Mergers & Acquisitions: Lap One

Transcription

1 Mergers & Acquisitions: Lap One Michael J. Bowen Chair, State and Local Tax Practice Akerman Jacksonville, Florida Diane Mimmo Managing Director PwC LLP Boston, Massachusetts Lenore Vidal Tax Director Forsythe Technology Chicago, Illinois

2 Agenda Successor Liability State Tax Diligence Considerations Income / Franchise Tax Sales / Use Tax Property Tax Employment Tax Abandoned & Unclaimed Property Other State Taxes Transactional Tax Considerations Planning Considerations Examples of Acquisition Formats High-level Considerations of Stock vs Asset Deal IRC Section 338 in Detail

3 Successor Liabilities

4 Myth 1 Myth No income/franchise taxes attach in an asset acquisition Reality Some states have broad successor liability statutes that will include income/franchise taxes on the sale of assets (i.e. FL, PA, SC, etc.). Other exposures transferred include: Gross receipts taxes; Sales/use taxes; Unemployment taxes (in some cases) successor employer;

5 Myth 2 Myth Bulk sale procedures are necessary in every asset deal Reality Bulk sale procedures are cumbersome and often the acquiring entity will choose to rely on broad indemnities

6 Myth 3 Myth Sales and use taxes are the main consideration on asset sales Reality While these are often a heavy consideration, all applicable tax types should be reviewed

7 SALT Tax Considerations

8 Income Tax Nexus Does the Target have Nexus in Additional States? 1. Physical Presence (property, payroll) 2. P.L i. Sales of services versus sales of tangible personal property ( TPP ) ii.certain states (i.e. Texas) do not conform 3. Geoffrey/Economic Nexus (non-exhaustive) Arkansas, Florida, Louisiana, New Jersey, Oklahoma, and South Carolina 4. Factor Nexus (non-exhaustive) California, Colorado, Connecticut, Iowa, Michigan, Wisconsin 5. Foreign Sales 80/20 Illinois, Massachusetts

9 Income Tax Nexus Due Diligence Considerations Delivery by company owned vehicles (possibly allowed) Flow-through nexus (partnerships) Wrigley tests (86-272) Target has an IP company Low total apportionment

10 Income Tax Nexus Exposure Calculation Sales by state Single sales factor apportionment Federal taxable income

11 Income Tax Filing method Combined Reporting 2014 / 2015 Historic Filings Combined Unitary Consolidated Separate CA OR WA NV ID AZ UT MT WY CO NM* ND SD NE KS OK MN IA MO AR WI IL MI IN KY TN OH PA WV VA NC SC NY* VT NH MA CT NJ DE MD DC ME RI AK MS AL GA TX LA HI FL *New York and Rhode Island adopt unitary combined reporting in 2015

12 Income Tax Tax Base Starting Point: Federal Taxable Income* Additions State & local income taxes Foreign income taxes Interest from state obligations Excess depreciation & depletion Federal NOL/capital loss Related party interest and royalty payments Section 199 deduction

13 Income Tax Tax Base Starting Point: Federal Taxable Income* Subtractions: Dividends received deductions Dividends from CFCs Federal work opportunities Interest - US Obligations State income tax refunds Current year capital loss Subpart F income Federal income tax

14 Historic Filings Position and the Impact on Tax Liability Credit Carryforward NOLs AK HI CA OR WA NV ID AZ UT MT WY CO NM ND SD NE KS OK MN** IA MO AR WI IL MI OH IN KY TN PA WV VA NC SC* NY ME VT NH MA CT RI NJ DE MD DC MS AL GA Related member expense addback required (including DC, NYC) TX LA Related member expense addback legislative proposals considered in recent years FL No related party addback provisions imposed Repealed in OR eff. 1/1/13 and in RI eff. 1/1/15 *South Carolina disallows deductions for an expense between related parties where a payment is accrued, but not actually paid and on interest deductions on obligations issued as a dividend or paid instead of a dividend **Minnesota requires addback of interest and intangible expenses, losses, and costs paid, accrued, or incurred by any member of the taxpayer's unitary group to a foreign operating corporation that is a member of the taxpayer's unitary business group, However FOCs were repealed for tax years beginning on or after 1/1/13

15 1. Business v. Non Business Income Business income arises as a part of the taxpayer s regular course of business Determined by one of the following tests: 1. Transactional 2. Functional Apportioned Non-Business income is all income other than business income Allocated Examples Capital gains, interest, dividends, etc.

