Rev. Rul. 79-155

ISSUES

(1) Will changes, negotiated as part of a plan of reorganization, in terms of the securities of T, the acquired corporation in a reorganization under section 368(a)(1)(A) and (a)(2)(D) of the Internal Revenue Code of 1954, constitute a taxable exchange to the T security holders?

(2) Is gain realized and recognized by the security holders of T upon the subsequent conversion of their securities into stock of P, the controlling corporation in the reorganization under section 368(a)(1)(A) and (a)(2)(D)?

FACTS Corporation T, incorporated in state A, had outstanding one class of common stock and 8 percent convertible securities in the principal amount of 50,000x dollars with a maturity date of July 1, 1995. The terms of the securities contained a provision that they were convertible into T common stock, but did not impart to the holders thereof any rights or liabilities as shareholders of T. The security holders owned no T stock.

In order to have the stock of T owned by a holding company, and to enable joint sharing of the liability for the convertible securities, corporation P and its wholly-owned subsidiary, S, were incorporated in state A to effect a merger of T into S.

Pursuant to the laws of state A, T merged into S in exchange for the stock of P, and S received all of the assets of T and assumed all of T's liabilities. The shareholders of T exchanged their T stock for P common stock. If T had merged into P the merger would have been a reorganization under section 368(a)(1)(A) of the Code.

As part of the plan of reorganization, negotiations were entered into with the T security holders, whose consent was a precondition to the merger. An agreement was reached pursuant to which P and S became jointly and severally liable for the convertible securities; the securities became convertible into P common stock; the security holders obtained the right to convert the securities into S common stock if P disposed of its S stock, although there was no plan on the part of P to do so; the interest rate on the securities was increased to 9 percent; the maturity date was changed to July 1, 1990; and the T security holders consented to the merger. The principal amount of the outstanding securities remained unchanged.

Subsequent to the merger, certain holders of the convertible securities exercised their rights and converted their securities into P common stock.

LAW AND ANALYSIS

ISSUE (1)

Under section 368(a)(2)(D) of the Code the acquisition by S in exchange for stock of P, of substantially all of the properties of T, which in the transaction is merged into S, will not be disqualified under section 368(a)(1)(A) provided the transaction would qualify under section 368(a)(1)(A) if the merger had been into P and no stock of S is used in the transaction.

The transaction in the instant case is a reorganization as defined in section 368(a)(2)(D) of the Code. The convertible debentures of T do not confer upon the holders thereof rights or liabilities as shareholders of S unless and until P divests itself of its S stock and subsequently the security holders elect to convert their securities into S stock. Moreover, there was no intention on the part of P to divest itself of its S stock at the time of the merger. Thus, S stock is not deemed to have been issued upon the merger of T into S. See Rev. Rul. 69-91, 1969-1 C.B. 106. Further, no gain or loss is recognized to T upon the assumption by P and S of the liability for the convertible securities. See section 357 and section 1.368-2(b)(2) of the Income Tax Regulations. See also Rev. Rul. 73-257, 1973-1 C.B. 189.

Under section 1001 of the Code and section 1.1001-1(a) of the regulations, unless otherwise provided in subtitle A of the Code, the gain or loss realized from the exchange of property for other property differing materially either in kind or in extent is treated as income or as loss sustained.

Under section 354(a)(1) and (a)(2) of the Code no gain or loss shall be recognized if securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for securities in such corporation or in another corporation a party to the reorganization if the principal amount of any securities received does not exceed the principal amount of any such securities surrendered.

When the changes in the terms of outstanding securities are so material as to amount virtually to the issuance of a new security, the income tax consequences will follow as if the new security were actually issued. See Rev. Rul. 73-160, 1973-1 C.B. 365.

In this instant case, the convertible securities of T, an operating company, became the joint and several obligations of P and S, a holding company and an operating company, respectively, and became accompanied by a right of conversion into stock of P. The addition of P as an obligor, the change in conversion rights from the right to convert into the stock of an operating company, T, to the right to convert into the stock of a holding company, P, the increase in the interest rate, and the earlier maturity date, are, taken together, material changes that would otherwise constitute an exchange subject to recognition of gain or loss under section 1001 of the Code. However, section 354(a)(1) and (a)(2) applies to the transaction since it qualified as a reorganization under section 368(a)(1)(A) and (a)(2)(D) and since the securities deemed to be exchanged were of the same principal amount.

ISSUE(2)

Rev. Rul. 72-265, 1972-1 C.B. 222, holds that if the owner of a corporate obligation exercises the right provided for in the obligation to convert it into stock of the obligor corporation, such conversion does not result in the realization of gain or loss. In contrast, Rev. Rul. 69-135, 1969-1 C.B. 198, holds that if the obligations of one corporation are converted into common stock of another corporation, gain or loss is recognized because the obligations and stock are issued by two separate and distinct corporations.

In the instant case, Rev. Rul. 69-135 is distinguishable because P, the issuer of the stock, is also an obligor on the convertible securities. Further, consistent with Rev. Rul. 72-265, the security holders converted their securities into stock of P, an obligor corporation, pursuant to a right provided for under the terms of the securities, as amended by the agreement with the security holders.

HOLDINGS

(1) The change in terms of the T securities constituted an exchange of securities upon which no gain or loss was recognized.

(2) Gain or loss was not realized or recognized to the security holders upon the subsequent conversion of the securities into stock of P.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 69-135 is distinguished.