Firm Seeks Guidance on Satisfying the Exchange Requirement in Cross-Chain Transfers

Dear Mr. Shulman and Mr. Mundaca:

We request that the Treasury Department ("Treasury") and the Internal Revenue Service (the "IRS") issue guidance to confirm that the requirement that stock be issued in a section 351 exchange is deemed satisfied where the transferor is treated as in control of the transferee under Treas. Reg. § 1.1502-34, but does not actually receive stock in the exchange. We believe that this result is consistent with current law treating a requirement that stock be issued as satisfied if the actual issuance would be a "meaningless gesture." Below we describe the fact pattern that raises the issue and our recommendation as to its tax treatment.

Fact Pattern Raising the Issue

P owns all of the stock of S1 and S2. P and S1 are members of a consolidated group. S2 files a separate return. S1 transfers property to S2 but does not receive stock or other consideration in exchange. S1 continues its business activities after the transfer of property.

To qualify as a section 351 exchange, S1 must transfer property to S2 in exchange for stock (the "exchange requirement") and be in control of S2 immediately after the exchange (the "control requirement"). See section 351(a). S1 satisfies the control requirement under section 351 because it is treated as owning the S2 stock held by P, a member of its consolidated group, by reason of the consolidated stock attribution rule of Treas. Reg. § 1.1502-34. However, it is unclear whether S1 can satisfy the exchange requirement under section 351, because S1 does not receive S2 stock in the exchange.

Discussion of the Meaningless Gesture Doctrine

The IRS and courts historically have treated the exchange requirement under section 351 as satisfied when a parent corporation transfers property to a wholly-owned subsidiary without receiving stock in the exchange. See Rev. Rul. 64-155, 1964-1 C.B. 138; Lessinger v. Commissioner, 85 T.C. 824 (1985), rev'd on other grounds, 872 F.2d 519 (2d Cir. 1989); see also section 367(c)(2). In this situation, the exchange requirement is not strictly applied because the actual issuance of stock would be a "meaningless gesture" since the transferor already owns all of the transferee stock. In the above example, S1 constructively owns all of the stock of S2. Accordingly, an actual issuance of S2 stock would not affect S1's ownership of S2 and the issuance of S2 stock therefore should be viewed as a meaningless gesture.

In applying the meaningless gesture doctrine to the above example, Treasury and the IRS would be applying the same standard they apply to acquisitive "D" reorganizations. To qualify as an acquisitive "D" reorganization, the transferor must distribute stock or securities of the transferee in an exchange described in section 354 or section 356 (the "distribution requirement"). See section 368(a)(1)(D). Section 354, in turn, requires that stock in a corporation a party to a reorganization be exchanged solely for stock in such corporation or in another party to the reorganization. Thus, similar to the exchange requirement under section 351, transferee stock must be exchanged in order to satisfy section 368(a)(1)(D). In recent temporary and proposed regulations, Treasury and the IRS reaffirmed their position that the distribution requirement under section 368(a)(1)(D) will be treated as satisfied if the distribution of transferee stock would be a meaningless gesture. See T.D. 9303 (Dec. 18, 2006), as modified by T.D. 9313 (Feb. 28, 2007).

Notably, the IRS has not required, and the temporary regulations do not require, direct ownership of the transferee for the meaningless gesture doctrine to apply. Under the regulations, the meaningless gesture doctrine will apply so long as the same person or persons own, directly or indirectly,¹ all of the stock of the transferor and transferee in identical proportions. See Temp. Treas. Reg. § 1.368-2T(l)(2)(i). Thus, for example, transferee stock held by a member of a consolidated group may be attributed to another member for purposes of applying the meaningless gesture doctrine. Similarly, the S2 stock held by P is attributed to S1 in the above example, and such attribution should result in the application of the meaningless gesture doctrine.

Further, in applying the meaningless gesture doctrine, the IRS has treated the transferee as issuing stock to the transferor to the extent the transferee does not exchange value for the transferor's assets. See P.L.R. 9336029 (June 14, 1993); P.L.R. 9229026 (Apr. 21, 1992); P.L.R. 8911067 (Dec. 22, 1998). The transferor is then treated as distributing these deemed shares to its shareholders in satisfaction of the distribution requirement under section 368(a)(1)(D). If necessary, the deemed shares are then treated as distributed further up, or contributed down, the chain of ownership to the direct owner of the transferee in order to reflect the actual stock ownership in the transferee. In the temporary regulations, Treasury and the IRS extend the deemed share approach to all-cash "D" reorganizations where the transferor receives full value in the exchange by treating the transferee as issuing a "nominal share" to the transferor. See Temp Treas. Reg. § 1.368-2T(l)(2)(i). In the above example, no consideration (stock or cash) is exchanged for the transferor's assets. Accordingly, the nominal share rule as applied to all-cash "D" reorganizations is unnecessary. However, the letter rulings cited above make clear that the transferor will be deemed to receive stock to the extent that it does not receive value in the exchange. The same approach should apply to the above example resulting in a deemed transfer of S2 stock from S2 to S1 and then from S1 to P to reflect the actual stock ownership in S1. This recharacterization would eliminate any disparity in the tax treatment between the above example and the transaction in which S2 actually issued a share of stock.

In sum, we believe that S1's transfer of property to S2 should satisfy the exchange requirement under section 351 even though S1 does not receive actual stock in the exchange. We would appreciate the opportunity to meet with your offices to discuss the issues addressed in this letter and will contact them shortly to schedule a meeting.