Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 72-57

1972-1 C.B. 103

Sec. 368
Sec. 1031
Sec. 1036

IRS Headnote

A reclassification of common stock by a subsidiary, whereby the parent receives new shares and cash on exchange and its minority shareholders' interests are redeemed for cash, is a section 368(a)(1)(E) reorganization and not an exchange of stock under section 1036(a) of the Code.

Full Text

Rev. Rul. 72-57

Advice has been requested with respect to the Federal income tax consequences of a reclassification by a subsidiary corporation of its outstanding common stock under the circumstances described below.

Corporation X had outstanding five dollar par value common stock of which approximately 99 percent was owned by corporation Y, the parent of X. The balance of the outstanding X common stock was held by its various minority shareholders, none of whom owned as much as 10 shares of X's stock or any shares of Y, either directly or indirectly.

X felt it necessary to simplify its capital structure by eliminating the interest of its minority stockholders. As a means of accomplishing this, X amended its articles of incorporation so that 10 shares of old five dollar par value common stock would constitute one share of new fifty dollar par value common stock. X paid cash in lieu of issuing any fractional share interests caused by its capital reclassification so that no fractional shares would be outstanding after the exchange. Thus, as a result of the exchange, all of the X minority shareholder interests were eliminated by a cash payment while Y, the parent corporation, received new X common shares and cash in exchange for its old X common shares. The cash payment represented merely a mechanical rounding off of the fractions in the exchange and was not a separately bargained for consideration.

Section 1036(a) of the Internal Revenue Code of 1954 states in part that no gain or loss will be recognized if common stock is exchanged solely for common stock in the same corporation. Where an exchange is not solely in kind, section 1036(b) of the Code refers to sections 1031(b) and (c) of the Code for the rules relating to recognition of gain or loss.

Section 1036-1(a) of the Income Tax Regulations states in part that a transaction between a shareholder and the corporation may qualify not only under section 1036(a) of the Code but also under section 368(a)(1)(E) of the Code as a recapitalization.

Section 1031(b) of the Code provides in part that where, an exchange would be within the provisions of section 1036(a) of the Code if it were not for the fact that the property received in the exchange consisted not only of property permitted by such section to be received without the recognition of gain but also of other property or money, then the gain, if any, to the recipient will be recognized, but in an amount not in excess of the sum of the money and the fair market value of the other property. Section 1.1031(b)-1(a)(3) of the regulations states in part that if the taxpayer receives other property or money in an exchange described in section 1036(a) and not in connection with a corporate reorganization, the gain, if any, to the taxpayer will be recognized under section 1031(b) of the Code.

Section 368(a)(1)(E) of the Code states that a "reorganization" includes a recapitalization. A recapitalization has been defined as a "reshuffling of a capital structure within the framework of an existing corporation" by the Supreme Court of the United States in Helvering v. Southwest Consolidated Corp., 315 U.S. 194, at 202 (1942), Ct. D. 1544, C.B. 1942-1, 218, at 222.

Section 354(a) of the Code states in part that no gain or loss will be recognized if stock in a corporation, that is a party to a reorganization, is exchanged solely for stock in such corporation.

Revenue Ruling 69-34, C.B. 1969-1, 105 states that where cash is received by shareholders in lieu of fractional shares of stock in a reorganization defined in section 368(a)(1)(E) of the Code and the cash represents merely a mechanical rounding off of the fractions in the exchange and is not separately bargained for consideration, the cash payments will be tested under section 302 of the Code.

Section 302(a) of the Code provides, in part, that if a corporation redeems its stock and if section 302(b)(1) or (3) of the Code applies such redemption will be treated as a distribution in part or full payment in exchange for the stock.

Section 302(b)(1) of the Code provides that section 302(a) of the Code will apply if the redemption is not essentially equivalent to a dividend. In United States v. Maclin P. Davis et ux., 397 U.S. 301 (1970), Ct. D. 1937, C.B. 1970-1, 62, the Supreme Court of the United States held that for a redemption to qualify under section 302(b)(1) of the Code it must result in a meaningful reduction of the shareholder's proportionate interest in the corporation.

Section 302(b)(3) of the Code provides that section 302(a) of the Code will apply if the redemption is in complete redemption of all of the stock of the corporation owned by the shareholder.

The question presented in the instant case is whether the transaction is governed by section 1036(a) of the Code and section 1031(b) of the Code, or section 368(a)(1)(E) of the Code and its related sections.

X, by amending its articles of incorporation, as described, "reshuffled" its capital structure. Consequently, the resulting exchange was pursuant to a reorganization under section 368(a)(1)(E) of the Code.

The effect of section 1.1031(b)-1(a)(3) of the regulations is that when an exchange involving cash and stock qualifies under section 368 of the Code as a reorganization, sections 1036 and 1031(b) of the Code are not applicable to the transaction.

Based solely on the foregoing it is held as follows:

(1) The transaction is a reorganization defined in section 360(a)(1)(E) of the Code.

(2) No gain or loss is recognized to Y upon the exchange of 5 dollar par value X stock for 50 dollar par value X stock pursuant to section 354(a)(1) of the Code.

(3) Section 1031(b) of the Code is not applicable, pursuant to section 1.1031(b)-1(a)(3) of the regulations, to the cash received by Y in lieu of fractional shares since the cash was received in connection with a reorganization. Pursuant to  Revenue Ruling 69-34 the cash will be treated under section 302 of the Code as having been received by Y in redemption of its fractional share interest. Since after the redemption Y owns all of the X stock, the redemption did not result in a meaningful reduction of Y's proportionate interest in X and therefore the cash payment is essentially equivalent to a dividend within the meaning of section 302(b)(1) of the Code and the Davis case. Accordingly, the cash payment is treated under section 302(d) of the Code as a distribution to which section 301 of the Code applies.

(4) The minority shareholders of X who received only cash in the exchange are treated, pursuant to Revenue Ruling 69-34, as having had their fractional share interests redeemed under section 302 of the Code. Since all of their stock interest in X was terminated, section 302(b)(3) is applicable and the cash is treated as full payment in exchange for the fractional share interests.