Companies looking to buy foreign corporations have new leverage on M&A deals thanks to IRS rules that shield the seller’s gains from getting taxed twice—if they sign a closing agreement.
Treasury finalized an election, under the Section 245A dividends-received deduction rules (T.D. 9909; RIN: 1545-BP35), that requires every U.S. shareholder of companies engaged in the sale or purchase of a controlled foreign corporation to agree to close the taxable year upon closing of the sale—ensuring the dividends from that transaction can return to the U.S. tax free.
The final rules clarify that the U.S.-resident shareholders of both the buying and selling party need to agree to close the tax year before the election is made. Without unanimous agreement on the close-of-year election, the selling company could get hit with a double tax on the earnings and profits of it controlled-foreign corporations. CFCs are more than 50% owned by U.S. shareholders who own 10% or more of the total stock in it.
“If the purchaser doesn’t consent here, the seller is going to be tagged with a full 21% U.S. tax on income that was already taxed in the foreign jurisdiction—and the purchaser could use that as a hammer to strike a better deal,” said Mitchell Weiss, an adjunct law professor at Northwestern University, who focuses on international tax.
But getting those shareholders to reach an unanimous decision can be an onerous negotiation. That’s because making the election could have positive and negative tax consequences on each shareholder, depending on the assets up for sale. The threat sellers face of getting taxed twice could lead to strategic behavior from purchasing companies.
“There would likely be inefficient and strategic behavior taking advantage of the regulations, because they give purchasers significant leverage because of the overreach of these regulations,” Weiss said.
An extraordinary reduction rule under Section 245A, which includes the election to close the tax year, limits the deduction in situations where a shareholder disposes of CFC stock, or its interest in CFC stock, but the CFC’s tax year doesn’t end. That’s because both the seller and buyer would have the CFCs assets on their books, regardless of post–or pre–sale amounts.
“Without the election, the buyer of the CFC can reduce foreign income inclusions if the seller has received dividends from the CFC before or in connection with the sale, but the seller loses their ability to claim the deduction,” said Bradford LaBonte, a partner at McDermott Will & Emery LLP in New York who focuses on U.S. and international tax issues.
The election closes the tax year upon the day of the sale to create two short years so that the buyer retains the income of the CFC in the post-sale year, and the seller retains the foreign income in the pre-sale year—which restores the seller’s ability to claim the full dividends-received deduction.
“In certain situations this can be very significant because all the U.S. shareholders that are impacted have to agree to make the election, and if they’re shareholders of a company that isn’t wholly owned, it’s going to be a serious negotiation,” said Jose Murillo, EY Americas director of international tax and transaction services.
But under current economic uncertainty caused by the coronavirus pandemic, the effectiveness of closing a tax year upon a sale may not be guaranteed to have an intended long-term outcome, Weiss and LaBonte said.
“This will be an ongoing issue for all multinationals that engage in M&A activity, because any transaction in the future will bring up the same question again,” Murillo said.