Tax issues for foreign acquisitions: a tax attorney outlines the benefits and challenges of specific tax code treatments involving overseas buyers and sellers. (International Taxation).

Should you buy assets or stock? Every acquisition of a corporation, even a foreign-owned business, has tax consequences. Stock sales typically generate a single level of tax to shareholders; asset sales generate a step-up in the basis of the acquired assets to reflect the purchase price paid, which generates greater future tax deductions for the buyer.

The key, then, if you are a U.S. corporation planning to buy 80 percent or more of a foreign target company, is to structure that acquisition to realize the best tax advantage.

By enabling the Internal Revenue Code Section 338 election, Congress made it possible to have the best of both worlds by permitting corporations purchasing a controlling interest in another corporation through a qualified stock purchase to elect to have that stock acquisition treated as a purchase of assets. Foreign targets are ineligible for the special Section 338(h)(10) election. They are eligible, however, for a Section 338(g) election -- referred to in this article as "338(g)" -- made by the purchaser.

A 338(g) election often is useful in reducing the ultimate U.S. tax cost when the target's earnings are repatriated or the target is subsequently sold at a gain. Generally, as long as the target is not engaged in a U.S. business, a buyer's 338(g) election for its purchase of the foreign target won't incur any U.S. tax cost. And since the 338(g) election doesn't apply overseas, no foreign taxes are incurred.

To benefit fully, pay attention to filings and compliance. For example, failure to provide timely notice to even one U.S. person required to receive it invalidates the 338(g) election unless the IRS determines that the purchaser made a "good faith" effort to identify and provide timely notice to all required recipients. So, to be absolutely certain, send a notice to all sellers regardless of whether or not they are U.S. persons [taxpayers]. And consider adding a schedule to the purchase agreement in which non-U.S. sellers represent that fact, and also the fact they are not U.S.-owned.

Issues for U.S. Sellers Of a Foreign Target

* Special Target Status. If the foreign target is a Controlled Foreign Corporation, or CFC (more than 50 percent owned by U.S persons, each of whom owns at least 10 percent directly or indirectly), or a Foreign Personal Holding Company (FPHCO), some or all of the deemed asset sale gain could be Subpart F or FPHCO income. That portion of the gain (all of the gain in the case of a FPHCO) would be taxed as ordinary income.

* Foreign Tax Credit Limitation. Typically, a target's earnings and profits increase by the deemed gain on the deemed asset sale. This means there are more earnings and profits that (under Section 1248 for a CFC) convert a seller's gain to ordinary dividend income.

Atypically, however, a U.S. corporate seller cannot use this portion of the Section 1248 gain to increase the amount of its foreign tax credit limitation.

* Impact on C-corporation Sellers. Unless there is a difference between the tax basis of the selling company's stock and its assets, a 338(g) election may not mean much to a U.S. C-corporation seller. If there is a difference, making 338(g) target affiliate elections for each of the CFC's subsidiaries can re-characterize the gain as non-Subpart F and non-FFHCO income, and can reduce the seller's U.S. tax by making foreign tax credits available through operation of the Subpart F provisions, Of course, when the gain increases the CFC's accumulated earnings without incurring a foreign tax, it often reduces the foreign tax credit mechanism's effectiveness.

* Impact on Individual U.S. Sellers (including S Corporations and Partnerships of individuals). Even in the absence of a 338(g) election, U.S. sellers realize a gain on their stock sale. To the extent the gain exceeds the Section 1248 amount, it is a capital gain. Ordinary income would be increased by a 338(g) election (for the amount of gain), and thus would usually result in an increase in U.S. tax. This is because under Section 951, the seller is deemed to hold the stock through the date of sale. And under Section 338, the deemed asset sale gain occurs on the date of sale.

Issues for Controlled Foreign Corporation (CFC) Sellers of a Foreign Target

Because it is considered Subpart F and FPHCO income, gain on subsidiary stock sales is taxable to the U.S. owners. Applying a 338(g) election to the target's subsidiary may defer U.S. tax on the gain for the CFC's U.S. owners until the CFC distributes proceeds or is sold.

Ordinarily, sellers would require the purchaser to indemnify them for any U.S. tax cost incurred or accelerated as a result of purchaser making a 338(g) election. However, for CFC sellers, when the seller defers repatriation of the proceeds, it's the opposite. U.S. parents of such CFC sellers may wish to require the purchaser to make a 338(g) election. Then the CFC can reinvest the proceeds in other non-U.S. businesses without first incurring a U.S. tax on the gain.

Stephen J. Epstein, CPA, Esq., is a Partner in New York City's Richard A. Eisner & Company's Tax Consulting & Financial Services Practices. He can be reached at [e-mail].