How did a federal Section 338(h)(10) stock acquisition affect the target's former Texas earned-surplus and taxable-capital franchise-tax calculations?

Plain-English summary

Texas recognized the Section 338(h)(10) deemed asset sale for earned surplus, but not for taxable capital.

The target corporation remained in existence after its stock changed hands. For earned surplus, deemed asset-sale amounts were included in the target's income and the receipts were apportioned under the rules for the assets sold. Tangible-property receipts followed Section 171.1032(a); intangible receipts followed the payer's legal domicile.

For taxable capital, the federal deemed-sale treatment did not apply because Texas law supplied no statutory basis for it. The target also could not revalue its assets through push-down accounting.

The letter did not answer everything. QSSS treatment was deferred while Rule 3.556 was being revised, and the sales-tax issue was sent to another section for a separate letter.

What this means for you

Buyers making a Section 338(h)(10) election

The former Texas franchise-tax system could treat the same transaction differently under its earned-surplus and taxable-capital components.

Tax professionals

Classify each deemed-sold asset before sourcing receipts, and preserve explicit non-answers concerning QSSS and sales tax.

Common questions

Q: Did the target include deemed-sale amounts in earned surplus?
A: Yes.

Q: Could the target push up asset values for taxable capital?
A: No.

Q: Did the stock acquisition require a final report?
A: No, because the target continued as an authorized corporation subject to franchise tax.

Q: Did this letter decide QSSS or sales-tax treatment?
A: No.

Citations and references

• Texas Tax Code Secs. 171.001, 171.202, 171.1032(a), 171.110, and 171.109
• 34 Tex. Admin. Code Sec. 3.557(e)(10)
• I.R.C. Secs. 338(h)(10) and 1361

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/9712532L

Original ruling text

December 9, 1997

Dear Mr. **:

Thank you for the information contained in your letter dated December 2, 1997.
This response represents the Texas franchise tax implications of the situation
described in your letter.

You've indicated that a corporation (**) is authorized to do
business in Texas. It owns a 1% interest in a Texas limited partnership and a
100% interest in two non-Texas corporations. The corporations are all
qualified subchapter S subsidiary (QSSS) corporations in accordance with Sec.
1361 of the Internal Revenue Code (IRC).

A group is interested in acquiring the stock of these corporations. This
transaction will be treated as an asset sale pursuant to Sec. 338(h)(10) of the
IRC. After the acquisition, ** will continue its operations, but
with new shareholders.

Listed below are your questions with our responses. The responses related to
the earned surplus component are based on the presumption that the income in
question is unitary income.

1. Is the income generated from Florida or Missouri from either operating
   activities or from the deemed sale of assets under IRC Section 338(h)(10)
   includable in the earned surplus or taxable capital calculation for franchise
   tax purposes?

Response: At this time, we are amending Franchise Tax Rule 3.556, Earned
Surplus: S Corporations to address the treatment of a QSSS and its parent
corporation. Therefore, I am unable to respond to your question about the
effects involving the QSSS corporations. Once Rule 3.556 has been revised, we
should be able to address your inquiry about the QSSS treatment. The following
responses are based on our policy with respect to Section 338(h)(10)
transactions.

For reporting earned surplus, the amounts received by the target corporation
that are treated as sales of assets (by the target) under IRC Section
338(h)(10) would be included in the target's earned surplus. The receipts from
these sales would be apportioned according to the rules applicable to sales of
such assets under the Tax Code. For example, if tangible personal property is
sold, Sec. 171.1032(a) would apply. If intangibles are sold, the location of
payer rule (i.e., legal domicile of the payer) would apply. The purchaser of
the target's stock will be considered the purchaser of the assets.

For reporting taxable capital, the Section 338(h)(10) treatment would not apply
because there is no statutory basis to recognize such treatment. See response
to Question No. 5 for a more detailed explanation.

2. Under what circumstances would the deemed sale pursuant to IRC Section
   338(h)(10) for ** be subject to Texas sales tax?

Response: We have referred this question to our Sales Tax section which will
answer the question by separate letter.

3. With regard to **, how are the gross receipts in Texas and the
   gross receipts everywhere calculated when the purchaser is located in Texas as
   compared to an out-of-state purchaser?

Response: As noted in the response to Question No. 1, the receipts for earned
surplus are to be apportioned in accordance with the apportionment guidelines
applicable to the assets sold. With respect to the sales of intangibles, the
location of payer/legal domicile of a corporation is its state of
incorporation. Please see Rule 3.557(e)(10) for more information about the
apportionment guidelines for deemed sales of assets under IRC Section
338(h)(10).

4. What are the mechanics of filing the necessary Texas franchise tax returns
   as a result of an IRC Section 338(h)(10) election?

Response: As an ongoing legal entity (authorized to do business in Texas),
** corporation will be liable for the franchise tax and must file
franchise tax reports in accordance with the statutory requirements. Sections
171.001 and 171.202, Texas Tax Code.

If ** stock is acquired on January 4, 1998, it will need to file
its annual 1998 franchise tax report before May 16, 1998 (an extension may be
requested and will be granted provided the necessary requirements are met
pursuant to Sec. 171.202). The corporation should use its last accounting
period that ends in 1997 on the 1998 report.

A final franchise tax report must be filed when a corporation is no longer
subject to the earned surplus component of the franchise tax. Presuming
** corporation will continue to be subject to the earned surplus
component of the tax (as a corporation authorized to do business in Texas), it
would not have to file a final report in connection with the transaction
described in the ruling request.

5. Can you provide us with an overall explanation and authority for the state
   of Texas' treatment of IRC Section 338(h)(10) elections?

Response: Sec. 171.110(a)(1) of the Tax Code holds that a corporation's earned
surplus is computed by determining its reportable federal taxable income (with
certain modifications). Sec. 171.110(d) specifically refers to the Internal
Revenue Code for purposes of determining reportable federal taxable income.
Because of the requirements set out in these statutory provisions, the Section
338(h)(10) treatment is recognized in the computation of earned surplus. Rule
3.557(e)(10) addresses the apportionment considerations (for earned surplus)
with respect to Section 338(h)(10) transactions.

The starting point for computing the taxable capital component is generally
accepted accounting principles (GAAP). Sec. 171.109(b). The statute does
provide exceptions to the GAAP standard, including the use of FIT accounting
methods for certain corporations. However, the FIT provision is limited to
accounting methods and as such may be overridden by specific mandates, such as
Sec. 171.109(m).

Sec. 171.109(m) states that a corporation may not use the push-down method of
accounting in computing or reporting its surplus. Thus, a corporation whose
stock has been acquired cannot revalue its assets pursuant to push-down
accounting.

Because there is no statutory basis to recognize the Section 338(h)(10)
treatment, it is not recognized in the computation of taxable capital.

These responses are based on the facts presented. If there are different or
additional facts, the responses may change.

If you have any questions, please call toll-free 1-800-531-5441, extension
3-4496 or (512)463-4496.

Sincerely,

Jerry Bobbitt
Tax Policy Division