Does a sale of a subsidiary in an IRC section 338(a) transaction require the target to recapture the investment tax credit it previously claimed under section 210.12?

Plain-English summary

Arthur Andersen LLP asked whether selling a subsidiary ("Corporation X") in an IRC section 338(a) transaction -- where buyer and seller treat a qualified stock purchase as a deemed sale of the target's assets -- requires the target to recapture the investment tax credit (ITC) it had claimed under section 210.12. The selling group also planned a section 338(h)(10) election.

New York's ITC must be recaptured if credit property is disposed of before the end of its useful life (section 210.12(g); 20 NYCRR 5-2.8). A "disposition" includes a sale, but not a tax-free transfer to which IRC section 381(a) applies (e.g., a section 332 liquidation or a section 368 reorganization) -- and prior opinions held a tax-free section 351 transfer is likewise not a disposition (Coats & Clark).

A section 338(a) election is different: the target is treated as having sold all its assets at fair market value in a single transaction, and the new target is treated as buying them (by "purchase" under IRC section 179(d)(2), with a stepped basis). So the transaction is a disposition under 20 NYCRR 5-2.8, and the old target must recapture its ITC.

For Article 9-A, the section 338(h)(10) election is ignored in all cases (TSB-M-91(4)C); the transaction is treated as if only a 338(a) election were made, computed as if seller and target filed separately. Corporation X files two short-period returns -- a final return as "old target" and a first return as "new target." On the old target's final return, it includes any deemed gain or loss and adds back the recaptured ITC; any ITC carryover ceases and is not carried into the new target's first year. As new target, with a stepped basis, Corporation X may claim its own ITC if the property qualifies.

What this means for you

A 338(a) deemed sale triggers recapture

Treating a stock sale as an asset sale makes it a disposition for New York ITC purposes, so the old target must recapture the credit.

338(h)(10) is ignored for Article 9-A

New York disregards the (h)(10) election and treats the deal as a 338(a) deemed sale on a separate-return basis, producing two short-period returns.

The carryover does not survive

Any unused ITC carryover ends with the old target; the new target starts fresh and may earn its own ITC on the stepped-up basis.

Common questions

Q: Is a tax-free reorganization also a disposition?
A: No. Transfers under IRC section 381(a) (or a tax-free section 351 transfer) are not dispositions and do not trigger recapture.

Q: Where is the ITC recaptured?
A: On the old target's final short-period return, where it is added back to the tax due.

Q: Can the buyer use the seller's leftover ITC carryover?
A: No. The carryover ceases; the new target can only claim ITC it earns itself on the stepped-up basis.

Citations and references

Statutes, regulations, and authorities:
- Tax Law section 210.12 (investment tax credit)
- Tax Law section 210.12(g) (recapture on disposition before end of useful life)
- 20 NYCRR 5-2.8 (recapture of investment tax credit on disposition)
- 20 NYCRR 5-2.8(e) (no disposition where IRC section 381(a) applies)
- IRC section 338(a) (qualified stock purchase treated as a deemed asset sale)
- IRC section 338(h)(10) (election to recognize gain at the selling group)
- IRC section 179(d)(2) (acquisition by purchase)
- TSB-M-91(4)C (April 17, 1991) (section 338(h)(10) ignored for Article 9-A)
- Coats & Clark Inc., TSB-A-88(16)C (Aug. 11, 1988)
- Arthur Andersen LLP, TSB-A-98(20)C (Nov. 3, 1998)

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/corporation_ao_1998.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/corporation/a98_20c.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-A-98(20)C
Corporation Tax
November 3, 1998

STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. C980626A

On June 26, 1998, a Petition for Advisory Opinion was received from Arthur
Andersen LLP, 400 Atlantic Street, Stamford, Connecticut 06912.
The issue raised by Petitioner, Arthur Andersen LLP, is whether the sale
of the target corporation in a section 338(a) of the Internal Revenue Code
transaction represents a disposition of assets requiring recapture of the target
corporation's investment tax credit carryover which was previously claimed under
section 210.12 of the Tax Law,.
Petitioner submits the following facts as the basis for this Advisory
Opinion.
Corporation X is a wholly owned subsidiary of Seller. Seller intends to
sell its shares of Corporation X to an unrelated third party ("Buyer"). Both
Seller and Buyer intend to make a section 338(a) of the Internal Revenue Code
("IRC") election that would treat the sale of Corporation X's shares as a deemed
asset sale.
Additionally, the selling consolidated group intends to make an election
under section 338(h)(10) of the IRC, whereby recognition of the gain or loss on
the deemed sale of assets may be made by the selling consolidated group. The
consolidated group would, therefore, be required to recognize gain or loss on the
sale of Corporation X's deemed assets.
Historically, Corporation X has claimed an investment tax credit for
qualifying assets purchased and placed in service in New York.
Discussion
Section 210.12(g) of the Tax Law and section 5-2.8(a) of the Article 9-A
Regulations provide that if property on which investment tax credit has been
claimed is disposed of or ceases to be in qualified use prior to the end of its
useful life, the difference between the credit taken and the credit allowed for
actual use must be added back to the tax otherwise due in the year of disposition
or disqualification.
Section 5-2.8(b) of the Article 9-A Regulations provides that when a
disposition occurs, the amount of investment tax credit that must be added back
is computed as follows:
(1) the total number of months in qualified use of the
property divided by the total number of months of useful life;
(2) multiply the amount computed in (1) by the amount of the
credit claimed on the property to ascertain the credit allowed for
actual use;
(3) subtract the credit allowed for actual use from the credit
claimed on the property to determine the amount of investment tax
credit to be added back; and

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Corporation Tax
November 3, 1998

(4) add the amount to be added back to the tax due for the
year the property was disposed of or ceases to qualify.
Section 5-2.8(c) of the Article 9-A Regulations provides that a disposition
of qualified property includes:
(1) a sale of the property;
(2) a liquidation other than as part of a statutory merger or
consolidation;
(3) a legal dissolution of the taxpayer;
(4) a trade-in of the property;
(5) a gift of the property;
(6) transfer upon foreclosure of a security interest in the
property;
(7) retirement of the property before expiration of its useful
life;
(8) condemnation of the property;
(9) loss of the property due to fire, theft, storm or other
casualty; and
(10) transfer of the property to a corporation not taxable
under article 9-A.
Section 5-2.8(e) of the Article 9-A Regulations provides that:
[f]or purposes of this section, a disposition does not occur
where property is transferred from a corporation as part of a
transaction to which section 381(a) of the Internal Revenue Code
applies; e.g., a complete liquidation of a subsidiary under section
332 of the Internal Revenue Code, or a reorganization under section
361 and 368(a)(1)(A) (statutory merger or consolidation), section
368(a)(1)(C) (certain acquisitions of property from one corporation
by another), section 368(a)(1)(D) (certain transfers of assets),
section 368(a)(1)(F) (mere change in identity, form or place of
organization, however effected) or section 368(a)(1)(G) (bankruptcy
reorganizations). As there is no disposition in these cases, an add
back is not required provided that the property continues in
qualified use and is acquired by a corporation subject to tax under
article 9-A. Generally, in these cases, the acquiring or surviving
corporation cannot claim an investment tax credit because it takes
over such property at the adjusted basis of the transferor and the
transfer therefore does not qualify as a purchase pursuant to
Internal Revenue Code, section 179(d)(2). If the property in the
hands of the acquiring corporation is not in qualified use for its
entire life or for more than 12 consecutive years, a recovery from
the acquiring corporation is required. In measuring the period of
qualified use, the period during which the property was held by the
transferor corporation and the acquiring corporation are to be taken
into account.

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TSB-A-98(20)C
Corporation Tax
November 3, 1998

