Rev. Rul. 59-222

Advice has been requested whether an exchange of common stock of a corporation pursuant to a plan of reorganization under Chapter X of the Bankruptcy Act is within the purview of the nontaxable reorganization provisions of the Internal Revenue Code of 1954.

An insolvent corporation, M , filed in the current year a voluntary petition for reorganization under Chapter X of the Bankruptcy Act. The United States District Court appointed two trustees and authorized them to operate and manage the corporation's property. At the time of the petition, the corporation's liabilities included four and one-half percent first mortgage bonds (principal amount 6,000 x dollars), six percent subordinated debentures (principal amount, 7,300 x dollars), a bank loan of 250 x dollars, and general unsecured claims of approximately 1,100 x dollars. The capital stock consisted of 1,000 x shares of common stock, plus outstanding stock options and stock purchase warrants. The balance sheet disclosed a deficit of 4,000 x dollars.

The N corporation desired to acquire the M corporation for its expansion program. At the time of the transaction N was neither a stockholder nor a creditor of M corporation. Consequently, N corporation made an offer to the trustee of M , which is summarized as follows:

(1) The acquiring corporation will issue part of its common stock to M corporation in exchange for a new issue of common stock of the latter which will constitute all of its outstanding capital stock.

(2) All liabilities of M corporation, other than its first mortgage bonds, will be satisfied or otherwise discharged through the use of its assets in the hands of the trustees.

This offer formed the basis of a plan of reorganization proposed by the trustees in their report to the court. The plan as finally accepted by the court provides that:

(a) M corporation will emerge as a wholly-owned subsidiary of N corporation with 1,000 x shares of common stock.

(b) Obligations incurred or assumed by the trustees and preferred claims will be paid in full out of the funds in the hands of the trustees.

(c) The first mortgage bonds will remain outstanding.

(d) (1) The bank loan will be paid in cash.

(2) The general unsecured creditors will receive their proportionate share of N's stock in satisfaction of their claims.

(3) The debenture holders will receive the balance of N's stock. Such stock will represent between 30 and 35 percent of the principal amount of the debenture holders' claims.

(e) The holders of the old common stock, stock options and purchase warrant will receive nothing.

The facts in the instant case disclose that, due to the insolvency of M corporation the holders of the subordinated debentures and unsecured claims are, in reality, the owners of the equity remaining in M after giving effect to the lien of the first mortgage bonds. The effect of the transaction is the same as though the debenture holders and unsecured creditors surrendered their claims, received the new issue of M common stock and then exchanged such stock for the stock of N .

In view of the above, it is the position of the Internal Revenue Service that:

(A) The acquisition by N corporation of all of the capital stock of M corporation in exchange solely for part of the voting stock of N constitutes a reorganization within the meaning of sections 368(a)(1)(B) of the Code. No gain or loss is recognized to N or M as a result of the exchange.

(B) The basis to N corporation of the stock of M corporation is the same as the cost or other basis of the subordinated debentures, in the hands of those persons deemed to have received stock of M in exchange therefor and to have exchanged such stock for stock of N , plus the fair market value of the portion of the stock of M deemed to have been given in exchange for unsecured claims prior to the exchange for stock of N corporation. See section 362(b) of the Code. The acquisition does not constitute a purchase by N as defined in section 382(a)(4) of the Code.

(C) The satisfaction of the claims of M's creditors pursuant to the plan of reorganization does not require any reduction in the basis of M's property by reason of section 270 of the Bankruptcy Act or any provision of the Code. The substitution of common stock for debentures and unsecured claims does not effect a cancellation, reduction or discharge of indebtedness, but rather amounts to a transformation from a fixed indebtedness to a capital stock liability. See Tower Building Corporation v. Commissioner , 6 T.C. 125, acquiescence, C.B. 1947-1, 4.

(D) No gain or loss is recognized to the holders of subordinated debentures of M corporation as a result of the exchange of such debentures for shares of common stock of N corporation, since it is considered that such debenture holders first exchanged such debentures for common stock of M and then exchanged the stock of M for stock of N corporation. As such, the exchanges fall within the provisions of section 354(a)(1) of the Code.

(E) The basis to the holders of subordinated debentures of the stock of N corporation received is the same as the cost or other basis of the debentures surrendered under section 358(a) of the Code.

(F) Gain or loss is recognized to the general creditors upon the receipt of stock of N corporation in satisfaction of their claims measured by the difference between the fair market value of the stock received and the cost or other basis of their claims.