreciation deduction afforded by the step-up in asset basis was nearly always positive. In particular, additional amortization and depreciation reduced E&P that could be subject to U.S. tax when distributed. However, post-TCJA, reducing E&P and tested income does not always produce the best outcome.
For example, if the election is not made and the foreign target is in a country with a tax rate high enough to eliminate any incremental tax from GILTI inclusions by virtue of foreign tax credits, then the amortization and depreciation deductions could ultimately do more harm than good. This is because without the election, the current-year earnings could be includible in U.S. tax under GILTI and offset by a foreign tax credit. The inclusion creates U.S. tax basis under Sec. 961 (subject to several other issues discussed further below). This tax basis will reduce any future capital gain when exiting the investment. Now, contrast that result with a situation where the election is made, and the GILTI inclusion may be reduced or eliminated. Thus, any potential basis increases under Sec. 961 would in turn also be reduced or eliminated. Further, any potential untaxed E&P that may be recharacterized as a dividend under Sec. 1248 and eligible for a 100% Sec. 245A DRD would also be reduced. This can result in a higher capital gain upon exiting the investment in Foreign Target.
Beyond the items highlighted above, post-TCJA, a number of other pros and cons for either a U.S. buyer or seller with respect to the Sec. 338(g) election must be considered. Many of these are summarized in the table "Pros and Cons of the Sec. 338(g) Election."
The absent basis quandary
Sec. 961 provides general rules for adjusting the basis of a U.S. shareholder's stock in a CFC and the basis of property by which a U.S. shareholder is considered under Sec. 958(a)(2) as owning stock in a CFC (e.g., the basis of a foreign partnership interest through which a CFC is held). Following the TCJA, the rules for adjusting the basis of a U.S. shareholder's stock in a CFC have become even more complicated and murky.
Sec. 961(a) provides for an increase to a U.S. shareholder's basis in stock or property to the extent an amount was included in the shareholder's gross income under Sec. 951(a). A subsequent distribution of previously taxed income would then reduce the shareholder's basis under Sec. 961(b). To the extent an amount distributed exceeds the shareholder's basis in the foreign corporation, the amount received in excess of stock basis would generally be treated as capital gain. Sec. 961(c) provides similar basis adjustments as provided in Secs. 961(a) and (b) with respect to the basis that an upper-tier CFC has in a lower-tier CFC, but only for purposes of determining the amount to be included in a U.S. shareholder's gross income under Sec. 951. No regulations are in effect under Sec. 961(c).
Following the enactment of the TCJA, the transition tax under Sec. 965, as well as the GILTI provisions, have made the determination of a U.S. shareholder's basis in its investments in CFCs more problematic. Both the transition tax and GILTI provisions include coordinating rules that generally provide for the application of the basis-adjustment rules under Secs. 961(a) and (b), but many questions and complications remain.
Current regulations under Sec. 965 provide special rules for adjusting basis following a Sec. 965 inclusion. Under Regs. Sec. 1.965-2(e), a U.S. shareholder's tax basis in a deferred foreign income corporation (DFIC) is increased by income inclusions under Sec. 965(a). The regulations indicate that no basis adjustments are made to account for the reduction to the Sec. 965(a) inclusion due to allocations of deficits under Sec. 965(b) to a DFIC.
However, an election is available that allows the tax basis to be increased in the DFIC if a corresponding reduction of the tax basis of the E&P deficit corporation is made. If this election is made, a U.S. shareholder is allowed basis adjustments only with respect to E&P offset by deficits to the extent of downward basis adjustments made with respect to the stock of an E&P deficit foreign corporation. Absent an action by the taxpayer, no basis adjustments are allowed. Additionally, the basis-shifting election only operates to move basis from first-tier E&P deficit foreign corporations to first-tier DFICs and does not apply down a chain of foreign corporations under Sec. 961(c).