16 Income Tax Tax Base (cont) Due Diligence Considerations Any income allocated as non-business

17 Income Tax Apportionment State Specific Apportionment Formulas State apportionment formulas are premised on one or more of the following factors Payroll, Property and Sales Three Factor Apportionment Formulas Movement to Hybrid and Single Sales Factor Formulas

18 Income Tax Apportionment Sales Factor Considerations UDITPA Income Producing Activity /Costs of Performance Market Sourcing Customer location/benefits received Why the move to Market Sourcing? 1. Vagueness of Income Producing Activity 2. What costs qualify for Costs of Performance? 3. Binary sourcing of Sales under UDITPA 4. Disconnect between situs of costs and resulting benefit

19 Income Tax Apportionment Sales other than TPP More States adopting Market Sourcing Market Sourcing and Nexus? Almost even split between UDITPA/Market Sourcing PROBLEM: Multiple taxation of same income between UDITPA and Market Sourcing States? SOLUTION: Alabama regulation provides for non-binding mediation to address disputes involving different sourcing methods

20 Income Tax Apportionment Does Throwback or Throwout Apply? Throwback Sales of TPP are thrown back to the state the item was shipped from if (1) the purchaser is the U.S. government or (2) the taxpayer is not taxable in the state of the purchaser Throwout Removes sales from both the numerator and denominator if they are not taxable in the state where they would be sourced NOTE: The growth of economic nexus will continue to minimize the impact of throwback and throwout rules

21 Income Tax Apportionment Due Diligence Considerations How does the company earn revenue? Sales of TPP, services, mixed? Does the company take an operational or transactional approach to Costs of Performance? Is the company subject to a blanket sourcing methodology or more likely various methods? Does the company have foreign sales or nowhere sales? Is the company subject to an industry-specific apportionment formula and/or sourcing? Is the company potentially subject to multiple taxation?

22 Income Tax Common Exposure Issues 1. Nexus 2. Related Party Add backs Management Fees/ Overhead allocations Royalties Intercompany Interest 3. Incorrect Transfer Pricing Between Related Parties 4. Apportionment Sourcing Methodology 5. Nonresident Withholding (Partnership / S-Corps)

23 Sales Tax 1. Sales of tangible personal property ( TPP ) almost always subject to tax unless a resale or exemption certificate is collected: Casual Sale exemption Manufacturing exemption Sale for Resale Other exempt property 2. Sales of services or intangibles not generally subject to tax unless specifically enumerated as taxable (about 8 states tax consulting services)

24 Sales Tax Areas of Interest Nexus Minimal physical presence actual presence Filing requirement (e.g. even if no tax) Collection Requirement Burden Entity with nexus has collection requirement may shift to buyer Collecting with failure to remit may be criminal (longer statute of limitations)

25 Sales Tax Areas of Interest Software and Information Services SaaS/ Hosted/ Cloud Transactions Canned vs. Custom Maintenance/Upgrade Mandatory/Optional Electronic/Load and Leave

26 Use Tax Use Tax is complementary tax to sales tax Buyer s responsibility State where purchase is made or item is used How to perform diligence? Former audits and current notices Tangible property in multiple locations (central point of purchase) Significant exemptions Leased property Purchase invoices

27 Sales / Use Tax Does the Target have the Appropriate Documentation? Resale Certificates TPP or Taxable Services Correct State Valid Year MTC or SSUTA certificate Exemption Documentation Sales to exempt entities (state and local governments, non-profit, etc.) Generally sales to U.S. government do not need exemption documentation

28 Sales / Use Tax Due Diligence Considerations Where registered and/or filing compared to sales schedule Copies of invoices (for presentation) Nonfiling states (no running of statute of limitations coupled with no documentation collection) Prior audit assessments and current audit list Process maps for both sales and use Bulk Sale or Tax Clearance on file VDAs? Pending Refunds? Standard contract terms (re Tax) Bulk Sales/Tax Clearances on file

29 Sales / Use Tax Exposure Calculation Sales by state Combined state and local rates % mitigated (audits, retroactive collection, etc.)

