REORGANIZATIONS AND CONTINUITY OF PROPRIETARY INTERESTS

ISSUE

Whether the continuity of proprietary interest requirement of section 1.368-1(b) of the Income Tax Regulations is satisfied in the following situation.

FACTS

Corporation X owns all the stock of the corporation Y and Z. Z in turn, owns all the stock of corporation N. This relationship has existed for many years, during which each corporation has been engaged in the active conduct of a separate trade or business.

Pursuant to an integrated plan of acquisition adopted for good business reasons, Y acquired substantially all of the assets of N solely in exchange for shares of Y voting stock and the assumption by Y of the liabilities of N. N was liquidated and the Y stock received by N was distributed to Z and then immediately by Z to X.

LAW AND ANALYSIS

Section 368(a)(1)(C) of the Internal Revenue Code defines the term "reorganization" to include an acquisition by one corporation, in exchange solely for all or part of its voting stock (or voting stock of its parent), of substantially all of the properties of another corporation.

Section 1.368-1(b) of the regulations provides that requisite to a reorganization under the Code is a continuity of interest in the business enterprise under modified corporate form on the part of those persons who, "directly or indirectly", were the owners of the enterprise prior to the reorganization. This section further explains that the purpose of this requirement is to insure that the exceptions to the general rule of taxability are limited to readjustments of corporate structures that are required by business exigencies and that effect only a readjustment of continuing interest in property under modified corporate forms.

The "directly or indirectly" phrase in section 1.368-1(b) of the regulations clearly encompasses the transferor corporation (N in this case) as the direct owner of the business enterprise prior to the reorganization and the shareholders of the transferor corporation (Z in this case), who through their ownership of the corporation are the indirect owners of the enterprise. See Rev. Rul. 66-23, 1966-1 C.B. 67. The question presented is if the transferor corporation is a wholly owned subsidiary of another corporation does such corporation's sole shareholder (X in this case) also qualify as an indirect owner of the business enterprise.

In Rev. Rul. 62-138, 1962-2 C.B. 95, a realty corporation (Realty) engaged in two active businesses transferred one of them, which represented less than "substantially all" of its assets, to a newly created corporation (Newco) in exchange for all of its stock and distributed that stock to its sole shareholder, a banking corporation (Banking), also in the active conduct of a business. Banking, in turn, distributed the stock of Newco to its shareholders. Rev. Rul. 62-138 holds that the successive distributions of stock qualify for nonrecognition pursuant to section 355. The ruling concludes that the overall transaction satisfies the continuity of interest requirement under section 1.355-2(c) of the regulations. Although Banking, the immediate shareholder of Realty, did not retain the Newco stock, the shareholders of Banking qualified as indirect owners of Realty within the meaning of section 1.355-2(c) inasmuch as Banking owned 100 percent of Realty. As Rev. Rul. 62-138 states:

In the instant case, there is no change in the aggregate interests held by the banking corporation's shareholders, no new parties in interest were added as a result of the transaction and none were eliminated. The shareholders after the transaction held the same enterprises in modified corporate form as before the transaction and the corporate enterprises were continued as such.

As in Rev. Rul. 62-138, the distribution by Z of the Y stock to X does not result in a change in X's aggregate interests, because X was the 100 percent parent of Z, which, in turn, owned all of N. Accordingly, the distribution of Y stock by Z to X did not violate the continuity of proprietary interest requirement because X was an indirect owner of N within the meaning of such phrase in section 1.368-1(b) of the regulations.

HOLDING

The continuity of proprietary interest requirement of section 1.368-1(b) of the regulations is satisfied when the stock of the acquiring corporation given in exchange for the acquired corporation is distributed through its 100 percent parent corporation to such corporation's 100 percent parent.

SECTION 451. -- GENERAL RULE FOR TAXABLE YEAR OF INCLUSION

Taxable year of inclusion; "deficiency takings" under "take or pay" gas purchase contracts. The deficiency taking amount in a "take or pay" gas purchase contract determined at December 31, the last day of the contract year, must be included in the taxpayer's gross income for its tax year ended June 30, the tax year in which the amount of the deficiency taking became fixed and determinable.