Rev. Rul. 79-194

ISSUE

Is the control requirement of section 351(a) of the Internal Revenue Code of 1954, which provides for nonrecognition of gain or loss on transfers of property to a controlled corporation, satisfied where part of the stock of the controlled corporation received by a transferor in exchange for property is sold to other persons who also transferred property to the corporation in exchange for stock?

FACTS

Situation (1)

Corporation Z and a group of investors, pursuant to a binding agreement between them, transferred property to a newly organized corporation, Newco, in exchange for all of Newco's stock (a single class of voting common stock). Z and the investors received 80 percent and 20 percent, respectively, of Newco's stock. Pursuant to the agreement Z sold an amount of its Newco stock for its fair market value to the investors to bring its ownership down to 49 percent. Newco would not have been formed if the investors had not agreed to transfer property to it and their agreement to do so was conditioned on the sale by Z to them of part of Z's Newco stock.

Situation (2)

X, a domestic corporation, operates a branch in a foreign country. The foreign country enacted a nationalization law that required that the business that X's branch was engaged in be incorporated in the foreign country and that its citizens be the majority owners of such corporation. A governmental agency in the foreign country directed X to transfer all of the assets of its branch to a newly formed foreign country corporation that is, or will be, at least 51 percent owned by its citizens. Accordingly, X and a group of investors, who were citizens of the foreign country, pursuant to a binding agreement between them, transferred property to Newco, a corporation newly organized in the foreign country, in exchange for all of Newco's stock (a single class of voting common stock). X and the investors received 99 percent and one percent, respectively, of Newco's stock. Pursuant to the agreement, X sold an amount of its Newco stock for its fair market value to the investors to bring its ownership down to 49 percent; the investors would pay X in a series of yearly installments. Newco would not have been formed if the investors had not agreed to transfer property to it and their agreement to do so was conditioned on the sale by X to them of part of X's Newco stock. Further, the investors transferred property to Newco in order to become co-transferors with X, and they purchased X's Newco stock in lieu of the assets of X's branch because of the foreign governmental agency's directive. The transfer met the requirements of section 3.02(1) of Rev. Proc. 68-23, 1968-1 C.B. 821, and X timely requested a ruling under section 367(a)(1) of the Code, in accordance with Rev. Proc. 77-5, 1977-1 C.B. 536. The fair market value of each asset transferred is in excess of its basis.

LAW AND ANALYSIS

The specific sections of the Code that are applicable are section 351(a), which provides that no gain or loss will be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation and immediately after the exchange such person or persons are in control of the corporation, and section 368(c) which defines control for purposes of section 351(a), to mean the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation.

Since the sales of Newco stock by Z to the investors, and of Newco stock by X to the investors, were integral parts of the incorporations and pursuant to binding agreements entered into prior to the exchanges, the control requirement of section 351(a) of the Code is determined after the respective sales. See Hazeltine Corp. v. Commissioner, 89 F.2d 513 (3rd Cir. 1937), Intermountain Lumber Co. v. Commissioner, 65 T.C. 1025 (1976) and Rev. Rul. 70-522, 1970-2 C.B. 81.

In Situation (1), after the sales were completed, 49 percent of the Newco stock was owned by Z and 51 percent of the stock was owned by the investors. Therefore, the persons transferring property to Newco in exchange for Newco stock owned 100 percent of the Newco stock "immediately after the exchange" within the meaning of section 351(a). The fact that there was a shift in ownership of stock among the transferors after their exchanges with Newco does not affect the application of section 351(a). See example (1) under section 1.351-1(b) of the Income Tax Regulations in which transfers of property to a new corporation qualify under section 351 even though a shift in the ownership of stock among the transferors is considered to have occurred subsequent to the transfers.

In Situation (2), after the sales were completed, 49 percent of the Newco stock was owned by X and 51 percent of the Newco stock was owned by the investors. Because the amount of stock issued directly to the investors for property is of relatively small value in comparison to the value of all the stock received by them in the transaction, the stock received by the investors is not taken into account in considering whether the transaction qualifies under section 351(a) of the Code. Compare section 1.351-1(a)(1)(ii) of the regulations. Thus, for purposes of determining control under section 351, the investors were not transferors. Therefore, since the person (X) transferring property to Newco in exchange for Newco stock owned only 49 percent of the Newco stock "immediately after the exchange", the control requirement of section 351(a) is not satisfied. The fact that there was a shift in ownership of 49 percent of the Newco stock from a transferor (X) to a non-transferor (the investors) after their exchanges with Newco affects the application of section 351(a).

Compare Rev. Rul. 79-70, page 144, this Bulletin, which holds that the control requirement of section 351(a) is not satisfied where part of the stock of the controlled corporation is sold to another person who transferred property to the corporation in exchange for securities.

HOLDING

Situation (1)

The control requirement of section 351(a) of the Code is satisfied. No gain or loss is recognized to Z or the investors under section 351(a) on the transfer of property to Newco. Gain or loss to Z upon the sale of the Newco stock will be determined and recognized under section 1001.

Situation (2)

The control requirement of section 351(a) of the Code is not satisfied. Gain is recognized to X on the transfer of property to Newco pursuant to section 1001. Gain or loss, if any, to X upon the sale of the Newco stock to the investors will be determined and recognized under section 1001.