30 Sales / Use Tax Does the Target have Nexus? Property in the State Payroll / Solicitation in the State Employees Soliciting Sales Independent Contractors Click Through Nexus Commissions paid to third party Banner ads or other online publication Independent Representatives that maintain customer relationships Large amount of internet sales Affiliate sellers or partners

31 Sales / Use Tax Does the Target Charge Sales Tax on All Taxable Products? Software Cloud-Based or ASP Electronically Downloaded Other Services that May be Taxable Data Processing Services Information Services Management Consulting (limited states) Freight and Shipping Target generates revenue from license or subscription fees Target bundles on invoices instead of separately stating all items and services provided to customer

32 Sales / Use Tax Does the Target Self-Assess and Remit Use Tax? Improper Application of Manufacturing Exemption States with Broad Exemptions o Georgia and South Carolina States with a Narrow Exemption o California Consumables (e.g., oil and grease) may be taxable on the user in certain state, such as Florida. Reciprocity Relief for Use Tax Liability Centralized Purchasing

33 Sales / Use Tax Due Diligence Considerations Manufacturing facility in state with narrow exemptions of manufacturing equipment Services that require consumables to perform services Large amount of out of state or internet purchases History of use tax audit assessments in some facilities but not others Exposure Calculation Purchases where sales tax has not been paid Combined state and local rates

34 Sales / Use Tax Are There Any Other Sales Tax Considerations? Leasing Upfront states (some mandatory): IL, ME, NJ, OH, (many more for installment sales) Florida Sales Tax on Leases Tax is due on commercial lease payments in the state The lessee is responsible for paying this tax Rate of approximately 6% depending on local tax New York City Commercial Rent Tax Tax is assessment of certain leases in Manhattan Annual lease payment > $250k Located in Manhattan, south of 96th Street City of Chicago Lease Tax Users of SaaS in City

35 Sales / Use Tax Common Exposures 1. Nonfiling where Nexus (by entity) 2. Failure to Collect/Validate Exemption Certificates 3. Taxability of Service Transactions or Software 4. Bundling 5. Misclassification of Transaction as Service v. TPP 6. Lack of Use Tax Procedures a. Purchases by service providers (consumables) b. Improper application of manufacturing exemptions.

36 1. Compliance 2. Property in non-filing jurisdictions 3. Misclassification of asset types 4. Property shifts between multiple jurisdictions

37 Personal property located at remote offices Inventory exemption in warehouse locations? Exposure Calculation Property by State Average 2% Rate

38 Employment Tax Common Exposures Nonresident Withholding on Travelling Employees Percentage of time travelling Average salaries Number of travelling employees Independent Contractors Reclassification

39 Employment Tax Due Diligence Considerations Significant number of salespeople with sales throughout the U.S. Exposure Calculation Average salary of employees Percentage of year travelled % average withholding rate

40 Significant Customer Credits Negative A/R balances Uncashed Vendor Checks Uncashed Payroll Checks Rare with direct deposit Duplicate Insurance Payments (Health Care Providers) Gift Cards Does the Company maintain holder information? Where is the Company incorporated? Certain states have preferential treatment for these entities (likely locations for gift card companies)

41 Large customer base Healthcare industry Financial services industry Large retailers Example Coin-op Laundry with Prepaid Laundry cards- potential exposure in tens of millions

42 Texas Margin Tax Texas does not adhere to P.L Three methods to calculate: Cost of Goods Sold Method Compensation Method 70% Method Rate of 1% or 0.5% depending on industry (temporary rate reductions in effect for 2014 and 2015)

43 Franchise Taxes Generally net worth (capital stock, paid in capital, retained earnings) Apportionment could be different from income tax apportionment Rate is based on net worth or net capital * Pennsylvania Capital Stock calculation is a unique type of franchise tax calculation that starts with an average of historic book income.

