Guidance Regarding the Active Trade or Business Requirement Under Section 355(b), 26012-26037 [07-2269]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 72, Number 88 (Tuesday, May 8, 2007)]
[Proposed Rules]
[Pages 26012-26037]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 07-2269]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-123365-03]
RIN 1545-BC94


Guidance Regarding the Active Trade or Business Requirement Under 
Section 355(b)

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations that provide 
guidance regarding the active trade or business requirement under 
section 355(b) of the Internal Revenue Code. These proposed regulations 
provide guidance on issues involving the active trade or business 
requirement under section 355(b), including guidance resulting from the 
enactment of section 355(b)(3). These proposed regulations will affect 
corporations and their shareholders.

DATES: Written or electronic comments and requests for a public hearing 
must be received by August 6, 2007.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-123365-03), room 
5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
123365-03), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically via the Federal 
eRulemaking Portal at www.regulations.gov (IRS REG-123365-03).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Russell P. Subin, (202) 622-7790; concerning submissions and the 
hearing, Kelly Banks, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background and Explanation of Provisions

A. Background and Overview of the Key Aspects of the Proposed 
Regulations

1. Background
    Section 355(a) of the Internal Revenue Code (Code) provides that, 
under certain circumstances, a corporation may distribute stock and 
securities of a corporation it controls to its shareholders and 
security holders without causing either the corporation or its 
shareholders and security holders to recognize income, gain or loss. 
Sections 355(a)(1)(C) and 355(b)(1) generally require that the 
distributing corporation (distributing) and controlled corporation 
(controlled) each be engaged, immediately after the distribution, in 
the active conduct of a trade or business. Section 355(b)(2)(A) 
provides that a corporation shall be treated as engaged in the active 
conduct of a trade or business if and only if it is engaged in the 
active conduct of a trade or business, or substantially all of its 
assets consist of stock and securities of a corporation controlled by 
it (immediately after the distribution) which is so engaged. For this 
purpose, control is defined under section 368(c). All references to 
control in this preamble are references to control as defined in 
section 368(c).
    Section 202 of the Tax Increase Prevention and Reconciliation Act 
of 2005, Public Law 109-222 (120 Stat. 345, 348) (TIPRA) amended 
section 355(b) by adding section 355(b)(3). Section 355(b)(3)(A), as 
amended by Division A, Section 410 of the Tax Relief and Health Care 
Act of 2006, Public Law 109-432 (120 Stat. 2922, 2963), provides that 
in the case of any distribution made after May 17, 2006, a corporation 
shall be treated as meeting the requirement of section 355(b)(2)(A) if 
and only if such corporation is engaged in the active conduct of a 
trade or business. Section 355(b)(3)(B) provides that for purposes of 
section 355(b)(3)(A) (and, consequently, section 355(b)(2)(A)), all 
members of such corporation's separate affiliated group (SAG) shall be 
treated as one corporation (SAG rule). For purposes of the preceding 
sentence, a corporation's SAG is the affiliated group which would be 
determined under section 1504(a) if such corporation were the common 
parent and section 1504(b) did not apply.
    Thus, the separate affiliated group of distributing (DSAG) is the 
affiliated group that consists of distributing as the common parent and 
all corporations affiliated with distributing through stock ownership 
described in section 1504(a)(1)(B) (regardless of whether the 
corporations are includible corporations under section 1504(b)). The 
separate affiliated group of controlled (CSAG) is determined in a 
similar manner (with controlled as the common parent). Accordingly, 
unlike prior law, a corporation is not treated as engaged in the active 
conduct of a trade or business solely as a result of substantially all 
of its assets consisting of stock, or stock and securities, of one or 
more

[[Page 26013]]

corporations that are merely controlled by it (immediately after the 
distribution) each of which is engaged in the active conduct of a trade 
or business.
    Section 355(b)(2)(B) requires that the trade or business have been 
actively conducted throughout the five-year period ending on the date 
of the distribution (pre-distribution period). Section 355(b)(2)(C) 
provides that the trade or business must not have been acquired in a 
transaction in which gain or loss was recognized, in whole or in part, 
within the pre-distribution period. Section 355(b)(2)(D), as amended in 
1987 and 1988, provides that control of a corporation which (at the 
time of acquisition of control) was conducting the trade or business 
must not have been directly or indirectly acquired by any distributee 
corporation or by distributing during the pre-distribution period in a 
transaction in which gain or loss was recognized, in whole or in part. 
See Public Law 100-203 (101 Stat. 1330, 1330-411 (1987)) and Public Law 
100-647 (102 Stat. 3342, 3605 (1988)). For purposes of section 
355(b)(2)(D), all distributee corporations which are members of the 
same affiliated group (as defined in section 1504(a) without regard to 
section 1504(b)) shall be treated as one distributee corporation. The 
requirements under section 355(b) are collectively referred to in this 
preamble as either the active trade or business requirement or the 
requirements of section 355(b).
    Accordingly, the requirements of section 355(b) are generally 
satisfied if distributing and controlled each have engaged in the 
active conduct of a trade or business throughout the pre-distribution 
period, are so engaged immediately after the distribution, and there 
have been no acquisitions of control of distributing or controlled 
during such period.
    The active trade or business requirement is one of several 
requirements that must be satisfied in order for a distribution to 
qualify under section 355. For example, section 355(a)(1)(B) states 
that a transaction must not be used principally as a device for 
distributing the earnings and profits of distributing, controlled, or 
both. In addition, Sec.  1.355-2(b)(1) provides that section 355 will 
apply to a transaction only if it is carried out for one or more 
corporate business purposes.
    The active trade or business requirement, in tandem with the device 
prohibition and business purpose requirement, limits a corporation's 
ability to convert dividend income into capital gain through the use of 
a section 355 distribution. See S. Rep. No. 83-1622, at 50-51 (1954) 
and Coady v. Commissioner, 33 TC 771, 777 (1960), acq., 1965-2 CB 4, 
aff'd, 289 F.2d 490 (6th Cir. 1961). In Coady, the Tax Court stated 
that one purpose of section 355(b) is ``to prevent the tax-free 
separation of active and inactive assets into active and inactive 
corporate entities.'' The court also stated that a tax-free separation 
under section 355 ``will involve the separation only of those assets 
attributable to the carrying on of an active trade or business * * *.'' 
Coady, 33 TC at 777.
    The IRS and Treasury Department are aware of a number of issues 
that have arisen regarding the active trade or business requirement, 
including issues arising as a result of the enactment of section 
355(b)(3). The following sections describe the active trade or business 
requirement and the significant issues that are addressed in these 
proposed regulations. No inference should be drawn from these proposed 
regulations regarding the definition of trade or business or active 
trade or business under any other provision of the Code or Treasury 
regulations, even if such provision specifically references section 
355. Comments are requested as to whether or the extent to which these 
proposed regulations should apply to other provisions that specifically 
reference section 355.
2. Overview of the Key Aspects of the Proposed Regulations
    Principally, these proposed regulations provide guidance regarding 
the application of section 355(b)(3), the application of the 
acquisition rules in section 355(b)(2)(C) and (D) and the impact 
thereon of section 355(b)(3), and the determination of whether a 
corporation is engaged in a trade or business through the attribution 
of trade or business assets and activities from a partnership.
    As discussed in section A.1. of this preamble, section 355(b)(3) 
treats all SAG members as one corporation. Accordingly, as discussed in 
detail in section B. of this preamble, these proposed regulations 
provide that subsidiary SAG members (SAG members that are not the 
common parent of such SAG) are treated like divisions of distributing 
or controlled, as the case may be. These proposed regulations also 
clarify that controlled may be a DSAG member during the pre-
distribution period. Most significantly, these provisions treat a stock 
acquisition that results in a corporation becoming a subsidiary SAG 
member as an asset acquisition. As a result, the applicability of 
section 355(b)(2)(D) is substantially reduced. Further, as discussed in 
section E. of this preamble, this treatment alters the analysis 
regarding whether an existing business may be expanded as a result of a 
stock acquisition.
    Notwithstanding that these proposed regulations provide that 
certain stock acquisitions may be treated as asset acquisitions under 
section 355(b)(3), purchases of stock of controlled during the pre-
distribution period may be subject to section 355(a)(3)(B). See section 
F. of this preamble.
    As discussed in detail in section C. and section D. of this 
preamble, these proposed regulations interpret section 355(b)(2)(C) and 
(D) to mean that a corporation generally cannot use its assets to 
acquire a trade or business to be relied on to facilitate a 
distribution under section 355. Accordingly, these proposed regulations 
generally prohibit acquisitions made in exchange for distributing's 
assets even if no gain or loss is recognized in connection with the 
acquisition. Further, these proposed regulations provide certain 
exceptions to the literal application of section 355(b)(2)(C) and (D) 
for acquisitions in which gain or loss is recognized where the purposes 
of that section are not violated. However, these proposed regulations 
do not disregard the recognition of gain or loss in transactions 
between affiliates unless the affiliates are members of the same SAG. 
See section G. of this preamble.
    Section I. of this preamble explains how these proposed regulations 
clarify a corporation's ability to be attributed the trade or business 
assets and activities of a partnership. Most significantly, these 
partnership provisions yield results similar to the rules regarding the 
satisfaction of the continuity of business enterprise requirement, and 
thus allow a partner to be attributed the partnership's trade or 
business assets and activities where the partner owns a significant 
interest in the partnership.

