When a buyer made an I.R.C. section 338(g) election for a foreign target already unitary with the buyer, whose apportionment formula applied to the deemed asset-sale gain?

Plain-English summary

California Chief Counsel Ruling 2019-02 held that gain from an I.R.C. section 338(g) deemed asset sale had to be reported by the target corporation and apportioned using the target's adjusted California apportionment formula.

The buyer had acquired enough target stock to make the section 338(g) election, and the target had become unitary with the buyer before the election date.

That unitary relationship did not move the deemed-sale gain into the buyer's combined report. The old target was treated as the seller and had to report the gain on its own return.

Acquisition facts

The taxpayer was a global media and technology company filing California returns on a worldwide basis.

Its lower-tier wholly owned buyer acquired a foreign, publicly traded target in multiple tranches. The buyer first crossed 50% ownership, making the target instantly unitary with the taxpayer, and later crossed the 80% threshold required for a section 338(g) election.

The taxpayer had not yet made the election when it requested the ruling.

What a section 338(g) election did

California conformed to I.R.C. section 338 through Revenue and Taxation Code section 24451.

The election treated the stock acquisition as though the old target sold all of its assets at the close of the acquisition date. A new corporation was then treated as owning those assets.

The old target—not the electing buyer—recognized the gain from that deemed asset sale.

Why the target reported the gain separately

The target and its subsidiaries were foreign corporations that could not join the buyer in a federal consolidated return.

Treasury Regulation section 1.338-10 required the old target to report the deemed-sale consequences on its final return and prevented it from being treated as a member of the buyer's affiliated group for that sale.

FTB also relied on Legal Ruling 2006-03 for the principle that gain inherent in the target's assets did not relate to the acquiring corporation's unitary business, even if the target became instantly unitary.

How California apportioned the gain

Because the target was already unitary with the taxpayer when the acquisition occurred, the partial-period combined-reporting regulation applied.

Under title 18, regulation section 25106.5-9(a), the target had to use an adjusted formula combining, on a pro-rata basis:

• its intrastate apportionment percentage for the pre-combination portion of the relevant period; and
• its intrastate percentage reflecting the combined group's factor denominators for the portion of the period when it was a group member.

The ruling therefore required the target to report and apportion the deemed-sale gain using that adjusted target-level formula.

What this means for you

Corporate acquirers

A section 338(g) election did not automatically place deemed-sale gain in the buyer's combined report, even when the target had become unitary with the buyer.

Multinational groups

Foreign-corporation status and federal consolidated-return eligibility were material. The ruling distinguished earlier guidance involving targets that had been members of a seller's federal consolidated group.

Corporate tax departments

Track each stock-purchase tranche, the dates when ownership crossed the unitary and section 338 thresholds, the election date, the target's federal return status, and the target's pre- and post-combination factor data.

Common questions

Q: Who recognized the deemed asset-sale gain?

A: The old target, not the electing buyer.

Q: Did the buyer include the gain in its combined report because the target was unitary?

A: No. The target reported the gain on its own return.

Q: Whose apportionment formula applied?

A: The target's adjusted formula under title 18, regulation section 25106.5-9(a).

Q: Why was the formula adjusted?

A: The target had a partial combined-reporting period, so the regulation required a pro-rata combination of the relevant pre- and post-combination percentages.

Q: Did the ruling decide whether the taxpayer should make the election?

A: No. It addressed how California would report and apportion the gain if the election was made.

Citations and references

• I.R.C. §§ 338(a), (d)(3), (g), (h)(9), 1501, and 1504
• Treas. Reg. §§ 1.338-10 and 1.1502-0 et seq.
• Cal. Rev. & Tax. Code §§ 21012(a)(1), 23051.5(d), 24451, 25105, and 25106.5
• Cal. Code Regs., tit. 18, §§ 25106.5-9(a) and 25106.5(b)(22)
• FTB Legal Ruling 2006-03
• Appeals of S.C.V. Realty & Development Co., Ltd., et al., 94-SBE-015 (Dec. 14, 1994)

Source

• Landing page: California FTB Chief Counsel Rulings
• Official PDF: Chief Counsel Ruling 2019-02

Original ruling text

STATE OF CALIFORNIA
FRANCHISE TAX BOARD
chair Betty T. Yee| member Malia M. Cohen| member Keely Bosler

Legal Division MS A260
PO Box 1720
Rancho Cordova, CA 95741-1720
tel: 916.845.2578 fax: 916.843.0453
ftb.ca.gov

07.11.19
Chief Counsel Ruling 2019 - 02

RE: Chief Counsel Ruling Request for * ** *** ***

Dear *** *,

This letter is in response to your Chief Counsel Ruling ("CCR") request dated * ** and supplemented on ** . In the request, you ask for the Franchise Tax Board's ("FTB") guidance as to California apportionment of gain resulting from *
* *** **** ("Taxpayer") making an Internal Revenue Code ("IRC") section 338(g) election.