44 Gross Receipts Based Taxes Possible threshold exemptions Examples: Washington Business & Occupational Tax (0.471%- 1.5% depending on the type of receipt). Economic nexus for service providers. Ohio Commercial Activity Tax (0.26%)- Large, ongoing combination issue with private equity owned portfolio companies. No unitary requirement. Combination based on ownership only. Michigan Business Tax (0.8% on gross receipts base) 2008 through 2011 (Plus Surcharge)

45 Credits/ Incentives Does the Company benefit from significant credits or incentives that could be affected by a change in ownership? Recapture

46 Transactional Tax

47 Transaction Tax? Transfer Taxes Sales Taxes Exemptions Special Rules Sales for Resale Reorg Manfg, Occasional No Vehicles Special Limitations* Real Estate Controlling Interest Owned Property Leased Property Traditional 50% Ownership Real Estate Entity 50% Ownership *States with no or limited occasional sale exemptions: Alaska, Colorado, Maryland, Missouri, Montana, New York, Oklahoma, and Oregon.

48 Planning Considerations

49 Examples of Acquisition Formats Stock Asset Taxable Straight stock purchase Reverse cash merger Combination Purchase / redemption 338(h)(10) - legal Straight asset purchase Forward cash merger 338(h)(10) federal tax Tax Free 368(a)(1)(B) stock for voting stock 368(a)(1)(A), (a)(2)(e) reverse triangular merger 368(a)(1)(A) straight merger 368(a)(1)(A), (a)(2)(d) forward triangular merger 368 (a)(1)(c) practical merger

50 Asset Sale Potential Considerations Issues for Seller - Income Tax Characterization of gain Business vs. Nonbusiness Capital vs Ordinary Treatment of proceeds in the apportionment factor. Basis differences. Recapture of credits Tax Attributes Transfer Taxes

51 Asset Sale Potential Considerations Issues for Buyer - Income Tax Choice of proper entity to acquire assets: Type of entity - e.g., LLC, Partnership, etc. State effective tax rate Segregation of assets Administrative convenience Unitary filing positions Acquisition debt Credit and incentive opportunities Tax Attributes Transfer Taxes

52 Buyer - Section 381/382 Limitations Before Merger A B 100 NOL 100 NOL After Merger Section 381 In certain corporate transactions the acquiring corporation shall succeed to and take into account certain tax attributes of the distributor or transferor corporation 3 variations 1. Fully adopt 2. No conformity 3. Adopt, but limited usage A 100 NOL OR 200 NOL Section 382 Limitation of post-acquistion losses Considerations 1. Does the state follow? 2. If yes, apportion limit? 3. If apportion, which year to use? 4. How does state calculate NOLs?

53 Other Considerations- Intercompany Transactions

54 Purpose of Rules to provide rules to clearly reflect the taxable income (and tax liability) of the group as a whole by preventing intercompany transactions from creating, accelerating, avoiding, or deferring consolidated taxable income or tax liability (Reg (a)(1)) Treat timing and character of items as if consolidated group was a single entity.