B. TIPRA

    Congress enacted section 355(b)(3) because it was concerned that, 
prior to a distribution under section 355, corporate groups conducting 
business in separate corporate entities often had to undergo elaborate 
restructurings to place active businesses in the proper entities to 
satisfy the active trade or business requirement. See, for example, 
H.R. Rep. No. 109-304, at 53, 54 (2005). By treating a SAG as one 
corporation, Congress believed that it would greatly reduce the need 
for such restructurings. However, the introduction of the affiliation-
based SAG rule into the active trade or business requirement

[[Page 26014]]

significantly impacts the application of section 355(b)(2) in certain 
situations.
    Accordingly, consistent with congressional intent, these proposed 
regulations provide several rules interpreting section 355(b)(3) in a 
manner that diminishes the need for pre-distribution restructurings 
while fully integrating the various provisions in section 355(b). These 
rules are intended to more closely reflect the way corporate groups 
structure their businesses while, at the same time, ensuring that the 
purposes underlying section 355(b)(2)(C) and (D) are not circumvented.
    Specifically, to accomplish these objectives the IRS and Treasury 
Department believe that it is appropriate to apply the SAG rule by 
disregarding the separate existence of all subsidiary SAG members for 
purposes of determining whether distributing and controlled satisfy the 
requirements of section 355(b).
1. SAG Rule Applicable During the Pre-Distribution Period
    The IRS and Treasury Department believe that it is appropriate to 
apply the SAG rule for purposes of determining whether the trade or 
business was actively conducted throughout the pre-distribution period 
and whether the requirements of section 355(b)(2)(C) or (D) have been 
violated.
    The SAG rule applies for purposes of determining whether 
distributing and controlled are engaged in the active conduct of a 
trade or business immediately after the distribution. Specifically, the 
legislative history to section 355(b)(3) describes the corporations 
included in the DSAG and CSAG by reference to post-distribution 
affiliation. See H.R. Rep. No. 109-455, at 88 (2006) (Conf. Rep.); H.R. 
Rep. No. 109-304, at 54 (2005). However, there is nothing in the 
statute or legislative history that precludes the SAG rule from 
applying throughout the pre-distribution period.
    The IRS and Treasury Department believe that applying the SAG rule 
throughout the pre-distribution period is consistent with the single-
entity approach. If the SAG rule is not applied during the pre-
distribution period, there may be unintended consequences. For example, 
assume that an active trade or business is segmented among the SAG 
members in a manner that precludes any one member from individually 
being treated as engaged in an active trade or business. Under the SAG 
rule the segments are aggregated and may be treated as a single active 
trade or business immediately after the distribution. However, if the 
SAG rule is not applied throughout the pre-distribution period, there 
would be no five-year active trade or business because no one member 
would be engaged in that trade or business. The IRS and Treasury 
Department do not believe there is any policy reason to apply the SAG 
rule in such a disparate manner. Accordingly, these proposed 
regulations apply the SAG rule throughout the pre-distribution period. 
This approach is consistent with Congressional intent to view SAGs as 
an aggregate for purposes of the active trade or business requirement.
    Because the SAG rule treats all SAG members as one corporation, the 
separate existence of subsidiary SAG members are disregarded and all 
assets (and activities) owned (and performed) by SAG members are 
treated as owned (and performed) by distributing or controlled, as the 
case may be, for purposes of determining whether distributing or 
controlled is engaged in a five-year active trade or businesses. 
Therefore, where one DSAG or CSAG member satisfies the active trade or 
business requirement, distributing or controlled, as the case may be, 
satisfies the active trade or business requirement.
    Consistent with the foregoing, these proposed regulations provide 
that the SAG rule also applies for purposes of determining whether 
there has been an impermissible acquisition, as discussed in section C. 
of this preamble, of a trade or business during the pre-distribution 
period under section 355(b)(2)(C) or (D). Because the SAG rule 
disregards the separate existence of subsidiary SAG members, these 
proposed regulations generally treat stock acquisitions that result in 
a corporation becoming a subsidiary SAG member as a direct acquisition 
of any assets (or activities) owned (or performed) by the acquired 
corporation. Further, these proposed regulations generally disregard 
transfers of assets (or activities) that are owned (or performed) by 
the SAG immediately before and immediately after the transfer. Such 
transfers cannot result in an acquisition. Under the SAG rule, such 
transfers have the effect of a transfer between divisions of a single 
corporation.
2. The DSAG May Include CSAG Members Throughout the Pre-Distribution 
Period
    The IRS and Treasury Department believe that it is appropriate to 
include the CSAG members in the DSAG during the pre-distribution period 
if the applicable affiliation requirements are satisfied. The IRS and 
Treasury Department believe this approach is consistent with the 
purposes of section 355(b)(3) and the SAG rule's general single-entity 
approach, and provides flexibility for the division of SAG members 
between distributing and controlled.
    For example, assume that during the pre-distribution period, 
segments or portions of the business to be conducted by controlled are 
held by distributing (or other subsidiaries that are not directly or 
indirectly owned by controlled) and that distributing intends to 
transfer those portions of the business to controlled immediately prior 
to the distribution. If the DSAG does not include the CSAG members 
throughout the pre-distribution period, it is possible that neither SAG 
would be engaged in the active conduct of that trade or business 
throughout the pre-distribution period, because neither SAG would have 
all the appropriate segments of that business to satisfy the active 
trade or business requirement. The IRS and Treasury Department believe 
that such a result is inconsistent with the purposes of section 
355(b)(3). Accordingly, by including the CSAG members in the DSAG 
throughout the pre-distribution period if the ownership requirements 
are satisfied, these proposed regulations give appropriate credit to 
five-year active trades or businesses regardless of how the assets and 
activities may be owned (and performed) by the SAG members throughout 
the pre-distribution period.
3. Acquisitions of Stock in Subsidiary SAG Members
    Section 355(b)(3) treats SAG members as one corporation for 
purposes of satisfying the requirements of section 355(b). As a result, 
the SAG rule alters the application of section 355(b)(2)(C) and (D) 
with respect to the acquisition of stock of a corporation that is or 
becomes a subsidiary SAG member. Further, because section 355(b)(3) 
supplanted the holding company rule in section 355(b)(2)(A), section 
355(b)(2)(D) is now only applicable to certain acquisitions of stock of 
distributing and certain acquisitions of stock of controlled.
    The SAG rule alters the application of section 355(b)(2)(C) and (D) 
with respect to the acquisition of stock of a corporation that is or 
becomes a subsidiary SAG member. Section 355(b)(3) treats SAG members 
as one corporation for purposes of satisfying section 355(b). 
Consequently, a transaction that results in a corporation--including 
controlled--becoming a subsidiary SAG member is treated as a direct 
acquisition of all the assets (and activities) owned (and performed) by 
the acquired corporation

