Rev. Rul. 83-23

ISSUE

Advice has been requested as to whether the transaction described below qualifies as a spin-off under section 355 of the Internal Revenue Code, and whether stock of a controlled foreign corporation is distributed in the transaction.

FACTS

P, a domestic corporation, owns 60 percent of the outstanding voting stock of FX, a foreign corporation incorporated in foreign country FC. FC nationals own the other 40 percent of the FX voting stock. FX is engaged in two businesses: importing and manufacturing. Each business has been actively conducted by FX during the past five years, during which time there have been no changes in the ownership of FX.

Recently, a decree of FC was promulgated which requires all manufacturing businesses in FC to be at least 40 percent directly owned by FC nationals, and all importing businesses to be at least 60 percent directly owned by FC nationals. P wishes to maintain as much of its ownership of each business of FX as possible.

In order to comply with the decree, and to maximize P's ownership in each business of FX, the following transaction has been proposed. FX will form FZ, a new FC corporation, and will contribute all of the assets of the importing business (the liabilities of this business do not exceed the adjusted basis of these assets) to FZ in exchange for 100 shares of FZ voting common stock. Immediately thereafter, FX will distribute the FZ voting stock to its stockholders, pro rata. P will then immediately transfer 20 shares of FZ voting stock to the other FZ shareholders, receiving no consideration in exchange. Thereafter, P will own 60 percent of the FX voting stock and 40 percent of the FZ voting stock, and FC nationals will own the remaining voting stock of FX and FZ. FX and FZ will continue the manufacturing and importing businesses, respectively.

LAW AND ANALYSIS

Section 368(a)(1)(D) of the Code holds that a transfer by a corporation of all or part of its assets to another corporation is a reorganization if the transferor corporation, its shareholders, or a combination thereof, control the transferee corporation; but only if as part of the plan, stock or securities of the transferee corporation are distributed in a transaction which qualifies under section 354, 355 or 356.

Section 361(a) of the Code provides that no gain or loss shall be recognized to the transferor corporation on the transfer of assets to the transferee corporation solely in exchange for stock, if the transaction qualifies as a reorganization.

Section 355(a) of the Code provides that if a corporation distributes stock of a controlled corporation to its shareholders, then no gain or loss will be recognized to the shareholders of the distributing corporation upon the receipt of stock of the controlled corporation, if the following requirements are met: (1) the transaction is not used principally as a device for the distribution of earnings and profits, (2) the distributing and controlled corporations each continue to operate an active trade or business as described in section 355(b), and, (3) the distributing corporation distributes all of the stock of the controlled corporation held by it immediately before the distribution.

Sections 1.355-2(b) and (c) of the Income Tax Regulations state that for a transaction to qualify under section 355(a) of the Code it must have: (1) continuity of business enterprise, (2) continuity of shareholder interest, and, (3) an adequate business purpose.

FX has conducted both the importing and the manufacturing businesses for the past five years as described in section 355(b) and all the voting stock of FZ will be distributed in the transaction. The distribution of the FZ voting stock is not a device for the distribution of earnings and profits because it is necessitated by a foreign governmental decree. See Rev. Rul. 78-383, 1978-2 C.B. 142. This is true even though the distribution is followed by the transfer of 20 percent of the FZ voting stock by P in a transaction that is neither a sale nor an exchange. Olson v. Commissioner, 48 T.C. 855 (1967), acq., 1968-2 C.B. 2. The transaction has an adequate business purpose and continuity of shareholder interest and business enterprise are also satisfied.

Section 367(c)(1) of the Code provides that a distribution described in section 355 is to be treated as an "exchange" for the purposes of section 367. The distribution by FX of the FZ voting stock to P would be an "exchange" to which section 367(b)(1) applies. Under section 367(b)(1), section 355 will apply to the "exchange" only if P complies with the requirements of the temporary regulations under section 367(b).

Under section 7.367(b)-1(b) of the temporary regulations, P is required to comply with the requirements of sections 7.367(b)-1 through 7.367(b)-12 of the temporary regulations.

Section 7.367(b)-10(c) of the temporary regulations provides that sections 7.367(b)-10(d)--(j) of the temporary regulations apply when a foreign corporation having a United States shareholder distributes stock in another corporation in a transaction described in section 355 of the Code.

Section 7.367(b)-10(i)(2) of the temporary regulations provides that when, as a result of a transaction described in section 355 of the Code, a United States shareholder receives stock in a foreign corporation which is not a controlled foreign corporation, the United States shareholder shall include an amount in its gross income determined under section 7.367(b)-10(i)(3)(i).

Section 7.367(b)-2(a) of the temporary regulations provides that a "controlled foreign corporation", as that term is used in the regulations, is defined in section 957 of the Code and the regulations thereunder. Section 957 defines a "controlled foreign corporation" as any foreign corporation of which more than 50 percent of the combined voting power of all classes of stock entitled to vote is owned, or considered as owned, by United States shareholders on any day of the taxable year of such foreign corporation.

Section 1.957-1(b) of the regulations provides that in determining whether United States shareholders own the requisite percentage of total combined voting power of all classes of stock entitled to vote, consideration will be given to all the facts and circumstances of each case.

Section 7.367(b)-2(b) of the temporary regulations provides that for purposes of the temporary regulations, a "United States shareholder" is a United States person who satisfies the ownership requirements of section 1248(a)(2) or of section 1248(c)(2) of the Code with respect to a foreign corporation.

Under section 7.367(b)-10(i)(2) of the temporary regulations it must be determined whether FZ is a controlled foreign corporation at the time its stock is received by P, or whether the subsequent transfer of FZ stock by P to the FC nationals will be taken into account so that P is treated as receiving stock of a foreign corporation which is not a controlled foreign corporation.

For purposes of section 351(a) of the Code, stock received by a transferor who, at the time of the exchange, is under a pre-existing binding obligation to dispose of such stock will not be counted to determine control. Intermountain Lumber Co. v. Commissioner, 65 T.C. 1025 (1976); Rev. Rul. 70-522, 1970-2 C.B. 81; Rev. Rul. 79-194, 1979-1 C.B. 145. This is analogous to the present case. In order to comply with the FC decree, P is obligated to immediately dispose of a portion of its FZ stock.

The effect is to cause FZ not to be a controlled foreign corporation. P's obligation to dispose of a portion of its FZ stock is no less binding than the contractual obligation in Intermountain Lumber and Rev. Rul. 70-522. P's obligation, in fact, is similar to that in Rev. Rul. 79-194 in that each arose by force of a law of a foreign government. In view of the coercive effect of the FC decree, no importance is attached to the lack of any formal contract between P and the FC nationals. Because P is under a pre-existing obligation to dispose of a portion of the FZ stock received in the distribution, its holding of that portion will be considered transitory and without substance for the purpose of determining whether stock of a controlled foreign corporation is distributed in the transaction. See Rev. Rul. 70-522.

Therefore, under section 1.957-1(b) of the regulations the facts and circumstances in this case are such that FZ will not be considered to be a controlled foreign corporation.

HOLDING

The distribution by FX of the FZ stock to its shareholders will qualify under section 355 of the Code provided P complies with the requirements of section 7.367(b)-1 through 7.367(b)-12 of the temporary regulations.

Section 7.367(b)-10(i)(2) of the temporary regulations will apply to the transaction described above and therefore P shall include in gross income an amount determined under section 7.367(b)-10(i)(3)(i).