Rev. Rul. 56-613: Direct stock ownership required for § 368(c) control

Citations: Rev. Rul. 56-613; 1956-2 C.B. 212

Rev. Rul. 56-613

Advice has been requested with respect to an acquisition by one corporation of certain common stock of another corporation under the circumstances described below.

X corporation's capital stock consists of shares of Class A and Class B common stock, evenly divided. These shares have equal voting and liquidation rights, the only distinction between them being in the payment of dividends. In the year 1949, X corporation sold all Class A stock to eight persons who continued to hold such stock until 1955. In that year, all of the Class A stock of the X corporation was acquired by Y corporation from the original shareholders in exchange for common stock of Y corporation. The Class B stock of X corporation was purchased in 1950 by Z corporation in an independent transaction in which Y had no interest. Thereafter, in 1951, all of the Z stock was acquired by Y . Thus, inasmuch as the Y corporation has now all of the Class A stock of X , and its subsidiary, Z , owns all of the Class B stock of X , the Y corporation has, for practical purposes, 100 percent voting control of X corporation.

The specific question presented is whether the exchange of Class A stock of the X corporation for Y's stock is a tax-free exchange to the shareholders participating in that exchange.

As a general rule, the entire amount of gain or loss on the exchange of property (which includes stock) is recognized for Federal income tax purposes. However, in the case of certain exchanges of stock pursuant to a plan of reorganization, no gain or loss is reognized. At issue in this case is whether the acquisition of stock by Y corporation constitutes a reorganization as defined in section 368(a)(1)(B) of the Internal Revenue Code of 1954.

Section 368(a)(1) of such Code states, in part, that the term `reorganization' means-

(B) the acquisition by one corporation, in exchange solely for all or a part of its voting stock, of stock of another corporation if, immediately after the acquisition, the acquiring corporation has control of such other corporation (whether or not such acquiring corporation had control immediately before the acquisition);

The term `control' under section 368(c) of the Code means ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation.

In the instant case, the acquisition by Y corporation does not qualify as a reorganization under section 368(a)(1)(B). Y corporation does not have control of X corporation immediately after the acquisition of the Class A stock, since it directly owns stock possessing only 50 percent of all of the voting power of the stock outstanding. Section 368(c) specifically defines control in terms of direct ownership of stock and not in terms of practical control. There is no basis for disregarding the separate legal entities of the parent and its subsidiary and for attributing the subsidiary's ownership of the X corporation stock to the parent.

In view of the foregoing considerations, the Service holds that gain or loss is recognized to the shareholders on the exchange of their Class A stock of the X corporation for common stock of Y corporation in accordance with the provisions of section 1002 of the Code. The amount of gain or loss to each shareholder is the difference between the adjusted basis of his stock in X corporation and the fair market value of the Y stock received in exchange therefor. Such gain or loss constitutes capital gain or loss subject to the provisions of Subchapter P of Chapter 1 of the Code.

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