The Allocation of Consideration and Allocation and Recovery of Basis in Transactions Involving Corporate Stock or Securities, 3509-3526 [E9-1100]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 74, Number 12 (Wednesday, January 21, 2009)]
[Proposed Rules]
[Pages 3509-3526]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E9-1100]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-143686-07]
RIN 1545-BH35


The Allocation of Consideration and Allocation and Recovery of 
Basis in Transactions Involving Corporate Stock or Securities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations under sections 
301, 302, 304, 351, 354, 356, 358, 368, 861, 1001, and 1016 of the 
Internal Revenue Code (Code). The proposed regulations provide guidance 
regarding the recovery of stock basis in distributions under section 
301 and transactions that are treated as dividends to which section 301 
applies, as well as guidance regarding the determination of gain and 
the basis of stock or securities received in exchange for, or with 
respect to, stock or securities in certain transactions. The proposed 
regulations affect shareholders and security holders of corporations. 
These proposed regulations are necessary to provide such shareholders 
and security holders with guidance regarding the allocation and 
recovery of basis on distributions of property.

DATES: Written or electronic comments, and a request for a public 
hearing, must be received by April 21, 2009.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-143686-07), room 
5203, Internal Revenue Service, P.O. 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-
143686-07), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically, via the Federal 
eRulemaking Portal at www.regulations.gov (IRSREG-143686-07).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations 
under sections 301, 302, and 304, Theresa M. Kolish, (202) 622-7530; 
concerning the proposed regulations under sections 351, 354, 356, 358, 
368, 1001, and 1016, Rebecca O. Burch, (202) 622-7550; concerning the 
proposed regulations under section 861, Jeffrey L. Parry, (202) 622-
4476; concerning submission of comments or to request a hearing, 
Richard Hurst (202) 622-7180 (not toll free numbers).

Background

    The primary objective of these proposed regulations is to provide a 
single model for stock basis recovery by a shareholder that receives a 
constructive or actual distribution to which section 301 applies and a 
single model for sale and exchange transactions to which section 302(a) 
applies, including certain elements of a reorganization exchange. 
Further to this objective, these proposed regulations define the scope 
of the exchange that must be analyzed under particular Code provisions, 
and provide a methodology for determining gain realized under section 
356 and stock basis under section 358.
    In addition, these proposed regulations respond to comments 
received by the IRS and Treasury Department regarding the current 
section 358 regulations, such as suggestions to expand the tracing 
rules to stock transfers that are subject to section 351 but do not 
qualify as reorganizations, questions regarding whether (and, if so, to 
what extent) shareholder elections constitute terms of an exchange, and 
whether the terms of an exchange control for purposes of qualifying a 
transaction as a reorganization under section 368. Finally, these 
proposed regulations include amendments to the section 304 regulations 
that import the statutory amendments to that section. See section 226 
of the Tax Equity and Fiscal Responsibility Act of 1982, Public Law 97-
248 (96 Stat. 325, 490) (September 3, 1982), section 712(l) of the 
Deficit Reduction Act of 1984, Public Law 98-369 (98 Stat. 494, 953-55) 
(July 18, 1984), section 1875(b) of the Tax Reform Act of 1986, Public 
Law 99-514 (100

[[Page 3510]]

Stat. 2085, 2894) (October 22, 1986), and section 1013 of the Taxpayer 
Relief Act of 1997, Public Law 105-34 (111 Stat. 788, 918) (August 5, 
1997).

