A buyer and seller will make a federal I.R.C. § 338(h)(10) election treating a stock sale as a deemed asset sale, after the target pre-distributes assets to the seller in a tax-free liquidation. How do the resulting federal gains (and non-gains) flow into net earnings for Tennessee excise tax?

Plain-English summary

A corporate Seller plans to sell its subsidiary, the Target, to an unrelated Buyer. Two federal-tax moves are layered into the deal: first the Target distributes more than half its assets back to the Seller (the "Distribution"); then the Target's stock is sold, and Buyer and Seller make a joint I.R.C. § 338(h)(10) election — a federal election that treats a stock sale as if it were an asset sale. Under that election, the Target is treated as selling its assets (and recognizes the gain), while the Seller recognizes no gain on the stock. The taxpayers asked how these federal results carry into net earnings for the Tennessee excise tax.

The answer rests on one structural fact: Tennessee's excise tax (6.5% on net earnings) starts from federal taxable income. "Net earnings" is defined as federal taxable income (before the net-operating-loss and certain special deductions), adjusted by a specific list of Tennessee additions and subtractions (§ 67-4-2006(a)(1), (b)). Tennessee neither adopts nor disallows the federal § 338(h)(10) election (or the §§ 332/337 liquidation rules), and it has no comparable election of its own. So whatever the federal election puts into — or leaves out of — federal taxable income simply flows through to Tennessee, unless a listed adjustment changes it. Three results:

• Target's deemed-asset-sale gain — included. Because the § 338(h)(10) election makes the Target recognize gain federally, that gain is part of the Target's federal taxable income, and no Tennessee subtraction removes it (§ 67-4-2006(b)(2)). So the gain is in the Target's Tennessee net earnings and is subject to excise tax.
• Seller's stock sale — no net earnings. The election means the Seller recognizes no federal gain on the stock, so there's nothing in its federal taxable income to start from, and no Tennessee addition puts it back (§ 67-4-2006(b)(1)). The Seller has no Tennessee net earnings from the Sale.
• The pre-sale Distribution — no net earnings. If the Distribution qualifies as a tax-free liquidating distribution under I.R.C. §§ 332 and 337, neither the Target nor the Seller recognizes federal gain on it, so it's excluded from both parties' Tennessee net earnings (again, no addition adjustment applies).

(The ruling assumes the federal treatment is as described — the Department doesn't rule on federal tax law — and notes that federal court interpretations of federal tax aren't binding on Tennessee courts construing Tennessee tax.)

What this means for you

Companies structuring M&A deals with Tennessee nexus

A federal § 338(h)(10) election has real Tennessee excise-tax consequences because Tennessee piggybacks on federal taxable income. Expect the Target to bear Tennessee excise tax on the deemed-asset-sale gain, while the Seller generally has no Tennessee net earnings from the stock sale. Tennessee won't second-guess the federal election — but it also won't give you a separate state election to change the result.

Pre-closing distributions and liquidations

If a target distributes assets before sale and that distribution is a tax-free liquidation under I.R.C. §§ 332/337 federally, it generally produces no Tennessee net earnings for either party — because there's no federal gain feeding the Tennessee starting point. The state result follows the federal characterization, so getting the federal treatment right is what drives the Tennessee answer.

Accountants and tax professionals

The mechanism is pure conformity-plus-adjustments: net earnings = federal taxable income before NOL/special deductions (§ 67-4-2006(a)(1)), then the enumerated additions/subtractions of § 67-4-2006(b) (and the NOL rules of (c)). Tennessee neither adopts nor disallows § 338(h)(10) or §§ 332/337 and has no parallel deemed-asset-sale election, so the federal items flow through unless a specific adjustment applies — none did here. Watch the conditional: the ruling expressly assumes the federal characterization holds; if the IRS treats it differently, the ruling's conclusions don't apply.

Common questions

Q: Does a federal § 338(h)(10) election affect Tennessee excise tax?
A: Yes. Tennessee net earnings begin with federal taxable income. The election makes the target recognize the asset-sale gain federally, so that gain is in the target's Tennessee net earnings; the seller recognizes no federal stock gain, so it has no Tennessee net earnings from the sale.

Q: Can Tennessee disregard or override the federal election?
A: No. Tennessee neither adopts nor disallows the § 338(h)(10) election and has no comparable state election. It simply follows whatever lands in federal taxable income and applies its own statutory addition and subtraction adjustments.

