Rev. Rul. 78-47

Advice has been requested whether the acquisition of the properties of a corporation by a second corporation that was owned in part by the first corporation qualified as a reorganization within the meaning of section 368(a)(1)(C) of the Internal Revenue Code of 1954.

Corporation X is a manufacturing corporation that had outstanding 100 shares of voting common stock. For a number of years, 5 shares of X's stock were owned by corporation Y, a holding company. The remaining shares of X stock were held by 49 individuals, 5 of whom owned 12 shares of X stock as well as all of the outstanding stock of Y. With the exception of the 5 shareholders of X who owned Y stock, the individual shareholders of X had no direct or indirect interest in Y.

In addition to the 5 shares of X stock, which had a value of 90x dollars, the assets of Y consisted of 6x dollars in cash and land having a fair market value of 36x dollars. Y had liabilities of 6x dollars.

In order for X to acquire the land owned by Y, X and Y entered into a plan and agreement of reorganization whereby X acquired all of the assets of Y, solely in exchange for 7 shares of X voting stock plus the assumption by X of Y's liabilities. In order to eliminate a state transfer tax, however, X only issued 2 shares of its stock to Y in exchange for Y's assets, and upon its dissolution, Y distributed the 2 shares of X stock received from X plus the 5 shares of X stock that it already owned to its 5 shareholders in exchange for all of their Y stock.

Section 368(a)(1)(C) of the Code provides, in part, that the term "reorganization" means the acquisition by one corporation, in exchange solely for all or a part of its voting stock, of substantially all of the properties of another corporation. In the case of a reorganization resulting from the acquisition by one corporation of the properties of another, section 368(b) defines "a party to the reorganization" to include both corporations.

Section 361(a) of the Code provides that no gain or loss shall be recognized if a corporation a party to a reorganization exchanges property, in pursuance of the plan of reorganization, solely for stock or securities in another corporation a party to the reorganization.

Section 354(a)(1) of the Code provides that no gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization.

Section 1.368-1(b) of the Income Tax Regulations provides, in part, that a continuity of interest on the part of those persons who, directly or indirectly, were the owners of the enterprise prior to a reorganization is a prerequisite to a reorganization under the Code. The interest continued must be definite and material and must represent a substantial part of the value of the property transferred. See Helvering v. Minnesota Tea Co., 296 U.S. 378 (1935), XV-1 C.B. 189 (1936). The continuity of interest requirement, under which the owners of the acquired corporation must receive a substantial proprietary or equity interest in the acquiring corporation, is necessary in order to distinguish sales transactions from reorganizations. See LeTulle v. Scofield, 308 U.S. 415 (1940), 1940-1 C.B. 151 (1940).

Unless specifically excepted, gain or loss must be accounted for upon the exchange of property if the new property differs materially, either in kind or in extent, from the old property. The reorganization provisions serve to specifically except from this general rule certain specifically-described exchanges incident to readjustments of corporate structures which are effected in accordance with the provisions of section 368 of the Code, which are required by business necessities, and which affect only a readjustment of continuing interests in property under modified corporate forms. See section 1.368-1(b) of the regulations.

The issue of whether a "downstream" merger comes within the intendment of the reorganization statutes was determined in Gilmore v. Commissioner, 44 B.T.A. 881 (1941), aff'd., 1930 F.2d 791 (3rd Cir. 1942), acq., 1946-2 C.B. 2. Therein, the downstream merger of a holding company whose principal asset was the stock of its subsidiary corporation into its subsidiary was held to be a reorganization within the meaning of section 112(g)(1) of the Revenue Act of 1934, predecessor to section 368(a)(1)(A) of the Internal Revenue Code of 1954.

The question in the instant case is whether Y transferred "substantially all" of its assets to X as required by section 368(a)(1)(C) of the Code, since Y's principal asset, the stock of X, was not transferred to X. In George v. Commissioner, 26 T.C. 396 (1956), acq., 1956-2 C.B. 5, approximately 56 percent of the net assets of a holding company was represented by its 50 percent stock interest in an operating company. Contemporaneously with the transfer by the operating company of all of its assets to a new corporation in exchange for its voting stock, the holding company transferred all of its assets, except for its 50 percent stock interest in the operating company, to the new corporation in exchange for additional shares of the new corporation's voting stock. Having found the transfer of the operating company's assets to the new corporation to be a reorganization within the meaning of section 112(g)(1)(C) of the Internal Revenue Code of 1939, predecessor to section 368(a)(1)(C) of the Internal Revenue Code of 1954, the Tax Court concluded that the acquisition of the holding company's assets also qualified as a reorganization under section 112(g)(1)(C), notwithstanding the fact that the holding company did not transfer its stock in the operating company to the new corporation. The Tax Court stated at page 404: "Both of the old corporations transferred 100 percent of all the business assets and liabilities held between them."

Accordingly, since Y transferred all of its business assets to X pursuant to a plan of reorganization solely in exchange for voting stock of X (consisting of the 5 shares of X stock originally held by Y and the 2 shares of newly-issued X stock), the transaction between X and Y qualified as a reorganization within the meaning of section 368(a)(1)(C) of the Code.