FACTS

Taxpayer is a global media and technology company that provides media, entertainment, and telecommunication services. * * * ("Buyer") is Taxpayer's lower- tier, wholly-owned company incorporated in the * * and registered in
* and **. For California tax purposes, Taxpayer files its California franchise and income tax returns on a worldwide basis.

*** *** ("Target") is a top-tier parent company that is incorporated in the **
* and registered in * and . Target is publicly traded on the
**. Target is also in the media and telecommunications business, providing services similar to Taxpayer's, throughout the * *, *, *,
*, and . In addition to owning numerous subsidiaries operating internationally, Target owns *** ** * *, also a foreign company but with operations in the . * has filed an IRS 1120-F for federal purposes and on a Water's-Edge basis for California purposes.

From * * through * , Buyer purchased Target's stock in separate transactions, or tranches. On * ** **, Buyer completed its first purchase of 29 percent of Target's stock. Buyer continued purchasing tranches of Target's stock and by

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* ** ****, Buyer effectively owned more than 50 percent of Target's stock, and on that date was instantly unitary with Target. 1

Buyer continued purchasing additional tranches of Target's stock and by * ***
*, Buyer effectively owned more than 80 percent of Target's stock. Pursuant to federal rules, Taxpayer became eligible, as of * *** , to make an IRC section 338(g) election and to treat its purchase of Target's stock as a purchase of Target's assets. 2 On
* ** ****, Buyer acquired the remainder of Target's stock, thereby becoming Target's sole owner. 3 Taxpayer has not yet made the election, and has until the fifteenth day of the ninth month beginning after the month in which Taxpayer became eligible to make the election. 4

ISSUE

Whether gain realized from Taxpayer making an IRC section 338(g) election must be apportioned using Target's apportionment formula.

HOLDING

Pursuant to federal and California authorities, as discussed below, any gain on the deemed asset sale pursuant to the election must be apportioned using Target's adjusted apportionment formula as provided by California Code of Regulations, title 18, section 25106.5-9(a).

LAW AND ANALYSIS

On May 5, 2006, FTB issued Legal Ruling 2006-03 which addressed the apportionment of gains resulting from an IRC section 338 election. However, Legal Ruling 2006-03 did not address how gains from an IRC section 338 election are apportioned for a transaction involving a group of foreign corporations. Also, Legal Ruling 2006-03 is only applicable to taxpayers that had been members of the seller's federal consolidated return group. 5 IRC section 1501 provides that "a consolidated return [requires] all corporations [to be] members of the affiliated group." IRC section 1504(a)(1)(A) states "[an] 'affiliated group' [is] 1 or more chains of includable corporations connected through stock ownership with a common parent corporation which is an includable corporation." Pursuant to IRC section 1504(b)(3), a foreign corporation is not an "includable corporation." As Target is a foreign

1 California Revenue and Taxation Code section 25105.

2 IRC section 338(a) and (d)(3); IRC section 1504(a)(2).

3 Specifically, in * ** *, Buyer acquired Target's stock in more than ten separate purchases. In * ** , Buyer acquired more of Target's stock in another five separate purchases. Finally, in * ** **, Buyer acquired the remainder of Target's stock in three additional purchases. 4 IRC section 338(g)(1).

5 See United States Treasury Regulation section 1.1502-0 et seq.

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corporation that does not own a U.S. corporation, neither Target nor its subsidiaries are eligible to file a federal consolidated return.

California Revenue & Taxation Code ("CRTC") section 24451 conforms to IRC section 338 by reference. 6 IRC section 338(g) allows the acquiring corporation to make an election to treat its acquisition of a target's stock as a purchase of the target's assets. 7 When the election is made, the acquired corporation ("Old Target") is deemed to have sold all of its assets at the close of the acquisition date. 8 Thereafter, Old Target is treated as a new corporation ("New Corporation") that owns Old Target's assets. 9

In this case, Taxpayer making an IRC section 338(g) election will result in Target's deemed sale of its assets at the close of * *** ****, the date Taxpayer became eligible to make the election.

