Rev. Rul. 74-101

Advice has been requested whether the provisions of section 47 of the Internal Revenue Code of 1954 result in a recapture of previously allowed investment credit under the circumstances described below.

X is a domestic corporation which, since 1964, has been engaged in the active conduct of three business activities: (1) the manufacturing and selling of ice cream in State A; (2) the manufacturing and selling of ice cream in State B; and (3) the manufacturing and selling of ice cream in State C. In 1970, pursuant to a plan of reorganization, X formed two new corporations, Y and Z. Immediately after formation of Y and Z, X transferred all of the assets of the State B business to Y in exchange solely for all of the stock of Y, and all of the assets of its State C business to Z in exchange solely for all of the stock of Z. For good business reasons, immediately upon receiving the Y and Z stock, X distributed all of the shares of such stock to X's sole shareholder. In each instance, the transfer by X of the respective assets to Y and Z solely for Y and Z stock, followed immediately by the distribution of the Y and Z stock to X's sole shareholder, constituted a divisive reorganization within the meaning of section 368(a)(1)(D) of the Code and met the requirements for non-recognition of gain or loss to X's sole shareholder pursuant to section 355(a), including the requirement of section 355(b)(1)(A) that X, Y, and Z be engaged immediately after the distribution of stock in the active conduct of a trade or business. A portion of the assets transferred to Y and Z in this transaction consisted of section 38 property having a useful life of 8 years or more on which in prior years X had been allowed an investment credit computed in accordance with the provisions of section 46.

The question is whether the investment credit previously computed on the section 38 property transferred by X to Y and Z, respectively, must be adjusted in the year of transfer to reflect the early disposition of such property pursuant to section 47(a)(1) of the Code.

Section 47(a)(1) of the Code provides, in part, that if any property is disposed of or otherwise ceases to be section 38 property with respect to the taxpayer before the close of the useful life on which the credit under section 38 was computed, the Federal income tax shall be adjusted accordingly for the taxable year in which the "cessation" took place.

Section 47(b)(2) of the Code provides for exceptions to the "recapture" provisions of section 47(a) insofar as is pertinent here, (1) if the transaction is one to which section 381(a) applies or (2) if the transaction involves a mere change in form of conducting the trade or business so long as the property transferred is retained in such trade or business as section 38 property and the taxpayer retains a substantial interest in such trade or business.

Section 381(a)(2) of the Code provides, in effect, that a transaction involving an exchange of assets for stock meeting the requirements of section 368(a)(1)(D) is subject to the provisions of section 381 only if the corporation to which the assets are transferred acquires substantially all of the assets of the transferor of such assets and otherwise meets the requirements of section 354(b)(1). Section 381 is not applicable to transactions qualifying as reorganizations under section 368(a)(1)(D) which so qualify only because they meet the requirements of section 355 as divisive reorganizations. Section 1.381(a)-1(b)(3) of the regulations provides that section 381 does not apply to divisive reorganizations. Therefore, section 381 was not applicable to the foregoing transactions. Thus, the exception to the application of the recapture of investment credit provisions of section 47(a)(1) for a transaction in which section 381(a) applies is not applicable in the instant case.

Regarding the exception to recapture of the investment credit under section 47(b)(2) of the Code relating to a mere change in form of conducting the trade or business (provided the section 38 property is retained as section 38 property in the same trade or business), section 1.47-3(f) of the regulations provides, in effect, that this exception to recapture investment credit will not apply unless certain conditions are met including the condition that the transferor of the section 38 property retain a "substantial interest" in such trade or business.

In the instant case, X, immediately after the transfer of a portion of X's property to Y and Z, respectively, in lieu of retaining a substantial interest therein, distributed the Y and Z stock received in the exchange to X's sole shareholder. Thus, X, after the reorganizations was not the owner of a substantial interest in either the State B business or the State C business transferred to Y and Z, respectively.

Accordingly, since the transaction in the instant case is not a mere change of form within the meaning of section 47(b)(2) of the Code, the exception to recapture of the investment credit is not applicable. Accordingly, the investment credit allowed to X in prior years with respect to the section 38 property transferred to Y and Z must be adjusted in the year of transfer to reflect the early disposition of such section 38 property by X (prior to the close of the useful life of such property) pursuant to the provisions of section 47(a)(1).