Rev. Rul. 83-142

ISSUES

1. Whether X will include in its basis of its FY stock cash transferred to FY when as part of the same transaction the cash is returned to X?

2. Whether the cash returned by FY to X will be treated as a dividend?

FACTS

X, a domestic corporation, owns all of the stock of FY, a corporation formed under the laws of foreign country FC. FY is engaged in the active conduct of two businesses and has been for each of the past five years. For valid business reasons, FY proposes to transfer one of its businesses to FZ, a newly formed FC corporation, in exchange for all of the FZ stock. Immediately thereafter, FY will distribute all of the FZ stock to X in a transaction that is intended to qualify under section 355 and is subject to section 356 of the Internal Revenue Code. The exchange of the FY business for the FZ stock is intended to qualify as a reorganization within the meaning of section 368(a)(1)(D). The distribution of the stock of FZ is described in section 367(b)(1) and section 7.367(b)-1O(c) of the Temporary Income Tax Regulations. All relevant requirements of section 7.367(b)-1(c) and (d) and section 7.367(b)-10(c) will be satisfied.

A distribution described in section 355 of the Code does not qualify for tax-free treatment under FC law. Rather, under FC law, X is required to purchase the FZ stock from FY at its fair market value. Therefore, as part of the transaction, X will pay to FY an amount of money equal to the fair market value of the FZ stock. FY will then make a cash distribution to X that under FC law is treated as a dividend and subject to withholding tax. The amount of the distribution to X will be great enough to allow X to receive, after payment of the withholding tax to FC, an amount equal to the fair market value of the FZ stock. It is assumed that the withholding tax imposed by FC is a creditable income tax under section 901 of the Code and, subject to limitations such as section 904, will be claimed by X.

LAW AND ANALYSIS

It is a well established principle of tax law that transitory steps occurring as part of a plan of reorganization are disregarded where allegedly disqualifying interim steps are undertaken in order to comply with applicable law. See Rev. Rul. 78-397, 1978-2 C.B. 150.

Section 356(b) of the Code provides that if section 355 would apply to a distribution but for the fact that the property received in the distribution consists not only of property permitted by section 355 to be received without the recognition of gain, but also of other property or cash, then an amount equal to the sum of the money and the fair market value of the other property shall be treated as a distribution of property to which section 301 applies.

The payment by X to FY equal to the fair market value of the FZ stock and the divided distribution by FY to X is a circular flow of cash to the extent that X's payment is returned by FY. This circular flow of cash is a transitory step that has no federal income tax consequences. However, FY's distribution includes additional cash in the amount of the withholding taxes paid to FC. This additional cash is a distribution deemed to be received by X along with the FZ stock and constitutes money received by X within the meaning of section 356(b) of the Code.

HOLDING

1. The cash paid by X to FY and thereafter returned by FY to X as a dividend is disregarded and has no effect on X's basis in the FY stock.

2. The distribution of the cash by FY to X is disregarded to the extent it represents a return of cash received by FY from X. The amount of the distribution representing the withholding taxes paid to FC is a distribution of money subject to the rules of section 301 of the Code by the application of section 356(b).