55 Definition of Intercompany Transaction A transaction between corporations that are members of the same consolidated group immediately after the transactions (Reg (b)(1)) o o o o o o o o o Intercompany sales or exchanges of inventory Intercompany sales of fixed assets Intercompany sales of intangible assets Intercompany provision of services Intercompany payment of rent and interest IRC 351 transactions between members (contributions) IRC 332 transactions involving members (liquidations) Intercompany distributions between members Intercompany licensing of technology

56 Matching Matching -Achieve desired result by matching seller s recognition of income with buyer s additional expense Gain or loss on the transfer of property from one member (the selling member or S) to another member (the buying member or B) is deferred and taken into account by S based on later events such as when the property is depreciated B takes a cost basis (to B) in the transferred property (i.e. stepped up basis)

57 Acceleration Rule Applies when matching rule no longer causes the intercompany transaction to be treated as if it were between divisions of a single corporation. Examples Buyer or Seller leaves the group The asset in question leaves the group in a tax free transaction Consolidated return is not filed

58 Intercompany Transactions State Issues Separate filing states that adopt federal taxable income as a starting point will usually not follow the federal consolidated return rules and intercompany transaction rules (IRC ) Any income, gain, loss, or deduction of the separate corporation resulting from intercompany transactions will be treated as if the transaction is between S and an unrelated third party

59 Combined & Consolidated States Intercompany transactions can impact the state taxable income subject to apportionment and the apportionment factors States will generally handle intercompany items / transactions by either conforming to the federal rules (or having their own set of rules that are similar to the federal rules) States rules will only apply with respect to the companies that are included in the filing of the combined or consolidated return

60 Separate Company States Transactions generally respected as though conducted by unrelated third parties

61 Distributions with Respect to Stock Distributee corporation Under IRC section 301, distributions with respect to stock will be treated as a dividend, return of capital or capital gain IRC sections contain the federal dividends received deduction (DRD) rules that apply to the portion of the distribution that is treated as dividend under IRC section 301 Distributing corporation Under IRC section 311(b), a distributing corporation recognizes gain on the distribution of appreciated property with respect to stock to the extent that the value of the property exceeds its basis

62 Federal Consolidated Return Rules Distributee corporation Intercompany distributions with respect to stock are not included in the distributee member s gross income to the extent that the distribution results in a corresponding negative basis adjustment in that member s basis in the stock of the distributing company Distributing corporation Distribution by one member of a consolidated group to another member is considered an intercompany transaction Any gain recognized under IRC Section 311(b) to the distributing corporation will be deferred under the consolidated section regulations In Unitary State Income Tax Returns, federal consolidated return treatment generally followed

63 Planning Considerations IRC 338 in Detail

64 IRC 338 Transactions IRC 338 Overview IRC 338(h)(10) IRC 338(g) IRC 338 State Conformity Seller Issues Buyer Issues S Corporation Issues California Issues

65 Typical Targets S Corporation C-Corporation Subsidiaries from Consolidate group Potential Deal Considerations Gross up Selling Shareholder 1. Entity-Level Tax 2. Individual Level Tax State Considerations Conformity to (h)(10) election Built in gain holding period Business / Non-business treatment of sale Apportionment / allocation of proceeds from assets sale

66 1. Entity Level a. Deemed gain x apportionment % x rate b. Deemed gain or proceeds included in sales factor i. Types of Assets ii. Distortion Rule 2. Individual Level a. Gain from sale of stock taxable in resident state only, but deemed gain from sale of assets taxable in nonresident states. b. Gain from sale of assets taxed in nonresident states according to entity apportionment formula c. Taxes paid credit available Limitations applicable

67 IRC 338 Transactions Legal P T stock Cash S T T

68 IRC 338(h)(10) Legal Transaction, Sale of Stock Legal P Stock of T Cash S T T

69 IRC 338(h)(10) Election P Stock S deemed liquidation Cash New T deemed sale of assets T Election jointly made by buyer & seller Gain/loss on stock sale is disregarded Gain on T s assets is included in S consolidated federal return New T gets stepped-up basis T s tax attributes remain with S

70 IRC 338(g) Transactions P Stock Cash S New T T T deemed sale Election made by the seller Buyer elects Gain/loss on stock sale is disregarded S has taxable Gain gain on T s on sale assets of stock is taxable, but instead of being included in S T has taxable consolidated gain sale federal of assets return the tax is paid by P T is deemed New to T have gets sold stepped-up all assets basis to New T Buyer gets T s stepped-up tax attributes basis remain with S

71 IRC 338 State Conformity Virtually all states have adopted 338(h)(10) after the federal changes. However, the election is not recognized for purposes of the Ohio Commercial Activities Tax (CAT) With the exception of California and Wisconsin, the states are bound by the federal election. California and Wisconsin can make state-only 338(h)(10) elections.