Explanation of Provisions

I. Introduction--Exchanges and Distributions to Which Sections 301 and 
302 Apply

    Section 301 provides rules for the treatment of a distribution with 
respect to stock but does not specify how to identify the shares upon 
which a distribution is made. Furthermore, the tax law does not provide 
rules concerning whether a shareholder recovers its stock basis in the 
aggregate, or alternatively, whether a shareholder is required to 
recover stock basis share-by-share. Finally, the tax law does not 
provide specifically that transactions treated as section 301 
distributions (i.e., redemptions under section 302(d), certain section 
304 transactions, and certain reorganizations) should be subject to the 
same rules as actual section 301 distributions. In the reorganization 
context, the Code provides consequences resulting from different types 
of exchanges, but does not specify whether the exchange is based on a 
shareholder's aggregate stock holdings, or alternatively, based on 
particular elements of the overall exchange.
    Rules related to stock basis recovery and stock basis 
determinations have evolved independently over many years on a 
transactional basis. Ad hoc development of these authorities has lead 
to the possibility of variant treatment of economically similar 
transactions to which section 301 or 302(a) applies either directly or 
through the operation of other Code provisions. Moreover, because there 
has not been a comprehensive review of these issues, many questions 
lack definitive answers. Prior guidance attempted to address particular 
areas of uncertainty within the subject matter of basis recovery and 
basis identification. Without the benefit of addressing all related 
issues, however, certain of this prior guidance was needed 
reconsidered. See REG-150313-01. Other guidance built the framework for 
basis identification that has encouraged the development of these 
proposed regulations.
    Building on themes developed in Sec.  1.358-2 and comments received 
from the tax community, this proposal is intended to be a comprehensive 
approach to stock basis recovery and stock basis identification to 
produce consistent results among economically similar transactions, 
regardless of the transaction type or the specific Code provision that 
results in the application of section 301 or 302(a).
    The cornerstone of this proposal is that a share of stock is the 
basic unit of property that can be disposed of and, accordingly, the 
results of a transaction should generally derive from the consideration 
received in respect of that share. This guiding principle has section 
1012 as its underpinning and has become fundamental to the tax 
treatment of shareholders, regardless of the specific nature of a 
shareholder's exchange. See Sec.  1.358-2 and Sec.  1.367(b)-13. A 
corollary to this basic premise is that a reorganization exchange is 
not an event that justifies alteration of a shareholder's tax position 
beyond what is necessary to reflect the results of the reorganization.
    To harmonize the tax treatment of economically similar 
transactions, these proposed regulations adopt a single model for 
section 301 distributions (dividend equivalent transactions) and a 
single model for sale or exchange transactions to which section 302(a) 
applies (non-dividend equivalent transactions), regardless of whether 
section 301 or section 302(a) applies directly or by reason of section 
302(d), 304 or 356.

II. Distributions With Respect to Stock and Dividend Equivalent 
Transactions

A. Section 301 Distributions
    Consistent with the fundamental notion that a share of stock is the 
basic unit of property, the results of a section 301 distribution 
should derive from the consideration received in respect of each share 
of stock, notwithstanding designations otherwise. Johnson v. United 
States, 435 F.2d 1257 (4th Cir. 1971). Accordingly, these proposed 
regulations treat a section 301 distribution as received on a pro rata, 
share-by-share basis with respect to the class of stock upon which the 
distribution is made. Thus, a distribution that is not a dividend 
within the meaning of section 301(c)(1) can result in gain with respect 
to some shares of a class while other shares have unrecovered basis.
B. Dividend Equivalent Redemptions
    To promote consistency among transactions treated as section 301 
distributions under the Code, these proposed regulations apply the same 
basis recovery rules described above to both dividend equivalent 
redemptions and certain section 304 transactions. Accordingly, under 
these proposed regulations, a dividend equivalent redemption results in 
a pro rata, share-by-share distribution to all shares of the ``redeemed 
class'' held by the redeemed shareholder immediately before the 
redemption. The proposed regulations define the term ``redeemed class'' 
to mean all of the shares of that class held by the redeemed 
shareholder. Similar to an actual section 301 distribution, the 
proportional approach to basis recovery in dividend equivalent 
redemptions can produce gain with respect to some shares while other 
shares have unrecovered basis.
    The constructive section 301 distribution is limited to the shares 
of the redeemed class (instead of constructing a pro rata distribution 
among all shares of various classes held by the redeemed shareholder) 
because different classes of stock have distinct legal entitlements 
that are respected for federal income tax purposes. H.K. Porter Co., 87 
T.C. 689 (1986); Comm'r v. Spaulding Bakeries, 252 F.2d 693 (2d Cir. 
1958). Accordingly, a constructive section 301 distribution is 
conformed to an actual section 301 distribution by identifying those 
shares with respect to which an actual section 301 distribution would 
have been received, and by reducing the basis of only those shares.
i. Basis Adjustments in Dividend Equivalent Redemptions if Less Than 
All of the Shares of a Single Class Held by the Taxpayer Are Redeemed
    If less than all of the shares of a class of stock held by the 
taxpayer are redeemed, the proposed regulations provide that in a 
hypothetical recapitalization described in section 368(a)(1)(E), the 
redeemed shareholder is deemed to exchange all its shares in the class, 
including the redeemed shares, for the actual number of shares held 
after the redemption transaction. The tracing rules of the section 358 
regulations apply to preserve the basis of the shares exchanged in the 
recapitalization in the remaining shares of the redeemed class held by 
the shareholder. Thus, under these proposed regulations, a dividend 
equivalent redemption is generally treated in the same manner, and its 
results are the same as, a section 301 distribution in which no shares 
were cancelled.
ii. Basis Recovery in Dividend Equivalent Redemptions in Which the 
Taxpayer Surrenders All of Its Shares in a Single Class
    Under current law, if all of the shares of a single class held by a 
shareholder are redeemed in a dividend equivalent redemption, any 
unrecovered basis in the redeemed shares is permitted to shift to other 
shares in certain circumstances. See Sec.  1.302-2(c). The

