Citations: Rev. Rul. 74-605; 1974-2 C.B. 97

Rev. Rul. 74-605

Advice has been requested regarding the application of section 304 of the Internal Revenue Code of 1954 in the transaction described below.

X corporation owns 100 percent of the stock of corporation Y and Y owns 100 percent of the stock of corporation Z. Y purchased all of the stock of S, a wholly owned subsidiary of Z, for cash. The purchase price of the S stock was its fair market value. All of the corporations are domestic corporations.

Section 304(a)(1) of the Code provides, in part, that for purposes of section 302, if one or more persons are in control of each of two corporations and, in return for property, one of the corporations acquires stock in the other corporation from the person so in control, then such property will be treated as a distribution in redemption of the stock of the corporation acquiring such stock. In any such case, the stock so acquired will be treated as having been transferred by the person from whom acquired, and having been received by the corporation acquiring it, as a contribution to the capital of such corporation.

Section 304(c)(1) of the Code provides that for purposes of section 304, "control" means the ownership of stock possessing at least 50 percent of the total combined voting power of all classes of stock entitled to vote, or at least 50 percent of the total value of shares of all classes of stock.

Section 304(c)(2) of the Code makes section 318(a) (relating to the constructive ownership of stock) applicable to section 304, with certain modifications not here relevant, for the purposes of determining control under section 304(c)(1).

Section 318(a)(2)(C) of the Code provides, with percentage ownership requirements not here relevant, that if stock in a corporation is owned, directly or indirectly, by or for any person, such person will be considered as owning the stock owned, directly or indirectly, by or for such corporation.

Section 318(a)(3)(C) of the Code provides, with a percentage ownership requirement not here relevant, that if stock in a corporation is owned, directly or indirectly, by or for any person, such corporation will be considered as owning the stock owned, directly or indirectly, by or for such person.

Section 318(a)(5)(A) of the Code provides, in part, with exceptions not here relevant, that stock constructively owned by a person by reason of the application of paragraph (1), (2), (3), or (4) of section 318(a) will, for purposes of applying paragraphs (1), (2), (3), and (4) of section 318(a), be considered as actually owned by such person.

Section 1.318-1(b)(1) of the Income Tax Regulations provides that in applying section 318(a) of the Code to determine the stock ownership of any person for any one purpose, a corporation will not be considered to own its own stock by reason of section 318(a)(3)(C).

Under section 318(a)(2)(C) of the Code, X is considered as owning the stock of Z through its ownership of the Y stock. Since X is considered as owning the Z stock, Z would be considered as owning, under section 318(a)(3)(C), the stock which X owns, so that Z would be considered as owning the stock of its parent corporation, Y. This application of the constructive ownership rules of section 318 would result in the purchase by Y of the S stock from Z being within the terms of section 304(a)(1), since Z would be in control of Y within the meaning of section 304(c)(1). However, if under section 318(a)(3)(C) Z were considered as owning the Y stock, it would, through such ownership, own the stock owned by Y which would include its own stock. This result follows from the application of section 318(a)(3)(C), because under section 318(a)(5)(A) the stock of Y constructively owned by Z under section 318(a)(3)(C) is to be considered as actually owned by Z, so that under section 318(a)(2)(C), Z is considered as owning the stock which Y owns, that is, its own stock.

Section 1.318-1(b)(1) of the regulations (which provides that a corporation is not to be considered as owning its own stock by reason of section 318(a)(3)(C) of the Code) is applicable to the constructive ownership of the Y stock by Z under section 318(a)(3)(C), since, by reason of that application of section 318(a)(3)(C), sections 318(a)(5)(A) and 318(a)(2)(C) would apply to make Z the owner of its own stock. As a result, Z cannot be considered as owning the stock of Y under section 318(a)(3)(C). However, Z would be considered as owning, under section 318(a)(3)(C), the stock of other corporations owned by X. See Rev. Rul. 70-496, 1970-2 C.B. 74, wherein the constructive ownership of one subsidiary corporation by another subsidiary corporation through a common parent corporation under section 318(a)(3)(C) is unaffected by the fact that section 1.318-1(b)(1) applies to prevent either subsidiary from constructively owning its own stock.

Accordingly, section 304(a)(1) of the Code is not applicable to the purchase by Y of the S stock from Z because Z is not in control of Y within the meaning of section 304(c)(1). Gain or loss is recognized to Z upon the sale of its stock of S to Y under sections 1001 and 1002, measured by the difference between the amount realized therefrom and the adjusted basis of the S stock in the hands of Z.

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