Rev. Rul. 81-247

ISSUE

Will the application of the continuity of business enterprise rules of section 1.368-1(d) of the Income Tax Regulations to Situations 1, 2, and 3 prevent the transactions between X and Y in each of the situations from qualifying as tax free reorganizations under sections 368(a)(1)(A) and (a)(2)(C) of the Internal Revenue Code?

FACTS

Situation 1:

In a transaction meant to qualify as a tax free reorganization under sections 368(a)(1)(A) and (a)(2)(C) of the Code, corporation X, a holding company, acquired, under the applicable merger laws of State M, a significant portion of the historic business assets of corporation Y, a manufacturing business. Immediately thereafter, X transferred all assets received from Y to corporation Z, its wholly-owned subsidiary engaged in a manufacturing business. Z then used the assets in its manufacturing business.

Situation 2: The facts are the same as in Situation 1 except that X was also engaged in a manufacturing business, and X transferred less than a significant portion of Y's assets to Z and retained less than a significant part of Y's assets. Both X and Z used their respective parts of Y's assets (which together totaled more than a significant portion of the historic business assets of Y) in their separate manufacturing businesses.

Situation 3:

The facts are the same as in Situation 1, except that X transferred a part of the assets received from Y to each of three wholly owned manufacturing subsidiaries. The separate parts of the assets transferred to the three wholly owned subsidiaries each represented less than a significant portion of the historic business assets X received from Y. However, the total of all of the assets X transferred to the three subsidiaries represented all the assets X received from Y which, as stated above, was a significant portion of Y's historic business assets.

In none of the situations described above did X, Z or any of X's other subsidiaries, continue an historic trade or business of Y.

LAW AND ANALYSIS

Section 1.368-1(b) of the regulations provides, in part, that requisite to a reorganization is the continuity of the business enterprise under the modified corporate form.

Section 1.368-1(d) of the regulations provides the general rule that continuity of business enterprise requires that the transferee (acquiring corporation) in a corporate reorganization either (i) continue the transferor's (acquired corporation) historic business, or (ii) use a significant portion of the acquired corporation's historic business assets in a business.

The second sentence of section 1.368-1(d)(2) states that the application of this general rule to certain transactions, such as mergers of holding companies, will depend on all facts and circumstances. That section goes on to state that the policy underlying this general rule, which is to ensure that reorganizations are limited to readjustments of continuing interests in property under modified corporate form, provides the guidance necessary to make these facts and circumstances determinations.

Section 368(a)(1)(A) of the Code provides that the term "reorganization" includes a statutory merger or consolidation. Section 1.368-2(b) of the regulations provides that the words "statutory merger or consolidation" refer to a merger or consolidation made under the corporation laws of the United States, a state, or territory, or the District of Columbia. Section 368(a)(2)(C) provides, in part, that a transaction otherwise qualifying under paragraph (1)(A) of section 368(a) will not be disqualified because part or all of the assets that were acquired in the transaction are transferred by the corporation to another corporation it controls.

In Rev. Rul. 68-261, 1968-1 C.B. 147, a parent corporation acquired all the assets of a target corporation. The target had conducted its business through six divisions. Immediately after the merger of the parent and the target corporation, the parent transferred the assets of each of the six divisions of the target to six wholly owned subsidiaries of the parent. The revenue ruling concludes that the transaction is a reorganization within the meaning of sections 368(a)(1)(A) and 368(a)(2)(C) of the Code.

In Rev. Rul. 64-73, 1964-1 (Part I) C.B. 142, a parent corporation acquired the assets of a target corporation in a reorganization under sections 368(a)(1)(C) and 368(a)(2)(C) of the Code. Some of the target assets were transferred to the parent and some of the assets were transferred to a second tier subsidiary of the parent, wholly owned by a wholly owned subsidiary of the parent. The revenue ruling states that neither the assets transferred to the subsidiary nor to the parent constituted separately substantially all of the target assets, but together constituted all of the target's assets. The revenue ruling concludes that the transaction qualifies as a reorganization as defined in section 368(a)(1)(C).

Both Rev. Rul. 68-261 and Rev. Rul. 64-73 are consistent with the legislative intent of section 368(a)(2)(C) of the Code, which permits transactions to continue to qualify as reorganizations within the meaning of section 368(a)(1)(A) and 368(a)(1)(C) whether any of the assets received by the acquiring corporation are transferred to corporations it controls.

HOLDING

The application of the continuity of business enterprise rules of section 1.368-1(d) of the regulations to Situations 1, 2, and 3 will not prevent the transactions between X and Y, in each of the situations, from qualifying as tax free organizations under sections 368(a)(1)(A) and (a)(2)(C) of the Code, because the significant portion of Y's historical business assets received by X remained with X or corporations directly controlled by X. Therefore, in Situations 1, 2, and 3 the mergers of Y into X, followed by the specific transfers described in each situation, are statutory mergers within the meaning of sections 368(a)(1)(A) and 368(a)(2)(C).

The above holdings regarding Situations 1, 2, and 3 would also apply in situations that meet the qualifications of an asset acquisition under section 368(a)(1)(C) and (a)(2)(C) or a stock acquisition within the meaning of section 368(a)(1)(B) and (a)(2)(C) of the Code.