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Ruling 2003-3, Corporation Business Tax / Internal Revenue Code §338(h)(10) Elections

FACTS:

A foreign Parent Corporation (Parent) owns Holding Company (Holding), which is based in the United States.  Holding has a wholly owned subsidiary Company A.  Company A acquired another company, Company B.  Parent’s management, which is located outside the United States, finalized the sale of Company B to another foreign-based entity (Foreign Company).  Company A and Foreign Company joined in an Internal Revenue Code (I.R.C.) §338(h)(10) election with respect to Company A’s sale of Company B stock to Foreign Company. 

ISSUES:

  1. Whether the I.R.C. §338(h)(10) gain is apportionable business income for purposes of Company B’s Connecticut corporation business tax return.
  2. Whether the I.R.C. §338(h)(10) election to treat the sale of Company B as a sale of assets, rather than as a stock sale, should be reflected in Company B’s receipts factor as a sale of stock or a sale of assets.

RULING: 

  1. The I.R.C. §338(h)(10) gain is apportionable business income for purposes of the Connecticut corporation business tax. 
  2. The I.R.C. §338(h)(10) election to treat the sale of the subsidiary as a deemed asset sale, rather than as a stock sale, should be treated as a sale of assets and reflected in Company B’s receipt factor as a sale of assets.

DISCUSSION:

I.R.C. §338(h)(10) allows a corporation engaged in a sale of stock to elect to treat the sale as a sale of assets rather than a stock sale.  Treating such sale as a sale of assets allows for the elective recognition of gain or loss on the deemed sale of assets by the corporation that is being sold (target corporation), together with the nonrecognition of gain or loss on the stock sold by the selling consolidated group.  Thus, if an election under I.R.C. §338(h)(10) is made, the parent that is selling the subsidiary does not recognize the gain.  Instead, it is the subsidiary or target corporation that recognizes the gain.  The gain is based on the difference between the target’s basis in its assets and the selling price.  Thus, where the election is made, the buyer stands to gain significant tax benefits from stepping up the basis of the subsidiary’s assets to reflect the price it paid for the stock.  The buyer may then depreciate the assets, which had been previously depreciated by the target corporation. 

If an I.R.C. §338(h)(10) election is not made, the parent corporation recognizes the gain on the sale of stock.  The parent corporation’s gain or loss will depend on the difference between the sales price and its adjusted basis in the subsidiary’s stock.

Company A and Foreign Company elected the treatment that is provided for in I.R.C. §338(h)(10).  Company A raises two issues regarding the effect of its election on its Connecticut corporation business tax return that it will file with Company B, which will cover the period up to the election, and the tax consequences of the election for Company B.  The first issue is whether the income from the sale of Company B constitutes apportionable business income. 

For purposes of the Connecticut corporation business tax, Connecticut does not distinguish between business income and non-business income.  Connecticut law requires that a corporation apportion all income, including business income of domiciliary corporations.  See generally Conn. Gen. Stat. §12-218.  Company A represents that the income from the sale of Company B is business income.  Accordingly, this income is subject to apportionment.  However, even if it were determined that this was non-business income of this domiciliary corporation, the income from the sale would be subject to apportionment.  Special Notice 93(26), Effect of Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768, 112 S.Ct.2251, 119 L.Ed. 2d 533 (1992), on the Exclusion of Income Derived From the Holding or Sale of Stock in a Non-Unitary Business From Apportionable Net Income. Thus, the income from the sale of Company B is subject to apportionment.

The second issue raised by Company A is whether the I.R.C. §338(h)(10) election to treat the sale of Company B as an asset sale, rather than as a stock sale, should be treated for apportionment purposes as a sale of stock and reflected in Company B’s receipts factor.  In Ruling No. 89-46, the Department stated that “for purposes of the Connecticut Corporation Business Tax, the Department will follow federal law incorporating the effects of an I.R.C. §338(h)(10) election in computing tax.”  This brief statement, however, does not directly deal with whether the income should be reflected in the receipts factor. 

Conn. Gen. Stat. §12-218 provides for the apportionment of net income.  For income years commencing prior to January 1, 2001, Connecticut applied a three-factor formula to income derived from the manufacture, sale or use of tangible personal or real property.  This three-factor formula consisted of the sum of the property factor, the payroll factor and twice the receipts factor divided by four.

Conn. Gen. Stat. §12-218(c)(3) provides that the receipts factor represents: 

The part of the taxpayer’s gross receipts from sales or other sources during the income year, computed according to the method of accounting used in the computation of its entire net income, which is assignable to the state … including receipts from sales of tangible property if the property is delivered or shipped to a purchaser in this state … , receipts from services performed within the state, rental and royalties from properties situated within the state, royalties from the use of patents or copyrights within the state, interest managed or controlled within the state, net gains from the sale or other disposition of tangible assets situated within the state and all other receipts earned within this state.

(Emphasis added.)  Here, Company A has made a federal election to treat the sale of stock as if it were a sale of assets.  The courts of Connecticut have held that federal elections or federal deeming statutes can be binding with respect to state taxes.  See, e.g., Skaarup Shipping Corp. v. Commissioner, 199 Conn. 346, 507 A.2d 988 (1986) and Circuits, Inc. v. Dubno, 213 Conn. 442, 568 A.2d 457 (1990) (both ruling that a federal election to take a tax credit is binding, in that it precludes a taxpayer from taking the credits as deductions for state purposes).  In general, the Department follows the federal tax treatment of an election.  See, e.g., Special Notice 99(3), Effect of Federal Tax Law Changes on the Taxation of Limited Liability Companies and S Corporations and Their Shareholders. (Department follows federal tax treatment as determined under the check-the-box regulations). 

Company A maintains that its sale of Company B should be treated as a stock sale rather than a deemed asset sale, because in reality it is a sale of stock.  For the state to take this position, however, would result in inconsistent tax treatment.  If an election had not been made under I.R.C. §338(h)(10), the stock sale would be reported as income of Company A, the parent of Company B.  It would also mean that the sale of the Company B stock would be treated as a sale of intangible assets. 

The election under I.R.C. §338(h)(10), however, results in Company B, the target, reporting the income, rather than Company A, which is the entity that sold the stock.  Net income, as defined in Conn. Gen. Stat. §12-213(10), means

Net earnings received during the income year and available for contributors of capital, whether they are creditors or stockholders, computed by subtracting from gross income the deductions allowed by the terms of section 12-217 … .

The net income of Company B that must be reported on Company B’s Connecticut corporation business tax return includes the gain on the sale of assets, not the gain on the sale of stock.  Accordingly, it is consistent for purposes of the Connecticut corporation business tax to recognize the sale, as it is federally treated, as a deemed sale of assets.  Treating the transaction as an asset sale reflects the reality of the situation in terms of who recognizes the gain and the amount of gain that is recognized.

Furthermore, the Department is bound to follow its long-standing position, announced in Ruling No. 89-46, that “for purposes of the Connecticut Corporation Business Tax, the Department will follow federal law incorporating the effects of an I.R.C. §338(h)(10) election in computing tax.”  Conn. Gen. Stat. §12-218(c)(3) clearly provides that net gains from the sale of tangible assets that are situated within Connecticut are included in the receipts factor.  There is nothing in Conn. Gen. Stat. §12-218(c)(3) that authorizes the Commissioner to ignore this sale of assets, whether tangible or intangible, or to “throw-out” the sale of assets from the receipts factor.  Accordingly, the income from the deemed sale of assets must be treated as a sale of assets and included in the receipts factor. 

LEGAL DIVISION

July 14, 2003