Rev. Rul. 60-236

Advice has been requested whether state income taxes paid by a corporation upon gains realized on the sale of all its assets, pursuant to a plan of complete liquidation under section 337(a) of the Internal Revenue Code of 1954, are deductible as "taxes" under section 164 of the Code in view of the limitation imposed by section 265 of the Code on the deductibility of "expenses" allocable to tax-exempt income.

Having adopted a plan of complete liquidation under section 337 of the Code, the taxpayer corporation sold all of its property and distributed the proceeds thereof to its shareholders. The gains realized on these sales were subject to a state income tax which the taxpayer paid during the taxable year of liquidation.

Section 337(a) of the Code provides that, in prescribed circumstances, no gain or loss shall be recognized to a corporation on the sale or exchange of its property during a 12-month period preceding the complete liquidation of the corporation. Thus, the gains realized by the taxpayer in the instant cases were not recognized for Federal income tax purposes.

Section 161 of the Code provides, in substance, that, in computing taxable income, there shall be allowed as a deduction those items specified in section 161 to section 179 of the Code, subject to the exceptions provided in section 261 to section 273 of the Code.

The pertinent provision of section 164 of the Code reads as follows:

(a) * * * Except as otherwise provided in this section, there shall be allowed as a deduction taxes paid or accrued within the taxable year.

Section 261 of the Code provides that, in computing taxable income, no deduction shall in any case be allowed in respect of the items specified in section 262 to 273 of the Code.

The pertinent provision of section 265 of the Code reads as follows:

No deduction shall be allowed for--

(1) EXPENSES.--Any amount otherwise allowable as a deduction which is allocable to one or more classes of income * * * wholly exempt from the taxes imposed by this subtitle.

Section 1.265-1(b)(1) of the Income Tax Regulations provides that a class of income wholly exempt from Federal income tax includes any class of income which is wholly excluded from gross income under any provision subtitle A of the Code or wholly exempt from Federal income tax under the provision of any other law.

In Hawaiian Trust Company, Limited v. United States, 178 Fed. Supp. 637, the taxpayer, hereinafter referred to as "Refiners," was a corporation organized under the laws of Hawaii and principally engaged in the manufacture and sale of petroleum products and the distribution of butane. During the taxable year 1955, Refiners sold all of its assets pursuant to a plan of complete liquidation and was formally dissolved in 1956. Pursuant to section 337 of the Code, no gain or loss was recognized to Refiners for Federal income tax purposes upon the sale of its assets.

In its Federal income tax return for 1955, Refiners claimed a deduction for accrued Territorial net income taxes. These taxes were imposed upon Refiners' net income reportable for Territorial net income tax purposes. This income included the gains realized by Refiners upon the sale of its assets in 1955. The Commissioner of Internal Revenue disallowed that portion of the Territorial net income tax allocable to the gain from the sale of Refiners' assets as a deduction for Federal income tax purposes on the grounds that section 265 of the Code prohibited the deduction of expenses allocable to income exempt from Federal income tax. The court, in holding that the Commissioner correctly disallowed the claimed deduction for Territorial taxes paid, cited section 265(1) of Code and section 1.265-1(b) of the regulations and stated, in part, as follows:

From the foregoing, it is apparent that there are only two classes of income involved; taxable income and exempt income, the latter being defined as that which is not required to be included in gross income.

As we have seen, it is agreed that "No gain or loss to Refiners was recognized on the sale of its assets to Standard and Honolulu Gas," under the provisions of Section 337 of the Code of 1954. Accordingly, it must qualify as exempt income. Since the gain is not included in Refiners' income, it follows that there is no basis for allowing a deduction for the expenses--that is to say, the Territorial tax--related to such income.

Accordingly, it is held that gains not recognized under 337(a) of the Code constitute wholly exempt income for purposes of section 265 of the Code and, hence, state income taxes allocable to such income represent "expenses" which are not deductible as "taxes" under section 164 of the Code.

The holding in the instant case is distinguishable from the decision in the case of Cotton States Fertilizer Company v. Commissioner, 28 T.C. 1169, acquiescence, C.B. 1958-1, 4. In that case the taxpayer's fertilizer plants were destroyed by fire. To collect the insurance proceeds, it was necessary for the taxpayer to employ an architect and a contractor to recreate the plans and specifications of the destroyed plants. The insurance proceeds exceeded the adjusted basis of the destroyed property and were expended for replacement property, the cost of which exceeded the proceeds. The taxpayer elected under section 112(f)(3)(A) of the Internal Revenue Code of 1939 (now section 1033(a) of the 1954 Code) not to report the gain. The Tax Court of the United States held that section 24(a)(5) of the 1939 Code (now section 265 of the 1954 Code) was not applicable because nonrecognized gain under section 112(f)(3)(A) of the 1939 Code was not a class of exempt income. The court stated, in effect, that the gain was not exempt from Federal income taxation but the tax was merely postponed. Moreover, section 113(a)(9) of the 1939 Code operates to reduce the basis of the replacement property by the amount of the gain which was not recognized under 112(f)(3)(A) of the 1939 Code. In the instant case, the net effect of section 337(a) of the 1954 Code is to release items of corporate gain completely from Federal income taxation.