72 338(h)(10) Issues for Seller Characterization of gain (business vs. nonbusiness). Treatment of proceeds in the apportionment factor. Basis differences. Possible sheltering of gain in unitary states. Recapture of credits.

73 338(h)(10) Issues for Seller Characterization of gain (business vs. nonbusiness) Why states and taxpayers would want to classify the gain following a 338(h)(10) as business vs. nonbusiness income. States that classify the gain as business income include California, Indiana, North Carolina, and Tennessee. Some states may classify the gain as nonbusiness income. Some states, such as Connecticut and Georgia, do not distinguish between business and nonbusiness and subject all income to apportionment.

74 338(h)(10) Issues for Seller Characterization of gain (business vs. nonbusiness) California business income See, Jim Beam Brands Co. v. Franchise Tax Board North Carolina business income See, North Carolina Dep t of Rev., CD-02-3, May 31, 2002; but see, Final Agency Decision No. 09 REV 5669, N.C. Dept. of Revenue, Apr. 21, 2011 Tennessee business income See, Newell Window Furnishings, Inc. v. Commissioner of Revenue

75 338(h)(10) Issues for Seller Characterization of gain (business vs. nonbusiness) Missouri nonbusiness income See, ABB C-E Nuclear Power, Inc. v. Director of Revenue Illinois nonbusiness income See, American States Insurance Co. v. Illinois Dep t of Rev; however, note subsequent law change modifying the definition of business income (35 Ill. Comp. Stat. 5/1501(a)(1))

76 338(h)(10) Issues for Seller Characterization of gain (business vs. nonbusiness) New Jersey nonbusiness income See, McKesson Water Products Co. v. Division of Taxation. Note 2014 subsequent law change modifying the definition of business income. Connecticut apportionable income See Conn. Dept. of Rev., Legal Ruling No (7/14/03)

77 338(h)(10) Issues for Seller Treatment of proceeds in the apportionment factor Massachusetts L. 2004, c. 262 (enacted 8/9/04), provides that, for apportionment purposes, a target corporation is treated as having sold its assets in any case in which a purchasing corporation makes an election under Sec. 338, effective for tax years beginning on or after January 1, As a result, the decision in Combustion Engineering v. Mass. Comr. of Rev., No (Mass. App. Tax Bd. 3/29/00), where the Massachusetts ATB ruled that receipts resulting from the deemed sale of a target corporation s assets under an IRC 338 transaction are not included in the target corporation s apportionment formula, will no longer be followed. See Mass. Dept. of Rev., TIR (12/8/04). Note Massachusetts has since changed its law to exclude from the receipts factor process related to the sale of goodwill.

78 338(h)(10) Issues for Seller Treatment of proceeds in the apportionment factor Oregon On July 31, 2003, the Oregon Department of Revenue amended Reg. Sec to clarify that the gross receipts from the deemed sale of assets in an I.R.C. Sec. 338 transaction are not included in the target's sales factor for Oregon apportionment purposes. Indiana In Indiana Revenue Ruling IT-99-01, taxpayer was allowed to exclude from the sales factor the proceeds from the deemed asset sale due to a Sec. 338(h)(10) election, since the inclusion would have been distortive and would not fairly represent income derived from Indiana sources. Specifically, the inclusion of the proceeds would have increased the sales factor by over 300%.

79 338(h)(10) Issues for Seller Business Income/Apportionment Factor Issues North Carolina The North Carolina Dept. of Rev. explained in CD 02-3 (5/31/02) that the gain from the deemed asset sale under 338(h)(10) is apportionable business income because the assets are integral to the target's trade or business operations. However, gross receipts from the deemed sale are excluded from the sales factor as a casual sale because the target does not produce or acquire assets for sale in the regular course of business.

