Rev. Rul. 64-102

Advice has been requested as to the Federal income tax consequences of a non pro rata distribution by a corporation of stock of a controlled corporation to certain of its shareholders in exchange for all their stock where such distribution is immediately preceded by a large contribution by the distributing corporation to the capital of the controlled corporation.

A corporation, engaged for more than five years in the active conduct of a business, owned all the capital stock of another corporation, which was also engaged for more than five years in the active conduct of a separate business. All the stock of the subsidiary corporation had been acquired more than five years previously by the parent corporation.

A minority group of shareholders owning one third of the stock of the parent was primarily involved in the management of the subsidiary. In order to resolve managerial policy differences between this group of shareholders and the majority group, it was decided to distribute all the stock of the subsidiary to the minority shareholders in exchange for all their stock in the parent. Prior to the distribution, the parent made a capital contribution of 13 x dollars to the subsidiary in order to equalize the value of the subsidiary's stock with the value of the parent's stock owned by the exchanging shareholders. The capital contribution did not cause changes of such character as to constitute the acquisition of a new or different business. After the contribution to capital and prior to the distribution of the stock of the subsidiary, the stock of the parent corporation had a value of 72 x dollars and the stock of the subsidiary corporation had a value of 24 x dollars. The one-third of the parent's stock owned by the minority shareholders was then surrendered in exchange for all the subsidiary's stock.

Section 355 of the Internal Revenue Code of 1954 provides rules for the separation of two or more existing businesses formerly operated directly or indirectly by a single corporation without recognition of gain or loss to the shareholders and security holders. See section 1.355-1(a) of the Income Tax Regulations.

Section 355(a)(2) of the Code states that the general rule set forth in section 355(a)(1) of the Code will be applied without regard to whether the distribution is pro rata or whether the shareholders surrender stock in the distributing corporation. However, section 355(a)(1)(B) of the Code provides that the transaction must not be used principally as a device for the distribution of earnings and profits of the distributing corporation or the controlled corporation or both.

Although the parent corporation made a large contribution to the capital of the subsidiary immediately before the distribution of the subsidiary's stock to the minority shareholders, the minority shareholders who received the controlled corporation's stock surrendered in exchange all their stock in the distributing corporation. This distribution, if it were considered taxable, would not result in dividend income to the shareholders receiving the subsidiary's stock because the exchange would be in complete redemption of all their stock interest in the distributing corporation and could be qualified under section 302(b)(3) of the Code. Hence, the test prescribed by section 355(a)(1)(B) of the Code is satisfied. Accordingly, notwithstanding the large contribution to capital, there can be no device to distribute earnings and profits (that is, to convert dividend income into capital gains) because of the non pro rata distribution. Furthermore, the active business requirements of section 355(b) of the Code are met. Consequently, the distribution qualifies for tax-free treatment under section 355 of the Code. See Revenue Rulings 56-117, C.B. 1956-1, 180, and 56-655, C.B. 1956-2, 214.

Revenue Ruling 58-68, C.B. 1958-1, 183, is distinguishable from the instant case. There the parent corporation made a large contribution to the capital of its subsidiary immediately before the distribution of the subsidiary's stock to its sole shareholder. The Internal Revenue Service concluded in that ruling that the transaction was used principally as a device for the distribution of the earnings and profits of the parent to its sole shareholder. Here, for the reasons noted above, the non pro rata distribution of the controlled corporation's stock to the minority shareholders in exchange for all their stock in the parent could not be used as a device for the distribution of earnings and profits.

Accordingly, it is held that no gain or loss is recognized to those shareholders who received stock in the subsidiary corporation in exchange for all their stock in the parent corporation under section 355 of the Code.

Revenue Ruling 58-68 also indicates that the active business requirements of section 355(b) of the Code were not satisfied. That Revenue Ruling is hereby modified to remove therefrom the implication that those active business requirements can never be met where more than 50 percent of the assets of a controlled corporation were acquired by a capital contribution immediately prior to the distribution.