Rev. Rul. 78-408

Advice has been requested whether, under the circumstances described below, the exchange of outstanding stock warrants resulted in gain or loss to warrantholders.

X corporation acquired all the outstanding voting common stock of Y corporation pursuant to a plan of reorganization. Under the plan each share of Y voting common stock was exchanged for one share of voting common stock of X.

Y also had warrants outstanding for the purchase of Y voting common stock. Pursuant to the plan of reorganization, X issued a warrant for the purchase of X voting common stock in exchange for each of the Y warrants. Each X warrant was identical to the Y warrant in terms, conditions, and other respects (including number of shares and price per share) except that the warrantholder was entitled to receive X stock rather than Y stock. Some of the warrantholders of Y also owned stock in Y so that they received both X voting common stock and X warrants in the two exchanges.

The voting common stock and warrants of Y were traded on the over-the-counter market. The stock and warrants of Y were widely held so that before the reorganization there were large numbers of Y stockholders who did not own Y warrants.

Section 1001(a) of the Internal Revenue Code of 1954, provides, in part, that the gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 1011 for determining gain, and the loss shall be the excess of the adjusted basis provided in such section for determining loss over the amount realized.

Section 1.1001-1(a) of the Income Tax Regulations provides, in part, that the gain or loss realized from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or in extent, is treated as income or as loss sustained. The amount realized from a sale or other disposition of property is the sum of any money received plus the fair market value of any property (other than money) received.

Section 1001(c) of the Code provides that, except as otherwise provided in subtitle A, the entire amount of the gain or loss on the sale or exchange of property shall be recognized.

Section 368(a)(1)(B) of the Code provides, in part, that a reorganization includes the acquisition by one corporation, in exchange solely for all or part of its voting stock, of stock of another corporation if, immediately after the acquisition, the acquiring corporation has control of such other corporation. Under section 1.368-2(c) of the regulations, if consideration other than voting stock is used in the acquisition of stock of the acquired corporation, the transaction is not a reorganization under section 368(a)(1)(B).

Section 354(a)(1) of the Code provides, in part, that no gain or loss will be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in another corporation a party to the reorganization. Under section 1.354-1(e) of the regulaitons, stock warrants are not included in the term "stock or securities" for the purpose of section 354.

In some cases a corporation acquires debentures, warrants, previously unissued stock, or other property as part of an overall plan of reorganization. It must be determined in each such case whether the acquiring corporation has provided consideration other than voting stock indirectly to the shareholders of the acquired corporation in return for their stock. If the acquiring corporation has provided such impermissible consideration for the stock, the reorganization will not qualify under section 368(a)(1)(B) of the Code, but if it has acquired stock solely for voting stock, the exchange of stock can qualify under section 368(a)(1)(B). In the latter case, other exchanges of property in connection with the plan or reorganization may be treated as separable transactions. For examples, see Rev. Rul. 69-91, 1969-1 C.B. 106; Rev. Rul. 69-142, 1969-1 C.B. 107; Rev. Rul. 70-41, 1970-1 C.B. 77; Rev. Rul. 70-269, 1970-1 C.B. 82; and Rev. Rul. 72-522, 1972-2 C.B. 215. Compare Rev. Rul. 75-360, 1975-2 C.B. 110.

In Rev. Rul. 69-142 the acquiring corporation acquired all of the outstanding capital stock of another corporation in exchange for its voting stock. Pursuant to the plan of reorganization, the acquiring corporation also exchanged its own debentures for all of the outstanding debentures of the acquired corporation. Some debentures of the acquired corporation were held by its shareholders, but a substantial proportion of such debentures was held by persons who owned no stock of the acquired corporation. Rev. Rul. 69-142 holds that the exchange of debentures was not indirect nonqualifying consideration for the stock of the acquired corporation in view of the substantial split in ownership of the stock and debentures.

The plan of reorganization in Rev. Rul. 69-142 consisted of two separable transactions. The exchange of stock for stock was a reorganization described in section 368(a)(1)(B) of the Code with respect to which section 354 provided for nonrecognition of gain or loss. However, the exchange of debentures was held to be a taxable transaction governed by section 1001.

The exchanges in the present case were like those in Rev. Rul. 69-142 because of the substantial split in ownership of stock and warrants. X acquired the stock of Y solely in exchange for voting stock of X. Since all the other requirements of section 368(a)(1)(B) of the Code were met, the exchange of stock qualified for nonrecognition under section 354(a). However, the exchange of warrants was a separable transaction to which no nonrecognition provision applied.

Accordingly, in the instant case, the warrantholders receiving the X warrants, will have recognized gains or losses on the exchange determined in accordance with section 1001 of the Code.