Q: What about a tax-free liquidating distribution before the sale?
A: If the distribution qualifies as tax-free under I.R.C. §§ 332 and 337 federally, neither the target nor the seller recognizes federal gain, so it produces no Tennessee net earnings for either party.

Q: Can I rely on this letter ruling?
A: No. A Tennessee letter ruling binds the Department only as to the specific taxpayer and facts it was issued to, and it can be revoked or modified. It also assumes the stated federal tax treatment. Confirm your own facts with a tax professional.

Citations and references

Tennessee statutes (Tenn. Code Ann.):

• § 67-4-2007(a) (excise tax at 6.5% of net earnings); § 67-4-2004(38) ("person" subject to the tax)
• § 67-4-2006(a)(1) (net earnings = federal taxable income before NOL/special deductions, 26 U.S.C. §§ 241–247); § 67-4-2006(b) (addition/subtraction adjustments; (b)(1) additions, (b)(2) subtractions); § 67-4-2006(c) (net operating loss)
• § 67-4-2105(a), § 67-4-2106(a) (franchise tax of $0.25 per $100 of net worth)

Federal law and cases:

• I.R.C. § 338(h)(10), § 338(a) (election treating a stock sale as a deemed asset sale); I.R.C. §§ 331, 332, 336(a), 337 (corporate liquidations); Treas. Reg. § 1.338(h)(10)-1
• Little Six Corp. v. Johnson, 1999 WL 336308 (Tenn. Ct. App. 1999); Tidwell v. Berke, 532 S.W.2d 254 (Tenn. 1975) (federal-court rulings on federal tax are not binding on Tennessee courts construing Tennessee tax)

Source

• Landing page: https://www.tn.gov/revenue/tax-resources/legal-resources/tax-rulings.html
• Original PDF: https://www.tn.gov/content/dam/tn/revenue/documents/rulings/fae/14-01fe.pdf

Original ruling text

TENNESSEE DEPARTMENT OF REVENUE
LETTER RULING # 14-01

Letter rulings are binding on the Department only with respect to the individual taxpayer
being addressed in the ruling. This ruling is based on the particular facts and
circumstances presented, and is an interpretation of the law at a specific point in time. The
law may have changed since this ruling was issued, possibly rendering it obsolete. The
presentation of this ruling in a redacted form is provided solely for informational purposes,
and is not intended as a statement of Departmental policy. Taxpayers should consult with a
tax professional before relying on any aspect of this ruling.

SUBJECT

The computation of net earnings for Tennessee excise tax purposes by taxpayers who have made
an election under I.R.C. § 338(h)(10).

SCOPE

This letter ruling is an interpretation and application of the tax law as it relates to a specific set of
existing facts furnished to the Department by the taxpayer. The rulings herein are binding upon
the Department, and are applicable only to the individual taxpayer being addressed.

This letter ruling may be revoked or modified by the Commissioner at any time. Such revocation
or modification shall be effective retroactively unless the following conditions are met, in which
case the revocation shall be prospective only:

(A) The taxpayer must not have misstated or omitted material facts involved in
the transaction;

(B) Facts that develop later must not be materially different from the facts upon
which the ruling was based;

(C) The applicable law must not have been changed or amended;

(D) The ruling must have been issued originally with respect to a prospective or
proposed transaction; and

(E) The taxpayer directly involved must have acted in good faith in relying upon
the ruling; and a retroactive revocation of the ruling must inure to the taxpayer’s
detriment.

FACTS

1. Corporate Structure
   [SELLER’S PARENT] (“Seller’s Parent”), a [REDACTED] corporation, owns all of the issued

and outstanding stock of [SELLER] (“Seller”), a [REDACTED] corporation. Seller owns all of
the issued and outstanding stock of [TARGET] (the “Target”), a [REDACTED] corporation.

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2. Proposed Transaction

An unrelated corporation (“Buyer”) has offered to buy the Target from Seller. The following
steps, collectively referred to as the “Proposed Transaction,” will occur to effectuate the
proposed sale of Target stock to Buyer within a single taxable year of the Target:

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Step 1: Seller’s Parent, Seller, the Target, and Buyer agree to undertake the
transaction described in Steps 2 and 3 (in that order), and, following
Step 3, to make the election described in Step 4.

