Rev. Rul. 74-564

Advice has been requested whether the transaction described below qualifies as a reorganization within the meaning of section 368(a)(1)(B) of the Internal Revenue Code of 1954, even though it does not qualify as a reorganization under section 368(a)(1)(A) and (a)(2)(E) of the Code.

Corporation P is a publicly owned holding company which owns 100 percent of the stock of corporation S, an operating company. S has owned 98 percent of the stock of corporation R, also an operating company, for a number of years. The remaining stock of R was publicly held.

Under a plan to provide S with greater flexibility in the operation of R by owning all of the stock of R, the following steps were taken:

(a) P formed corporation Z and contributed cash, to satisfy capital requirements, and shares of P voting common stock equivalent in number to the outstanding shares of R stock publicly held in exchange for all of the Z stock.

(b) P contributed all of the Z stock to the capital of S.

(c) Pursuant to a joint merger agreement, Z was then merged into R under applicable state law, and R, the surviving corporation, acquired the P stock contributed to Z by P.

Each share of publicly held R common stock was exchanged for a share of P common stock, and the outstanding Z stock owned by S was converted into R stock. The cash transferred by P to Z was, upon the merger, transferred to R and from R to S and then back to P. R shareholders owning less than 5 percent of the publicly held R common stock dissented to the merger and had the right to receive the appraised value of their shares paid solely from assets of R. No funds, or other property, have been or will be provided by P for this purpose. After the consummation of the plan of reorganization described above, R continued its business but as a wholly owned subsidiary of S.

Section 368(a)(2)(E) of the Code, which is applicable to statutory mergers occurring after December 31, 1970, was enacted to permit, under certain circumstances, a tax-free statutory merger when stock of a parent corporation is used in a merger between a controlled subsidiary of the parent and another corporation, and the other corporation survives. See S. Rep. No. 91-1533, 91st Cong., 2d Sess. 1(1970), 1971-1 C.B. 622.

Section 368(a)(2)(E) of the Code provides that a transaction otherwise qualifying as a statutory merger under section 368(a)(1)(A) of the Code will not be disqualified by reason of the fact that stock of a corporation (controlling corporation) which before the merger was in control of the merged corporation is used in the transaction if (1) after the transaction, the corporation surviving the merger holds substantially all of its properties and of the properties of the merged corporation (other than stock of the controlling corporation distributed in the transaction), and (2) in the transaction, former shareholders of the surviving corporation exchanged, for an amount of voting stock of the controlling corporation, an amount of stock in the surviving corporation which constitutes control of such corporation.

In the instant case, the transaction does not qualify as a reorganization under section 368(a)(1)(A) and (a)(2)(E) of the Code, because (1) stock of P, rather than stock of the controlling corporation S, was transferred to the R shareholders, and (2) a sufficient amount of R stock to constitute control within the meaning of section 368(c) of the Code was not obtained by S in the transaction inasmuch as S already owned a controlling interest in R.

Section 368(a)(1)(B) of the Code provides, in part, that the term "reorganization" means the acquisition by one corporation, in exchange solely for all or a part of its voting stock, or in exchange solely for all or a part of the voting stock of a corporation which is in control of the acquiring corporation, of stock of another corporation if, immediately after the acquisition, the acquiring corporation has control of such other corporation (whether or not the acquiring corporation had control immediately before the acquisition).

In Rev. Rul. 67-448, 1967-2, C.B. 144, pursuant to a plan of reorganization, a parent corporation, P, issued some of its voting stock to its new subsidiary S and S, pursuant to the plan, merged into unrelated corporation, Y, with the Y shareholders exchanging their Y stock (amounting to 95 percent of the outstanding stock of Y) for the P stock received by Y in the merger of S into Y. Rev. Rul. 67-448 states that the net effect of this series of steps for Federal income tax purposes is a direct acquisition by P of 95 percent of the stock of Y from the Y shareholders in exchange solely for P voting stock and that the transitory existence of S is disregarded. Thus, Rev. Rul. 67-448 holds that the transaction will be treated as an acquisition by P, in exchange solely for a part of its voting stock, of stock of Y in an amount constituting control (as defined in section 368(c) of the Code) of Y, which qualifies as a reorganization within the meaning of section 368(a)(1)(B) of the Code.

In the instant case, the net effect of the steps taken was that S acquired, solely for voting stock of P (which was in control of S), additional shares of stock of R, a corporation which S already controlled and continued to control.

Accordingly, the transaction in the instant case will be treated as an acquisition by S, in exchange solely for a part of P voting stock (P being in control of S), of stock of R (S being in control of R after the transaction), which qualifies as a reorganization within the meaning of section 368(a)(1)(B) of the Code.

Pursuant to section 354(a) of the Code the former shareholders of R will recognize no gain or loss on the exchange of their R stock for P stock. Furthermore, the cash transferred by P to Z and returned to P in the transaction is disregarded and has no tax consequences. See Revenue Ruling 74-565, below, which holds that a similar transaction that does not qualify as a reorganization under section 368(a)(1)(A) and (a)(2)(E) of the Code is treated as a reorganization qualifying under section 368(a)(1)(B).