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with modifications (see also the proposal to eliminate the dividendwithin-gain limitation, discussed in Part V.B.1., below).

Opponents of repealing the earnings-and-profits limitation question whether it would be appropriate to tax all distributions as ordinary income and whether existing complexity would be reduced, since a similar concept would still be required for purposes of other statutory provisions. For example, the concept is used in determining the allowability of indirect foreign tax credits associated with dividends received from affiliated foreign corporations (sec. 902). Nevertheless, some commentators have suggested that it might be possible to formulate a less complicated standard of measure for other purposes if the dividend-definition aspect were eliminated. 118 As an alternative to repeal of the earnings and profits limitation, consideration could be given to amending the definition of earnings and profits to more clearly reflect economic income or income available for distribution-including, for example, a modification in the treatment of depreciation for earnings and profits purposes.

2. Bail-Outs Through Use of Related Corporations

Present Law and Background

Section 304 is designed to prevent shareholders from bailing out corporate earnings at capital gain rates through the device of selling stock in one corporation to a related corporation. In general, the sale of stock by a shareholder to a related corporation is treated as a redemption, with the result that the sale proceeds are taxed to the shareholder as a dividend unless the transaction qualifies under the rules for distinguishing a redemption from an ordinary distribution. The application of section 304 to corporate shareholders can produces incongruous results by characterizing amounts as dividends that are eligible for the dividends received deduction which generally benefits corporate taxpayers. Furthermore, Congress has found it necessary to address a host of technical problems that would not have arisen if the scope of section 304 were limited to individual shareholders. Finally, the application of section 304 has unintended effects that are unrelated to the purpose of the provision.

In the case of "brother-sister" transactions, if one or more persons in control of one corporation transfer stock in that corporation to another controlled corporation, the transaction is treated as a redemption of the shareholders' stock in the acquiring corporation (sec. 304(a)(1)). In the case of "parent-subsidiary" transactions, the transaction is recast as a redemption of the stock of the parent corporation (sec. 304(a)(2)). In determining the tax consequences of the deemed redemptions, dividend treatment generally results unless the transaction results in the termination of or a substantial reduction in the selling shareholder's interest (sec. 302). Even if the selling shareholder is treated as having sold the stock, the acquiring corporation is deemed to have received the stock as a contribution to capital (with the result that the corporation's basis in the stock

118 Hearing before the Senate Committee on Finance, 98th Cong. (1983) (Statement of William D. Andrews).

is determined by reference to the basis in the hands of the shareholder, not the corporation's purchase price).

The predecessor of section 304 (sec. 115(g) of the 1939 Code) was enacted in response to judicial decisions that permitted noncorporate taxpayers to avoid the ordinary income tax rates applicable to dividends by selling the stock of a controlled corporation to the corporation's subsidiary.119 The House version of the original legislation limited the provision to cases in which "individuals" sold stock to related corporations. The Senate bill extended the provision to stock sales by corporations. The committee report that accompanied the Senate bill does not offer an explanation for this change. The legislative history of the 1954 Code, which expanded the scope of the provision to include the sale of stock in one corporation to a commonly controlled corporation, indicates that the provision is intended to prevent tax avoidance. 120 In the case of individuals, section 304 discourages the prohibited transactions by treating what would be capital gain as dividend income. For corporations, however, dividends eligible for the dividends received deduction may be taxed significantly more lightly then capital gains. Thus, it is unclear what purpose is served by applying section 304 to corporate shareholders.

The application of section 304 to C corporations has engendered a number of technical corrections and other amendments that add to the complexity of the Code. For example, the Deficit Reduction Act of 1984 contained amendments that are designed to prevent the use of section 304 by corporations (1) to shift earnings and profits among members of controlled groups of corporations, and thereby create an opportunity to make nondividend distributions to noncorporate shareholders, and (2) to circumvent other statutory provisions that recharacterize gain on sale of stock in certain controlled foreign corporations as dividends that are ineligible for the dividends-received deduction.121

Possible Proposal

Consideration could be given to making section 304 inapplicable to the transfer of stock by corporate shareholders. In addition, where a selling shareholder is treated as having sold stock, the acquiring corporation could be treated as having purchased the stock. The latter proposal was included in the 1959 report submitted by the Advisory Group on Subchapter C to the House Committee on Ways and Means. 122

119 See H.R. Rep. No. 2319, 81st Cong., 2d Sess. 53 (1950); S. Rep. No. 2375, 81st Cong., 2d Sess. 43 (1950). See also Commissioner v. Wanamaker, 11 T.C. 365 (1948), aff'd per curiam, 178 F.2d 10 (3rd Cir. 1949) (which involved a stock sale by trustees of a testamentary trust and is cited in the 1950 committee reports).