Step 2: The Target will distribute more than fifty percent of its retained assets and
certain liabilities (the “Distribution Assets”) to Seller (the “Distribution”’).

Step 3: A subsidiary of Buyer will merge with and into the Target, with the Target
surviving as Buyer’s subsidiary, or Buyer will purchase all of the issued
and outstanding stock of the Target (the “Sale”). Seller will receive only
cash in exchange for the Sale, and Buyer will acquire all of the issued and
outstanding stock of the Target.

Step 4: Buyer and Seller will make a joint election under I.R.C. § 338(h)(10) with
respect to the Sale (the “I.R.C. § 338(h)(10) Election”).

RULINGS

Will the gain on the Sale that the Target recognizes for federal income tax purposes as a
result of the IL.R.C. § 338(h)(10) Election be included in the Target’s net earnings for
Tennessee excise tax purposes?

Ruling: Yes. Tennessee law neither adopts nor disallows the federal election under I.R.C.
§ 338(h)(10). Because the gain that the Target recognizes on the Sale pursuant to the
ILR.C. § 338(h)(10) Election is included in the Target’s federal taxable income, and
because such gain is not subtracted in the computation of the Target’s net earnings, such
gain will be included in Target’s net earnings for Tennessee excise tax purposes.

For Tennessee excise tax purposes, will Seller be required to recognize any net earnings
as a result of the Sale made pursuant to the I.R.C. § 338(h)(10) Election?

Ruling: No. Tennessee law neither adopts nor disallows the federal election under I.R.C.
§ 338(h)(10). Because no gain on the Seller’s sale of the Target’s stock is included in
Seller’s federal taxable income pursuant to the I.R.C. § 338(h)(10) Election, and because
such gain is not added to net earnings under Tennessee excise tax law, no gain arising
from the Sale will be included in Seller’s net earnings for Tennessee excise tax purposes.

Assuming that the Distribution is treated for federal income tax purposes as part of a tax-
exempt liquidating distribution pursuant to LR.C. §§ 332 and 337, will the Target or

Seller be required to recognize any net earnings for Tennessee excise tax purposes as a
result of the Distribution?

Ruling: No. Tennessee law neither adopts nor disallows the federal treatment of
liquidating distributions provided for by I.R.C. 8§ 332 and 337. Because no gain on the
Distribution is included in the Target’s federal taxable income, such gain will be
excluded from the Target’s net earnings for Tennessee excise tax purposes. Similarly,
because no gain on the Distribution is included in Seller’s federal taxable income, such
gain will be excluded from Seller’s net earnings for Tennessee excise tax purposes.

ANALYSIS

Overview of applicable federal income tax law’

a. Overview of ILR.C. § 338(h)(10)

For federal income tax purposes, when a buyer acquires stock of a target corporation, the sale
generally has no federal income tax consequences for the target. Instead, the target’s former
shareholders recognize gain or loss on the sale or exchange of the target corporation’s shares.

Provided certain requirements are met, the buyer and the seller may jointly elect under I.R.C.
§ 338(h)(10)° to treat a stock sale as an asset sale for federal income tax purposes. Upon making
an LR.C. § 338(h)(10) election, the target corporation (referred to here as the “old target”®) is
treated as transferring all of its assets to an unrelated person in exchange for consideration in a
single transaction at the close of the acquisition date (but before the deemed liquidation,
described below).*

For federal income tax purposes, the old target generally recognizes the gain realized on the
deemed transfer of its assets; the realization event is deemed to occur prior to the close of the
acquisition date.” The seller recognizes no gain or loss on the sale or exchange of target stock

' The Department does not issue rulings on federal tax matters. This ruling is not an opinion regarding the
applicability of I.R.C. §§ 338(h)(10), 332, and 337 to the taxpayers. If the taxpayers’ federal tax treatment is not as
described, the conclusions in this ruling are inapplicable to the transaction.

? LR.C. § 338(h)(10) (LexisNexis 2014).

