Rev. Rul. 79-250

Rev. Rul. 79-250

ISSUE

Whether a series of events involving (1) a drop-down of all of the assets of a parent corporation to two newly created controlled subsidiaries, (2) a merger of an unrelated target corporation into one of the controlled subsidiaries in exchange for stock of the parent, and (3) a change in the place of organization of the parent should be characterized as two separate reorganizations under section 368(a)(1)(A), by reason of section 368(a)(2)(D), and section 368(a)(1)(F) of the Internal Revenue Code.

FACTS

W was a manufacturing corporation all the stock of which was owned by two individuals. W conducted a steel fabrication business and a drop forge business through its two divisions, A and B, respectively. W was incorporated in state M. Although W owned the land and facilities used by division A, the land and facilities used by division B were leased from Z, an unrelated corporation the stock of which was owned by 20 individuals.

The management of W determined that in order to obtain product liability insurance at reasonable rates for products produced by both divisions, it was necessary to insulate the activities of each division in separate corporations. Moreover, the management of W believed it would be more economical for the W enterprise to acquire all of the assets of Z rather than to continue the leasing arrangement with Z. Finally, the management of W determined that further economies would be realized if the entire W enterprise were reincorporated in state R, which had lower rates of business corporation taxes than state M.

Accordingly, for good business reasons and pursuant to an overall plan, W transferred all of the assets and liabilities of divisions A and B to two newly organized subsidiary corporations, X and Y, respectively, solely in exchange for all the stock of those corporations. These transactions qualify under section 351 of the Code. In addition, W also transferred shares of its newly issued preferred stock to Y. Thereafter, Z merged into Y pursuant to the state law of M, with the former Z shareholders receiving all the W preferred stock. Immediately following acquisition of Z, W changed its place of organization by merging into N, a newly organized corporation incorporated in state R. Upon W's change of place of organization, the holders of W common and preferred stock surrendered their W stock in exchange for identical N common and preferred stock, respectively.

LAW AND ANALYSIS

The specific sections of the Code that are applicable are section 368(a)(2)(D), which provides that stock of a corporation other than the acquiring corporation may be used as consideration in a reorganization under section 368(a)(1)(A) provided that the other corporation is in control, within the meaning of section 368(c), of the acquiring corporation; and section 368(a)(1)(F), which provides that a reorganization includes a mere change in identity, form, or place of organization, however effected.

The specific sections of the regulations that are applicable are section 1.368-1(b), which sets forth the requirement for continuity of interest in a reorganization, and section 1.368-2(b)(2), which sets forth certain requirements of a qualifying reorganization under section 368(a)(1)(A) of the Code, by reason of section 368(a)(2)(D).

If the several steps are viewed separately, the threshold statutory merger of Z into Y, in exchange for stock of W, satisfies the technical requirements of a reorganization under section 368(a)(1)(A) of the Code, by reason of section 368(a)(2)(D), since Y has acquired substantially all of the properties of Z solely in exchange for stock of W, the corporation which is in control of Y. Moreover, the requirements of business purpose, continuity of business enterprise, and continuity of interest are satisfied following completion of the merger. The fact that Y was formed immediately before the merger has no bearing on the qualification of this acquisition as a valid reorganization under section 368(a)(1)(A). See section 1.368-2(b)(2).

The subsequent change in place of organization of W by the merger of W into N satisfies the requirements of a valid reorganization under section 368(a)(1)(F) of the Code inasmuch as W only shifted its corporate charter from state M to state R, and no change in shareholders or their proprietary interests occurred as a result. See Helvering v. Southwest Consolidated Corp., 315 U.S. 194 (1942), Ct. D. 1544, 1942-1 C.B. 218; Rev. Rul. 75-561, 1975-2 C.B. 129; and Rev. Rul. 66-284, 1966-2 C.B. 115.

However, because this series of events was undertaken pursuant to an overall plan, a question arises regarding possible application of the "step transaction" doctrine to this transaction.

The step transaction doctrine generally permits a series of formally separate steps to be amalgamated and treated as a single transaction if they are in substance integrated, interdependent, and focused toward a particular end result. The Internal Revenue Service has indicated on several occasions that threshold steps will not be disregarded under a step transaction analysis if such preliminary activity results in a permanent alteration of a previous bona fide business relationship. Thus, the substance of each of a series of steps will be recognized and the step transaction doctrine will not apply, if each such step demonstrates independent economic significance, is not subject to attack as a sham, and was undertaken for valid business purposes and not mere avoidance of taxes. See, e.g., Rev. Rul. 78-330, 1978-2 C.B. 147; Rev. Rul. 77-227, 1977-2 C.B. 120; Rev. Rul. 76-223, 1976-1 C.B. 103; Rev. Rul. 75-456, 1975-2 C.B. 128; Rev. Rul. 69-516, 1969-2 C.B. 56.

One consequence of integrating the series of events presented in this case would be a failure of W's reincorporation in state R to qualify as a reorganization under section 368(a)(1)(F) of the Code because of the change in shareholders and their proprietary interests in W that occurred as a result of the acquisition of Z. See Southwest Consolidated Corp.

However, the facts of this case indicate that the threshold acquisition of previously unrelated Z resulted in a real and substantial change in form of ownership of the Z business that is sufficient to conclude that that acquisition comports with the underlying purposes and assumptions of a reorganization, under section 368(a)(1)(A) of the Code (see section 1.368-1(b)), and is not subject to attack as a sham or illusory. The subsequent reincorporation of W in state R, in which all of the W shareholders, including former Z shareholders, continue their stock interest in N, is likewise real and substantial and not subject to attack as a sham or illusory. Moreover, although the overall plan comprehends both the acquisition and the reincorporation transactions, the economic motivation supporting each transaction is sufficiently meaningful on its own account, and is not dependent upon the other transaction for its substantiation, to warrant the conclusion that the overall plan presents two separate and independent reorganizations. Thus, the step transaction doctrine will not be applied under the facts and circumstances presented here.

HOLDING

The merger of Z into Y in exchange for preferred stock of W qualifies as a reorganization under section 368(a)(1)(A) of the Code, by reason of section 368(a)(2)(D), notwithstanding W's subsequent merger into N. W's merger into N, for purposes of changing W's place of organization, qualifies as a reorganization under section 368(a)(1)(F).