Rev. Rul. 80-285

ISSUE

Will nonrecognition treatment under section 351(a) of the Internal Revenue Code be accorded to a transfer of all of the assets of a corporation (Y) to another corporation (Z) in exchange for Z stock and Z securities, where, as part of the plan, Y redeems 81 percent of its stock for the Z securities?

FACTS

Y, a manufacturing corporation, had outstanding 1,000x shares of capital stock. The fair market value of Y was 100,000x dollars, and the fair market value of each share of its outstanding stock was 100x dollars. Y's president and chairman of the board, A, owned 190x shares of its capital stock (19 percent). The remaining 810x shares of Y's capital stock (81 percent) were publicly held. X, a large publicly traded corporation unrelated to Y, wished to purchase all of the assets of Y and thereafter to have Y's business continued by a wholly owned subsidiary. While the other shareholders of Y were willing to accept cash or securities for their Y stock, A, who was of an advanced age and who had a very low basis in his 190x shares, was unwilling to sell the Y stock for cash or securities because the sale would result in recognition of taxable gain. The public shareholders of Y are unrelated to A, within the meaning of section 318 of the Code.

In order to accommodate A's wish to avoid recognition of gain, X and the Y shareholders agreed in January, 1980, to have X and Y organize a new corporation, Z, for the purpose of acquiring and holding all of the assets of Y. Several months later, pursuant to the agreement, X transferred 81,000x dollars in cash together with other property to Z solely in exchange for all of Z's common stock, and Y transferred all of its assets to Z solely in exchange for all of Z's voting preferred stock and Z securities. It was intended that this transaction would qualify as an exchange under section 351 of the Code. Thereafter, and as part of the overall plan, Y redeemed all of its stock (81 percent) held by its public shareholders for the Z securities. All transfers and exchanges were at fair market value. The value of the property and cash transferred by X to Z was over 80 times the value of the property transferred by Y to Z. Therefore, the Z common stock received by X in the exchange comprised over 80 percent of the total combined voting power of all classes of Z stock entitled to vote. Z remains in existence as an operating company, and Y remains in existence as a wholly owned holding company of A. After all of the exchanges occurred, Z owned all of the assets of Y, X owned all of the Z common stock, Y owned all of the Z voting preferred stock, A owned all of the Y stock, and the Y public shareholders received all of the Z securities in exchange for their Y stock.

LAW AND ANALYSIS

Section 351(a) of the Code provides that no gain or loss is recognized if persons who control (within the meaning of section 368(c)) a corporation transfer property to the corporation solely in exchange for stock or securities. Section 351(a) is an exception to the general rule that gain or loss must be recognized on any sale or exchange of property. See section 1.1002-1(b) of the Income Tax Regulations, which states that exceptions to the general rule (including section 351(a)) "are strictly construed and do not extend either beyond the words or the underlying assumptions and purposes of the exception. Nonrecognition is accorded by the Code only if the exchange is one which satisfies both (1) the specific description in the Code of an excepted exchange, and (2) the underlying purpose for which such exchange is excepted from the general rule."

Thus, while Y's exchange of assets for voting preferred stock and Z securities may satisfy all of the literal requirements of section 351 of the Code, it does not follow that Congress meant to cover such an exchange, even though "the facts answer the dictionary definition of each term used in the statute." See Helvering v. Gregory, 69 F.2d 809, 810 (2nd Cir. 1934) (Hand, J.), aff'd, 293 U.S. 465 (1935), Ct. D. 911, XIV-1 C.B. 193 (1935).

Section 351(a) of the Code is intended to apply to "certain transactions where gain or loss may have accrued in a constitutional sense, but where in a popular and economic sense there has been a mere change in the form of ownership and the taxpayer has not really 'cashed in' on the theoretical gain, or closed out a losing venture." Portland Oil Co. v. Commissioner, 109 F.2d 479, 488 (1st Cir. 1940), cert. denied, 310 U.S. 650 (1940). See also Rev. Rul. 73-472, 1973-2 C.B. 114. On the other hand, section 351(a) is not intended to apply to transactions that sufficiently resemble a sale so that gain is recognized in a popular and economic sense. Thus, the issue presented is whether, in terms of economic substance, there has been a mere change in the form of investment or a cashing in of that investment.

