Rev. Rul. 77-428

Advice has been requested whether the transactions described in Situation 1 and Situation 2, below, qualify as reorganizations under section 368(a)(1)(A) of the Internal Revenue Code of 1954 by reason of section 368(a)(2)(D) and section 368(a)(2)(E), respectively.

Situation 1.

P is a corporation chartered under state law that has been engaged in the commercial banking business for a number of years. P, for good business reasons, decided that its business activities could be expanded if its banking business were conducted by a corporation whose stock was owned by another corporation. The other corporation could then engage in related nonbanking activities, such as selling insurance to borrowers and leasing personal property, activities that could not be engaged in directly by P under state law. To accomplish this, P caused corporation S1 to be organized as a wholly owned subsidiary. S1 then caused corporation S2 to be organized as a wholly owned subsidiary. Other than the cash received from P to satisfy capitalization requirements, the only asset of S1 was the stock of S2, and the only asset of S2 was the cash received from S1 to satisfy capitalization requirements.

Pursuant to a plan of merger, P merged with and into S2 under the applicable state laws with S2 being the surviving corporation. On the effective date of the merger, each share of P stock held by the P shareholders was exchanged for a share of newly issued S1 stock. Thus, as a result of the merger, all the assets and business of P became the assets and business of S2, the P shareholders became the shareholders of S1, and S1 then engaged in the nonbanking activities described above.

Section 368(a)(2)(D) of the Code provides, in part, that the acquisition by one corporation, in exchange for stock of a corporation which is in control of the acquiring corporation, of substantially all of the properties of another corporation which in the transaction is merged into the acquiring corporation will not disqualify a transaction under section 368(a)(1)(A) if such transaction otherwise qualifies as a statutory merger and no stock of the acquiring corporation is used in the transaction. Section 1.368-2(b)(2) of the Income Tax Regulations provides that this provision applies whether or not the controlling corporation (or the acquiring corporation) is formed immediately before the merger, in anticipation of the merger, or after preliminary steps have been taken to merge directly into the controlling corporation.

While section 1.368-2(b)(2) of the regulations does not specifically provide for the formation of both the controlling and acquiring corporation, or for the acquiring of a related corporation, there is nothing in the legislative history of the enactment of section 368(a)(2)(D) of the Code to indicate that section was not intended to apply where such was the case.

Accordingly, the merger of P with and into S2 qualifies as a reorganization under section 368(a)(1)(A) of the Code by reason of section 368(a)(2)(D) even though S1 and S2 were newly organized corporations and even though a related corporation was acquired in the transaction. See Rev. Rul. 72-274, 1972-1 C.B. 97, in which a similar transaction was treated as a reorganization under section 368(a)(1)(A) by reason of section 368(a)(2)(D).

Situation 2.

The facts are the same as in Situation 1 except that S2 merged with and into P under the applicable state laws with P being the surviving corporation. On the effective date of the merger the S2 stock held by S1 was converted, pursuant to state law, into stock of P and each outstanding share of P stock not held by S1 exchanged for a share of S1 stock. Thus, as a result of the merger P became a wholly owned subsidiary of S1 and the former P shareholders became the shareholders of S1. After the merger, P held all of its assets and all the assets of S2.

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

The committee reports, H.R. Rep. No. 91-1778, 91st Cong., 2nd Sess. (1970), and S. Rep. No. 91-1533, 91st Cong., 2d Sess. (1970), 1971-1 C.B. 622, indicate that section 368(a)(2)(E) of the Code was enacted to allow as a tax-free reorganization a transaction identical to a transaction described in section 368(a)(2)(D) except that the surviving corporation was the acquired rather than the acquiring corporation. Since, as concluded in Situation 1, a corporation may form first- and second-tier subsidiaries and then merge into the second-tier subsidiary under section 368(a)(2)(D), a reverse merger of the second-tier subsidiary into the "grandparent" is permissible under section 368(a)(2)(E).

Accordingly, the merger of S2 with and into P qualifies as a reorganization within the meaning of section 368(a)(1)(A) of the Code by reason of section 368(a)(2)(E) even though S1 and S2 were newly organized corporations and a related corporation was acquired in the transaction.