[[Page 3511]]

IRS and Treasury Department believe that the shifting of stock basis is 
inconsistent with the fundamental principle that each share is a 
separate unit of property, and can lead to inappropriate results. 
Accordingly, these proposed regulations do not permit the shifting of 
basis to other shares held (directly or by attribution) by the redeemed 
shareholder. Instead, the proposed regulations preserve the tax 
consequences of the unrecovered basis for the redeemed shareholder by 
treating the amount of the unrecovered basis as a deferred loss of the 
redeemed shareholder that can be accessed when the conditions of 
sections 302(b)(1), (2), or (3) are satisfied, or alternatively, when 
all the shares of the issuing corporation (or its successor) become 
worthless within the meaning of section 165(g).
C. Dividend Equivalent Reorganization Exchanges
    If, pursuant to a reorganization, a shareholder receives qualifying 
property and boot in exchange for its target corporation stock, the tax 
consequences of the receipt of the boot under these proposed 
regulations will depend upon whether the reorganization exchange is 
dividend equivalent or not. See section III. of this Preamble for a 
description of the proposed rules that would apply if the 
reorganization is not dividend equivalent.
    In general, the determination of whether an exchange has the effect 
of the distribution of a dividend for purposes of section 356(a)(2) is 
determined by examining the effect of the shareholder's ``overall 
exchange.'' Commissioner v. Clark, 489 U.S. 726, 738 (1989). Thus, the 
key to this determination is the scope of the exchange. For example, if 
the shareholder exchanges shares of preferred stock solely for boot and 
shares of common stock solely for qualifying property pursuant to a 
plan of reorganization, is the determination of whether the exchange of 
the preferred stock for boot is dividend equivalent based solely on 
that particular exchange or on the overall exchange of the preferred 
and common stock for the qualifying property and the boot? The same 
question would arise with respect to each particular exchange if the 
shareholder exchanged the preferred and common stock for a combination 
of qualifying property and boot. The Clark decision examined a 
reorganization exchange involving a single class of stock, and does not 
provide guidance in the context of multiple classes of stock.
    In the case of a section 302 redemption, the exchanging shareholder 
determines dividend equivalency based on all the facts and 
circumstances. See Zenz v. Quinlivan, 213 F.2d 914 (C.A.6 1954). To 
promote consistency between sale or exchange transactions, these 
proposed regulations provide that the overall reorganization exchange 
shall be taken into account in determining whether a particular 
exchange is dividend equivalent. Thus, a shareholder that exchanges a 
class of stock solely for boot and another class of stock solely for 
nonqualifying property shall consider the overall exchange (the 
exchange of the two classes of stock for boot and qualifying property) 
in determining whether each particular exchange is dividend equivalent.
    If it is determined that a reorganization exchange is dividend 
equivalent, because different classes of stock have distinct legal 
entitlements that are respected for federal income tax purposes, the 
proposed regulations provide that an exchange of a class of stock 
solely of boot is an exchange to which section 302(d) (and not section 
356(a)(2)) applies.
    To ensure similar tax treatment of dividend equivalent 
reorganization exchanges and dividend equivalent redemptions, if the 
reorganization exchange is dividend equivalent the proposed regulations 
