Rev. Rul. 75-83

Advice has been requested concerning the application of section 356(a)(2) of the Internal Revenue Code of 1954 in the circumstances described below.

X, a corporation engaged in manufacturing, had outstanding 60 shares of voting common stock all of which were owned by A, an individual. The fair market value of each share of X common stock was 10x dollars.

Y, a corporation engaged in manufacturing, had outstanding 40 shares of voting common stock. Four individuals, B, C, D, and E (none of whom are related to one another nor to A within the meaning of section 318 of the Code), each owned 10 shares of Y stock.

It was decided that X would be merged with and into Y in a transaction intended to qualify as a reorganization under section 368(a)(1)(A) of the Code. As a result of arms length negotiations it was determined on the basis of fair market values that one share of Y stock should be issued in exchange for one share of X stock. However, certain of the Y shareholders objected to this arrangement because it would give A too much voting power in Y corporation. Therefore, it was agreed that Y would issue 35 shares of its voting common stock to A and, in addition, give A a note of Y with a fair market value of 250x dollars. This exchange was consummated pursuant to a plan of reorganization. A realized gain on the exchange.

Section 354(a)(1) of the Code provides, in part, that no gain or loss will be recognized if stock in a corporation a party to a reorganization is, in pursuance of a plan or reorganization, exchanged solely for stock in such corporation or in another corporation a party to the reorganization.

Section 356(a)(1) of the Code provides, in part, that if money or other property is received in an exchange to which section 354 would otherwise apply, then gain, if any, to the recipient will be recognized to the extent of the sum of the money and fair market value of the other property received. Section 356(a)(2) provides that if such exchange has the effect of the distribution of a dividend, then there will be treated as a dividend to each distributee such an amount of the gain recognized under section 356(a)(1) as is not in excess of his ratable share of the undistributed earnings and profits of the corporation accumulated after February 28, 1913, and the remainder, if any, of the recognized gain will be treated as gain from the exchange of property. Section 356(c) provides that no loss from the exchange will be recognized.

Section 302(a) of the Code provides, in part, that a redemption will be treated as a distribution in part or full payment in exchange for stock if the redemption satisfies the requirements of section 302(b)(1), 302(b)(2), or 302(b)(3); otherwise, pursuant to section 302(d), the redemption is treated as a distribution to which section 301 applies and included in the income of the shareholder as a dividend to the extent provided in section 301.

In the instant case, section 356(a)(1) of the Code applies to the exchange by A because the property he received in the exchange for his X stock consisted not only of Y stock, which is permitted by section 354, but also of other property, Y's note. Thus, gain is recognized to A under section 356(a)(1) in an amount not in excess of the fair market value of the other property.

However, a determination must be made whether the exchange had the effect of the distribution of a dividend to A within the meaning of section 356(a)(2) of the Code. In making this determination it is appropriate to look to principles developed under section 302 for determining dividend equivalency. See Rev. Rul. 74-515, 1974-2 C.B. 118. Furthermore, in applying the principles of section 302 in this context, the distribution is treated as though it were made by the acquired corporation (X in the instant case) and not the acquiring corporation. See Ross v. United States, 173 F. Supp. 793 (Ct. Cl. 1959), cert. denied, 361 U.S. 875 (1959); Hawkinson v. Commissioner, 235 F. and 747 (2d Cir. 1956); Commissioner v. Owens, 69 F. 2d 597 (5th Cir. 1934); See also Rev. Rul. 74-516, 1974-2 C.B. 121 and Rev. Rul. 74-515.

Therefore, in the instant case, A is treated as having received a note with a fair market value of 250x dollars from X in exchange for 25 shares of his X stock. While this exchange reduces the number of X shares held by A, it does not reduce his percentage ownership of X stock since he owned all of the X stock before the exchange and he owns all of the X stock after the exchange. In Davis v. United States, 397 U.S. 301 (1970), 1970-1 C.B. 62, the Supreme Court of the United States held that a distribution of property in exchange for stock was "essentially equivalent to a dividend" within the meaning of section 302(b)(1) of the Code where the shareholder owned, actually and constructively, all of the stock of the corporation both before and after the redemption. Therefore, the redemption did not meet the requirements of section 302(b)(1) and was treated under section 301.

Accordingly, in the instant case, the exchange on which gain is recognized to A under section 356(a)(1) of the Code has the effect of a dividend under section 356(a)(2). Therefore, such gain will be treated as a dividend to extent provided in section 356(a)(2).

In Wright v. United States, 482 F. 2d 600 (8th Cir. 1973), the United States Court of Appeals held that in determining whether a distribution has the effect of the distribution of a dividend within the meaning of section 356(a)(2) the distribution should be viewed as though it was made by the transferee corporation.

If the Wright decision were applied in the instant case, the transaction would be treated as though the note were issued by Y in exchange for a portion of Y stock (25 shares) A would have received if he had taken Y stock entirely instead of receiving Y stock and Y's note. Thus, as a result of this deemed exchange, A's stock interest in Y would be reduced from 60 shares of Y stock to 35 shares, and this reduction in interest would satisfy the substantially disproportionate redemption requirements of section 302(b)(2) of the Code. Therefore, the exchange would not have the effect of a dividend under section 356(a)(2) and would be treated as gain from the exchange of property under section 356(a)(1).

The Internal Revenue Service will not follow the Wright decision because it believes that the court erred in distinguishing a long line of cases holding that, regardless of which corporation makes a distribution, the amount of the dividend is measured by reference to the earnings and profits of the transferor. See Ross, Hawkinson, and Owens, above. The holdings of the above cases are in accord with the committee reports on the predecessor of section 356(a)(2) of the Code which indicate that the purpose of the section is to tax as dividends distributions having the same result as a dividend from the transferor corporation. See H.R. Rep. No. 179, 68th Cong., 1st Sess. 14-15 (1924); and S. Rep. No. 398, 68th Cong., 1st Sess. 15-16 (1924).

Accordingly, the Service in determining dividend equivalency under section 356(a)(2) of the Code will continue to view a distribution as having been made by the acquired or transferor corporation and not by the acquiring or transferee corporation as in the Wright decision.