Rev. Rul. 57-492

Advice has been requested whether, the provisions of section 355(a)(1) of the Internal Revenue Code of 1954 will be applicable to the distribution by a corporation to its stockholders, of stock of a controlled corporation under the circumstances described below.

A certain corporation has been engaged in the refining, transporting and marketing of petroleum products since 1929. Since 1947, it has been engaged in exploring for oil as a separate operation. It conducted negotiations for certain mineral rights in June, 1947. As the result of analytical work of its geologists in 1948 and 1949, as well as the purchase of geophysical work from other companies, further negotiations were carried on in March, 1949, modifying the area for which mineral rights were sought. This permit was granted in February, 1951. One of the terms thereof was that if the exploration should be successful and oil in commercial quantities should be found, a separate corporation would be formed to produce it, and the grantor of the mineral rights would receive a stock interest of ten percent.

In 1951 and 1952, geological and geophysical work continued. In April, 1953, drilling of the first exploratory wells commenced. Thereafter, drilling continued throughout 1953 and 1954. In the latter year, oil was found and development work established its presence in commercial quantities. The actual expenditures for exploration and drilling activities made by the corporation during the period from 1947 through 1954 reached substantial amounts and consisted of exploration trips, leasing costs, seismographic work, magnetometer work, drilling costs, and similar items.

With the discovery of oil in commercial quantities, the terms of the agreement required the formation of a separate corporation. Accordingly, the corporation transferred the exploration and producing assets and properties to a new corporation in exchange for over 80 percent of its capital stock. Thereafter, the old corporation distributed the stock of the new corporation to its shareholders.

The exploration and producing assets and properties had been operated by the old corporation as a completely (as well as geographically) separate activity from its principal activity of refining and marketing petroleum products. After the transfer of such assets to the new corporation, the old corporation no longer was engaged in exploration and producing activities and had no present intention of ever again engaging therein.

Section 1.355-1(c) of the Income Tax Regulations states, in part, that for purposes of section 355 of the Internal Revenue Code of 1954, a trade or business consists of a specific existing group of activities being carried on for the purpose of earning income or profit from only such group of activities, and the activities included in such group must include every operation which forms a part of, or a step in, the process of earning income or profit from such group. Such group of activities ordinarily must include the collection of income and the payment of expenses. It does not include a group of activities which, while a part of a business operated for profit, are not the themselves independently producing income even though such activities would produce income with the addition of other activities, or with large increases in activities previously incidental or insubstantial.

It is indicated by these regulations that a group of activities, in order to constitute an `active business' for five years, must be independent to the extent that for the five-year period they include all of the elements necessary to produce income from only such group of activities. The regulations further indicate that a group of activities, which are not themselves independently producing income, will not qualify as an `active business.'

The negotiations conducted by the old corporation for the mineral rights, the analytical work done by the old corporation's geologists in 1948 and 1949, the geophysical work purchased from other companies, and such related work as was done in the instant case, are not considered as constituting the commencement of an active business. Such activities were preliminary steps, either required by law or dictated by prudent business considerations to investigate, inspect and appraise the prospective venture in order to determine if the should be continued or abandoned. This is further borne out by the fact that, prior to February, 1951, the old corporation was forestalled from engaging in active exploration by operation of law, since the mineral rights were not acquired by the old corporation until that time.

Although substantial expenditures were made by the old corporation from 1947 through 1954 in the pursuit of this venture, nevertheless, section 355 of the Code contemplates that an active business ordinarily includes the collection of income as well as the payment of expenses. Before oil was discovered in commercial quantities in 1954, the venture here involved did not include any income producing activity or any source of income. If the venture had been discontinued anytime prior to such discovery of oil, the old corporation would never have been engaged in producing oil. Furthermore, prior to the discovery in 1954 of oil in commercial quantities, the exploration and producing activities conducted by the old corporation were not themselves independently producing income, nor did they contain for the past five years, all of the elements necessary to produce income. Therefore, the exploration and producing activities are not deemed to constitute an `active business' engaged in by the old corporation for five years preceding the date of the distribution of the stock of the controlled corporation.

Accordingly, it is held that the distribution of the stock of the new corporation to the stockholders of the old corporation does not qualify as a nontaxable distribution within the purview of section 355 of the Code. Such distribution, measured by the fair market value of the stock distributed, constitutes a dividend under sections 301 and 316 of the Code.

In view of the provisions of section 351 of the Code, no gain or loss is recognized to the old corporation as a result of the transfer of part of its assets to the new corporation solely in exchange for more than 80 percent of the latter's stock.