Rev. Rul. 66-112

Advice has been requested whether the transaction described below satisfies the `solely for voting stock' requirement of section 368(a)(1)(B) of the Internal Revenue Code of 1954.

The capital stock of M corporation was owned equally by X corporation and Y corporation. For good business reasons Y was interested in acquiring X's one-half interest in M . Because M was closely held it was difficult to ascertain the fair market value of the M stock. Accordingly, X and Y entered into an agreement pursuant to which X transferred its one-half interest in M to Y in exchange for 40,000 shares of Y's voting stock. In addition, the agreement accorded X the right to receive additional shares of Y's voting stock in each of the succeeding 4 years following the date of the initial exchange in which M's net income exceeded a specified amount. If M's net income in the succeeding 4 years did not exceed the specified amount, no additional shares were to be received by X . The maximum number of additional shares of Y voting stock which could be received under the plan of reorganization was 20,000 shares. The right to receive such additional shares was not assignable and such right could give rise to the receipt of only additional voting stock.

Section 368(a)(1)(B) of the Code provides that the term `reorganization' includes the acquisition by one corporation, inchange solely for all or a part of its voting stock, of stock of another corporation if, immediately after the acquisition, the acquiring corporation has control of such other corporation (whether or not such acquiring corporation had control immediately before the acquisition).

Section 354(a)(1) of the Code provides that in general no gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of a plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization.

The `control' requirement of section 368(a)(1)(B) of the Code is clearly satisfied since Y owns all of the stock of M immediately after the initial exchange. The only question remaining is whether the `solely for voting stock' requirement has been met. Whether this requirement has been met is dependent on the treatment to be accorded the contractual right of X to receive additional voting shares of Y based upon the net income of M . If such right is considered other property, the `solely for voting stock' requirement of section 368(a)(1)(B) of the Code will not have been satisfied nor will the requirements of section 354(a) of the code have been met.

Under the facts of this case, the reorganization exchange has been fully consummated, except insofar as the contingent contractual right to receive additional voting stock of Y is concerned. This right is not assignable and it can give rise to only additional Y voting stock. Because of this and the fact that only voting stock has been and can be issued under the terms of the plan of reorganization, the initial receipt by X of 40,000 shares of Y voting stock and the later receipt by X of up to 20,000 additional shares of such stock that may be issued in the 4-year period following the initial exchange will satisfy the `solely for voting stock' requirement of section 368(a)(1)(B) of the Code.

In James C. Hamrick , 43 T.C. 21 (1964), the Tax Court held that taxpayer's contractual right to receive additional stock, contingent upon the earnings of the corporation exceeding a specified amount, is the equivalent of `stock or securities' within the meaning of section 351(a) of the Code so that the receipt of additional shares in later years pursuant to the original incorporation agreement does not result in recognizable gain to him. The Tax Court relied to a large extent on Carlberg v. United States , 281 Fed.(2d) 507 (8th Cir., 1960), in support of its conclusion, which case conflicts with the Service's position as announced in Revenue Ruling 57-586, C.B. 1957-2, 249.

The position expressed above that a reorganization exchange can be fully consummated, except insofar as the right to receive additional stock is concerned, is equally applicable to section 351 exchanges. Since the contingent contractual right in James C. Hamrick was not specifically assignable nor readily marketable and could only give rise to the receipt of additional stock by one who was a party to the transfer, both the `stock or securities' and the `control' tests of section 351(a) of the Code were satisfied. Accordingly, the Internal Revenue Service acquiesces in result only in James C. Hamrick . See page 2 of this Bulletin.

The facts involved in the present case and in James C. Hamrick are distinguishable from those in Revenue Ruling 57-586 which, contrary to Carlberg , holds that negotiable certificates distributed to shareholders of an acquired corporation in connection with a statutory merger, representing contingent interests in shares of the common stock of the surviving corporation to be issued in certain eventualities along with cash representing the value of dividends which would have been paid in the meantime, are considered `other property' within the meaning of section 356 of the Code, relating to the treatment of additional consideration received in connection with reorganizations and other distributions.

In that ruling, a mere contract right only to future distributions of stock provided for in a reorganization agreement was not in question. The question was whether negotiable certificates of contingent interest were merely evidence of the existing right to receive additional common stock or whether they provided the holder of such certificates with something more. Since the issuance of these certificates created a transferable interest which contained a dividend income element, it was determined that the holder had been granted something more than a mere right to receive additional common stock. Therefore, the certificates were considered `other property' under section 356 of the Code.

In the present case the contingent contractual right to additional voting stock in the future is not assignable and can only ripen into additional voting stock. Accordingly, under the circumstances set forth above, the existence of this right will not be treated as violating the `solely for voting stock' requirement of section 368(a)(1)(B) of the Code.

The facts of every delayed stock issuance case, whether arising under section 368 or section 351 of the Code, will be carefully examined to insure that bona fide business reasons justify not issuing all of the stock immediately, and will also be examined to insure that stock issued as a bonus or compensation to the exchanging shareholders is not treated as received in the exchange.

For the effect section 483 of the Code, dealing with interest on certain deferred payments, has on delayed issuance of stock exchanges see sections 1.483-1(b)(6) Example 7, 1.483-1(e)(3) Emample 2 and 1.483-2(a)(2) of the Income Tax Regulations.

Revenue Ruling 57-586, C.B. 1957-2, 249, distinguished.