DIVISION OF BUSINESSES BETWEEN FOREIGN AND DOMESTIC SHAREHOLDERS PARTLY TAX-FREE.

UIL Number(s) 0355.00-00, 1202.00-00, 0368.04-00

                                             Date: December 3, 1997

[1] This letter responds to a request dated July 29, 1997 for rulings on the federal income tax consequence of a completed transaction. Supplemental information was submitted in letters dated October 29, November 3, November 20 and December 2, 1997. The information submitted for consideration is summarized below.

[2] Distributing, a state A corporation, is the common parent of an affiliated group of corporations that file a consolidated federal income tax return using an accrual method of accounting. Prior to date B, Distributing had two wholly owned subsidiaries, Sub 1 and Sub 2. Sub 1 in turn held an 80 percent interest in each of LLC #1 and LLC #2, and a 33 1/3 percent interest in LLC #3. Sub 2 had four wholly owned subsidiaries, Sub 3, Sub 4, Sub 5 and Sub 6. Distributing was owned by two groups of shareholders, the first consisting of A, B, C, D, E, F, G, H, I, J, K, L, M, and N, principally certain executives of Distributing (sometimes hereinafter referred to as the "Management Group") and the second consisting of FY, a country D corporation. FY was a wholly owned subsidiary of FX, a country E corporation. After conversion of Distributing's Convertible Preferred Stock, all of which was owned by FY, the Management Group and FY owned 51 percent and 49 percent, respectively, of the Distributing Common Stock. Distributing was engaged in business a and business b through Sub 1 and Sub 2, respectively. LLC #1, #2 and #3 were engaged in business c.

[3] We have received financial information indicating that Sub 1's business a and Sub 2's business b have each had gross receipts and operating expenses representative of the active conduct of a trade or business for each of the past five years.

[4] Over the last three years, the Management Group and FY, each of which had the right to elect three members of the six member Distributing board of directors, have developed different philosophies about the direction of Distributing, the emphasis to be placed on different business segments, the geocommercial problems of the business, the course of technological development at Distributing, and what approach should be taken to capitalize the ongoing business. These disagreements have led to a number of impasses and mutual claims of default with respect to a license agreement in which Distributing had licensed its technology to FY's parent, FX, and agreed to manufacture its patented machinery for FX (the "License Agreements"). These disagreements have also caused arguments about, and an unresolved delay in, attempts to finance Distributing.

[5] FX is interested primarily in the development of equipment which it can use in its worldwide business. This equipment must he capable of producing both product d and product e. The technical and operating requirements for such equipment may differ from equipment which is used only for product d; in addition, the regulatory requirements for such equipment differ in Europe and elsewhere from the requirements in the United States. Distributing (through Sub 2), on the other hand, has historically directed its research and development in equipment and in operational requirements to the utilization of its patented technology for making product d for a regulated American market.

[6] After three years of disputes, the shareholders agreed to split up Distributing functionally. In this connection, the following steps have been completed:

     (i) Sub 2 distributed all of the stock of Sub 3, Sub 4 and Sub 5

[8] With respect to the transfer of assets to Controlled and the distribution of the stock of Controlled by Distributing to the Management Group (steps (iii) and (iv), above), the taxpayers have made the following representations:

     (a) The fair market value of the Controlled stock and other

[10] Qualified small business stock is defined in section 1202(c) as any stock in a C corporation that is originally issued after August 10, 1993, if --

     (A) as of the date of issuance, the issuing corporation is a

     In the case of . . . a reorganization described in section 368,

[12] Section 1202(h)(4)(B) limits the amount of gain that can be excluded under section 1202(a) if the stock constitutes qualified small business stock by virtue of section 1202(h)(4)(A). However, the limitation does not apply if the stock is issued by a corporation that is itself a qualified small business as of the time of the reorganization.

[13] Section 1012 provides that, unless otherwise provided, the basis of property is its cost.

[14] Section 1.1012-1(c)(1) provides that if shares of stock are sold or transferred by a taxpayer who acquired lots of stock on different dates or at different prices, and the lot from which the stock was sold or transferred cannot be adequately identified, the stock sold or transferred shall be charged against the earliest of such lots acquired in order to determine the cost or other basis and the holding period of such stock. This rule does not apply if the lot from which the stock was sold or transferred can be adequately identified.

[15] In the instant case, the taxpayers have represented that the portion of the Distributing stock given up by A through N in exchange for Controlled stock was qualified small business stock (QSPS) and that Controlled was a qualified small business at the time of the reorganization. As part of the section 368 reorganization, A through N received Controlled stock in exchange for a portion of their Distributing stock and thereafter sold their remaining Distributing stock to FX. Unless the specific shares of Distributing stock exchanged for Controlled stock can be adequately identified by each of the exchanging shareholders, it is assumed pursuant to section 1.1012-1(c)(1) that the Distributing stock exchanged will be charged against the earliest of such lots acquired in order to determine cost or other basis and holding period. This rule also applies in determining whether the Distributing QSBS held by each of the exchanging shareholders at the time of the exchange was among the Distributing stock exchanged for Controlled stock.

[16] Based on the assumption that the portion of the Distributing stock given up by A through N was QSDS in the hands of such shareholders as determined by applying the rules of section 1.1012-1, a portion of the Controlled stock received by such shareholders in exchange therefor will be treated as QSBS acquired on the date the exchanged Distributing QSBS was acquired (section 1202(h)(4)(A)). If the stock exchanged by a Distributing shareholder consists of both QSBS and non-QSBS, then only a proportionate amount of the Controlled stock received in exchange will be treated as QSBS.

[17] Based on the assumption that Controlled was a qualified small business at the time of the reorganization, the 1202(h)(4)(B) limitation on excludible gain will not apply.

[18] Based on the information submitted and on the representations set forth above, we hold as follows:

     (1) The transfer by Distributing to Controlled of all of the

[20] We express no opinion about the tax treatment of the transaction under other provisions of the Code and regulations or about the tax treatment of any conditions existing at the time of, or effects resulting from, the transaction that are not specifically covered by the above rulings. Specifically, no opinion is expressed as to the federal income tax consequences of Sub 2's distribution to Distributing of all of the outstanding stock of Sub 3, Sub 4 and Sub 5 (step (i), above). Moreover, no opinion is expressed as to the amount of income that was recognized on the transfer of the "technology" to Controlled by Distributing (see ruling (3), above). Last, no opinion was requested, nor has any been expressed, concerning the foreign tax consequences of the transaction.

[21] If it is determined that any of the corporations included in this ruling request are passive foreign investment companies, no opinion is expressed with respect to the effect of sections 1291 through 1297 of the Code on the transaction. In particular, no opinion is expressed whether gain will be recognized in any of the transfers of stock pursuant to regulations under section 1291 notwithstanding any other provisions of the law.

[22] This ruling has no effect on any earlier documents and is directed only to the taxpayer who requested it. Section 6110(j)(3) provides that it may not be used or cited as precedent.

[23] The taxpayers must attach a copy of this letter to their federal income tax returns for the tax year in which the transaction covered by this ruling letter was consummated.

[24] In accordance with the power of attorney on file in this office, we have sent a copy of this letter to the taxpayer.

                                   Sincerely yours,