120 See H.R. Rep. No. 1337, 83d Cong., 2d Sess. 37 (1954); S. Rep. No. 1622, 83d Cong., 2d Sess. 45 (1954). See also Commissioner v. Pope, 239 F.2d 881 (1st Cir. 1957) (which involved a stock sale by an individual, between commonly controlled corporations).

121 See H.R. Rep. No. 861, 98th Cong., 2d Sess. 1222-1224 (1984) (Conference Report).

122 See Hearings before the House Committee on Ways and Means, 86th Cong. (1959), Revised Report on Corporate Distributions and Adjustments, prepared by the Advisory Group on Subchapter C.

B. Tax-Free Corporate Organizations and Reorganizations The corporate organization and reorganization provisions provide tax-free treatment to specifically described transactions that effect a readjustment of continuing interests in property in modified corporate form. For purposes of these nonrecognition provisions, qualified consideration is defined as stock or securities; anything else is "boot" that generally triggers taxable gain (but not deductible loss). 1. Dividend-Within-Gain Limitation on Boot Dividends Present Law and Background

Generally, no gain or loss is recognized by shareholders or security holders who exchange stock or securities solely for stock or securities in a corporation that is a party to the reorganization (sec. 354(a)(1)). If the exchange also involves the receipt of nonqualifying consideration, gain is recognized up to the amount of the boot. Further, part or all of that gain may be taxed as a dividend if the exchange has the effect of a dividend (sec. 356(a)(2)). In determining whether an exchange has the effect of a dividend, the principles that apply for purposes of distinguishing redemptions from ordinary distributions are applied. 123 Thus, an inquiry is made as to whether the exchange effected a meaningful reduction in the shareholder's interest. 124

Unlike the rules that apply to ordinary dividends, under the boot dividend rules, a shareholder's dividend income is limited to his ratable share of accumulated earnings and profits; current earnings and profits are not taken into account. If the amount of gain exceeds the allocable portion of earnings and profits, the excess is generally treated as capital gain.

Because the taxation of boot as a dividend is limited to an exchanging shareholder's gain, a shareholder may be able to withdraw corporate earnings at capital gain rates if the distribution occurs as part of a reorganization, even though the amount would be fully taxable as a dividend if distributed apart from a reorganization. This result is inconsistent with the theory that tax-free treatment is appropriate because the transaction is a continuation by the shareholder of his interest in the same corporate enterprise.

Possible Proposal

Consideration could be given to repealing the rule that treats boot as a dividend only to the extent of gain. The Advisory Group on Subchapter C included this proposal in its 1958 report to the House Committee on Ways and Means. 125 Further, the rule that

123 See Rev. Rul. 84-114, 1984-2 C.B. 90.

124 There is conflicting authority regarding whether dividend equivalency should be tested by looking at a hypothetical redemption of the exchanging shareholder's interest in the acquired corporation or the acquiring corporation. Compare Shimberg v. United States, 577 F.2d 283 (5th Cir. 1978) and Rev. Rul. 75-83, 1975-1 C.B. 112 with Wright v. United States, 482 F.2d 600 (8th Cir. 1973). For a discussion of whether both approaches have application in particular circumstances, see Kyser, The Long and Winding Road: Characterization of Boot under Section 356(a)(2), 39 Tax L. Rev. 297 (1984).

125 Hearing before the House Committee on Ways and Means, 86th Cong. (1959) Revised Report on Corporate Distributions and Adjustments, prepared by the Advisory Group on Subchapter C.

limits the amount of a boot dividend to the ratable share of accumulated earnings and profits could be repealed. 126 These proposals would have the effect of coordinating the rules for distributions occurring as part of a reorganization with those applicable to ordinary distributions.

2. Treatment of Securities as Boot

Present Law and Background

A shareholder or security holder is treated as receiving boot if the principal amount of securities received in a reorganization exceeds the principal amount of securities surrendered, or if securities are received and no securities are surrendered (sec. 354(a)(2)). In such a case, the amount of boot is the fair market value of the excess principal amount, or the fair market value of the principal amount if no securities are surrendered (sec. 356(d)).

