Rev. Rul. 79-314

ISSUE

Under the circumstances described below, do the provisions of section 311(a) of the Internal Revenue Code of 1954 prevail over the provisions of sections 302(a) and 1001(c)?

FACTS

X corporation and Y corporation were both engaged in the same business and were subject to government regulation. The stock of X and Y was publicly traded. X owned approximately 14 percent in value of Y's stock that was acquired in a single purchase and Y owned approximately 12 percent in value of X's stock. Each had owned the percentage of the other's stock for several years and each had held the other's stock as an investment. The government agency that regulated the business of both X and Y determined that X and Y should not be shareholders of a corporation engaged in the same business and ordered them to dispose of each other's stock. X and Y both explored other possibilities of disposing of the stock but they decided that the best way to dispose of the stock would be an exchange between them of each other's stock.

At the time of the exchange, the fair market value of the Y stock held by X was 20x dollars and the fair market value of the X stock held by Y was 15x dollars. Both X's and Y's adjusted basis in the other's stock was 10x dollars. Therefore, X transferred Y stock held by it worth 15x dollars to Y in exchange for X stock worth 15x dollars and X also transferred the remaining Y stock held by it worth 5x dollars to Y in exchange for cash in the amount of 5x dollars. Conversely, Y transferred X stock held by it worth 15x dollars to X in exchange for Y stock worth 15x dollars and Y also transferred 5x dollars cash to X in exchange for the remaining Y stock held by X worth 5x dollars. After the exchange, neither X nor Y directly owned stock in the other nor did they indirectly own stock in the other under the constructive ownership of stock rules contained in section 318 of the Code. By reason of the exchange of X and Y stock of equal value (15x dollars), X and Y were at the same time acting both in the capacity of a redeeming corporation (distributor) and a shareholder (distributee) in a redemption.

LAW AND ANALYSIS

The applicable sections of the Code and Income Tax Regulations thereunder are 302(a), 302(b)(3), 317, 1.302-1 and 1.302-4, relating to distributions in redemption of stock; 311(a)(2), 311(d)(2)(A), 1.311-1, and 1.311-2(b), relating to the taxability of a corporation when appreciated property is used to redeem stock; and 1001(b), 1001(c) and 1.1001-1, relating to the computation of realized and recognized gain or loss.

In each case, X's and Y's interest in the other was completely terminated so as to qualify as a redemption within the meaning of section 302(b)(3) of the Code. Therefore, section 302(a) applied and gain was realized to X and Y, in the capacity of each as a distributee on the exchange, as provided in section 1001(b). Under section 311(d)(2)(A), the distributions by X and Y of the Y and X stock worth 15x dollars are excepted from the application of section 311(d)(1) because the distribution received by each completely terminated its interest in the other within the meaning of section 302(b)(3), and each of the other requirements of section 311(d)(2)(A) was met. Therefore, no gain is recognized under section 311(a)(2) to either X or Y, in the capacity of each as a distributor, upon the distribution, with respect to its stock, of the stock worth 15x dollars to the other.

However, in the instant case, if the gain realized by X and Y on the exchange of the stock worth 15x dollars were recognized to them as distributees on the redemption of their stock worth 15x dollars in the other, the effect would be to make the nonrecognition provisions of section 311(a)(2) of the Code inapplicable because this is the same gain realized by X and Y as distributors of the other's stock worth 15x dollars that section 311(a)(2) provides is not to be recognized. See section 1001(c) which states that except as otherwise provided, the entire amount of the gain on the exchange of property shall be recognized. (Emphasis added)

With regard to that part of the exchange by X of Y stock worth 5x dollars for cash in the amount of 5x dollars, section 311(a) of the Code has no application at all to X because the distribution by X of the Y stock worth 5x dollars was not made with respect to its (X's) stock, as required by section 311(a), but rather was distributed in exchange for cash. Thus, only section 302(a) is applicable to that part of the exchange.

HOLDING

Under the circumstances in the instant case, the provisions of section 311(a) of the Code will prevail over the provisions of sections 302(a) and 1001(c). The gain realized under section 1001(b) on the exchange of stock worth 15x dollars by X and Y in the capacity of each as a distributee is not recognized to them under section 1001(c) by virtue of the application of section 311(a)(2) to the gain realized by X and Y on the exchange of stock worth 15x dollars in the capacity of each as a distributor. Sections 302(a) and 1001(c) alone are applicable to X on the exchange of Y stock worth 5x dollars for 5x dollars cash, and the gain realized by X thereon will be recognized by X under section 1001(c).