limit the ability of the exchanging shareholder to specify the terms of 
the exchange. Specifically, if the shareholder receives more than one 
class of stock or surrenders one class of stock and securities, the 
shareholder may specify the terms of the exchange between the classes 
of stock surrendered (or between one or more classes of stock and 
securities surrendered), provided the designation is economically 
reasonable, but not between particular shares of the same class of 
stock.
    As with the redemption of shares of a redeemed class in a dividend 
equivalent redemption, a shareholder's receipt solely of boot with 
respect to a class of stock in a reorganization exchange is treated as 
received pro rata, on a share-by-share basis, with respect to each 
share in the class--under the principles of Johnson, the shareholder 
cannot specify that the boot is received with respect to particular 
shares within the class. Consequently, such an exchange could result in 
gain recognition with respect to some shares while other shares in the 
class could have recovered basis.
    In formulating the proposed regulations, the IRS and Treasury 
Department considered different alternatives. For example, in a 
dividend equivalent reorganization exchange pursuant to section 
356(a)(2), the IRS and Treasury Department considered whether gain 
realized with respect to a class should be determined in the aggregate 
(for example, with respect to all shares within a class). Under this 
approach, no gain would be realized with respect to a class that has a 
block of built-in gain stock and block of built-in loss stock where the 
built-in loss is at least equal to the built-in gain. The IRS and 
Treasury Department rejected such an approach because it would 
contradict the fundamental principle that a share is a discrete unit of 
property, and also would compromise the principle that a reorganization 
exchange is not an event that justifies stock basis averaging. The IRS 
and Treasury Department also considered eliminating a shareholder's 
ability to specify the terms of a dividend equivalent reorganization 
exchange based on the premise that under Johnson, all consideration 
received in such an exchange should be considered received pro rata 
among all shares, regardless of whether more than one class is 
surrendered. The IRS and Treasury Department rejected this approach in 
favor of the approach of the proposed regulations that is analogous to 
the proposed treatment of dividend equivalent redemptions, under which 
each share of the redeemed class is treated as receiving a pro rata 
share of the proceeds, and shares outside of the redeemed class are not 
treated as receiving any part of the distribution.
D. Special Rules Related to Apportionment of Interest and Other 
Expenses
    Under section 864(e), taxpayers apportion interest expense between 
statutory and residual groupings on the basis of the relative values of 
their assets in each grouping. For this purpose, taxpayers may choose 
to value their assets using either fair market value or tax book value 
(adjusted basis). The proposed regulations provide that for purposes of 
apportioning expenses on the basis of the tax book value of assets, the 
adjusted basis in any remaining shares of the redeemed class owned by 
the redeemed shareholder, any shares that are not in the redeemed 
class, or any shares owned by certain affiliated corporations shall be 
increased by the amount of the unrecovered basis of redeemed shares. 
Thus, under the proposed regulations, the interest expense allocation 
and apportionment consequences of a dividend equivalent redemption are 
the same as an actual section 301 distribution.