Y's transfer of assets for voting preferred stock and Z securities is an integral part of a larger transaction. In the larger transaction, X, acting through its subsidiary, Z, acquires all the assets of an unrelated third corporation, Y. Thus, viewed from the perspective of all the parties, the larger transaction fits a pattern common to acquisitive reorganizations. Contrast Rev. Rul. 57-190, 1957-1 C.B. 121, and Rev. Rul. 57-464, 1957-2 C.B. 244 (which describe transfers to a controlled corporation as part of a larger transaction that fits a pattern common to divisive reorganizations).

A well-established continuity of interest test applies to acquisitive reorganizations. See section 1.368-1(b) of the regulations and Rev. Rul. 66-224, 1966-2 C.B. 114. The object of the continuity of interest test is to identify acquisitive transactions that sufficiently resemble a sale so gain is recognized in the ordinary business sense. See Roebling v. Commissioner, 143 F.2d 810, 812 (3rd Cir. 1944), cert. denied, 323 U.S. 773 (1944).

Under the continuity of interest test, a substantial portion of the consideration paid must consist of stock in the acquiring corporation. See Southwest Natural Gas Co. v. Commissioner, 189 F.2d 332, 334 (5th Cir. 1951), cert. denied, 342 U.S. 860 (1951). If an acquisitive transaction fails the continuity of interest test, then the transaction as a whole sufficiently resembles a sale so all the parties recognize gain in the ordinary business sense.

The larger acquisitive transaction in which Z obtains all of the assets of Y, and the public shareholders receive Z securities for their 81 percent interest in Y, fails the continuity of interest test. It follows that the transaction as a whole sufficiently resembles a sale so all of the exchanging parties (including Y) recognize gain in the ordinary business sense. Because section 351 of the Code is not intended to apply where gain is recognized in the ordinary business sense, Y's exchange is not within the "underlying assumptions and purposes" of section 351. See section 1.1002-1(b) of the regulations.

No other conclusion would be consistent with the history and purpose of continuity of interest. In a series of decided cases, the courts have denied nonrecognition treatment to acquisitive transactions that lacked continuity of interest. See, e.g., in addition to the cases cited above, LeTulle v. Scofield, 308 U.S. 415 (1940), Ct. D. 1432, 1940-1 C.B. 151, Pinellas Ice & Cold Storage Co. v. Commissioner, 287 U.S. 462 (1933), Ct. D. 630, XII-1 C.B. 161 (1933), and Cortland Specialty Co. v. Commissioner, 60 F.2d 937 (2nd Cir. 1932), cert. denied, 288 U.S. 599 (1933). The defect in each case was entirely one of substance; the transaction at issue satisfied all of the technical requirements for nonrecognition under the statutory provisions that were directly relevant. A defect of this kind cannot be remedied by means that are essentially formal. In particular it cannot be remedied merely by rearranging the form of an acquisitive transaction so that the technical requirements of section 351 of the Code are satisfied, but without altering the substance of the transaction.

In this ruling, the facts reveal an acquisitive transaction which does not meet the continuity of interest test and thus is equivalent to a sale. Accordingly, although the technical requirements of section 351(a) of the Code are satisfied, the transaction is beyond the underlying assumptions and purposes of section 351(a). Therefore, its substance as a sale remains the same, and the transaction will be treated as a taxable exchange. Compare Rev. Rul. 80-284, page 8, this Bulletin, which reaches the same result when stock, instead of assets, is acquired under similar circumstances.

Y redeemed its stock (within the meaning of section 317(b) of the Code) held by its public shareholders for Z securities at fair market value. Since each such shareholder's interest in Y was completely terminated, each exchange qualifies as a redemption within the meaning of section 302(b)(3). Therefore, section 302(a) applies to the gain realized on the exchange by each public shareholder. See Rev. Rul. 79-273, 1979-2 C.B. 125, for a similar result where a redemption and statutory merger are used to acquire stock.

HOLDING

Y's exchange of all of its assets for Z voting preferred stock and Z securities does not qualify for nonrecognition treatment under section 351(a) of the Code, and gain is therefore recognized on the exchange. X's exchange of cash and property for Z common stock qualifies for nonrecognition of gain or loss under section 351(a), since X controls over 80 percent of the total combined voting power of all classes of stock of Z entitled to vote, and at least 80 percent of the total number of shares of all other classes of Z stock (since there were none), immediately after the transfer. See Rev. Rul. 68-43, 1968-1 C.B. 146.