° For federal income tax purposes, if an election under I.R.C. § 338(h)(10) is made, the target corporation is treated
as though it were two separate corporations, Old Target and New Target. ILR.C. § 338(a). Old Target is treated as if,
before the close of the acquisition date, after the deemed asset sale, and while Old Target is a member of the selling
consolidated group, it transferred all of its assets to members of the selling consolidated group and ceased to exist.
Treas. Reg. § 1.338(h)(10)-1(d)(4) (LexisNexis 2014). Members of the selling consolidated group are treated as if,
after the deemed asset sale and before the close of the acquisition date, they received the assets transferred by Old
Target. Treas. Reg. § 1.338(h)(10)-1(d)(5)(i). In other words, immediately after the deemed asset sale, Old Target is
treated as having liquidated into its parent company or companies. New Target is treated as a separate corporation
that acquired the assets of Old Target.

• Treas. Reg. § 1.338(h)(10)-1(d)(3).

° Td.

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included in the qualified stock purchase; however, the seller may recognize gain or loss on the
target stock in the deemed liquidation. °

The seller is treated as if, after the deemed asset sale and before the close of the acquisition date,
it received the assets transferred by the old target.’ The old target is treated as if, before the close
of the acquisition date but after the deemed asset sale, it transferred all of its assets to the seller
and ceased to exist.® The transfer may be treated as a distribution in pursuance of a plan of
reorganization; a distribution in complete cancellation or redemption of all its stock; one of a
series of distributions in complete cancellation or redemption of all its stock in accordance with a
plan of liquidation; or part of a circular flow of cash.”

b. Overview of I.R.C. §§ 332, 337

Under LR.C. §§ 332 and 337,” no gain or loss is recognized for federal income tax purposes
when property is distributed by a subsidiary to the owner pursuant to the subsidiary’s complete
liquidation. Without these provisions, such liquidating distributions would be treated for federal
income tax purposes as amounts received by the owners in exchange for the subsidiary’s shares,
and both the subsidiary and its owners could recognize gain or loss on the distribution.

In conjunction with an effective I.R.C. § 338(h)(10) election, the assets and liabilities that a
target distributes to its shareholders prior to being sold may be treated for federal tax purposes as
having been made pursuant to a plan of reorganization, a distribution in complete cancellation or
redemption of all its stock, or similar transaction.'7 When these distributions meet all the
necessary requirements for tax-exempt treatment under I.R.C. §§ 332 and 337, the seller and the
target do not recognize gain or loss for federal income tax purposes on the assets and liabilities
transferred from the target to the seller prior to the sale.

Computation of net earnings for Tennessee excise tax purposes

Tennessee imposes an excise tax at the rate of 6.5% on the net earnings of all persons, as defined
under TENN. CODE ANN. § 67-4-2004(38) (2013), doing business within Tennessee.’

° Treas. Reg. § 1.338(h)(10)-1(d)(5)(iii).

’ Treas. Reg. § 1.338(h)(10)-1(d)(5).

® Treas. Reg. § 1.338(h)(10)-1(d)(4).

"Td.

LR.C. §§ 332, 337 (LexisNexis 2014).

"TR.C. § 331 (LexisNexis 2014); Treas. Reg. § 1.332-1 (1960); I.R.C. § 336(a) (LexisNexis 2014).

” Treas. Reg. 1.338(h)(10)-1(d)(4) to (5) (as amended in 2007).

'S TENN. CODE ANN. § 67-4-2007(a) (2013). Tennessee also imposes a franchise tax at the rate of $0.25 per $100, or

major fraction thereof, on the net worth of a person doing business in Tennessee, pursuant to TENN. CODE ANN.
§§ 67-4-2105(a) and 2106(a) (2013).

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Corporations, such as the Target and Seller, are included among the types of entities defined as
“persons” for purposes of the Tennessee excise tax.'* For corporations, TENN. CODE ANN.
§ 67-4-2006(a)(1) (2013) defines “net earnings” as “federal taxable income or loss before the
operating loss deduction and special deductions provided for in 26 U.S.C. §8§ 241, 242
[repealed], 243-247,” as adjusted by TENN. CODE ANN. § 67-4-2006(b)-(c).”

1-2. The I.R.C. § 338(h)(10) election and the Tennessee excise tax

Tennessee law neither adopts nor disallows the election under I.R.C. § 338(h)(10) and the
accompanying federal regulations.'° Additionally, the Tennessee franchise and excise tax laws
do not provide for a comparable election to treat a stock sale as a deemed asset sale.