80 338(h)(10) Issues for Buyer Should New T remain as a corporate entity? Unitary considerations: State effective tax rate. Placement of acquisition debt. Credit and incentive opportunities.

81 338(h)(10) Special Issues for S Corps Taxability change from seller s state of residence to state where assets are located. Entity level tax - e.g., Illinois, California, Tennessee: Negotiate responsibility for the tax. Possible argument to treat the transaction as a straight stock sale in states where S status not elected: NYC adopted rule amendments that give effect to a 338(h)(10) election in all cases except where the target corporation is an S corporation for federal income tax purposes.

82 338(h)(10) Special Issues for S Corps (cont d) In Mandelbaum v. Director, Division of Taxation, 20 N.J. Tax 141 (N.J. Tax Ct. 5/17/02), the New Jersey Tax Court ruled that the deemed asset sale provisions of I.R.C. Sec. 338(h)(10) do not apply in determining gain from the disposition of S corporation stock for N.J. individual gross income tax purposes. Under the strict reading of the statute, the division must issue formal regulations if it wants to apply federal taxation principles applicable to a Sec. 338(h)(10) election to the gross income tax act.

83 338(h)(10) Special Issues for S Corps (cont d) In Petition of Baum, New York Tax Appeals Tribunal, DTA Nos and , 2/12/09, the New York Tax Appeals Tribunal ruled that nonresident shareholders in a New York S corporation were not subject to New York income tax on the gain associated with the deemed sale of assets following a Sec. 338(h)(10) election because the election did not apply in computing the S corporation's entire net income "as if" it were a C corporation. Note the State has enacted NY Statute Sec. 632 to address the treatment of non-resident shareholders of an S corporation in which a 338(h)(10) election is made. Any gain recognized on the deemed asset sale for federal income tax purposes will be treated as New York source income. The amount of the gain to be included in New York source income is determined using the applicable allocation percentage

84 338(h)(10) Special Issues for S Corps (cont d) Oklahoma Gain from the sale of an S corporation s stock was subject to Oklahoma income tax based on the parties election to treat the transaction as a deemed asset sale under Sec. 338(h)(10). General Accessory Manufacturing Co. v. Oklahoma Tax Commission, No (Okla. Ct. Civ. App. 10/20/05). The court rejected the nonresident shareholder/seller s request to reclassify the deemed sale of assets as a sale of stock subject to tax only in the shareholder/seller s state of domicile.

85 338(h)(10) Special Issues for S Corps (cont d) States in which federal S corp. can be treated as C corp. include: Arkansas, Georgia, Mississippi, New Jersey, and New York.

86 338(h)(10) Special Issues for S Corps (cont d) An IRC 338(h)(10) election may be made for federal tax purposes for targets which are members of affiliated groups or S corporations. Prior to the regulation s amendment in the early 90s, (h)(10) elections could only be made for targets which were members of consolidated groups. Before the regulations were amended, many separate filing states issued rulings stating that (h)(10) elections could not apply for state purposes. Most of these states reversed their positions when the federal regulations were amended.

87 338(h)(10) Special Issues for S Corps (cont d) Under California law, conformity to the federal S election is required and separate state elections either in or out of IRC 338(h)(10) are prohibited for S corporation targets. However, conformity issues may remain in states which do not recognize S corps and tax such as C corps, or in states which require separate elections where the target may have elected to be a C corporation.

88 338(h)(10) Special Issues for S Corps (cont d) Other issues may arise, such as: - Shareholder taxation in states where the personal income tax is imposed under a separate body of law with no reference to IRC 338(h)(10). - The S corporation is sold in an installment sale and operates in states which impose some degree of corporate level tax on S corporations (e.g., California). These issues may be critical in negotiating the terms of an acquisition where the selling S corporation shareholder(s), who reside in low tax or no tax states may seek additional consideration for additional state taxes they would incur if an (h)(10) election were made.

89 338(h)(10) Special California Issues Federal election automatic absent affirmative statespecific action (Note. CRTC (e)). Asset basis differences can be material: No ACRS or MACRs adoption. No federal investment account adjustment.

