Rev. Rul. 70-496

Advice has been requested regarding the Federal income tax treatment of the transaction described below.

Corporation X owns 70 percent of the stock of corporation Y and 100 percent of the stock of corporation Z. Y sold all of the stock of its wholly owned subsidiary, S, to Z for cash. The purchase price of the S stock was its fair market value. All of the corporations are domestic corporations.

Section 304(a)(1) of the Internal Revenue Code of 1954 provides that for purposes of section 302 and section 303 of the Code, if one or more persons are in control of each of two corporations and in return for property, one of the corporations acquires stock in the other corporation from the person so in control, then such property shall be treated as a distribution in redemption of the stock of the corporation acquiring such stock. In any such case, the stock so acquired shall be treated as having been transferred by the person from whom acquired, and having been received by the corporation acquiring it, as a contribution to the capital of such corporation.

Section 304(c)(1) of the Code provides that for purposes of section 304 of the Code control means the ownership of stock possessing at least 50 percent of the total combined voting power of all classes of stock entitled to vote, or at least 50 percent of the total value of shares of all classes of stock.

Section 304(c)(2) of the Code makes section 318(a) of the Code (relating to the constructive ownership of stock) applicable to section 304 of the Code, with certain modifications not here relevant, for the purposes of determining control under section 304(c)(1) of the Code.

Y actually owned 100 percent of the stock of S before the transaction and by the application of section 318(a)(3)(C) of the Code (relating to the constructive ownership by a corporation of stock owned by its parent corporation) Y is considered to have owned all of the stock of Z before the transaction. Accordingly, since Z acquired the stock of S for cash from a person (Y) in control of both the issuing corporation (S) and the acquiring corporation (Z), the transaction is considered to be an acquisition of stock by a related corporation within the meaning of section 304(a)(1) of the Code and thus a redemption of the stock of Z, the acquiring corporation.

Under section 1.304-2(a) of the Income Tax Regulations the amount received by Y is treated as a distribution of property under section 302(d) of the Code unless the distribution is to be treated as received in exchange for stock pursuant to section 302(a) or section 303 of the Code. Section 303 of the Code (relating to distributions in redemption of stock to pay death taxes) is not applicable in the instant case. Section 302(a) of the Code is applicable if the requirements of section 302(b) of the Code are satisfied.

Section 304(b)(1) of the Code provides that the applicability of section 302(b) of the Code is made by reference to the stock of the issuing corporation, S. In the instant case, there can be no complete termination of Y's interest in the stock of S within the meaning of section 302(b)(3) of the Code nor can there be a substantially disproportionate redemption within the meaning of section 302(b)(2) of the Code, since Y owned 100 percent of the stock of S before the transaction and by reason of the application of section 318(a) of the Code, Y owns 100 percent of the stock of S after the transaction (see section 1.318-4(c) of the regulations).

The "not essentially equivalent to a dividend" test of section 302(b)(1) of the Code cannot be met since there has been no meaningful reduction in Y's proportionate interest in the stock of S as a result of the transaction. In determining the existence of a meaningful reduction, the constructive ownership rules of section 318 of the Code are applied (see United States v. Maclin P. Davis et ux., 397 U.S. 301 (1970), Ct. D. 1937, C.B. 1970-1, 62).

The inapplicability of section 303 and section 302(a) of the Code results in the amount received by Y being treated as a distribution under section 302(d) of the Code. Accordingly, the distribution is treated as a dividend to Y from Z to the extent of Z's earnings and profits as provided in section 301(c)(1) and section 316 of the Code. Amounts received by Y in excess of Z's earnings and profits are taxable as gain as provided in section 301(c)(3) of the Code.

Section 1.304-2(a) of the regulations provides that with respect to transactions to which section 304(a)(1) of the Code applies, the stock received by the acquiring corporation shall be treated as a contribution to the capital of such corporation and that section 362(a) of the Code is applicable in determining the basis of such stock. Section 1.304-2(a) of the regulations further provides that the transferor's basis for his stock in the acquiring corporation shall be increased by the basis of the stock surrendered by him.

Accordingly, the basis of the S stock in the hands of Z is the same as the basis of the S stock in the hands of Y. Furthermore, since the transferor (Y) had no direct stock ownership in the acquiring corporation (Z) before or after the transaction, the basis of the S stock surrendered by Y disappears and cannot be used to increase the basis of any asset of Y. However, Y now has additional cash. The transaction has no effect on X's basis in the stock of Y or Z.