[[Page 26015]]

at the time of the acquisition. Thus, such an acquisition is tested 
under section 355(b)(2)(C) rather than section 355(b)(2)(D). 
Nevertheless, as discussed in sections B.4 and C.3.a.ii. of this 
preamble, section 355(b)(2)(D) has continuing limited application.
    In addition, an acquisition that results in a corporation becoming 
a subsidiary SAG member in a transaction in which gain or loss is 
recognized might satisfy the requirements of section 355(b)(2)(C) as an 
expansion of one of the acquiring SAG's existing businesses, as 
discussed in section E. of this preamble. Finally, because the SAG rule 
treats subsidiary SAG members like divisions, the acquisition of 
additional stock of a current subsidiary SAG member has no effect for 
purposes of applying section 355(b)(2)(C).
4. Acquisitions of Control of Controlled Where It Is Not a DSAG Member
    While section 355(b)(2)(D) is not applicable to acquisitions of 
stock of subsidiary SAG members, the requirements of section 
355(b)(2)(D) must be satisfied where the DSAG acquires control of 
controlled where controlled is not and does not become a DSAG member 
prior to the distribution. This rule applies where distributing 
acquires stock constituting control of controlled but not stock meeting 
the requirements of section 1504(a)(2).

C. Acquisitions of a Trade or Business

    Section 355(b)(2)(C) and (D) generally provide that a trade or 
business acquired, directly or indirectly, during the pre-distribution 
period will not satisfy the active trade or business requirement unless 
it was acquired in a transaction in which no gain or loss was 
recognized. The IRS and Treasury Department believe that these 
provisions have been and should continue to be interpreted and applied 
in a manner consistent with the overall purposes of section 355. For 
example, in certain situations, transactions in which gain or loss is 
recognized have been found not to violate the purposes of section 
355(b)(2)(C) and (D). See, for example, C.I.R. v. Gordon, 382 F.2d 499 
(2d Cir.1967), rev'd on other grounds, 391 U.S. 83 (1968) (discussed in 
section C.2. of this preamble). Additionally, while the enactment of 
section 355(b)(3) substantially revised how distributing and controlled 
may satisfy the active trade or business requirement, TIPRA did not 
contain conforming amendments to section 355(b)(2)(C) and (D). As such, 
the IRS and Treasury Department also believe that a purpose-based 
interpretation of section 355(b)(2) is essential to harmonize these 
provisions. Accordingly, these proposed regulations interpret and apply 
section 355(b)(2)(C) and (D), and section 355(b)(3), in a manner 
consistent with their purpose, even if not always consistent with the 
literal language of the statute.
1. Purpose of Section 355(b)(2)(C) and (D)
    Section 355 ``contemplates that a tax-free separation shall involve 
only the separation of assets attributable to the carrying on of an 
active business.'' S. Rep. No. 83-1622, at 50 (1954). The active trade 
or business requirement is intended to ensure that only these types of 
separations qualify under section 355. Further, it operates as an 
additional safeguard to the device prohibition (a prohibition against 
disguised dividends) in section 355(a)(1)(B).
    As discussed in section A. of this preamble, the active trade or 
business requirement is designed to limit the potential for the 
conversion of dividend income into capital gain through a section 355 
distribution. Specifically, section 355(b)(2)(C) and (D) is intended to 
prevent dividend avoidance otherwise available through the purchase of 
a new business in order to facilitate a tax-free distribution under 
section 355. See Gordon, 382 F.2d at 506-507 (stating that ``[t]o 
safeguard against this possibility, subsections (b)(2)(C) and (D) 
prohibit acquisition of a trade or business, or of a corporation, in a 
transaction in which gain or loss was recognized.''). Thus, the statute 
prohibits acquisitions of a trade or business in which gain or loss is 
recognized. Nevertheless, the recognition of gain or loss, in and of 
itself, does not violate the purposes of section 355. Rather, 
recognition of gain or loss is generally indicative of the type of 
consideration used in the transaction. Typically, a transaction in 
which gain or loss is recognized consists of an acquisition in exchange 
for assets. On the other hand, a transaction in which no gain or loss 
is recognized typically consists of an acquisition in exchange for the 
corporation's equity.
    Accordingly, the IRS and Treasury Department believe that the 
common purpose of section 355(b)(2)(C) and (D) is to prevent 
distributing from using assets--instead of its stock or stock of a 
corporation in control of distributing--to acquire a new trade or 
business in anticipation of distributing that trade or business (or 
facilitating the distribution of another trade or business) to its 
shareholders in a tax-free distribution. A distribution of a 
corporation holding assets that would have been used to effect a 
purchase generally would be treated as a dividend and section 355 was 
not intended to allow a tax-free separation of such assets. Acquiring a 
new trade or business using these assets and distributing it (or an 
existing trade or business) would effectively accomplish such a 
separation, and should not qualify under section 355.
    Complementing the principle that the common purpose of section 
355(b)(2)(C) and (D) is to prevent distributing from using it assets--
instead of its stock, or stock of a corporation in control of 
distributing--to acquire a new trade or business is the notion that 
section 355 is intended to apply to separations of active trades or 
businesses with which the participants have a historic relationship. 
Section 355, like the reorganization provisions, involves the 
maintenance by the shareholders of a continuing interest in their 
business or businesses in modified corporate forms. For section 355 to 
apply to a divisive transaction, it is essential that distributing and 
its shareholders have a historic relationship with the active trades or 
businesses in the two resulting corporations. See, for example, Sec.  
1.355-1(b) (``[section 355] applies only to the separation of existing 
businesses that have been in active operation for at least five years * 
* * and which, in general, have been owned, directly or indirectly, for 
at least five years by the distributing corporation''). These 
requirements ensure that the historic owners of the acquired trade or 
business are participants in the divisive transaction and minimize the 
potential for transactions that violate the common purpose of section 
355(b)(2)(C) and (D).
    Where distributing issues its own equity (or uses the equity of a 
corporation in control of distributing) to acquire an active trade or 
business in a transaction in which no gain or loss is recognized, 
distributing is not acquiring the trade or business in exchange for its 
assets and the historic owners of the trade or business will be 
participants in the divisive transaction. In such cases, the common 
purpose of section 355(b)(2)(C) and (D) is carried out.
    Finally, an additional purpose of section 355(b)(2)(D) is to 
prevent a distributee corporation from acquiring control of 
distributing in anticipation of a distribution to which section 355 
would otherwise apply, enabling the disposition of controlled without 
the proper recognition of corporate level gain. See H.R. Rep. No. 100-
391, at 1080, 1082-1083 (1987).