As there are no lower-tier basis adjustments, U.S. sellers must proceed with caution when contemplating transactions within tiered structures. The lack of basis adjustments can present surprising gains when disposing of lower-tier CFCs. The lack of lower-tier basis adjustments also presents risks when contemplating pre- or post-acquisition distributions from lower-tier to upper-tier entities. These distributions could generate unexpected capital gains, which may be includible in the U.S. shareholder's income under Subpart F.
Similar challenges arise with respect to GILTI inclusions. As Sec. 961(c) provides adjustments "only for the purposes of determining the amount included under [Sec.] 951," a sale of a lower-tier subsidiary presents the risk of increased gain recognition treated as tested income, thus potentially causing double taxation. Sec. 961(c) generally operates to prevent double taxation that could result from Subpart F. But it does not indicate that it should operate with respect to GILTI inclusions, leaving taxpayers uncertain when contemplating lower-tier transactions.
For example, if a lower-tier CFC has a Subpart F inclusion, the amount is included in the U.S. shareholder's taxable income. Upon subsequent disposition of the stock, the basis has been increased under Sec. 961(c), thereby reducing the gain by the amount already subject to U.S. tax. However, there currently does not seem to be a similar mechanic for GILTI. How
If the tested income of the lower-tier CFC is included in income of the U.S. shareholder and subjected to U.S. tax, then, absent an adjustment to the upper-tier CFC's basis in the lower-tier CFC stock, the disposition of the stock could create tested income (despite the fact that some of the appreciated value has already been subject to U.S. tax).
The IRS acknowledged this issue in the preamble to the final GILTI regulations (T.D. 9866). But the IRS said it was concerned that by providing for basis adjustments under Sec. 961(c) for GILTI inclusions, such adjustments could inappropriately provide for additional untaxed E&P at the first-tier foreign corporation, which could in turn make any future gain on the upper-tier CFC eligible for a DRD under Sec. 245A. Example 1 illustrates these issues:
Example 1: USP owns CFC1 (fair market value: $100; basis: $0). CFC1 owns CFC2 (fair market value: $100; basis: $0). In year 1, CFC2 earns $100 of tested income, taxable to USP under Sec. 951A. In year 2, CFC1 sells CFC2 for $100. Assume no other income, foreign tax credits, qualified business asset investment, or other attributes, and a full Sec. 250 deduction is permitted to USP.
In year 1, the tested income of CFC2 gives rise to $100 of Sec. 961(c) basis step-up for Sec. 951(a) purposes as a result of the taxable GILTI inclusion. In year 2, CFC1's gain for purposes of computing Subpart F on the sale of CFC2 is reduced by the additional basis provided under Sec. 961(c). However, absent further guidance, there appears to be no similar basis adjustment for purposes of computing tested income of CFC1 in year 2. This implication for the sale of CFC2 is computed as shown in the table "Effects of Sale of CFC2."
Conversely, if a Sec. 961(c) basis adjustment were allowed for purposes of computing tested income, there would be no gain under Sec. 951(a) or Sec. 951A, but the $100 of proceeds would still give rise to an additional $100 of E&P that is untaxed (as there is no basis step-up for E&P purposes, and the earnings were not subject to tax under either the Subpart F or GILTI regime in the year). If, assuming a Sec. 961(c) basis adjustment were allowed for purposes of computing tested income, the implication for the sale of CFC2 is computed as shown in the table "Sale of CFC2 With Sec. 961(c) Basis Adjustment."
Under the first scenario, CFC1 does not incur a gain on the disposition of CFC2 for purposes of computing Subpart F but does incur $100 of gain on the disposition for purpose of computing tested income. Thus, total tax over the two years would be $21 ($100 of tested income of CFC2 subjected to GILTI in year 1 + $100 of tested income of CFC1 generated on the sale of CFC2 in year 2). However, in the second scenario, if a Sec. 961(c) basis adjustment is permitted for purposes of computing tested income, there would be no gain for Subpart F or GILTI purposes in year 2, and the proceeds would give rise to $100 of untaxed E&P. This untaxed E&P would then be eligible for a DRD deduction when ultimately distributed or in the event CFC1 is sold by USP. Therefore, the total tax over the two years would be $10.50 ($100 of tested income of CFC2 subjected to GILTI in year 1). The additional $100 of untaxed E&P would also potentially be eligible for a Sec. 245A DRD either on a future sale of CFC1 stock under Sec. 1248 or on a future dividend distribution out of the untaxed earnings.
