Rev. Rul. 76-36

Advice has been requested whether the provisions of section 382(b)(3) of the Internal Revenue Code of 1954 are applicable to a statutory merger of two corporations under the circumstances described below.

A, an individual, owned all the outstanding stock of X, a domestic corporation, until December 31, 1974. X was engaged in the business of mining coal. X owned all the outstanding stock of Y, a domestic corporation, until December 31, 1974. Y was engaged in the business of operating a radio station. For several years, X and Y had operated their respective businesses as separate corporate entities. In 1974, for valid business reasons, it was decided that X and Y should merge. However, because of the difficulty of transferring of Y's license, it was decided to merge X into Y. This merger was effected on December 31, 1974, and qualified as a tax-free reorganization under section 368(a)(1)(A) of the Code to which section 361 applies. As a result of this merger, A, who previously owned the stock of X, now owns all the stock of Y, the surviving corporation.

Prior to the merger, Y had net operating loss carryovers from earlier taxable years that could be carried over to 1975 and subsequent taxable years. As of December 31, 1974, the total value of Y's outstanding stock was 10x dollars and the total value of X's stock was 100x dollars.

Section 381(a)(2) of the Code provides, that in the case of the acquisition of assets of a corporation by another corporation in a transfer to which section 361 applies, but only if the transfer is in connection with certain of the reorganizations described in section 368(a)(1), the acquiring corporation shall succeed to and take into account, as of the close of the day of distribution or transfer, the items described in section 381(c) of the transferor corporation, subject to the conditions and limitations specified in section 381(b) and (c).

Section 382(b)(1) of the Code provides that in a reorganization specified in section 381(a)(2), if the transferor corporation or the acquiring corporation has a net operating loss which is a carryover to the first taxable year of the acquiring corporation ending after the date of transfer, and the stockholders (immediately before the reorganization) of the loss corporation, as the result of owning stock of the loss corporation, own (immediately after the reorganization) less than 20 percent of the fair market value of the outstanding stock of the acquiring corporation, the total net operating loss carryover from prior taxable years of the loss corporation to the first taxable year of the acquiring corporation ending after the date of transfer shall be reduced by the percentage determined under section 382(b)(2).

Section 382(b)(3) of the Code provides that the limitation of the loss carryover provided for in section 382(b)(2) shall not apply if the transferor corporation and the acquiring corporation are owned substantially by the same persons in the same proportions.

The specific question is whether the provisions of section 382(b)(3) of the Code apply to prevent any limitations on Y's net operating loss carryovers under section 382(b)(2).

In the instant case, Y contends that, under the constructive ownership of stock rules in section 318(a)(2)(C) of the Code, A should be regarded as owning, before the merger, 100 percent of the stock of Y and X, since A directly owned 100 percent of X, and X directly owned 100 percent of Y. Y further contends that under the above constructive ownership the provisions of section 382(b)(3) would be met, and there would be no reduction of Y's net operating loss carryovers under section 382(b)(2).

Section 318(a) of the Code provides that the constructive ownership of stock rules contained therein are applicable only to those Code sections that expressly make such rules applicable. Section 382(b) and the Income Tax Regulations thereunder contain no provision making the constructive ownership of stock rules of section 318(a) applicable to section 382(b). Therefore, the constructive ownership of stock rules of section 318(a) have no application to the provisions of section 382(b). Rev. Rul. 56-613, 1956-2 C.B. 212, states that section 368(c) specifically defines control in terms of direct ownership of stock and not in terms of practical control. There is no basis for disregarding the separate legal entities of the parent and its subsidiary and for attributing the subsidiary's ownership of stock to the parent. The Internal Revenue Service does not follow World Service Life Insurance Co. v. United States, 471 F. 2d 247 (8th Cir. 1973), which holds to the contrary.

In the instant case, however, section 382(b)(5) of the Code, relating to attribution of ownership, does take into account, for purposes of section 382(b), the ownership by X of all of the stock of Y before the reorganization. X, as the stockholder of the loss corporation Y, actually owns no stock of Y after the reorganization since X's existence terminated upon the merger.

Section 382(b)(5) of the Code treats X, solely for the purpose of section 382(b), as remaining in existence and owning immediately after the reorganization that percentage of Y's stock that bears the same ratio to the percentage of the stock of Y immediately before the reorganization owned by X as the total value of Y's stock before the reorganization bears to the total value of the stock of Y after the reorganization. Since X owned all the stock of Y before the merger, and the value of the Y stock was 10x dollars before the merger and 100x dollars after the merger (the combined value of the X and Y stock before the merger), X is treated, under section 382(b)(5), as owning 10 percent of the stock of Y (10/100x 100 = 10) after the reorganization. Therefore, the amount of Y's net operating loss carryovers must be reduced by 50 percent under section 382(b)(2).

Accordingly, in the instant case, the provisions of section 382(b)(3) of the Code do not apply to prevent limitations on Y's net operating loss carryovers under section 382(b)(2). Further, Y's net operating loss must be reduced under section 382(b)(2) as set forth in the preceding paragraph.

However, it should be noted that if the circumstances of the instant case had permitted Y to liquidate into X under section 332 of the Code, the amount of Y's net operating loss carryovers would have been available for use by X without reduction. This result would obtain because section 382(b) applies only to transactions described in section 381(a)(2) and a section 332 liquidation is not described there but rather in section 381(a)(1).