Rev. Rul. 78-330: Cancellation of debt respected; § 357(c) does not apply in merger

Citations: Rev. Rul. 78-330; 1978-2 C.B. 147

Rev. Rul. 78-330

ISSUE

Is section 357(c) of the Internal Revenue Code of 1954 rendered inapplicable by a creditor-parent corporation's cancellation of indebtedness of its wholly-owned debtor-subsidiary immediately before the merger of the debtor-subsidiary into another wholly-owned subsidiary of the parent corporation?

FACTS

Corporation P owned all the stock of corporations S-1 and S-2. For valid business reasons the decision was made to combine S-1 and S-2 pursuant to a plan of reorganization under which S-1 transferred all its assets and liabilities to S-2 in a statutory merger pursuant to state law. As a preliminary step, P gratuitously cancelled the principal amount of a debt owed by S-1 to P so that the basis of S-1's assets would exceed the total amount of its liabilities prior to the reorganization. The debt had been incurred for valid business reasons and had been outstanding for a number of years prior to the reorganization.

LAW AND ANALYSIS

Since S-1 was merged into S-2 in a transaction described as a reorganization within the meaning of section 368(a)(1)(A) of the Code as well as section 368(a)(1)(D), gain or loss to S-1 is determined under section 361.

If the sum of the amount of the liabilities assumed, plus the amount of the liabilities to which the property is subject, exceeds the total of the adjusted basis of the property transferred in the case of an exchange to which section 361 of the Code applies by reason of a plan of reorganization within the meaning of section 368(a)(1)(D), section 357(c)(1)(B) provides that the excess shall be considered as gain from the sale or exchange of a capital assets or of property that is not a capital asset, as the case may be.

The Internal Revenue Service has concluded that section 357(c)(1)(B) of the Code applies in a situation such as this case because that provision contains no exception for its application when a reorganization qualifies under section 368(a)(1)(A) as well as section 368(a)(1)(D). See Rev. Rul. 75-161, 1975-1 C.B. 114.

In general, if a shareholder forgives a debt owed to it by its corporation, the transaction is treated as a contribution to capital of the corporation to the extent of the principal amount of the debt under section 1.61-12(a) of the Income Tax Regulations. Under section 118(a) of the Code, a contribution to capital is excluded from the gross income of the corporation.

In this case P's cancellation of S-1's obligation had independent economic significance because it resulted in a genuine alteration of a previous bona fide business relationship. In similar situations threshold transactions that demonstrate independent economic significance have been given substance for tax purposes. See Simpson v. Commissioner, 43 T.C. 900, 916 (1965), acq., 1965-2 C.B. 6, wherein the United States Tax Court acknowledged that a taxpayer-transferor in an incorporation under section 351 of the Code may take the preliminary steps necessary to arrange the transaction so as to avoid the effect of section 357(c) on an otherwise tax-free exchange. See also Rev. Rul. 77-227, 1977-2 C.B. 120; Rev. Rul. 76-223, 1976-1 C.B. 103; and Rev. Rul. 69-407, 1969-2 C.B. 50.

HOLDING

P's cancellation of the principal amount of the debt owed by S-1 to P will be given substance as a contribution by P to the capital of S-1. Section 357(c) of the Code will not apply to the subsequent merger transaction since the liabilities of S-1 assumed by S-2 did not exceed the adjusted basis of the S-1 assets transferred to S-2.

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