However, this raises the question of whether the gain is gross income taken into account under Subpart F first and then reduced by basis adjustments under Sec. 961(c) so that it is excluded under Sec. 951A(c)(2)(A)(i)(II), which provides that any gross income taken into account in determining the Subpart F income of a corporation is excluded from the definition of tested income. This purported theory provides that, as the gain on the sale of stock may be Subpart F income, it may qualify for the exclusion from tested income. However, this theory is subject to debate, is untested, and lacks the certainty that many taxpayers look for when contemplating M&A sales transactions.
While it is expected that this issue will be addressed in forthcoming regulations, as it currently stands, taxpayers are left with little guidance on how to treat lower-tier distributions or sales of lower-tier stock as they pertain to GILTI.
New trap under Sec. 245A
In 2019, the IRS released temporary regulations (T.D. 9865) under Secs. 245A and 954(c)(6) that limit certain planning strategies the Service said used the DRD provisions contrary to legislative intent. The rules are complex but are targeted and limit the Sec. 245A deduction (or the application of Sec. 954(c)(6)) only in a relatively narrow set of circumstances. The regulations provide that for any tax year, an otherwise qualifying taxpayer may not claim a Sec. 245A deduction to the extent the dividend is an "ineligible amount." The ineligible amount comprises 50% of the portion of the dividend attributable to "extraordinary disposition" amounts and 100% of amounts attributable to "extraordinary reduction" amounts.
The extraordinary-disposition rules target transactions that occurred during a short period following the enactment of the TCJA. During this period, GILTI was not yet effective for some taxpayers, while the Sec. 245A benefit was, creating a mismatch of old and new systems. This incentivized certain transactions that the IRS believed were not consistent with the intent of Sec. 245A. However, this window has since closed. Although these rules are important to understand and identify during due-diligence exercises, their temporal limitation reduces their impact on future M&A transactions.
However, the "extraordinary reduction" rules may have ongoing significant consequences. U.S. sellers should be aware of these rules when disposing of stock in a foreign corporation. An extraordinary-reduction amount occurs if either: (1) the controlling U.S. shareholder sells more than 10% of the stock of the CFC, or (2) there is a greater-than-10% change in the controlling Sec. 245A shareholder's overall ownership of the CFC. In these instances, the extraordinary-reduction account is increased by the E&P representing the amount of dividends paid by the corporation that is attributable to Subpart F income or tested income. But this occurs only to the extent such income would have been taken into account by the Sec. 245A shareholder had the reduction not occurred and the income would not otherwise have been taken into account by a domestic corporation or a citizen or resident of the United States.
These provisions are largely designed to combat planning based on Sec. 951(a)(2)(B) and the repeal of Sec. 958(b)(4). Both provisions, absent this rule, allow taxpayers to avoid subjecting income to the Subpart F and GILTI regimes in a way that allows the use of Sec. 245A to contravene congressional intent.
The temporary regulations also deny the Sec. 954(c)(6) lookthrough treatment for dividends paid by lower-tier CFCs to upper-tier CFCs, thereby causing a U.S. shareholder's Subpart F inclusion to increase by the amount not eligible for lookthrough treatment. Sec. 954(c)(6) provides an exception to the foreign personal holding income rule under Subpart F allowing a lookthrough exception for dividends paid from lower-tier to upper-tier CFCs that are not Subpart F or effectively connected income. The IRS expressed concern that the exception may cause dividends from one CFC to another to result in tax consequences similar to, but not dependent upon, those presented in a first-tier extraordinary-reduction or extraordinary-disposition transaction. Under the temporary regulations, dividends paid from a lower-tier CFC to an upper-tier CFC are eligible to apply the Sec. 954(c)(6) exception to only 50% of the amount that would constitute an extraordinary-disposition amount of the CFC.