Because the applicable statutory provision focuses on "principal amounts," but does not take the time value of money into account, the measurement of boot is distorted. For example, no amount is treated as boot as long as there is no differential between the principal amount of the security received and that of the security surrendered, even if the value of the new security exceeds the adjusted basis of the old security.

Possible Proposal

The amount of nonqualifying consideration received by an exchanging security holder could be measured by the difference between the adjusted issue price of securities surrendered and the issue price of securities received. The term "issue price" would be defined as in sections 1273 and 1274 (relating to the calculation of original issue discount). "Adjusted issue price" would be defined as in section 1275(a)(4)(B)(ii)(I).

Conforming amendments would be made to section 355, relating to the distribution of stock or securities of controlled corporations.

3. Treatment of Acquired Corporation's Debts

Present Law and Background

In general, no gain or loss is recognized by a corporation that exchanges property, pursuant to a plan of reorganization, solely for stock or securities of the acquiring corporation (sec. 361(a)). In addition, the transferor corporation recognizes no gain or loss on account of the receipt of boot, provided the corporation distributes the boot in pursuance of the plan of reorganization (sec. 361(b)). If a reorganization takes the form of one corporation transferring its assets to another corporation, the transferor corporation generally is required to completely liquidate. Because the transferor corporation goes out of existence, the parties to the reorganization must provide a mechanism for settling the corporation's debts. The tax consequences to the transferor corporation turn on the form, not

126 This modification would also be appropriate as a conforming amendment should the proposal to eliminate the earnings-and-profits concept be adopted.

the substance, of the transaction by which the corporation is relieved of its liabilities.

Under present law, the following procedures may be followed without the transferor corporation being treated as receiving boot, or otherwise recognizing gain:

(1) The acquiring corporation may assume the transferor corporation's liabilities, unless a principal purpose of the assumption or acquisition is tax avoidance (sec. 357). In such a case, the transferor corporation would receive qualified consideration with a value equal to that of the transferred assets, net of the liabilities assumed;

(2) the shareholders of the transferor corporation may assume its liabilities (in which case, the corporation would be viewed as having received a tax-free contribution to capital); or

(3) the transferor corporation may retain enough cash (or other liquid assets) to satisfy its liabilities.

In any case, the parties to the reorganization would end up in the same posture: the transferor corporation would be relieved of its liabilities, and the consideration ultimately received by its shareholders would be reduced by the amount of such liabilities. On the other hand, as described below, the use of other procedures that have the same economic effect may result in the recognition of income by the transferor corporation.

If the transferor corporation distributes boot to creditors rather than stockholders, the transfer would not be considered as made in pursuance of the plan of reorganization. 127 Thus, the transferor corporation would be taxed on receipt of the boot. In addition, the Internal Revenue Service views the transfer of qualified consideration to a creditor as a taxable exchange, resulting in the realization of gain or loss by the transferor corporation. 128 These tax consequences occur even though the parties to the reorganization may have been able to achieve the same economic results by utilizing one of the procedures described in the preceding paragraph.

One other possibility for nonrecognition treatment is provided by the statutory provision that governs the treatment of a corporation that liquidates within twelve months of adopting a plan of complete liquidation, described in Part III., above (sec. 337). If section 337 applies, the transferor corporation would recognize no gain or loss on a deemed sale to a creditor within the twelve-month liquidation period. This nonrecognition provision may be unavailable because there is conflicting case law regarding whether the liquidation provisions and the reorganization provisions are mutually exclusive.129 In this connection, many tax practitioners assume that section 336, which is also a liquidation provision, provides nonrecognition treatment to a corporation that distributes qualified consideration pursuant to a plan of reorganization. 130 If so, it would

127 Minnesota Tea Company v. Helvering, 302 U.S. 609 (1938).

128 Rev. Rul. 70-271, 1970-1 C.B. 166 (situation 1).

129 See, FEC Liquidating Corporation v. United States, 548 F.2d 924 (Ct. Cl. 1977) (the application of which would deny nonrecognition treatment under section 337 on a "deemed sale" of stock to a creditor); and, General Housewares Corporation v. United States, 615 F.2d 1056 (5th Cir. 1980) (holding that section 337 applied where the acquired corporation sold part of the stock received as consideration for its assets in a reorganization and used the sale proceeds to pay debts).

130 See, e.g., B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders, 14-103 n. 274 (4th ed. 1979).

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