90 338(h)(10) Special California Issues NOLs & Credits: California s intrastate apportionment mechanism can cause a mis-match of income and attributes Assignment of credits between members of a group are irrevocable Apportionment/Allocation issues under California Reg

91 338(h)(10) Special California Issues Under CRTC (e), federal elections made by a taxpayer prior to the time such taxpayer becomes subject to the franchise or income tax apply for California taxes, unless otherwise provided by law. If a taxpayer has not made a proper election prior to the time the taxpayer becomes subject to the California tax, and the time for making such election has passed, the taxpayer may not make a separate California election. Thus, a taxpayer that, prior to becoming a California taxpayer, did not make a valid federal I.R.C. 338(h)(10) election would be prohibited from making a separate California 338(h)(10) election unless the 8 ½ month election window is still open.

92 338(h)(10) Special California Issues Chief Counsel Ruling (CCR) A foreign parent owned US companies A and B. Buyer acquired Company A and made a CA-only 338(g) election; no federal short period return was filed to report the 338(g) gain that was deemed to occur immediately after the transfer of target stock.

93 338(h)(10) Special California Issues The CCR states that even though the gain is reported on the post-acquisition return, it is apportioned using only the factors attributable to the transaction itself: Property factor: uses pre-sale cost basis Payroll factor: no payroll factor because the deemed asset sale occurs instantaneously Sales factor: includes only the gross receipts from the deemed asset sale.

94 338(h)(10) Special California Issues FTB Information Letter, 10/28/03 If the buying entity is not a CA taxpayer (both buying and selling entity for a 338(h)(10)), it is not entitled to make CA elections. Therefore, it cannot have a deemed federal election. Result, no 338 treatment Presumably Reg allows elections if the buyer and/or seller are members of a combined reporting group that includes CA taxpayers, even if not taxpayers themselves FTB Letter does not reconcile this position with CRTC (e).

95 338(h)(10) Special California Issues FTB Notice (10/24/03) Rev Proc grants 12-month extension of time for making federal 338 elections. Authority is under Treas. Reg , to which CA does not conform. FTB will treat federal elections made under RP as deemed state elections. No state-only elections can be made after normal election period has expired. This means that by the time the federal election is made, it may be too late to elect out for CA purposes.

96 338(h)(10) Special California Issues FTB Legal Ruling Deals with apportionment of gains arising from IRC 338 elections Key Conclusions Reached: On an IRC 338(g) election where a one-day return results (e.g., a member of a selling group is acquired), the gain will not be included in the acquirer s combined group even if instantly unitary. This is despite the fact that the IRC treats the gain as arising after the sale.

97 338(h)(10) Special California Issues Key Conclusions Reached: While CCR 25137(c)(1)(A) generally excludes proceeds from asset sales which are occasional and substantial, IRC 338 deemed asset sale proceeds should be included in the sales factor in a one-day return because the payroll factor is typically discarded. The sale is the only event and is not occasional and to do otherwise would distort the factor since intangibles are excluded from the property factor and the apportionment would otherwise be driven by the historical cost of tangible property only.

98 338(h)(10) Special California Issues The ruling suggests that it may be appropriate to include asset sale proceeds in other cases where there are substantial gains and limited day-to-day activities in the year of sale. Given the regulation, it may be necessary to petition the FTB for such adjustments, however.

99 Possible Elimination of Stock Sale Gain through California-only 338(h)(10) Election P Domiciled in California Not unitary with S Federal 338(h)(10) election not made S 100% in Illinois If no 338(h)(10) in CA, treated as a stock sale and gain taxable in CA If 338(h)(10) in CA only: P s stock gain is not taxable in Illinois S does not pay any tax on deemed asset sale in CA or IL P does not have a gain on sale of stock in CA S gets stepped-up basis in assets Even if unitary, may get California factor dilution under Query: Is this stepped-up basis worth anything to buyer?

100 Questions?