Rev. Rul. 89-18

1989-1 C.B. 14, 1989-7 I.R.B. 4.

                       Internal Revenue Service

                                 Revenue Ruling

             RECAPTURE; INVESTMENT CREDIT, DIVISIVE REORGANIZATIONS

                          Published: February 13, 1989

Section 47. - Certain Disposition, Etc., of Section 38 Property, 26 CFR 1.47-3: Exceptions to the application of section 1.47-1.

(Also Sections 38, 355, 368.)

  Recapture; investment credit, divisive reorganizations. When, pursuant to a single integrated transaction, a corporation transfers section 38 recovery property to a newly formed subsidiary in year one and distributes its stock in the subsidiary to its shareholders in year two, the disposition of the section 38 recovery property triggering investment credit recapture under section 47(a) of the Code occurs in year one.

  Under an integrated plan of reorganization, a corporation transferred, on December 31, 1988, assets to a newly formed subsidiary in exchange for the new subsidiary's stock. The assets transferred included section 38 property, with respect to which the parent had been allowed an investment credit in an earlier year. On February 1, 1989, the parent distributed the subsidiary's stock to its shareholders. The transfer of assets, followed by the stock distribution, constituted a tax-free divisive reorganization under sections 368(a)(1)(D) and 355(a)(1).

  ISSUE. At issue is when the disposition of the section 38 property occurred for purposes of the section 47(a) investment credit recapture provision: in 1988 or 1989?

  HOLDING. The Service has held that, for investment credit recapture purposes, the disposition occurred in 1988.

  ANALYSIS. The Service noted that in two prior rulings, Rev. Ruls. 74-101, 1974-1 C.B. 7, and 82-20, 1982-1 C.B. 6, divisive section 368(a)(1)(D) reorganizations had been found to trigger investment credit recapture. The Service, in the situations in the two prior rulings, concluded that the 'mere- change-in-form' exception found in section 47(b) did not apply. However, neither ruling addressed whether the triggering event was the transfer of section 38 property or the subsequent stock distribution. Noting in the instant situation that the parent retained no substantial interest in the transferred property after the reorganization has been completed, the Service concluded that the mere-change-in-form exception was inapplicable. 'Therefore,' the Service said, 'the general recapture rules of section 47(a) of the Code are triggered by the transfer of the section 38 property to [the subsidiary]

and [the parent] is subject to recapture in the year the property is so transferred.'

  For further information concerning Rev. Rul. 89-18, contact Paul F. Handleman of the Office of the Assistant Chief Counsel (Passthroughs and Special Industries) at (202) 566-4121.

ISSUE

  If, pursuant to a reorganization described under sections 368(a)(1)(D) and 355(a)(1) of the Internal Revenue Code, section 38 recovery property of a corporation is transferred to a newly formed subsidiary in year one and the subsidiary's stock is distributed to the corporation's shareholders in year two, then, for purposes of section 47(a), does the resulting disposition of the section 38 recovery property occur in year one or in year two?

FACTS

  X, a domestic corporation, has several divisions that conduct separate businesses. X files its federal income tax return on the basis of a calendar year.

  On May 1, 1988, X announced a plan to transfer the assets of division a and certain of X's liabilities to Y, a newly formed corporation, in exchange for the stock of Y, and then to transfer to the X shareholders the stock received from Y.

  The transfer to Y of division a's assets and of X's liabilities took place on December 31, 1988. The assets that were transferred included section 38 recovery property with respect to which X had been allowed an investment credit in an earlier year. X distributed Y's stock to X's shareholders on February 1, 1989. Both the transfer of the assets to Y and the distribution of Y's stock to the X shareholders were part of a single integrated plan, all aspects of which were known when the transaction began.

  X's transfer of the assets to Y solely for Y stock followed by the subsequent distribution of Y's stock to X's shareholders constituted a divisive reorganization within the meaning of section 368(a)(1)(D) of the Code. It met the requirements for nonrecognition of gain or loss to X's shareholders pursuant to section 355(a). As a result of the integrated transaction, the section 38 recovery property that had been transferred from X to Y ceased to be section 38 property with respect to X.

  The specific issue is whether that section 38 recovery property was disposed of, for purposes of section 47(a) of the Code, when the assets were transferred to Y (in X's 1988 taxable year) or when X distributed the Y stock to the X shareholders (in X's 1989 taxable year).

