Rev. Rul. 56-116

Advice has been requested with respect to the tax consequences, for Federal income tax purposes, of a proposed transaction hereinafter described.

Under a plan providing for the merger of Y corporation into X corporation, both preferred stock and voting common stock of X will be issued in exchange for the common stock of Y .

The common stocks of both Y and X are widely held, and these corporations are not related through the ownership of their common stocks.

After the merger, the total percent of common stock in X held by the former Y's stockholders will be less than 20 percent.

The reasons for issuing both preferred and common stocks of X in exchange for stock of Y are that the business of X has shown more dynamic growth over the period of the last several years than has that of Y and it is therefore desired to limit the extent to which the former Y's stockholders may share in the future growth of the common equity. By limiting the amount of X's common stock issued to the former Y's stockholders, there will be less dilution of the voting power of the present X's common stockholders.

The management of X has no intention of redeeming any of the preferred stock which would be issued in the merger, except as required under the provisions of the purchase fund and the sinking fund agreements, the terms of which are not here relevant.

Section 368(a)(1)(A) of the Internal Revenue Code of 1954 provides that the term `reorganization' includes a statutory merger or consolidation; section 368(b) provides that the term `a party to a reorganization' includes both corporations, in the case of a reorganization resulting from the acquisition by one corporation of stock or properties of another; and section 354(a) provides that no gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation. Pursuant to the afore-mentioned sections of the Code, it is held that no gain or loss will be recognized to Y, X or their stockholders from the proposed statutory merger of Y into X .

The term `section 306 stock' means stock which meets the requirements of subparagraph (A), (B), or (C) of section 306(c)(1). Subparagraph (B), which is applicable to the instant case, provides as follows:

(B) Received in a corporate reorganization or separation.-Stock which is not common stock and-

(i) which was received, by the shareholder selling or otherwise disposing of such stock, in pursuance of a plan of reorganization (within the meaning of section 368(a)), or in a distribution or exchange to which section 355 (or so much of section 356 as relates to section 355) applied, and

(ii) with respect to the receipt of which gain or loss to the shareholder was to any extent not recognized by reason of part III, but only to the extent that either the effect of the transaction was substantially the same as the receipt of a stock dividend, or the stock was received in exchange for section 306 stock. For purposes of this section, a receipt of stock to which the foregoing provisions of this subparagraph apply shall be treated as a distribution of stock.

Section 1.306-3(d) of the regulations under Subchapter C, as published in Treasury Decision 6152, C.B. 1955-2, 61, provides, in part, as follows:

Ordinarily, section 306 stock includes stock which is not common stock received in pursuance of a plan of reorganization (within the meaning of section 368(a)) or received in a distribution or exchange to which section 355, (or so much of section 356 as relates to section 355) applies if cash received in lieu of such stock would have been treated as a dividend under section 356(a)(2) or would have been treated as a distribution to which section 301 applies by virtue of section 356(b) or section 302(d).

As to dispositions of `section 306 stock,' section 306 provides, in part, as follows:

(a) GENERAL RULE.-If a shareholder sells or otherwise disposes of section 306 stock (as defined in subsection (c))-

(1) DISPOSITIONS OTHER THAN REDEMPTIONS.-If such disposition is not a redemption * * *

(A) The amount realized shall be treated as gain from the sale of property which is not a capital asset. * * *

*

(b) EXCEPTIONS.-Subsection (a) shall not apply-

*

(4) TRANSACTIONS NOT IN AVOIDANCE.-If it is established to the satisfaction of the Secretary or his delegate-

(A) that the distribution, and the disposition * * * or

* was not in pursuance of a plan having as one of its principal purposes the avoidance of Federal income tax.'

It is held that the preferred stock received in connection with the merger is `section 306 stock' as provided by section 306(c)(1)(B) of the 1954 Code. It is further held that the provisions of section 306(a)(1) of the 1954 Code shall not be applicable to the proceeds of the disposition of the preferred stock of X which will be issued in the merger, unless such disposition is in anticipation of a redemption after the issuance of the stock. See section 1.306-2(b)(3) of the regulations under Subchapter C, Treasury Decision 6152, supra .