[[Page 3512]]

E. Section 1059
    Section 1059(a) provides that if a corporation receives an 
extraordinary dividend with respect to any share of stock and such 
corporation has not held such stock for more than two years before the 
dividend announcement date, then the corporation's basis in such stock 
shall be reduced (but not below zero) by the non-taxed portion of such 
dividends.
    Except as provided in regulations, in the case of any redemption of 
stock which would not have been treated (in whole or in part) as a 
dividend if any options had not been taken into account under section 
318(a)(4), or section 304(a) had not applied, any amount treated as a 
dividend is treated as an extraordinary dividend, without regard to the 
taxpayer's holding period in the stock. Section 1059(e)(1)(A)(iii). In 
the case of these types of redemptions, section 1059(e)(1)(A) (flush 
language) provides that only the basis of the stock redeemed shall be 
taken into account under section 1059(a). These proposed regulations do 
not affect the basis reduction provided for in section 1059(e)(1)(A) if 
section 1059(e)(1)(A)(iii) otherwise applies. Accordingly, to the 
extent of an extraordinary dividend described in section 
1059(e)(1)(A)(iii), a redeeming shareholder would first reduce basis as 
prescribed by section 1059(e)(1)(A). These proposed regulations would 
then apply to the extent the distribution is not a dividend within the 
meaning of section 301(c)(1).
F. Redemptions of Stock Held by Partnerships, Trusts, and S 
Corporations
    The treatment of unrecovered basis as a deferred loss raises 
special issues where the redeemed shareholder is an S corporation, a 
partnership, or a trust (each a flow-through entity). These proposed 
regulations reserve with respect to the issues relating to redeemed 
shareholders that are flow-through entities pending further study and 
comment. The primary issue under study is whether an ``outside'' basis 
adjustment that reflects the deferred loss should occur at the time of 
the dividend equivalent redemption, or alternatively, when there is an 
inclusion date with respect to the deduction.
    In general, a deferred loss is reflected in the outside basis of an 
interest in a flow-through entity when the deduction can be accessed by 
the entity. Accordingly, as a general matter, disconformity can exist 
between inside attributes and outside basis where an inside attribute 
is a deferred loss. Conversely, a net operating loss of a flow-through 
entity reduces the outside basis of an interest in the entity in the 
year that the net operating loss arises.
    Although disconformity generally can exist where a flow-through 
entity has a deferred loss, the IRS and Treasury Department are 
concerned that deferred losses arising from unrecovered basis presents 
an opportunity to separate the deferred loss from the dividend income 
resulting from the redemption. The IRS and Treasury Department question 
whether such a separation would be appropriate, and believe that 
treating the deferred loss as a net operating loss in the year of the 
redemption for basis adjustment purposes may be the better approach. 
However, the IRS and Treasury Department acknowledge that it may be 
inappropriate to require the owners of a flow-through entity to reduce 
outside basis before the deferred loss can be accessed, simply because 
the owners of the flow-through entity cannot access the deferred loss. 
The IRS and Treasury Department request comments on this issue.
    Flow-through entities also present the question of when it is 
appropriate to treat an owner of the flow-through entity as the 
redeemed shareholder, and when it is appropriate to treat the flow-
through entity itself as the redeemed shareholder. For example, where 
the owner completely divests of its interest in the flow-through 
entity, it may be appropriate to treat the owner as the redeemed 
shareholder for determining whether the sale of the flow-through entity 
interest is an inclusion date with respect to that owner. This 
treatment may be more appropriate if the deferred loss is treated as a 
net operating loss that already has reduced the outside basis of the 
entity's owner. Conversely, if the deferred loss is not treated as a 
net operating loss, it may be more appropriate to treat the flow-
through entity as the redeemed shareholder in all cases. The IRS and 
Treasury Department request comments on this issue.
G. Consolidated Groups and Basis Recovery in Dividend Equivalent 
Redemptions
    The IRS and Treasury Department continue to study the issues raised 
when a redeemed shareholder with a deferred loss files a consolidated 
return. The IRS and Treasury Department believe that certain of the 
concerns raised by REG-150313-01 are addressed in these proposed 
regulations by the deemed recapitalization mechanic described in 
section II.B.i. of this Preamble.

III. Redemptions Treated as a Sale or Exchange Pursuant to Section 
302(a)

A. In General
    Under current law for redemptions characterized under section 
302(a), a shareholder that owns shares of stock with different bases 
can decide whether to surrender for redemption high basis shares, low 
basis shares or any combination thereof. See Sec.  1.1012-1(c). 
Consistent with treating a share as a discrete unit of property, the 
proposed regulations do not limit this electivity. Additionally, as 
further discussed below, these proposed regulations affirm the ability 
of a shareholder to specify the terms of a reorganization exchange 
where the receipt of boot results in sale or exchange treatment.
B. Reorganization Exchanges That Result in Sale or Exchange Treatment
    If it is determined that the reorganization exchange is not 
dividend equivalent (as described in section II.C. of this Preamble), 
section 302(a) will apply to the extent shares are exchanged solely for 
boot. Just as a shareholder can elect to surrender high basis shares, 
low basis shares or any combination thereof in a non-dividend 
equivalent redemption, a shareholder engaging in a reorganization 
exchange that is not dividend equivalent can specify the receipt solely 
of boot for a share, provided that the terms of the exchange are 
economically reasonable. In such case, the shareholder will recognize 
gain or loss with respect to that share pursuant to section 302(a), and 
section 356(a)(1) will not apply.