LAW AND ANALYSIS

  Section 47(a)(1) of the Code provides that, if during any taxable year any property is disposed of or otherwise ceases to be section 38 property with respect to the taxpayer before the close of the useful life that was taken into account in computing the credit under section 38, the tax for such taxable year shall be increased. Section 47(a)(5) provides a similar rule with respect to section 38 recovery property.

  Section 47(b) of the Code provides that property shall not be treated as ceasing to be section 38 property with respect to the taxpayer if the transaction involves a mere change in form of conducting the trade or business so long as the property transferred is retained in the trade or business as section 38 property and the taxpayer retains a substantial interest in the trade or business.

  Section 1.47-3(f)(1)(i) of the Income Tax Regulations provides that the mere- change-in-form exception to the recapture of the investment credit will not apply unless certain conditions specified in section 1.47-3(f)(1)(ii) are met, including the condition that the transferor of the section 38 property retains a 'substantial interest' in the trade or business.

  Section 1.47-3(f)(5)(ii) of the regulations provides rules concerning investment credit recapture for situations in which an initial transfer of section 38 property is subject to the mere-change-in-form exception but the transferor subsequently fails to retain a substantial interest in the trade or business.

  Rev. Rul. 74-101, 1974-1 C.B. 7, concerns a corporation engaged in the same business in three states that transferred its business activities in two of the states and all related assets, including section 38 property, to two newly formed corporations solely in exchange for all their stock and immediately thereafter transferred the stock to its sole shareholder in a section 368(a)(1)(D) divisive reorganization. The ruling holds that investment credit recapture under section 47(a)(1) of the Code is required. The mere- change-in-form exception does not apply, because after the reorganization the corporation was not the owner of a substantial interest in the transferred businesses.

  Rev. Rul. 82-20, 1982-1 C.B. 6, concerns a transfer of section 38 property between members of an affiliated group in a consolidated return year. The transfer was part of a plan to transfer the section 38 property outside the affiliated group in a transaction qualifying as a reorganization under section 368(a)(1)(D). Holding that the transfer constitutes a disposition of section 38 property under section 47(a)(1) of the Code, that ruling concludes that the exception to recapture of investment credit contained in section 1.1502- 3(f)(2)(i) of the regulations for transfers of section 38 property between members of the affiliated group does not apply to the transaction. The exception is inapplicable because the transfer of the section 38 property was a step in the planned transfer of the property outside the affiliated group.

  Both Rev. Rul. 74-101 and Rev. Rul. 82-20 conclude that recapture is triggered by the disposition of the section 38 property that occurred in the divisive section 368(a)(1)(D) reorganizations. Neither ruling, however, explicitly addresses the issue of whether the event triggering recapture is the transfer of section 38 property or the subsequent distribution of the stock.

  The legislative history to section 47 of the Code contains an example similar to the fact pattern in this ruling. In the example, section 38 property was transferred to a subsidiary as part of a transaction that included a subsequent transfer of the subsidiary's stock. Section 47(a) applied to the transfer of the section 38 property to the subsidiary. The mere-change-in-form exception of section 47(b) was not discussed. See Example 2 in S. Rep. No. 1881, 87th Cong., 2d Sess. 153 (1962), 1962-3 C.B. 707, 857.

  The transfer of section 38 property from a corporation to a newly formed subsidiary triggers investment credit recapture unless the mere-change-in-form exception is applicable. In the present situation, the transfer of the section 38 property by X to Y and the subsequent distribution by X of Y's stock to the X shareholders were parts of a single integrated transaction, a divisive reorganization. Because X retains no substantial interest in division a upon completion of the reorganization, the mere-change-in-form exception does not apply to this transaction. Therefore, the general recapture rules of section 47(a) of the Code are triggered by the transfer of the section 38 recovery property to Y, and X is subject to recapture in the year the property is so transferred. The rules of section 1.47-3(f)(5)(ii) of the regulations do not apply here, because the mere-change-in-form exception was not applicable to the transfer of the section 38 recovery property from X to Y.

HOLDING

  When, pursuant to a single integrated transaction, a corporation transfers section 38 recovery property to a newly formed subsidiary in year one and distributes its stock in the subsidiary to its shareholders in year two, the disposition under section 47(a) of the Code occurs in year one.

DRAFTING INFORMATION

  The principal author of this revenue ruling is Paul F. Handleman of the Office of the Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling contact Mr. Handleman on (202) 566-4121 (not a toll-free call).

Rev. Rul. 89-18, 1989-1 C.B. 14, 1989-7 I.R.B. 4.