[[Page 26016]]

2. Current Law and the Sec.  1.355-3(b)(4) Regulations
    Under current law, several authorities depart from the literal 
language of section 355(b)(2)(C) and (D) in order to carry out the 
common purpose underlying section 355(b)(2)(C) and (D). For example, in 
Gordon, gain was recognized when distributing transferred a trade or 
business to controlled. The Second Circuit concluded that, even though 
gain was recognized, section 355(b)(2)(C) was not violated because new 
assets were not brought within the combined corporate shells of 
distributing and controlled. Therefore, the common purpose of section 
355(b)(2)(C) and (D) was not violated. Furthermore, Rev. Rul. 69-461 
(1969-2 CB 52) held that a first-tier subsidiary's taxable distribution 
of stock of a second-tier subsidiary to its parent did not violate 
section 355(b)(2)(D). The ruling stated that section 355(b)(2)(D) is 
intended to prevent the acquisition of control of a corporation from a 
party not within the direct or indirect control of distributing. In 
addition, Rev. Rul. 78-442 (1978-2 CB 143) held that gain under section 
357(c) on the transfer from distributing to controlled does not violate 
section 355(b)(2)(C). Rev. Rul. 78-442 stated that section 355(b)(2)(C) 
is intended to prevent the acquisition of a trade or business by 
distributing or controlled from an outside party in a taxable 
transaction within five years of a distribution.
    Similarly, Sec.  1.355-3(b)(4) (generally applicable to 
distributions on or before December 15, 1987, but applied in various 
situations by the IRS administratively to distributions occurring after 
that date) provides an exception from the literal language of section 
355(b)(2)(C) and (D) for the direct or indirect acquisition of a trade 
or business by one member of an affiliated group from another member of 
the group, stating that an acquisition from another member of the 
affiliated group ``is not the type of transaction to which section 
355(b)(2)(C) and (D) is intended to apply.'' See Sec.  1.355-
3(b)(4)(iii).
    Section 1.355-3(b)(4) also departs from the literal language of 
section 355(b) in providing that a trade or business acquired, directly 
or indirectly, within the pre-distribution period in a transaction in 
which the basis of the assets acquired was not determined in whole or 
in part by reference to the transferor's basis does not qualify under 
section 355(b)(2), even though no gain or loss was recognized by the 
transferor. See Sec.  1.355-3(b)(4)(i). The reason for this departure 
is that in some circumstances a transaction in which no gain or loss is 
recognized may nevertheless constitute a prohibited acquisition of a 
trade or business in exchange for assets.
3. The Proposed Regulations
    Consistent with current law (and Sec.  1.355-3(b)(4)), these 
proposed regulations generally prohibit acquisitions in which gain or 
loss was recognized but apply section 355(b)(2)(C) and (D) in a manner 
consistent with their purposes. Accordingly, these proposed regulations 
provide for certain exceptions for acquisitions in which gain or loss 
is recognized, and prohibit certain transactions in which no gain or 
loss is recognized.
a. Certain Transactions in Which Recognized Gain or Loss Is Disregarded
    Under these proposed regulations, certain acquisitions are excepted 
from the general rule under section 355(b)(2)(C) and (D) that a trade 
or business, or control of a corporation engaged in a trade or 
business, cannot satisfy the active trade or business requirement if it 
was acquired during the pre-distribution period in a transaction in 
which gain or loss was recognized. These transactions are so excepted 
because they do not violate the purposes of section 355(b)(2)(C) and 
(D).
i. Certain Acquisitions by the DSAG or CSAG
    These proposed regulations provide a number of exceptions to the 
application of section 355(b)(2)(C) and (D) not contained in the 
current regulations (or Sec.  1.355-3(b)(4)). One of these exceptions 
disregards any gain or loss recognized in connection with an 
acquisition by the CSAG from the DSAG of a trade or business, an 
interest in a partnership engaged in a trade or business, or stock of a 
corporation engaged in a trade or business. This exception is 
appropriate because it is not a use of distributing's assets to acquire 
the trade or business
    Another exception disregards gain or loss recognized in an 
acquisition solely as a result of the payment of cash to shareholders 
for fractional shares where the cash paid represents a mere rounding 
off of the fractional shares in the exchange and is not separately 
bargained for consideration. The IRS and Treasury Department believe 
that this is not the type of transaction to which section 355(b)(2)(C) 
or (D) is intended to apply. Although such a transaction involves a 
small use of assets, these proposed regulations except such 
acquisitions because the small amount of assets are not separately 
bargained for and are used merely to simplify the exchange. Other 
authorities reach similar conclusions in the context of 
reorganizations. See Rev. Rul. 66-365 (1966-2 CB 116), amplified by 
Rev. Rul. 81-81 (1981-1 CB 122) (concluding that cash in lieu of 
fractional shares does not violate the solely for voting stock 
requirement of section 368(a)(1)(B) and (C) because it was merely a 
mathematical rounding off for simplicity, and the transaction ``was for 
all practical purposes ``solely in exchange for voting stock''').
    In addition, as discussed in section G. of this preamble, these 
proposed regulations provide a limited exception for taxable 
acquisitions from affiliates that are members of the same SAG. 
Specifically, acquisitions between SAG members (where the assets (or 
activities) are owned (or performed) by the SAG immediately before and 
immediately after the transfer) are disregarded whether they are 
taxable or not.
    Like the current regulations, these proposed regulations provide 
that acquisitions that expand a pre-existing business are generally 
exempted from the nonrecognition requirement. See Sec.  1.355-
3(b)(3)(ii). While these transactions may involve the use of the DSAG's 
or CSAG's assets, they are not acquisitions of a new or different trade 
or business. Because the DSAG or CSAG, as the case may be, is already 
in the business, such transactions are not considered acquisitions of a 
trade or business under section 355(b)(2)(C) and (D).
ii. Certain Acquisitions by a Distributee Corporation
    Consistent with the principles of Rev. Rul. 74-5 (1974-1 CB 82), 
obsoleted by Rev. Rul. 89-37 (1989-1 CB 107), these proposed 
regulations disregard the recognition of gain or loss in applying 
section 355(b)(2)(D) to certain acquisitions of the stock of 
distributing by a distributee corporation. Prior to the 1987 and 1988 
amendments noted in section A.1 of this preamble, section 355(b)(2)(D) 
was not violated in a case where distributing distributed the stock of 
controlled even though a purchaser acquired distributing's stock during 
the pre-distribution period in a transaction in which gain or loss was 
recognized. See Rev. Rul. 74-5 (reasoning that the purpose of section 
355(b)(2)(D) was to prevent distributing, rather than the shareholder 
of distributing, from accumulating excess funds to purchase the stock 
of a corporation engaged in an active trade or business). However, Rev. 
Rul. 74-5 held that the purchaser could not then further distribute the 
stock of controlled until five years after such

