TAM 9325001: de facto revocation of Rev. Rul. 72-498?

If a shareholder receives boot in a reorganization, the shareholder must recognize gain to the extent of the lesser of (1) the gain realized or (2) the fair market value (FMV) of the cash or property received (Sec. 356). If the receipt of boot "has the effect of the distribution of a dividend," the boot will be treated as a dividend to the extent of accumulated earnings and profits (AE&P); the remainder will be treated as gain from the exchange of property. This is the general rule of boot taxation.

In a consolidated return setting, dividend treatment is advantageous; intercompany dividends are eliminated from consolidated taxable income, while capital gain is either taxed immediately or deferred as intercompany gain. Rev. Rul. 72-498 considered whether the consolidated return regulations take precedence over Sec. 356. At the time the revenue ruling was issued, the Service's position was that when boot was received together with stock in a reorganization, boot was generally characterized as a dividend (the so-called automatic dividend rule). Rev. Rul. 72-498 also preceded the Supreme Court's decision in Clark, 489 US 726 (1989), which held that reorganizations with boot are recast as nonboot (stock only) reorganizations, followed by a hypothetical redemption of sufficient shares to equal the cash portion of the transaction. Application of Sec. 356 to that hypothetical redemption transaction will, in many cases, have the effect of replacing the automatic dividend rule with an automatic capital gain rule. See also Rev. Rul. 93-61 (same result).

In Rev. Rul. 72-498, X, the parent corporation of a consolidated group, owned all of the stock of corporation Y. Y merged into unrelated corporation Z pursuant to Sec. 368(a)(1)(A); X received Z stock with an FMV of $1,000 and $1,000 cash. After the merger, X owned 10% of Z; Z remained an independent corporation, not a member of X's consolidated group. The Service determined that the boot attributable to post-1965 AE&P did not have the effect of a dividend within the meaning of Sec. 356(a)(2), because post-1965 AE&P was reflected in X's basis in Y's stock through the investment adjustments under Regs. Sec. 1.1502-32. Thus, to the extent the boot was attributable to post-1965 AE&P, it was not a dividend that could be eliminated from consolidated taxable income. See also GCM 34652 (prepared in connection with the release of the ruling). Furthermore, the gain was not deferred under the intercompany transaction rules, because Z was not a member of the X consolidated group immediately after the merger.

The relationship between the consolidated return provisions and Sec. 356 was addressed again in Letter Ruling (TAM) 9325001. Both the facts and the applicable law (pre-Clark) were essentially the same as in Rev. Rul. 72-498. The Service's analysis, however, differed. The TAM concluded that the purpose of Rev. Rul. 72-498 was to prevent "dividend stripping" in a consolidated return setting, which it defined as a tax-free Sec. 301 dividend distribution without a corresponding reduction in stock basis. If stock basis were not reduced, a later sale of the stock would "produce uneconomic loss or reduce economic gain." A footnote stated that distributions were considered tax free if they were eliminated from consolidated taxable income. According to the TAM, the potential for such dividend stripping could be eliminated by providing for a reduction in stock basis (as in Reg. Sec. 1.1502-32(k)) or denying dividend treatment (as in Rev. Rul. 72-498). In the TAM, the Service permitted the shareholder's dividend treatment because stock basis was reduced under the consolidated return regulations. (The transaction took place before Clark was decided, and payment of the boot dividend was therefore deemed to have occurred before the acquisition, while the two corporations were still affiliated.) Thus, the potential for abuse was curbed but the methodology (basis reduction) was different from that employed in Rev. Rul. 72-498 (denial of dividend treatment).

In a post-Clark consolidated return setting in which a target corporation leaves the group, Rev. Rul. 72-498 will be of little significance, because the straightforward application of Sec. 356 will almost always cause boot distributions to result in capital gain. In a post-Clark consolidated return setting in which the target corporation remains in the group, application of Sec. 356 will generally cause the boot to be treated as a dividend. Nevertheless, because basis will have been reduced under the consolidated return regulations, denial of dividend treatment under Rev. Rul. 72-498 will not be necessary. Thus, the much-maligned, but for precedential purposes sparsely cited, revenue ruling appears to be defunct.