Pursuant to the IRC section 338(g) election, the old target, not the electing acquirer, recognizes the gain on the deemed sale of its assets. 10 United States Treasury Regulation ("Treasury Regulation") section 1.338-10(a)(1) sets forth, in relevant parts, a general rule that any tax consequences from the IRC section 338(g) deemed asset sale must be reported on the old target's final return for the taxable year ending at the close of the acquisition date. The exception to this rule set forth in paragraph (a)(2) of Treasury Regulation section 1.338-10 is not relevant in this case because Target and ** are foreign corporations ineligible to file a federal consolidated return.

Pursuant to paragraph (a)(5) of Treasury Regulation section 1.338-10, "[o]ld target may not be considered a member of any affiliated group that includes the purchasing corporation with respect to the deemed asset sale." This paragraph disallows inclusion of the old target and its deemed asset sale in a consolidated return which also includes the buyer making the election. As such, paragraphs (a)(1) and (a)(5) work in harmony, both directing the old target to report the deemed asset sale gain on its own return.

IRC section 338(h)(9) also provides that the target corporation will not be treated as a member of an affiliated group with respect to the sale described in subsection (a)(1). 11

FTB Legal Ruling 2006-03 addressed the apportionment of gains resulting from an IRC section 338(g) election by providing three scenarios and the associated tax outcomes for

6 The FTB has not issued any regulations pertaining to CRTC section 24451. Consequently, as there are no conflicting regulations issued by the FTB, pursuant to CRTC section 23051.5, subdivision (d), the federal regulations pertaining to IRC section 338 apply for California purposes. 7 IRC section 338(b)(3).

8 IRC section 338(a)(1).

9 IRC section 338(a)(2).

10 Treasury Regulation section 1.338-10.

11 IRC section 338(h)(9).

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each. 12 While all three fact patterns involved a seller that filed a federal consolidated income tax return, which is not the case in the situation presented, the ruling provides support for a conclusion that the target must report gains on the deemed asset sale separately from the buyer even if the buyer and the target were instantly unitary as a result of the acquisition. More specifically, while considering a situation in which "Old Target is a member of a federal consolidated return group, but not the common parent," FTB provided:

For California franchise and income tax purposes, the gain from the deemed sale of assets is treated as having arisen after Old Target's stock was sold.
(See Appeals of S.C.V. Realty & Development Co., Ltd., et al., 94-SBE-015, December 14, 1994.) … Because the gain is inherent in Old Target's assets when they are acquired by New Target, the gain does not relate to the unitary business of the acquiring corporation, even if instantly unitary. Therefore, the gain should not be included in the acquiring corporation's combined report, but should be reported on New Target's single day return. 13

Under the facts presented in this ruling, Target was already unitary with Taxpayer at the time of the acquisition. Therefore, the apportionment factors shall be determined pursuant to the regulations under CRTC section 25106.5. Accordingly, when Taxpayer makes the IRC section 338(g) election (effective * *** *), any gain realized on Target's deemed asset sale as a result of the election would be apportioned using California Code of Regulations, title 18, section 25106.5-9, which relates to partial combined reporting periods when a member is included in an existing combined reporting group. Utilizing the pro-rata method based on the number of days addressed in California Code of Regulations, title 18, section 25106.5-9(a), Target's apportionment factor percentage that will be utilized to source the gain on the deemed sale of the assets will be its intrastate apportionment percentage 14 from ** through * ** combined on a pro rata basis with its intrastate apportionment percentage taking into account the apportionment factor denominators of the combined reporting group that it became a member of during **
** through * *** **.

CONCLUSION

Gain realized as a consequence of Taxpayer making an IRC section 338(g) election must be reported by Target on Target's return and apportioned to California using Target's adjusted apportionment formula.

Please be advised that the tax consequences expressed in this CCR are applicable only to the named taxpayer and are based upon and limited to the facts you have submitted. In the event of a change in relevant legislation, or judicial or administrative case law, a change in federal interpretation of federal law in cases where our opinion is based upon such an interpretation, or a change in the material facts or circumstances relating to your request

12 FTB Legal Ruling 2006-03 (May 5, 2006), pp. 3-6.

13 FTB Legal Ruling 2006-03 (May 5, 2006), p. 5.

14 California Code of Regulations, title 18, section 25106.5(b)(22).

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upon which this opinion is based, this opinion may no longer be applicable. It is your responsibility to be aware of these changes, should they occur.

This letter is a legal ruling by the FTB's Chief Counsel within the meaning of paragraph (1) of subdivision (a) of section 21012 of the CRTC. Please attach a copy of this letter and your request to the appropriate return(s) (if any) when filed or in response to any notices or inquiries which might be issued.

Very truly yours,

Laura Taing
Tax Counsel