[[Page 26017]]

purchase, reasoning that the purchaser, the distributing corporation in 
the second distribution, indirectly acquired the stock of controlled 
through another corporation, the distributing corporation in the first 
distribution.
    The 1987 and 1988 amendments to section 355(b)(2)(D) prohibited 
such transactions because of a concern that such acquisitions were 
similar to transactions that permitted a corporation to dispose of an 
appreciated subsidiary without the proper recognition of gain contrary 
to the repeal of the General Utilities doctrine. For example, assume P, 
a corporation, acquired the stock of D in a transaction in which gain 
or loss was recognized and D immediately distributed the stock of C to 
P in a section 355 transaction. P would allocate its basis in the newly 
acquired D stock between the D stock and the C stock received in the 
distribution. P could then potentially sell the C stock without the 
appropriate recognition of gain. See H.R. Rep. No. 100-391, at 1080, 
1082-1083 (1987).
    However, there are transactions that violate the literal 
requirements of section 355(b)(2)(D) but do not violate the purpose of 
the 1987 and 1988 amendments. For example, assume that for more than 
five years, T, a corporation, owned all of the stock of D, which in 
turn owned all the stock of C. Throughout this period, D and C have 
each engaged in the active conduct of a trade or business. In year 6, P 
acquires the stock of T in a transaction in which gain or loss is 
recognized, and holds the T stock with a cost basis determined under 
section 1012. In year 7, P liquidates T in a transaction to which 
section 332 applies and in which no gain or loss is recognized, thereby 
eliminating its cost basis in the T stock. Thereafter, P holds the D 
stock with a basis equal to T's basis in the D stock. In year 8, D 
distributes the C stock to P. Under these facts, P cannot dispose of 
the D or C stock without recognizing the same amount of gain or loss 
that T would have recognized.
    Similarly, assume the same facts as the previous example, except 
that in year 6 P acquires all of T's assets, including the D stock, in 
exchange for P stock and cash in a reorganization described in section 
368(a)(1)(A). Because all of the cash is distributed to the T 
shareholders, T does not recognize any gain, and P's basis in the D 
stock is equal to T's basis in the D stock. See section 362(b). In year 
7, D distributes the C stock to P. Under these facts, P cannot dispose 
of the D or C stock without recognizing the same amount of gain or loss 
that T would have recognized.
    The IRS and Treasury Department believe that the distributee 
corporation language in section 355(b)(2)(D)(i) is intended only to 
prevent transactions that are contrary to the repeal of the General 
Utilities doctrine. In both of the examples just described, neither the 
D stock nor C stock can be disposed of in a manner that is contrary to 
the repeal of the General Utilities doctrine. Accordingly, these 
proposed regulations provide that section 355(b)(2)(D) is not violated 
where there is a direct or indirect acquisition by a distributee 
corporation of control of distributing in one or more transactions in 
which gain or loss is recognized where the basis of the acquired 
distributing stock in the hands of the distributee corporation is 
determined in whole by reference to the transferor's basis. However, 
consistent with the principles of Rev. Rul. 74-5, this rule is only 
applicable with respect to a distribution by the acquired distributing, 
and does not apply for purposes of any subsequent distribution by any 
distributee corporation.
b. Certain Nonrecognition Transactions Treated as Recognition 
Transactions
    Because the IRS and Treasury Department believe that acquisitions 
made in exchange for assets violate the common purpose of section 
355(b)(2)(C) and (D) even if no gain or loss is recognized, these 
proposed regulations provide that such transactions are treated as 
transactions in which gain or loss is recognized.
i. Acquisitions in Exchange for Assets
    As discussed in section C.1 of this preamble, the common purpose 
underlying section 355(b)(2)(C) and (D) is that distributing generally 
should not be able to use its assets to acquire a new trade or business 
in anticipation of distributing that trade or business (or facilitating 
the distribution of another trade or business) to its shareholders in a 
tax-free transaction. Similarly, and also discussed in section C.1. of 
this preamble, section 355(b), by permitting the use of distributing 
stock to acquire a trade or business, ensures a historic relationship 
between the distributing shareholders and the trades or businesses 
relied upon to satisfy the active trade or business requirement.
    The following examples illustrate distributing's use of its assets 
to acquire a new trade or business.
    First, assume that D, a corporation that does not directly conduct 
a five-year active trade or business, owns all of the stock of C, a 
corporation with a five-year active trade or business. D wishes to 
spin-off C to its shareholders, but to do so D must satisfy the active 
trade or business requirement. Accordingly, D contributes assets to an 
unrelated partnership that is engaged in a five-year active trade or 
business in a transaction to which section 721 applies in exchange for 
an interest in the partnership that otherwise satisfies the 
requirements for D to be attributed the trade or business assets and 
activities of the partnership, as discussed in section I. of this 
preamble. Two years after the transfer, when D's only active trade or 
business is the business conducted by the partnership, D distributes 
the C stock pro rata to the D shareholders.
    Alternatively, assume that D, a corporation with a five-year active 
trade or business, transfers assets to unrelated T, a corporation with 
a five-year active trade or business, in a transaction to which section 
351 applies in exchange for an amount of T stock constituting control. 
Two years after the transfer, when T's only active trade or business is 
the business T conducted before D's transfer, D distributes the T stock 
pro rata to the D shareholders.
    Similarly, assume that D, a corporation with a five-year active 
trade or business, owns all of the stock of C, a corporation that does 
not have a five-year active trade or business but has other assets. To 
cause C to satisfy the active trade or business requirement, D arranges 
for C to acquire a five-year active trade or business from T, an 
unrelated corporation, in a reorganization described in section 
368(a)(1)(A). In the reorganization, the shareholders of T receive 
solely common stock of C representing 20 percent or less of the voting 
power of all classes of C stock. Two years after the reorganization, D 
distributes the C stock pro rata to the D shareholders.
    In each of these examples, D has directly or indirectly acquired a 
trade or business in exchange for assets. See and compare Situation 2 
of Rev. Rul. 2002-49 (2002-2 CB 288) (corporation's use of appreciated 
securities to acquire a trade or business of a partnership in a 
transaction to which section 721 applies is treated as an acquisition 
in which gain or loss was recognized); section 4.01(29) of Rev. Proc. 
2007-3 (2007-1 IRB 108) (the IRS will not ordinarily rule where 
distributing acquires control of controlled by transferring inactive 
assets in a transaction meeting the requirements of section 351(a) or 
section 368(a)(1)(D) and in which no gain or loss is recognized). While 
these transactions satisfy the literal requirements of section 
355(b)(2)(C) or (D), the underlying common purpose of those provisions 
has been violated. In each case, distributing has acquired in exchange 
for distributing's assets, either

