Rev. Rul. 77-81

Advice has been requested whether, under the circumstances described below, the acquisition of stock is a "purchase" within the meaning of section 382(a)(4) of the Internal Revenue Code of 1954, before its amendment by the Tax Reform Act of 1976 (the Act), Pub. L. No. 94-455, 94th Cong., 2d Sess. (October 4, 1976), [1976-3 C.B. (Vol. 1) 76] for purposes of determining whether a corporation is precluded from using certain net operating loss carryovers.

X corporation had outstanding one class of common stock and one class of preferred stock. In 1975, X reorganized pursuant to a Chapter X bankruptcy proceeding by changing its business and by issuing its new voting common stock to its trade creditors in exchange for the creditors extinguishing of their claims against X. These claims were not acquired by the trade creditors for the purpose of acquiring this stock. X's preferred shareholders received 15 percent of the new X voting stock in exchange for their X preferred stock, which was cancelled. All of the prereorganization X common stock was cancelled and the holders thereof received nothing in exchange. After the exchanges described above, the bankruptcy proceedings were terminated and the former creditors of X owned 85 percent of the new X voting stock and were in control of X within the meaning of section 368(c) of the Code by reason of their common stock ownership.

The acquisitions of stock described above were not made to evade or avoid income tax within the meaning of section 269 of the Code.

Section 351(a) of the Code provides, in part, that no gain or loss will be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c)) of the corporation.

Section 382(a) of the Code (before its amendment by the Act) provided, in part, that if one or more of the ten largest unrelated shareholders in a corporation own, at the end of the corporation's taxable year, a percentage of the total fair market value of the outstanding stock, as a result of the purchase of stock, which percentage is at least 50 percentage points more than such person or persons owned at either the beginning of such taxable year or the prior taxable year, and if the corporation has not continued to carry on a trade or business substantially the same as that conducted before the change in percentage ownership of the fair market value of such stock, the net operating loss carryovers of such corporation to such taxable year and subsequent taxable years shall not be included in the net operating loss deduction for such taxable years (emphasis added).

Section 382(a)(4) of the Code (before its amendment by the Act) and section 1.382(a)-1(e)(1)(i) of the Income Tax Regulations thereunder provided, in part, that there is a purchase of stock only if the basis of such stock is determined solely by reference to its cost to the holder thereof.

For purposes of section 382(a)(4) of the Code (before its amendment by the Act) and section 1.382(a)-(1)(e)(1)(i) of the regulations thereunder, if the basis of the stock is determined by reference to its basis in the hands of the transferor thereof or of another person, or by reference of the basis of property (other than cash or its equivalent) exchanged for such stock, then the basis of such stock is not determined solely by reference to its cost to the acquirer. Thus, an acquisition by gift or inheritance is not a purchase. However, if stock is received in a "taxable exchange", its basis is considered to be determined solely by reference to its cost to the acquirer and, therefore, deemed a purchase.

Section 1012 of the Code provides, in part, that the basis of property will be the cost of such property. However, under section 358(a)(1) in the case of an exchange to which section 351 applies, the basis of property received under such section without the recognition of gain or loss will be the same as that of the property exchanged subject to certain adjustments that are not applicable here. Thus, pursuant to section 358(a)(1), the basis of stock received under section 351 in exchange for property will be the same as the transferor's basis in the transferred property and not be cost as determined under section 1012.

Therefore, if a stock acquisition is a tax free exchange under section 351(a) of the Code, it is not a purchase within the meaning of section 382(a)(4) (before its amendment by the Act). Thus, all of the net operating loss carryovers are available for inclusion in determining the net operating loss deduction for the year of the exchange and subsequent taxable years. This principle is set forth in Rev. Rul. 75-248, 1975-1 C.B. 125, where a corporate shareholder increased its ownership of stock in another corporation from 25 percent to 85 percent by a taxfree property exchange pursuant to section 351. It was held that since the stock acquisition is a tax-free exchange it is not a purchase within the meaning of section 382(a)(4) and therefore the net operating loss carryovers of the transferee corporation are available to it for inclusion in the net operating loss deduction for the year of the exchange and subsequent taxable years.

The issue in the instant case is whether the exchange between X and its creditors qualifies as an exchange pursuant to section 351 of the Code so that the creditors will not be deemed to have "purchased" their shares of new X voting common stock within the meaning of section 382(a)(4) (before its amendment by the Act), and, consequently, X will not be precluded from using its net operating loss carryovers.

In Alexander E. Duncan, 9 T.C. 468 (1947), acq., 1948-2 C.B. 2, the Tax Court of the United States held that the surrender of judgment claims to a debtor corporation in consideration of the issuance to the creditors of stock of the debtor corporation which gave the old creditors control, constituted a tax-free exchange within the meaning of section 112(b)(5) of the Internal Revenue Code of 1939, the predecessor Code section to section 351 of the 1954 Code. Section 112(b)(5) of the 1939 Code required a transfer of property to a corporation and the Duncan case held that the claims of judgment creditors constituted property.

Accordingly, in the instant case the issuance of the new voting common stock of X to X's creditors in exchange for X's creditors extinguishing of their claims against X is an exchange subject to section 351(a) of the Code and, therefore, is not a purchase within the meaning of section 382(a)(4) (before its amendment by the Act) and section 1.382(a)-1(e)(1) of the regulations. Therefore, X is not precluded from deducting any of its net operating loss carryovers by reason of section 382(a) (before its amendment by the Act).

Section 382(a)(5)(C) of the Code was added by the Act and provides, in part, that section 382(a) will not apply to a purchase or other acquisition of stock by a security holder or creditor in exchange for the relinquishment or extinguishment, in whole or in part, of a claim against the corporation, unless the claim was acquired for the purpose of acquiring such stock. Section 806(g)(2) of the Act provides that the amendments made by the Act to section 382(a) shall take effect for taxable years beginning after June 30, 1978, except that the beginning of the taxable years specified in section 382(a)(1)(B)(ii) shall be considered to be the later of (1) the beginning of such taxable years, or (2) January 1, 1978.