California: IRC section 338(g) Gain Must be Apportioned Using Target’s Factors

The California Franchise Tax Board recently issued a chief counsel ruling concluding that gain recognized from an IRC § 338(g) election must be reported by the target entity on its final return and apportioned to California using its own apportionment factors.  The Buyer at issue was a wholly-owned subsidiary of the taxpayer, a global media and technology company that filed California franchise tax returns on a worldwide basis.  The target entity was a foreign corporation that did not file a U.S. tax return. Through a series of purchases, the Buyer effectively owned more than 50 percent of Target’s stock and was instantly unitary with the Target.  The Buyer continued to purchase Target’s stock until it owned more than 80 percent of such stock. At that time, it became eligible to treat the purchase of Target’s stock as a purchase of Target’s assets under IRC § 338(g) election.

When a § 338(g) election is made, the acquired corporation is deemed to have sold all of its assets on the date of the close of the acquisition.  Thus, the acquired corporation recognizes the gain on the deemed sale of its assets and reports the gain on its final return.  The acquired corporation is then treated as a new corporation that owns the old acquired corporation’s assets. In a previous ruling, Legal Ruling 2006-03, the FTB addressed apportionment when the target was part of a federal consolidated group.  In that situation, the FTB concluded that gain resulting from the § 338(g) election “…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.” 

Legal Ruling 2006-03 does not apply to the acquisition of a foreign target that is not eligible to file a federal consolidated return. Nonetheless, in the FTB’s view, the ruling provides support that the Target must report gains from the deemed sale separately from the Buyer. Although Target was already unitary with Buyer at the time of the acquisition of shares that triggered eligibility for the election, the FTB determined that the gain from the deemed sale of Target’s assets did not relate to the Buyer’s unitary business.  Therefore, Target was required to report the gain from the deemed asset sale on its final return and using Target’s own apportionment factors for the partial period ending on the acquisition date. For more information on Chief Counsel Ruling 2019-02, please contact Candace Axline at 858-750-7241 or Scot Grierson at 949-885-5643.