[[Page 26018]]

directly or indirectly through the issuance of controlled stock the 
trade or business to be relied on by distributing or controlled.
    Furthermore, in each of these examples, the historic owners have 
supplied a trade or business for distributing or controlled, but they 
are not participants in the divisive transaction. Not being 
shareholders of D, the position of the historic owners of the acquired 
business is not altered by the distribution of the controlled stock. 
Accordingly, neither distributing nor the distributing shareholders 
have a historic relationship with the separated businesses, and the 
distribution of the controlled stock is not the type of transaction to 
which section 355 was intended to apply.
    By contrast, had D issued its own stock in the reorganization in 
the last example, the substance of the transaction would be different. 
D would not have indirectly acquired a trade or business in exchange 
for assets but rather for its own equity. Because D would not be 
purchasing a business for its shareholders, the distribution is not a 
substitute for a taxable distribution of the consideration that would 
have been used in the purchase. Furthermore, where D stock is used as 
the consideration the former T shareholders would have joined D's 
shareholder base, and become participants in the divisive 
reorganization.
    These proposed regulations prohibit the acquisition of a trade or 
business directly or indirectly in exchange for assets in order to 
ensure that the common purpose of section 355(b)(2)(C) and (D) are 
satisfied. Such an acquisition also would include a swap of an interest 
in an existing five-year active trade or business for an interest in a 
new active trade or business. This type of an acquisition could occur 
through the formation of a joint venture structure.
    For example, assume D and X form a partnership joint venture in 
which D contributes a five-year active trade or business (ATBD) and X 
contributes a different five-year active trade or business (ATBX). D 
and X each receive a 50-percent interest in the partnership. D's 
interest is sufficient to satisfy the requirements for D to be 
attributed the partnership's trade or business assets and activities 
(as discussed in section I. of this preamble). Prior to a potential 
section 355 distribution by D, and within five years of the 
contribution, the partnership sells ATBD.
    D cannot rely on ATBX until five years after the acquisition of its 
interest in the partnership because, in effect, at the time of the 
contributions D exchanged a 50-percent undivided interest in ATBD for a 
50-percent undivided interest in ATBX. Therefore, D acquired its 
interest in ATBX in exchange for its assets. While this was a 
transaction in which no gain or loss was recognized, the exchange of 
assets violates the common purpose of section 355(b)(2)(C) and (D). 
Further, the historic owner of ATBX would not participate in any 
distribution of controlled stock by D. Accordingly, such a distribution 
would not be the type of transaction to which section 355 was intended 
to apply.
    Similarly, a corporation can effectively swap its assets through 
the issuance of stock of a subsidiary (including controlled). 
Accordingly, these proposed regulations provide a specific rule to 
address tax-free acquisitions involving the issuance of subsidiary 
stock. These proposed regulations provide that if a SAG directly or 
indirectly owns stock of a subsidiary (including a subsidiary SAG 
member) and the subsidiary directly or indirectly acquires a trade or 
business, an interest in a partnership engaged in a trade or business, 
or stock of a corporation engaged in a trade or business from a person 
other than such SAG in exchange for stock of such subsidiary in a 
transaction in which no gain or loss is recognized (the acquisition), 
solely for purposes of applying section 355(b)(2)(C) or (D) with 
respect to the trade or business, partnership interest, or stock 
acquired by the subsidiary in the acquisition, the subsidiary's stock 
directly or indirectly owned by the SAG immediately after the 
acquisition is treated as acquired at the time of the acquisition in a 
transaction in which gain or loss is recognized.
    This rule reflects the fact that although the acquiring subsidiary 
did not make the acquisition in exchange for its assets (it issued its 
own stock), the SAG that owns stock of the subsidiary has exchanged an 
indirect interest in the subsidiary's assets for an indirect interest 
in the trade or business acquired by the subsidiary in the acquisition. 
Thus, the SAG has indirectly acquired a portion of the subsidiary's 
newly acquired trade or business (equal to the shareholder's stock 
interest in the subsidiary immediately after the acquisition) in 
exchange for assets. Further, the IRS and Treasury Department believe 
that it would be inappropriate to allow such acquired trade or business 
to be relied on to satisfy the active trade or business requirement 
within five years of its acquisition because the historic owners of 
that trade or business would not participate in any distribution of 
controlled stock.
    However, because such a transaction does not result in an 
acquisition of any pre-existing trade or business of the subsidiary, 
this rule merely treats the SAG's stock in the subsidiary immediately 
after the acquisition as acquired in a gain or loss transaction for 
purposes of applying section 355(b)(2)(C) or (D) to the newly acquired 
trade or business. Further, the impact of such a transaction on the 
ability to rely on the newly acquired trade or business to satisfy the 
requirements of section 355(b) depends upon how much subsidiary stock 
the SAG owns immediately after the transaction.
    For example, assume D owns all of the sole class of stock of S, a 
corporation that does not conduct a five-year active trade or business. 
T, an unrelated corporation with a five-year active trade or business 
(ATBT), merges into S in a reorganization described in section 
368(a)(1)(A) and (D) solely in exchange for 80 percent of the S stock, 
and no gain or loss is recognized. Immediately after the merger, D owns 
only 20 percent of the sole class of S stock. Solely for purposes of 
determining whether ATBT can be relied on to satisfy the active trade 
or business requirement, D is treated as having acquired its 20 percent 
of the S stock at the time of the merger of T into S in a transaction 
in which gain or loss was recognized. Accordingly, as described in 
section D.2.a. of this preamble regarding certain multi-step 
acquisitions of a subsidiary SAG member, if D subsequently acquired the 
80 percent of the S stock held by the other shareholders solely in 
exchange for D voting stock in a reorganization described in section 
368(a)(1)(B) in which no gain or loss was recognized, S would become a 
DSAG member and D could rely on ATBT to satisfy the active trade or 
business requirement.
    Accordingly, in light of all of these concerns, these proposed 
regulations generally provide that acquisitions paid for in whole or in 
part, directly or indirectly, with assets of the DSAG will be treated 
as acquisitions in which gain or loss is recognized. However, if a DSAG 
member or controlled acquires the trade or business solely in exchange 
for distributing stock, distributing acquires control of controlled 
solely in exchange for distributing stock, or controlled acquires the 
trade or business from distributing solely in exchange for stock of 
controlled, in a transaction in which no gain or loss is recognized, 
the requirements of section 355(b)(2)(C) and (D) are satisfied. Such 
acquisitions are

