Rev. Rul. 75-406

Advice has been requested as to the Federal income tax consequences of the transaction described below.

X corporation, whose stock is widely held and actively traded, is engaged in the manufacture and sale of machinery. Y corporation, engaged in the production and distribution of chemicals, has been a wholly owned subsidiary of X since X purchased the Y stock eight years ago. Both X and Y have actively conducted their respective businesses for more than five years.

In order to comply with an order of a governmental agency requiring X to divest itself of any interest in Y, X adopted a plan whereby it distributed pro rata to its shareholders all of the Y stock. No stock of X was surrendered.

Soon after the distribution, a plan of reorganization was submitted to the then Y shareholders by the management of Y in which Y was to be merged into Z, an unrelated corporation. The X shareholders were free to vote their Y stock for or against the merger. The Y shareholders approved the merger at a shareholder meeting, subsequent to the distribution, specifically called for such purpose. Y then merged into Z and as a result the Y stock was converted into Z stock. The Z stock so received represented 25 percent of the outstanding stock of Z.

Section 355(a) of the Internal Revenue Code of 1954 provides, in part, that where (1) a corporation distributes to its shareholders, with respect to its stock, all of the stock of a corporation which it controls immediately before the distribution, (2) the active-trade-or-business requirements of section 355(b) are met, and (3) the transaction is not used principally as a device to distribute earnings and profits, no gain or loss will be recognized to (and no amount will be includible in the income of) such shareholders on the receipt of such stock.

Section 368(a)(1)(A) of the Code defines the term "reorganization" to include a statutory merger.

Section 355(a) of the Code specifies that the distributing corporation must distribute to its shareholders an amount of stock in the controlled corporation constituting control within the meaning of section 368(c), but it does not require that the shareholders thereafter retain stock of the controlled corporation for an indefinite period. Nevertheless, any disposition of stock of either the distributing corporation or the controlled corporation by the shareholders pursuant to an arrangement negotiated or agreed upon by the shareholders prior to such distribution must be examined to determine whether the transaction was used principally as a device for the distribution of the earnings and profits of the distributing corporation or the controlled corporation or both. See section 1.355-2(b)(1) of the Income Tax Regulations.

In addition, any disposition of such stock by the shareholders in a subsequent reorganization negotiated or agreed upon by them prior to such distribution must be examined to determine whether the continuity-of-interest requirement set forth in section 1.355-2(c) of the regulations has been satisfied.

The subsequent disposition of the Y stock by the X shareholders in exchange for Z stock, pursuant to the statutory merger of Y into Z, resulted in a continuing stock interest in the business enterprise of Y by the X shareholders who, through their ownership of Z stock, were indirect owners of the enterprise subsequent to the exchange. Thus, the exchange soon after the distribution of Y stock did not violate the continuity-of-interest requirement of section 1.355-2(c) and section 1.368-1(b) of the regulations. Furthermore, the distribution of the Y stock to the X shareholders was not a transaction used principally as a device to distribute the earnings and profits of either corporation because afterwards the shareholders maintained a continuing stock interest in the business enterprise of X through their stock ownership in X and a continuing stock interest in the business enterprise of Y through their stock ownership in Z, which acquired the Y enterprise in a statutory merger. See Rev. Rul. 70-434, 1970-2 C.B. 83, and Commissioner v. Morris, 367 F.2d 794 (4th Cir. 1966).

After the distribution of the Y stock to the X shareholders, the ownership of the Y stock by the X shareholders was real and meaningful since the X shareholders were free to vote their Y stock for or against the merger of Y into Z.

Accordingly, the distribution of Y stock to the X shareholders qualifies as a distribution under section 355 of the Code, and the merger of Y into Z qualifies as a reorganization under section 368(a)(1)(A).