These rules present new challenges for taxpayers and can create adverse tax consequences when they enter into M&A transactions. Example 2 illustrates this point:
Example 2: At the beginning of CFC's tax year ending on Dec. 31, US1 owns 100% of CFC. As of the end of the year, CFC has $160 of tested income and no other income. CFC has $160 of E&P for the year. On Oct. 19, US1 sells all of its CFC stock to US2 for $100 in a transaction in which US1 recognizes $90 of gain.
Under Sec. 1248(a), the entire $90 of gain is included in US1's gross income as a dividend, and, pursuant to Sec. 1248(j), the $90 is treated as a dividend for purposes of applying Sec. 245A. However, at the end of year 2, under Sec. 951A, US2 takes into account $70x of tested income, calculated as $160 (100% of the $160 of tested income) less $90x, the amount of dividend deemed received by US1 described in Sec. 951(a)(2)(B).
Sec. 951(a)(2)(B) was intended to prevent double taxation, but, post-TCJA, the above example illustrates that it can now produce double nontaxation. This is a result of the interaction of the DRD, which eliminates taxation of the presale distribution, and Sec. 951(a)(2)(B), which reduces the post-sale tested income or Subpart F inclusion by the amount of the dividend. To prevent this double-nontaxation result, the deemed dividend in the above transaction would qualify as an extraordinary-reduction amount under the temporary regulations. Therefore, with respect to the dividend received of $90 by US1, no portion is eligible for the DRD allowed under Sec. 245A(a). Additionally, no foreign tax credits are allowed with respect to the deemed distribution under Sec. 1248. This subjects the entire $90 dividend to U.S. tax at the 21% rate without the benefit of a foreign tax credit.
This potentially punitive outcome can be avoided in certain situations. The rules include a de minimis exception that provides that no amount is considered an extraordinary-reduction amount if the sum of the CFC's Subpart F income and tested income for the tax year does not exceed the lesser of $50 million or 5% of the CFC's total income for the year. An extraordinary reduction also does not include a transaction that results in the close of a CFC's tax year where the controlling Sec. 245A shareholder includes its pro rata share of Subpart F and tested income. This can occur in a few situations. If a buyer makes a Sec. 338(g) election, for example, the tax year would close, and the seller would include its pro rata share of Subpart F and tested income.
The regulations also include an election that may be made by the CFC's controlling Sec. 245A shareholders. When this election is made, each controlling Sec. 245A shareholder avoids the application of the extraordinary-reduction rules by having the CFC close its tax year on the date of the extraordinary reduction. This election causes the controlling Sec. 245A shareholder to include in its income its pro rata share of the CFC's Subpart F income and tested income as of the date of the extraordinary reduction. The election may allow corporate U.S. shareholders to take advantage of the Sec. 250 deduction and foreign tax credits. If the election to close the year is made, foreign tax credits are allocated between the two U.S. tax years under the same rules that apply upon Sec. 338(g) elections.
Making this election can have significant benefits. Returning to Example 2, under Sec. 951A(a), US1 takes into account 100% of CFC1's tested income for the tax year beginning Jan. 1 and ending Oct. 19, and US2 takes into account 100% of CFC1's tested income for the tax year beginning Oct. 20 and ending Dec. 31. No amount is considered an extraordinary-reduction amount with respect to US1. Given that GILTI may be reduced by a Sec. 250 deduction, among other things, and the resulting tax can be reduced by foreign tax credits, this election can reduce or even eliminate the 21% tax that would be incurred absent such an election.
Opportunities and next steps
Although the TCJA created new traps and complications, well-informed taxpayers should be able to traverse the new landscape efficiently. Some questions remain, but proactive modeling and analysis allow taxpayers to make informed decisions, even in fast-shifting economic environments. Additionally, in some cases, the changes in tax law may allow a savvy taxpayer to reduce or eliminate taxation on certain transactions, but only if the taxpayer is prepared for the new, post-TCJA M&A paradigm.
EditorNotes
Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.
Contributors are members of or associated with Grant Thornton LLP.