The term �disposition� is not defined for purposes of section 210.12(g) of
the Tax Law or section 5-2.8 of the Article 9-A Regulations. It has been held
that a tax-free transfer pursuant to section 351 of the IRC, that for federal
income tax purposes would not require the recapture of the investment tax credit
taken on IRC section 358 property, does not constitute a "disposition" as
contemplated in section 210.12(g) of the Tax Law. See Coats & Clark Inc., Adv
Op Comm T & F, August 11, 1988, TSB-A-88(16)C; Milton Roy Company, Adv Op Comm
T F, February 10, 1993, TSB-A-93(7)C; and Morrison & Foerster LLP, Adv Op Comm
T & F, December 19, 1996, TSB-A-96(27)C.
However, there is no tax-free transfer of property where a section 338(a)
of the IRC election has been made. Under section 338(a) of the IRC, an election
may be made by the purchaser in a qualified stock purchase, which generally
involves the purchase of at least 80 percent of the stock of a corporation during
any 12 month period.
Pursuant to this election, the target corporation is
"treated as having sold all of its assets at the close of the acquisition date
at a fair market value in a single transaction." The target is then "treated as
a new corporation which purchased all of the assets as of the beginning of the
date after the acquisition date".
The result of this election is that the
difference between the fair market value of the assets and their basis is
recognized as gain or loss to the old target, and the basis of the assets in the
hands of the acquiring organization is stepped up or down, as the case may be.
Further, for purposes of section 179(d)(2) of the IRC, section 1.179-4(c)(2) of
the Treasury Regulations states that "[p]roperty deemed to have been acquired by
a new target corporation as a result of a section 338 election (relating to
certain stock purchases treated as asset acquisitions) will be considered
acquired by purchase."
Therefore, where a section 338(a) of the IRC election is made, the assets
of the target corporation are deemed sold at the close of the acquisition date
at a fair market value in a single transaction, and the new target corporation
is deemed to have acquired the assets by purchase for purposes of section
179(d)(2) of the IRC, with the basis of the assets stepped up or down, as the
case may be. Accordingly, this transaction would constitute a disposition as
contemplated under section 5-2.8(e) of the Article 9-A Regulations, and the new
target corporation may be allowed to claim an investment tax credit if the
property otherwise qualifies under section 210.12 of the Tax Law.
Pursuant to Technical Services Bureau Memorandum, TSB-M-91(4)C, April 17,
1991, for purposes of Article 9-A of the Tax Law, a section 338(h)(10) of the IRC
election is ignored in all cases, and the transaction is treated as if only a
section 338(a) of the IRC election were made, determined as if the seller and the
target corporation filed separately for federal income tax purposes. However,
in a typical situation, the target corporation will be filing only two reports,
a final short year of old target and the first short year as new target.
When determining the target corporation's federal taxable income as if it
had filed separately for federal income tax purposes, a gain (or loss) on the
deemed sale of the target's assets under a section 338(a) of the IRC election
would be included in old target's final return. For purposes of Article 9-A of
the Tax Law, gain (or loss) on the deemed sale of the target's assets would be
included on the old target's final return and the old target would also be
required to recapture the investment tax credit. When the target files as new
target, it would have a stepped up (or stepped down) basis for the assets and
could claim an investment tax credit if the property otherwise qualifies under
section 210.12 of the Tax Law. (See, Technical Services Bureau Memorandum, TSBM-86(3)C, April 3, 1986.)

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Corporation Tax
November 3, 1998

In this case, Corporation X, as a result of the section 338(a) of the IRC
election, will be deemed to have disposed of its assets pursuant to section 5­
2.8(c) of the Article 9-A Regulations. For purposes of Article 9-A of the Tax
Law, the section 338(h)(10) of the IRC election will be disregarded. Corporation
X will be required to file two short period returns. One will be the final
return of old target as of the close of the acquisition date, and one will be as
the new target. The starting point for computing entire net income for both
returns will be Corporation X's federal taxable income computed as if it had
filed separately for federal income tax purposes. Accordingly, when Corporation
X files its final return as old target corporation, it will include in the
computation of entire net income, any deemed gain (or loss) on the deemed sale
of the assets, and it must add back to the tax due the amount of investment tax
credit that must be recaptured pursuant to section 5-2.8(b) of the Article 9-A
Regulations. To the extent that the amount to be recaptured is a carryover of
a credit that was allowed for a taxable year but not deductible, the carryover
will cease, and will not be allowed to be carried over the first year of the new
target corporation.
Corporation X, as new target, may be able to claim an
investment tax credit if the property qualifies under section 210.12 of the Tax
Law.

DATED:

November 3, 1998

NOTE:

/s/
John W. Bartlett
Deputy Director
Technical Services Bureau

The opinions expressed in Advisory Opinions
are limited to the facts set forth therein.