When corporations make a federal I.R.C. section 338(h)(10) election to treat a stock sale as an asset sale, is the resulting gain apportionable business income for Connecticut, and is it a sale of stock or of assets in the receipts factor?

Plain-English summary

A U.S. subsidiary (Company A) sold the stock of its own subsidiary (Company B) to a foreign buyer, and the buyer and seller jointly made a federal I.R.C. section 338(h)(10) election. That election lets the parties treat what is legally a stock sale as if it were a sale of the target's assets — so the target corporation (Company B) recognizes the gain on a deemed asset sale (and the buyer gets a stepped-up basis in the assets), while the selling group does not recognize gain on the stock. Company A asked DRS two questions about Company B's final Connecticut corporation business tax return:

1. Is the section 338(h)(10) gain apportionable business income? — Yes. For the corporation business tax, Connecticut does not distinguish between business and non-business income; it requires a corporation to apportion all income, including the income of a domiciliary corporation (Conn. Gen. Stat. § 12-218). DRS noted that even if the gain were non-business income of this domiciliary corporation, it would still be apportioned (citing Special Notice 93(26), on the effect of Allied-Signal, Inc. v. Director). So the gain from the sale of Company B is subject to apportionment.

2. In the receipts factor, is it a sale of stock or a sale of assets? — A sale of assets. Connecticut follows the federal treatment of a section 338(h)(10) election (a position DRS took long ago in Ruling No. 89-46, and consistent with cases holding federal elections binding for state tax — Skaarup Shipping Corp. v. Commissioner; Circuits, Inc. v. Dubno). Because the election makes Company B (the target) — not the selling parent — report the gain, and that gain is on a deemed sale of assets, treating it as a stock sale would produce inconsistent results. The receipts factor (§ 12-218(c)(3)) expressly includes net gains from the sale of tangible assets situated in Connecticut, and nothing lets the Commissioner "throw out" or ignore the deemed asset sale. So the gain goes into Company B's receipts factor as a sale of assets.

In short: follow the federal election through to its logical end — the target reports the gain, the gain is apportionable, and it lands in the receipts factor as an asset sale.

What this means for you

Corporate tax professionals and M&A advisors

If a deal uses a section 338(h)(10) election, don't revert to stock-sale characterization for Connecticut apportionment. The target reports a deemed asset-sale gain, that gain is apportionable (Connecticut apportions all of a domiciliary corporation's income), and it enters the receipts factor as a sale of assets. Model the Connecticut result on the target's return, not the seller's.

CPAs preparing the target's final Connecticut return

Report the section 338(h)(10) gain on the target's corporation business tax return as an asset sale, and include Connecticut-situated tangible-asset gains in the receipts factor under § 12-218(c)(3). Because Connecticut apportions all income, don't try to exclude the gain as "non-business" income of a domiciliary corporation.

State tax directors and tax attorneys

The ruling is a clean statement that Connecticut conforms to the federal election's substance: a federal deeming statute that shifts who recognizes gain and recharacterizes the transaction is respected for the corporation business tax. Watch the apportionment-era caveat — the ruling describes the pre-2001 three-factor formula; confirm the apportionment method for the year at issue.

Common questions

Q: Is a section 338(h)(10) gain apportionable in Connecticut?
A: Yes. Connecticut apportions all income of a domiciliary corporation under § 12-218, without distinguishing business from non-business income, so the gain is apportioned.

Q: In the receipts factor, is the election reported as a stock sale or an asset sale?
A: As a sale of assets — Connecticut follows the federal election, under which the target reports a deemed asset-sale gain, and § 12-218(c)(3) includes gains from sales of Connecticut-situated tangible assets.

Q: Who reports the gain — the parent that sold the stock, or the target?
A: The target (Company B). That's the effect of the section 338(h)(10) election, and Connecticut follows it, so the gain appears on the target's corporation business tax return.

Q: Can the Commissioner disregard the deemed asset sale for the receipts factor?
A: No. DRS found nothing in § 12-218(c)(3) authorizing the Commissioner to ignore or "throw out" the sale of assets from the receipts factor.

Citations and references

Statutes:

• Conn. Gen. Stat. § 12-218 (apportionment of net income; Connecticut requires apportionment of all income, including business income of domiciliary corporations)
• Conn. Gen. Stat. § 12-218(c)(3) (receipts factor — includes net gains from the sale or other disposition of tangible assets situated within Connecticut)
• Conn. Gen. Stat. § 12-213(10) (definition of "net income," referencing the deductions allowed by § 12-217)

Federal law:

• I.R.C. § 338(h)(10) (election to treat a qualifying stock sale as a deemed sale of the target's assets)

Guidance and cases relied on:

• DRS Ruling No. 89-46 (Department follows federal law incorporating the effects of an I.R.C. § 338(h)(10) election)
• DRS Special Notice 93(26) (effect of Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768 (1992), on apportionment)
• Skaarup Shipping Corp. v. Commissioner, 199 Conn. 346, 507 A.2d 988 (1986)
• Circuits, Inc. v. Dubno, 213 Conn. 442, 568 A.2d 457 (1990)

Source

• Landing page: Connecticut DRS Rulings
• Ruling: Ruling 2003-3

Original ruling text

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:

Whether the I.R.C. §338(h)(10) gain is apportionable business income for purposes of Company B’s Connecticut corporation business tax return.

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:

The I.R.C. §338(h)(10) gain is apportionable business income for purposes of the Connecticut corporation business tax.

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