[[Page 26019]]

not made in exchange for assets of the DSAG.
    An additional question arising under section 355(b)(2)(C) and (D) 
is whether the assumption of liabilities is treated as a payment of 
money or other property, and hence the use of assets. See United States 
v. Hendler, 303 U.S. 564, reh'g denied, 304 U.S. 588 (1938) (viewing an 
assumption of a liability by a transferee as in substance a payment to 
the transferor). Congress has indicated that the assumption of 
liabilities is not to be treated as the payment of money or other 
property in certain transactions in which no gain or loss is 
recognized. For example, the assumption of liabilities is not treated 
as the payment of money or other property in certain exchanges to which 
section 351 or 361 applies. See section 357(a). Further, the assumption 
of liabilities does not violate the solely for voting stock requirement 
in a reorganization described in section 368(a)(1)(C) where the 
acquiring corporation does not otherwise exchange money or other 
property. See section 368(a)(1)(C) and (a)(2)(B). Because Congress has 
granted this special treatment for liability assumptions in certain 
nonrecognition transactions, the IRS and Treasury Department believe 
that similar treatment is generally appropriate for purposes of section 
355(b)(2)(C) and (D). Accordingly, these proposed regulations provide 
that the assumption by the DSAG or CSAG of liabilities of a transferor 
shall not, in and of itself, be treated as the payment of assets if 
such assumption is not treated as the payment of money or other 
property under any other applicable provision.
    Finally, these proposed regulations clarify that an acquisition to 
which section 304(a)(1) applies does not satisfy the requirements of 
section 355(b)(2)(C) or (D). The IRS and Treasury Department believe 
that a stock acquisition to which section 304 applies is a transaction 
in which gain or loss is recognized for purposes of section 
355(b)(2)(C) and (D) even if it merely results in the transferor's 
receipt of dividend income. These proposed regulations clarify that, 
regardless of the tax consequences to the transferor, such a 
transaction is an acquisition made in exchange for assets, and 
therefore does not satisfy the requirements of section 355(b)(2)(C) and 
(D).
ii. Partnership Distributions
    These proposed regulations provide that an acquisition consisting 
of a distribution from a partnership is generally treated as a 
transaction in which gain or loss is recognized because it constitutes 
an acquisition in exchange for assets. That is, the distributee partner 
is generally exchanging an indirect interest in all the assets of the 
partnership for a direct interest in the property distributed. However, 
these proposed regulations provide that if the corporation is already 
attributed the trade or business assets and activities of a 
partnership, the corporation's acquisition of such trade or business 
assets and activities from the partnership is not, in and of itself, 
the acquisition of a new trade or business. Further, these proposed 
regulations provide that an acquisition consisting of a pro rata 
distribution from a partnership of stock or an interest in a lower-tier 
partnership is not an acquisition in exchange for assets to the extent 
the distributee partner did not acquire the interest in the 
distributing partnership during the pre-distribution period in a 
transaction in which gain or loss was recognized and to the extent the 
distributing partnership did not acquire the distributed stock or 
partnership interest within such period. In such a case, the 
distributee partner has merely exchanged an indirect interest for a 
direct interest in the distributed stock or partnership interest, and 
continues to possess the same indirect interest in the remaining assets 
of the partnership.
iii. Lack of Transferred Basis
    Section 1.355-3(b)(4)(i) provides that a trade or business 
acquired, directly or indirectly, within the pre-distribution period in 
a transaction in which the basis of the assets acquired was not 
determined in whole or in part by reference to the transferor's basis 
does not qualify under section 355(b)(2), even though no gain or loss 
was recognized by the transferor. These proposed regulations do not 
include a similar provision. The IRS and Treasury Department believe 
that the prohibition against acquisitions in exchange for assets fully 
addresses such acquisitions.
c. Application of Section 355(b)(2)(C) and (D) to Predecessors
    Unlike Sec.  1.355-3(b)(4)(i), which only took ``a predecessor in 
interest'' into account for purposes of applying section 355(b)(2)(D), 
these proposed regulations provide that any reference to a corporation 
includes a reference to a predecessor of such corporation in applying 
both section 355(b)(2)(C) and (D). The IRS and Treasury Department 
believe that predecessors should be taken into account in applying both 
section 355(b)(2)(C) and (D) because the same policy concerns exist 
regardless of whether the transaction involves the acquisition of 
assets or stock. For this purpose, the proposed regulations define a 
predecessor of a corporation as a corporation that transfers its assets 
to such corporation in a transaction to which section 381 applies. The 
IRS and Treasury Department believe that it is appropriate to take 
predecessors into account in applying these provisions in order to 
appropriately minimize the significance of which corporation is the 
acquiror and which corporation is the target.
    Further, because the SAG rule effectively treats SAG members as a 
singly-entity for purposes of section 355(b), these proposed 
regulations also apply section 355(b)(2)(C) and (D) to acquisitions 
during the pre-distribution period by corporations that later become 
DSAG or CSAG members. These types of acquisitions are similar to 
predecessor asset acquisitions.
4. Requests for Comments Regarding Exceptions to Section 355(b)(2)(C) 
and (D)
    The IRS and Treasury Department request comments regarding whether 
any additional exceptions to section 355(b)(2)(C) and (D) are 
appropriate. In particular, the IRS and Treasury Department request 
comments regarding whether acquisitions in which gain is recognized 
solely as a result of the application of section 367 should be treated 
as violating section 355(b)(2)(C) or (D). The IRS and Treasury 
Department also request comments regarding whether an exception should 
exist for taxable acquisitions made by distributing solely in exchange 
for distributing stock because such acquisitions are not made in 
exchange for distributing's assets and do not appear to violate the 
common purpose of section 355(b)(2)(C) and (D).
    In addition, the IRS and Treasury Department request comments 
regarding whether a redemption of stock should be a transaction to 
which section 355(b)(2)(C) or (D) applies. Under current law, no relief 
is provided for such transactions. See McLaulin v. Commissioner, 276 
F.3d 1269 (11th Cir. 2001) (concluding that section 355(b)(2)(D) 
applies when distributing acquires control of a subsidiary through a 
redemption of subsidiary stock). Compare Rev. Rul. 57-144 (1957-1 CB 
123). Specifically, comments are requested on whether all types of 
redemptions should be subject to the same rule, whether the treatment 
of redemptions should be determined by the source of payment, whether 
the redemption constitutes an indirect exchange for assets of 
distributing or controlled, and the method of making these 
determinations. Alternatively, the

