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The California Franchise Tax Board (FTB) recently issued Chief Counsel Ruling 2019-02 addressing the manner in which a taxpayer is to apportion gain to California after electing under IRC Sec. 338(g) to treat its purchase of a foreign target corporation’s stock as a deemed asset sale.1
Under the facts of the ruling, the FTB determined that the gain from the deemed asset sale must be separately apportioned to California using the target’s adjusted apportionment as computed under the partial period combined reporting rules contained in the California regulations.2
The taxpayer requesting the Ruling, a global media and technology company (Taxpayer), is the sole owner of a lower-tier corporation (Buyer). The Buyer, through a series of stock acquisitions, acquired greater than 50% of the stock of a target corporation (Target). Upon obtaining greater than 50% ownership in Target, Target was treated as being instantly unitary with Buyer and Taxpayer for California corporation franchise tax purposes. Through additional stock purchases, Buyer subsequently acquired more than 80% of Target’s stock, thereby enabling it to make an election under IRC Sec. 338(g) to treat Target’s stock sale as a deemed asset sale.3
Before making this election, Taxpayer sought the Ruling to determine the proper method of reporting and apportioning Target’s gain, should an election under IRC Sec. 338(g) be made.
An election under IRC Sec. 338(g) permits an acquiring corporation to treat the purchase of another corporation’s stock as though it purchased that corporation’s assets.4
A corporation becomes eligible to make an election under IRC Sec. 338 upon acquiring greater than 80% of the total stock and voting power of the acquired target corporation.5
Mechanically, when this election is made, the target corporation is deemed to have sold its assets at the close of the date of acquisition to “new target,”6
and the new target is the treated as the acquired corporation bringing over assets having a stepped-up basis.7
Procedurally, an election under IRC Sec. 338(g) must be made within nine months and fifteen days of the month in which the taxpayer becomes eligible to make the election. Although California has historically permitted separate elections under IRC Sec. 338 to be made for California purposes, under Assembly Bill 91 passed on July 1, 2019, the ability to make a separate election under IRC Sec. 338 for California purposes has generally been eliminated except for acquisitions subject to a binding contract entered into before July 1, 2019.8
FTB endorses use of adjusted apportionment formula to apportion gain
Although the FTB previously addressed the California treatment of gains arising from elections under IRC Sec. 338 in Legal Ruling 2006-03, that legal ruling did not address how to apportion gains from a transaction involving a purely foreign target that did not file a federal consolidated return. Ruling 2019-02 addressed this situation by looking to federal rules requiring that the gain on the deemed asset sale be recognized by old target (and not the electing acquirer) and be reported on old target’s final return for the taxable year ending at the close of the acquisition date.9
Referencing these federal principles, Ruling 2019-02 held that the gain must be apportioned to California using Target’s adjusted apportionment formula.
Concerning the apportionment of the gain recognized by the Target, Ruling 2019-02 held that, because the Target was already unitary with the Taxpayer at the time the 80% stock ownership threshold was met, the apportionment factors used to source the gain to California “shall be determined pursuant to the regulations under [Cal. Rev. & Tax. Code] Section 25106.5.”10
Under these regulations, the FTB held that the gain will be separately apportioned using Target’s apportionment factor computed under the elective “pro rata” method described in Sec. 25106.5-9(a) of the California regulations. Under the elective pro rata method, Target’s apportionment percentage without factoring in the denominators of Taxpayer’s combined reporting group is combined on a pro rata basis with Target’s intrastate apportionment percentage taking into account the apportionment factor denominators of Taxpayer’s combined reporting group.
Chief Counsel Ruling 2019-02 provides helpful insight into how the FTB may potentially review and treat the apportionment of gains attributable to elections under IRC Sec. 338(g) on audit. Although Ruling 2019-02 is materially redacted, it clarifies that the FTB will treat gains as reportable by the Target and apportioned based on the Target’s apportionment percentage computed under the partial period combined reporting rules set forth in Sec. 25106.5-9 of the California regulations.
Importantly, Ruling 2019-02 only addresses the treatment of the IRC Sec. 338(g) gain when an election has been made under Sec. 25106.5-9(a) of the California regulations to use the pro rata method of partial period combined reporting. The Ruling does not address how the gain would have been apportioned by Target under the interim closing method (which is the default regulatory methodology for partial period combined reporting under Sec. 25106.5-9(a)), or under the “in lieu of” method elective available under Sec. 25106.5-9(c).
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