Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 66-37

1966-1 C.B. 209

Sec. 301
Sec. 302
Sec. 316
Sec. 317
Sec. 1502

IRS Headnote

The redemption by a subsidiary of all of its preferred stock all of which is held by its common parent corporation is a taxable dividend to the common parent to the extent of the subsidiary's earnings and profits. If a consolidated income tax return is filed for the taxable year in which the redemption occurs, the distribution represents an intercompany dividend to be eliminated under section 1.1502-31(b)(1) of the Income Tax Regulations in computing the consolidated taxable income. Under section 1.302-2(c) of the regulations, the parent's adjusted basis for the subsidiary's preferred stock will be transferred to and allocated ratably among the shares of the subsidiary's common stock owned by the parent at the time of redemption.

Full Text

Rev. Rul. 66-37

Advice has been requested as to whether the receipt of cash by a common parent corporation from its subsidiary, during a consolidated return period, in redemption by the subsidiary of all of its preferred stock, all of which is held by the parent corporation, constitutes an intercompany dividend to be eliminated, under section 1.1502-31(b)(1) of the Income Tax Regulations, in computing the consolidated taxable income.

Corporation X is the common parent of an affiliated group of corporations which filed consolidated income tax returns for the years 1958 through 1964. During 1958, corporation Y became a member of the affiliated group of which X was the common parent and Y joined in the filing of consolidated returns with X and its other subsidiaries from the time it became a member of the group.

As of July 30, 1964, Y had outstanding 240 y shares of 4 percent voting noncumulative preferred stock having a par and liquidating value of $100 per share and 400 y shares of voting common stock having a par value of $100 per share. As of such date, X owned all of Y's preferred stock and 320 y shares or 80 percent of Y's common stock.

Y's directors at their June 1964 meeting voted a redeem all of Y's outstanding preferred stock at par for cash which was done in October 1964.

X's tax basis for the Y preferred stock redeemed in 1964 was 14 x dollars and the profit to X on the redemption was 10 x dollars. The Y preferred stock was retired at the time of the redemption. Y's earnings and profits accumulated since February 28, 1913, as of December 31, 1963, exceeded the 24 x dollars cash distributed to X in the redemption.

Section 301 of the Internal Revenue Code of 1954 provides the general rule for treatment of distributions on or after June 22, 1954, of property by a corporation to a shareholder with respect to its stock. Under section 301(c)(1) of the Code that portion of the distribution which is a dividend (as defined in section 316 of the Code) shall be included in gross income.

Under section 302(a) of the Code, if a corporation redeems its stock (within the meaning of section 317(b) of the Code) and if paragraph (1), (2), (3), or (4) of subsection (b) applies, such redemption shall be treated as a distribution in part or full payment in exchange for the stock. Section 302(b)(1) of the Code provides that if the redemption is not essentially equivalent to a dividend, section 302(a) of the Code shall apply. Under section 302(d) of the Code, unless otherwise provided, a distribution in redemption of stock shall be treated as a distribution of property to which section 301 of the Code applies if the distribution is not within any of the provisions of section 302(b) of the Code.

Section 1.302-2(c) of the regulations provides that in any case in which an amount received in redemption of stock is treated as a distribution of a dividend, proper adjustment of the basis of the remaining stock will be made with respect to the stock redeemed.

Section 316 of the Code defines the term `dividend' as any distribution of property made by a corporation to its shareholders (1) out of its earnings and profits accumulated after February 28, 1913, or (2) out of its earnings and profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made .

Under section 317(b) of the Code, stock shall be treated as redeemed by a corporation if the corporation acquires it from a shareholder in exchange for property, including money, whether or not the stock is cancelled, retired, or held as treasury stock.

Section 1.1502-31(b)(1) of the regulations, pertaining to consolidated returns, provides, in part, that the taxable income of each corporation shall be computed in accordance with the provisions covering the determination of taxable income of separate corporations except that unrealized profits and losses in transactions between members of the affiliated group and dividend distributions from one member of the group to another member of the group (referred to in the regulations under section 1502 of the Code as intercompany transactions) are to be eliminated.

The acquisition by Y of all of its preferred stock in exchange for cash was a redemption of stock as defined in section 317(b) of the Code. Under the facts, subsections (2), (3), and (4) of section 302(b) of the Code clearly did not apply to the redemption. The redemption did not qualify as being not essentially equivalent to a dividend under section 302(b)(1) of the Code, the only other section 302 provision which would prevent dividend treatment for the redemption, because it did not change the essential relationship of X as the principal shareholder of Y. X's position as the holder of the majority of the common stock of Y was not affected by the redemption of Y's preferred stock. The net effect of the transaction was a distribution of Y's earnings to its controlling shareholder without any appreciable change in the position of the Y shareholders.

Therefore, if separate returns had been filed for the year 1964, the redemption by Y of its preferred stock held by X would be treated as a distribution of property to which section 301 of the Code applies, under the provisions of section 302(d) of the Code. Under sections 301(c)(1) and 316 of the Code, this cash distribution would have been treated as a dividend to X to the extent of Y's earnings and profits. The same rule would apply to a redemption during a consolidated return period.

Accordingly, under the facts in this case, if the affiliated group of which X is the common parent filed a consolidated income tax return for the year 1964, the receipt by X of the 24 x dollars in cash from Y in redemption of all of Y's outstanding preferred stock, represented an intercompany dividend to be eliminated under the provisions of section 1.1502-31(b) of the regulations in computing the taxable income of X . Under section 1.302-2(c) of the regulations, X's adjusted basis for Y's preferred stock will be transferred to and allocated ratably among the shares of Y's common stock owned by X at the time of the redemption.