Rev. Rul. 78-142

Advice has been requested as to the Federal income tax consequences of a statutory merger intended to qualify as a reorganization under section 368(a)(1)(A) of the Internal Revenue Code of 1954 by reason of section 368(a)(2)(D) under the circumstances described below.

Corporation S, a wholly owned newly formed subsidiary of corporation P whose stock is widely held, acquired, pursuant to a statutory merger, the assets of corporation T, an unrelated corporation, in exchange for 50x shares of P preferred stock and the assumption by S of the liabilities of T.

The preferred stock of P issued in the statutory merger was callable after 5 years following the effective date of this merger and was subject to mandatory serial redemption requirements after 5 years following the effective date of the merger. Such redemptions of the shares of preferred stock would not be made at more than 110 percent of the issue price of the preferred stock which is defined as the fair market value of the T stock exchanged for the P preferred stock. The obligation to redeem the preferred stock could be satisfied only out of the surplus of P. Each share of the P preferred stock was entitled to 1 vote per share, as was P's common stock. The P preferred stock was convertible into P common stock. Dividends payable on the P preferred stock were cumulative. Dividends were payable solely from earnings and were dependent solely upon declaration in the discretion of the board of directors, subject to typical shareholder remedies in case of nonpayment.

The terms of the P preferred stock included the following covenants that remained in effect as long as not less than 10x shares of P preferred stock remained outstanding: performance by P of its obligations with respect to the mandatory serial redemption of the P preferred stock; maintenance by P of its shareholders' equity by maintaining the consolidated net current assets in P and S at certain specified levels; maintenance by S at all times of bank deposits of a minimum specified amount; agreement by P not to incur any indebtedness (other than indebtedness incurred in the ordinary course of business) or liens or enter into any transaction not in the regular course of business without the consent of the representative of the former T shareholders (the representative). Notwithstanding the above, P was permitted to make withdrawals from S in the form of dividends, loans, or otherwise, provided that the withdrawals did not reduce the net worth of S below 600x dollars and provided P was still in compliance with all other covenants. Furthermore, two persons designated by the representative were to be elected to S's and P's board of directors, and S was to be operated as a separate corporation wholly-owned by P.

The terms of the P preferred stock also provided that in the event of a default by P with respect to any of the above covenants, the holders of the preferred stock of P have the option, exercisable through the representative, to require P to redeem all of the preferred stock of P for a redemption price payable in (a) all of the outstanding stock of S plus (b) an amount of P common stock determined by a formula. The formula is in the nature of a penalty payable to the former T shareholders for the expense and inconvenience of the default and subsequent exercise of the option. The number of shares of P common stock to be issued under the formula is decreased as the shares of P preferred stock are converted or redeemed.

In order to facilitate the distribution of S's stock in the event of a default with respect to any covenant and a subsequent exercise of the option, all of S's stock was placed in escrow. The provisions of the escrow agreement provided that until S's stock became distributable to the former T shareholders because of a default by P with respect to any covenant, P was to receive all cash dividends paid on S's stock. Prior to the occurrence of a default, P had the right to vote S's stock on all matters other than amendments to the certificate of incorporation or the by-laws of S, or on a disposition of the assets or business of S. In the event of default, the escrow agent had the immediate right to vote S's stock, in accordance with the representative's instructions, on all matters including the right to remove the directors elected by P and to elect new directors of S. Until the occurrence of a default, P had the right to elect all directors of S (with the exception of the two designated by the representative) and P also had the right to designate the total number of directors to serve on S's board of directors.

A default on any covenant gave the former T shareholders the option to rescind the transaction, but this was not a commitment on their part to do so. The terms of the escrow agreement did not grant to the former T shareholders any rights with respect to S's stock beyond those necessary to preserve their rights under the option.

The specific issues in the instant case are whether the merger meets the continuity of interest requirement necessary for qualification as a reorganization under sections 368(a)(1)(A) and 368(a)(2)(D) of the Code, and whether the rescission provisions contained in the stock constitutes "other property" under section 356.

Section 368(a)(1)(A) of the Code states that the term "reorganization" means a statutory merger or consolidation. Section 368(a)(2)(D) provides that the acquisition by one corporation, in exchange for stock of a corporation (controlling corporation) that is in control of the acquiring corporation, of substantially all of the properties of another corporation that in the transaction is merged into the acquiring corporation will not disqualify a transaction under section 368(a)(1)(A) if such transaction would have qualified under section 368(a)(1)(A) if the merger had been into the controlling corporation and if no stock of the acquiring corporation is used in the transaction.

Section 354(a)(1) of the Code provides, in part, that no gain or loss will be recognized if stock in a corporation a party to a reorganization is, in pursuance of the plan of reorganization, exchanged solely for stock in such corporation or in another corporation a party to the reorganization. Section 356(a)(1) of the Code provides, in part, that if money or other property is received in an exchange to which section 354 would otherwise apply, then gain, if any, to the recipient will be recognized to the extent of the sum of the money and fair market value of the other property received.

Section 368(a) of the Code provides, in part, that the term "a party to a reorganization" includes the controlling corporation referred to in section 368(a)(2)(D).

Section 1.368-1(b) of the Income Tax Regulations provides, in part, that requisite to a reorganization under the Code are a continuity of business enterprise under the modified corporate form, and a continuity of interest therein on the part of those persons who, directly or indirectly, were the owners of the enterprise prior to the reorganization.

Section 1.368-2(b)(2) of the regulations provides, in part, that the test of whether the transaction would have qualified under section 368(a)(1)(A) of the Code if the merger had been into the controlling corporation means that the general requirements of a reorganization under section 368(a)(1)(A), such as continuity of interest, must be met.

In the instant case, the rescission provision does not violate the continuity of interest requirement of section 1.368-1(b) of the regulations since the former T shareholders retained a continuity equity interest in the enterprise through the ownership of the P preferred stock. Rescission was contingent and beyond the control of the former T shareholders. Furthermore, the mandatory serial redemption feature does not violate the continuity of interest requirement because such redemptions cannot commence until after five years from the consummation of the reorganization. Rev. Rul. 66-23, 1966-1 C.B. 67.

The rescission provision contained in the terms of the preferred stock of P does not constitute "other property" within the meaning of section 356 because of the qualified and contingent nature of this provision and because this provision is inherent in the P preferred stock and is not personal to the former T shareholders. See Rev. Rul. 75-33, 1975-1 C.B. 115.

Accordingly, since the merger of T into S meets the requirements of sections 368(a)(1)(A) and 368(a)(2)(D) of the Code and since the continuity of interest requirement of section 1.368-1(b) of the regulations is met, the merger qualifies as a reorganization under these Code sections and under section 354(a)(1) no gain or loss is recognized to the former T shareholders upon the exchange of their T stock for P preferred stock.