Rev. Rul. 82-131

ISSUE

Is the business purpose requirement of section 1.355-2(c) of the Income Tax Regulations met by a distribution of stock of a controlled corporation, under the circumstances described below?

FACTS

X is a public utility corporation regulated by the Public Utilities Commission of State R ("Commission"). X has for more than 5 years owned all the stock of Y, which is a highly profitable corporation engaged in a business not regulated by the Commission. In each of the past 3 years, X applied to the Commission for a rate increase for its electric service. All three applications were denied because, for purposes of calculating X's income and return on investment, the Commission attributed to X a substantial portion of Y's earnings and profits. As a result of attributing Y's earnings and profits to X, X's earnings and profits appeared adequate and the Commission determined that no increase in the amount X could charge its customers was warranted.

X intends to apply to the Commission again next year for substantial rate increases to compensate it for the increases it previously did not receive, to cover the cost of building additional generating capacity, and to meet current increases in fuel and other costs. Because of the regulatory approach taken by the Commission in prior years, it is virtually certain that a continued affiliation between X and Y will present serious obstacles to X obtaining any rate increase.

An independent public utility counsel, A, has advised X that if X and Y cease to be affiliated as a parent-subsidiary and are not members of the same affiliated group, then there no longer would be any justification for the Commission to attribute Y's earnings and profits to X. In A's opinion, once the relationship between X and Y is terminated, the Commission cannot use the fact that they previously were parent and subsidiary to continue to attribute Y's earnings and profits to X. X has been advised by A that once the affiliation of X and Y is ended, it is likely that the Commission will grant X rate relief, whereas, if the affiliation is not ended, it is unlikely that X will receive rate relief. In accord with A's recommendation that X divest itself of its Y stock, X intends to distribute the stock of Y pro rata to the X shareholders. Except for the question here at issue with regard to business purpose, this distribution will meet all the requirements of section 355 of the Code and the regulations thereunder.

LAW AND ANALYSIS

Section 355 of the Code provides that under certain circumstances a corporation may distribute stock or securities in a corporation it controls to its shareholders or security holders in a transaction that is nontaxable to such shareholders or security holders. Section 1.355-2(c) of the regulations states that a distribution by a corporation of stock or securities of a controlled corporation to its shareholders with respect to its own stock will not qualify under section 355 of the Code when carried out for purposes not germane to the business of the corporation. This provision is intended to limit the application of section 355 to those readjustments of corporate structure that are required by business exigencies.

The distribution by X of the Y stock is for purposes germane to the business of X within the meaning of section 1.355-2(c) of the regulations, since it is reasonable to expect that the distribution will remove a state imposed impediment that has prevented X from realizing additional income in the form of rate increases.

HOLDING

The distribution of the Y stock is supported by a valid business purpose within the meaning of section 1.355-2(c) of the regulations. Since all other requirements of section 355 of the Code and the regulations thereunder have been met, the distribution qualifies under section 355.