Rev. Rul. 77-415

Advice has been requested concerning the Federal income tax treatment of an exchange of debentures and stock under the circumstances described below under the provisions of the Internal Revenue Code of 1954.

In order to improve its financial condition M, a solvent domestic corporation, undertook to rearrange its capital structure. M had outstanding voting common stock, nonvoting preferred stock, and subordinated debentures, all of which were widely held and actively traded on an established securities market. Pursuant to a plan, M offered to exchange its new 10-year 10-percent subordinated debentures maturing July 1985, for a like principal amount of its outstanding 20-year 8-percent debentures on the date of their maturity, July 6, 1975. Under the plan, M also offered to exchange its new debentures in the principal amount of $500,000x dollars for shares of its preferred stock outstanding in the ratio of 20x dollars principal amount of the new debentures for each share of outstanding preferred stock. The preferred stock had been issued for cash and there were no dividend arrearages.

On July 6, 1975, M acquired 25,000 shares of its preferred stock in exchange for a total amount of 500,000x dollars of its 20x dollars principal amount debentures. The mean of the high and low selling price of the preferred stock on the day after the exchange was 18x dollars. On the day of the exchange M also acquired all of its outstanding debentures in the principal amount of 1,000,000x dollars in exchange for its new debentures of the same amount. The debentures represent a bona fide indebtedness of the corporation and are "securities" within the meaning of that term as used in section 354 and 356 of the Code. A, who owned 100 shares of M preferred stock, exchanged such stock for 2,000x dollars principal amount of debentures. B, who owned debentures in the principal amount of 5,000x dollars, exchanged them for new M debentures of the same principal amount. Neither A nor B owned any stock of M constructively under the rules set forth in section 318.

The specific issues presented are (1) whether the provisions of section 1232 of the Code, relating to original issue discount, apply with respect to the M debentures received by A and B, and (2) whether the provisions of section 354 or 356 apply to the exchanges by A and B.

Section 1232(b)(1) of the Code defines the term "original issue discount" as the difference between the issue price and the stated redemption price at maturity of a bond or other evidence of indebtedness.

Section 1232(b)(2) of the Code provides, in part, that in the case of a bond or other evidence of indebtedness (other than a bond or other evidence of indebtedness issued pursuant to a plan of reorganization within the meaning of section 368(a)(1) or an insolvency reorganization within the meaning of section 371, 373, or 374), which is issued for property and which

(A) is part of an issue a portion of which is traded on an established securities market, or

(B) is issued for stock or securities which are traded on an established securities market,

the issue price of such bond or other evidence of indebtedness shall be the fair market value of such property. Except in cases to which the preceding sentence applies, the issue price of a bond or other evidence of indebtedness which is issued for property (other than money) shall be the stated redemption price at maturity.

Thus, under section 1232(b)(2) of the Code if the issuance is for property (other than money) pursuant to a plan of reorganization within the meaning of section 368(a)(1), the issue price of a bond or other evidence of indebtedness is the state redemption price of the bond at maturity, and no original issue discount arises on the issuance of such a bond. The threshold question in the instant case is whether the transaction qualifies as a reorganization under section 368(a)(1).

Section 368(a)(1)(E) of the Code provides that a "recapitalization" is a "reorganization". For this purpose a recapitalization has been defined as a "reshuffling of a capital structure within the framework of an existing corporation". Helvering v. Southwest Consolidated Corp., 315 U.S. 194 (1942), 1942-1 C.B. 218.

Section 1.368-1(b) of the Income Tax Regulations provides, in part, that requisite to a reorganization is a continuity of interest in the business enterprise on the part of those persons who were the owners of the enterprise prior to the reorganization.

In the instant case, the creation by the corporation of securities in the form of the debentures and its issuance of the debentures in exchange for outstanding debentures and stock is a reshuffling of the corporation's capital structure and, therefore, a recapitalization. See Commissioner v. Neustadt's Trust, 131 F.2d 528 (2d Cir. 1942), aff'g 43 B.T.A. 848 (1941), nonacq., 1941-1 C.B. 17, nonacq. withdrawn, acq., 1951-1 C.B. 2. The courts have held that the continuity-of-interest principle need not be applied to recapitalizations under section 368(a)(1)(E) of the Code. The considerations that make the continuity-of-interest requirement necessary in acquisitive reorganizations are not present in recapitalizations involving a single corporation. Hickok v. Commissioner, 32 T.C. 80 (1959), nonacq., 1959-2 C.B. 8, nonacq. withdrawn, page 3 of this Bulletin; Schoo v. Commissioner, 47 B.T.A. 459 (1942), nonacq., 1942-2 C.B. 31, nonacq. withdrawn, page 3 of this Bulletin; Berner v. United States, 282 F.2d 720 (Ct. Cl. 1960); Davis v. Penfield, 105 F. Supp. 292 (N.D. Ala. 1952), aff'd, 205 F.2d 798 (5th Cir. 1953). Thus, the recapitalization is a reorganization within the meaning of section 1232(b), which refers to section 368(a)(1), though A did not maintain a continuity of proprietary interest in M.

Accordingly, original issue discount did not arise on the issuance by M of its bonds under the circumstances of the instant case under section 1232(b) of the Code.

The remaining question is whether the provision of section 354 or 356 of the Code apply to the exchanges by A and B.

Section 354(a)(1) of the Code provides, in part, that no gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of a plan or reorganization, exchanged solely for stock or securities in such corporation. Where the exchange is solely of securities for securities, section 354(a)(1) is applicable only to the extent the principal amount of the securities received by the security holder does not exceed the principal amount surrendered. Section 354(a)(2)(A). Where securities are received and none are surrendered, section 354(a)(2)(B) and (a)(3) provides that section 354(a)(1) does not apply.

Section 356 of the Code provides for the treatment of additional consideration if section 354 would apply to an exchange but for the fact that property received in an exchange consists not only of property permitted by section 354 to be received without recognition of gain, but also of other property.

Section 317(b) of the Code provides that for the purposes of sections 301 through 318 stock shall be treated as redeemed by a corporation if the corporation acquires its stock from a shareholder in exchange for property. For this purpose, "property" is defined by section 317(a) to mean money, securities and any other property, except that such term does not include stock in the corporation making the distribution, or its stock rights.

Section 302 of the Code provides rules for treatment by shareholders of distributions received from a corporation in redemption of its stock within the meaning of section 317. Section 302(a) and (b)(3) provides, in part, that a distribution of property in complete termination of a shareholder's interest shall be treated as a distribution in part or full payment in exchange for the stock.

Accordingly, in the instant case, since the principal amount of securities received does not exceed the principal amount of securities surrendered by B, no gain or loss is recognized to B on the exchange of the M debentures for new debentures under section 354(a)(1) of the Code. The nonrecognition provisions of section 354(a)(1) do not apply, however, to the exchange by A of M stock for the new debentures because of section 354(a)(2)(B). Therefore, since A's exchange of stock for debentures does not qualify under section 354(a)(1), section 356 is not applicable to the exchange.

However, since M acquired its stock from A in exchange for property within the meaning of section 317(a) of the Code, the exchange with A is a redemption as defined in section 317(b).

Thus, the distribution of the debentures to A is a distribution in complete redemption of A's stock interest in the corporation within the meaning of section 302(b)(3) of the Code and, therefore, is treated as a distribution in full payment in exchange for the stock under section 302(a).