Nonetheless, gain that the Target recognizes for federal tax purposes pursuant to the I.R.C.
§ 338(h)(10) Election is included in the Target’s net earnings for Tennessee excise tax purposes.
If the I.R.C. § 338(h)(10) Election is properly made, then for federal income tax purposes the
Target will recognize gain arising from the Sale. As an item comprising part of the Target’s
federal taxable income before the net operating loss deduction and special deductions provided
for in 26 U.S.C. §§ 241, 242 [repealed], 243-247, such gain or loss is included in the starting
point for the computation of the Target’s Tennessee net earnings under TENN. CODE ANN.
§ 67-4-2006(a)(1). Furthermore, TENN. CODE ANN. § 67-4-2006(b)(2) does not provide for a
subtraction adjustment to federal taxable income that would require gain or loss arising from the
Sale to be excluded in the computation of Tennessee net earnings.

Accordingly, because the gain that the Target recognizes on the Sale pursuant to the LR.C.
§ 338(h)(10) Election is included in the Target’s federal taxable income, and because such gain
is not subtracted in the computation of the Target’s net earnings, such gain will be included in
Target’s net earnings for Tennessee excise tax purposes.

Gain that Seller does not recognize for federal income tax purposes on the Sale pursuant to the
ILR.C. § 338(h)(10) Election is excluded from Seller’s net earnings for Tennessee excise tax
purposes. If the I.R.C. § 338(h)(10) Election is properly made, then for federal income tax
purposes Seller will not recognize any gain or loss on the Sale. Because such gain or loss does
not comprise part of Seller’s federal taxable income before the net operating loss deduction and
special deductions provided for in 26 U.S.C. §§ 241, 242 [repealed], 243-247, such gain or loss
is not included in the starting point for the computation of Seller’s net earnings under TENN.
CoDE ANN. 8 67-4-2006(a)(1). Furthermore, TENN. CODE ANN. § 67-4-2006(b)(1) does not
provide for an adjustment to federal taxable income that would require gain or loss unrecognized

'4 TENN. CODE ANN. § 67-4-2004(38).

'’ TENN. CODE ANN. § 67-4-2006(b) requires specific addition and subtraction adjustments to federal taxable income
to arrive at Tennessee net earnings. TENN. CODE ANN. § 67-4-2006(c) relates to the deduction of net operating
losses.

'© Note that the Tennessee Court of Appeals has stated that “rulings of the federal courts in regard to federal tax laws
are not binding on Tennessee courts when they are called upon to interpret Tennessee tax laws.” Little Six Corp. v.
Johnson, 1999 WL 336308 at *3 (Tenn. Ct. App. May 28, 1999); see also Tidwell v. Berke, 532 S.W.2d 254 (Tenn.
1975).

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pursuant to the I.R.C. § 338(h)(10) Election to be included in the computation of Tennessee net
earnings.

Because no gain on the Seller’s sale of the Target’s stock is included in Seller’s federal taxable
income pursuant to the I.R.C. § 338(h)(10) Election, and because such gain is not added to net
earings under Tennessee excise tax law, no gain arising from the Sale will be included in
Seller’s net earnings for Tennessee excise tax purposes.

3. LR.C. §§ 332, 337 and the Tennessee excise tax

Tennessee law neither adopts nor disallows LR.C. §§ 332 and 337 and the accompanying federal
regulations for purposes of the Tennessee excise tax.

If the Distribution is treated for federal income tax purposes as part of a tax-exempt liquidating
distribution pursuant to I.R.C. §§ 332 or 337, the Target will not recognize any gain on the
Distribution for federal income tax purposes. Because gain on the Distribution does not comprise
part of the Target’s federal taxable income, such gain is not included in the starting point for the
computation of the Target’s Tennessee net earnings under TENN. CODE ANN. 8 67-4-2006(a)(1).
Furthermore, TENN. CODE ANN. § 67-4-2006(b)(1) does not provide for an adjustment to federal
taxable income that would require such gain to be added in the computation of Tennessee net
earnings.

Because no gain on the Distribution is included in the Target’s federal taxable income, such gain
will be excluded from the Target’s net earnings for Tennessee excise tax purposes. Similarly,
because no gain on the Distribution is included in Seller’s federal taxable income, such gain will
be excluded from Seller’s net earnings for Tennessee excise tax purposes.

Robert C. Guth
Assistant General Counsel
for Taxation

APPROVED: Richard H. Roberts
Commissioner of Revenue

DATE: March 18, 2014

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