[[Page 26020]]

IRS and Treasury Department request comments on whether an exception 
should be provided for redemptions of shareholders that exercise 
dissenters' rights. Compare Rev. Rul. 68-285 (1968-1 CB 147) 
(concluding that cash paid to dissenting target corporation 
shareholders by the target corporation does not violate the solely for 
voting stock requirement of section 368(a)(1)(B)) with Rev. Rul. 73-102 
(1973-1 CB 186) (concluding that cash paid to dissenting target 
corporation shareholders by the acquiring corporation is treated as 
money or other property paid by the acquiring corporation for the 
properties of the target corporation in a reorganization under section 
368(a)(1)(C)). These proposed regulations do not include an exception 
for redemptions generally or for those in connection with the exercise 
of dissenters' rights.
    Finally, the IRS and Treasury Department request comments regarding 
whether a transaction in which a distributee corporation acquires in a 
transaction in which no gain or loss is recognized newly issued stock 
of distributing in exchange for money or property previously acquired 
for cash during the pre-distribution period should be treated as a 
transaction in which gain or loss is recognized. For example, assume D 
and C have each engaged in the active conduct of a trade or business 
for more than five years. During the pre-distribution period, P, an 
unrelated corporation, purchases trucks and transfers them to D in 
exchange for D stock meeting the requirements of section 368(c) in a 
transaction to which section 351 applies. No gain or loss is 
recognized. D subsequently distributes all the C stock to P in a 
separate transaction within five years of P's acquisition of the D 
stock. Notwithstanding that this transaction satisfies the literal 
requirements of section 355(b)(2)(D), it appears to violate the General 
Utilities doctrine because it permits the distributee corporation, P, 
to receive a fair market value basis (or close to a fair market value 
basis) in the distributing stock, enabling the potential sale of 
controlled stock without the appropriate recognition of gain. 
Additionally, the IRS and Treasury Department are studying whether the 
principles of the foregoing rule should be extended to any distributee 
in regulations under section 355(d), and request comments on this 
point.

D. Treatment of Certain Multi-Step Acquisitions

    These proposed regulations provide specific rules regarding the 
application of section 355(b)(2)(C) and (D) to certain multi-step 
acquisitions. Based on the interpretation of section 355(b)(2)(D), and 
the enactment of section 355(b)(3), the IRS and Treasury Department 
believe that it is appropriate to apply section 355(b)(2)(C) and (D) to 
multi-step acquisitions in a consistent manner. Further, the IRS and 
Treasury Department believe that it is appropriate to treat certain 
multi-step acquisitions of target corporation stock as satisfying the 
requirements of section 355(b)(2)(C) or (D) (as applicable) 
notwithstanding that some portion of the stock may have been acquired 
in a separate transaction in which gain or loss was recognized.
1. Multi-Step Acquisition of Control of Distributing or Controlled
a. Direct Acquisitions
    Section 355(b)(2)(D) provides that control of distributing or 
controlled may be acquired within the pre-distribution period provided 
that ``in each case in which such control was so acquired, it was so 
acquired, only by reason of transactions in which gain or loss was not 
recognized in whole or in part, or only by reason of such transactions 
combined with acquisitions before the beginning of such period.'' The 
IRS and Treasury Department interpret this language to mean that at the 
time control is first acquired, the acquiring corporation (or its SAG) 
is required to own stock meeting the requirements of section 368(c) 
that was acquired in one or more transactions in which no gain or loss 
was recognized or by reason of such transactions combined with 
acquisitions before the beginning of the pre-distribution period. Thus, 
at the time an acquiring corporation (or its SAG) first satisfies the 
section 368(c) control requirement, the acquiring corporation (or its 
SAG) must possess section 368(c) control without relying on any stock 
acquired in a transaction in which gain or loss was recognized during 
the pre-distribution period.
    For example, assume that C has two classes of stock outstanding. X 
owns all 95 shares of the class A stock of C representing 95 percent of 
the voting power and 70 percent of the value and Y owns all of the 
class B stock of C representing five percent of the voting power and 30 
percent of the value. In year 1, unrelated D acquires 10 shares of the 
class A C stock from X in a transaction in which gain or loss is 
recognized. In year 2, D acquires an additional 80 shares of class A C 
stock from X in a separate transaction in which no gain or loss is 
recognized. In year 3, D acquires the remaining five shares of class A 
C stock from X in a separate transaction in which gain or loss is 
recognized. In year 4, D distributes the 95 shares of class A C stock 
to the D shareholders. Assuming all of the other requirements of 
section 355(b) are satisfied, the requirements of section 
355(b)(2)(D)(ii) are satisfied because at the time D first acquired 
control of C (immediately after the year 2 acquisition), D owned an 
amount of C stock constituting control that was acquired in a 
transaction in which no gain or loss was recognized (the 80 shares of 
class A C stock acquired in year 2). (However, the 10 shares of class A 
C stock acquired in year 1 and the five shares of class A C stock 
acquired in year 3 may be treated as moot under section 355(a)(3)(B).)
    On the other hand, assume the same facts as the previous example, 
except that, in year 2, D acquires only 75 shares of class A C stock 
from X. The requirements of section 355(b)(2)(D)(ii) are not satisfied 
because at the time D first acquired control of C (immediately after 
the year 2 acquisition), D did not own an amount of C stock 
constituting control that was acquired in one or more transactions in 
which no gain or loss was recognized or acquired prior to the pre-
distribution period. D only owns C voting stock representing 75 percent 
of the total voting power that was acquired in a transaction in which 
no gain or loss was recognized. The result would be the same if the 
year 3 acquisition was also a transaction in which no gain or loss was 
recognized.
b. Indirect Acquisitions
    These proposed regulations also provide that the principles of this 
rule will be applied with respect to