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Washington Tax Alert March 3, 2007 (IRC § 338 election -- acquisition of foreign corporation)

Washington Tax Alert from Don Barnes, dbarnes@washingtontaxlaw.com
March 3, 2007

The IRS Office of Chief Counsel recently issued generic legal advice (see AM 2007-006) regarding IRC § 338 elections where the acquired corporation is a foreign corporation not engaged in a U.S. trade or business. The legal memorandum acknowledges that the acquiring corporation can obtain the tax benefits of an IRC § 338 election, even though the acquired corporation does not incur any offsetting tax cost.

IRC § 338 permits a corporation to elect to treat the acquisition of 80% or more of the stock of a target corporation as an asset acquisition. If the election is made, the target corporation ("old target") is treated as selling all of its assets at fair market value, and a "new target" is treated as acquiring all of its assets on the next day. Although the acquirer and target must both be corporations in order to make an IRC § 338 election, there is no requirement in the Code or the regulations that either the acquirer or target be a U.S. corporation. In fact, the regulations provide special rules for making an IRC § 338 election where the acquirer and target are both foreign corporations. Treas. Reg. § 1.338-2(e).

The new legal memorandum issued by the Service concludes that an acquiring corporation can make an IRC § 338 election and obtain a stepped-up basis for the assets of a foreign target corporation, even though the old target suffers no tax consequences as a result of the election. If the target corporation is a foreign corporation not engaged in a U.S. trade or business, the gain realized on the deemed sale of its assets as a result of an IRC § 338 election is foreign source income and generally not subject to tax in the United States (unless the foreign corporation has U.S. real property interests). Similarly, the foreign target corporation will not realize any taxable gain in its home country because IRC § 338 elections are an invention of the U.S. tax system and generally not recognized by foreign countries.

The Service comments in the memorandum that this result is not inappropriate because any increase in the fair market value of the foreign target corporation's assets while the target corporation is outside the taxing jurisdiction of the United States should not be subject to U.S. tax.

Finally, the Service holds in the memorandum that the acquiring corporation can make an IRC § 338 election selectively, viz., make an IRC § 338 election with respect to the stock acquisition of a foreign corporation, but not make an IRC § 338 election with respect to the stock of a U.S. subsidiary owned by the foreign target corporation.