IV. Extension of Tracing Principles To Determine Basis in Certain Stock 
Transfers That Are Not Reorganizations, and Other Proposals in Response 
to Specific Comments

A. Application of Tracing Principles to Certain Section 351 Exchanges 
and Capital
    The current section 358 regulations apply tracing principles to 
determine the basis of stock received in a section 351 exchange only 
where the section 351 exchange also qualifies as a reorganization and 
no liabilities was assumed in the exchange. The principal reason for 
this limitation is the interaction of the basis tracing rules with the 
aggregate approach to gain determination under section 357(c). The IRS 
and Treasury Department continue to study this issue, but have 
concluded that the resolution of this issue is not necessary to broaden 
the application of the tracing rules to transfers of stock in section 
351 exchanges in which no

[[Page 3513]]

liabilities are assumed. Thus, for example, in an exchange to which 
section 351 applies where the transferor transfers two blocks of stock 
with disparate basis and other property, the separate bases will be 
preserved under section 358, provided that liabilities are not assumed 
in the exchange.
    In addition, these proposed regulations incorporate the deemed 
issuance and recapitalization approach of the current section 358 
regulations to section 351 exchanges to preserve basis if insufficient 
shares, or no shares at all, are actually issued in the exchange. These 
proposed regulations also extend the deemed issuance and 
recapitalization approach to shareholder capital contributions to which 
section 118 applies.
B. Miscellaneous
    The IRS and Treasury Department have received a number of comments 
on the current section 358 regulations. These proposed regulations make 
a number of clarifying, but nonsubstantive, modifications to the 
current section 358 regulations. Specifically, the proposed regulations 
add headings throughout the existing final Sec. Sec.  1.358-1 and 
1.358-2 regulations without substantive change. In addition, the 
proposed regulations address the following comments received with 
respect to the current section 358 regulations.
    Commentators questioned how shareholder elections factor into the 
terms of the exchange. These proposed regulations include two new 
examples illustrating the effect of such elections.
    Commentators questioned the effect of the terms of an exchange on 
the determination of whether a transaction qualifies as a 
reorganization, and therefore is not subject to the general rule of 
section 1001. These proposed regulations include cross-references in 
the regulations under sections 368 and 1001 to clarify that, to the 
extent the terms of the exchange specify that a particular property is 
received in exchange for a particular property, such terms shall 
control for purposes of determining whether a transaction qualifies as 
a reorganization provided such terms are economically reasonable.
    Finally, in addition to provisions relating to the determination of 
basis, these proposed regulations add a rule that addresses certain 
issues considered in Rev. Rul. 68-55 (1968-1 CB 140). Specifically, 
consistent with Rev. Rul. 68-55, these regulations provide that, for 
purposes of determining gain under section 351(b), the fair market 
value of each category of consideration received in a section 351 
exchange is allocated between the transferred assets in based on 
relative fair market values.

V. Specifically Requested Comments

    In addition to the comments requested throughout this Preamble, the 
IRS and Treasury request comments on the following areas.
    The proposed regulations under section 302 do not apply to a 
redemption of stock described in section 306(c). Pursuant to section 
306(a)(2), a redemption of stock described in section 306(c) is treated 
as a distribution of property to which section 301 applies. Example 2 
of Sec.  1.306-1 suggests that the unrecovered basis of redeemed 
section 306 stock is added to the basis of the stock with respect to 
which the section 306 stock was distributed. The IRS and Treasury 
Department request comments on whether such treatment is appropriate or 
whether an alternative regime should apply when such a section 306(c) 
redemption is treated as a section 301 distribution.
    Comments are also requested regarding whether, after a section 355 
pro rata split-up, the controlled corporations are the same as or 
different from the distributing corporation for purposes of determining 
whether the date of distribution would be an inclusion date for a 
deferred loss attributable to unrecovered basis.
    Finally, the IRS and Treasury Department recognize that the 
proposed regulations may not address all related issues arising in all 
cash ``D'' reorganizations. Specifically, these proposed regulations 
may heighten the importance of whether the nominal share deemed issued 
in such a reorganization is received in respect of particular shares 
surrendered by the exchanging shareholder. The IRS and Treasury 
Department request comments with respect to this issue.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. Further, it 
is hereby certified that these proposed regulations will not have a 
significant economic impact on a substantial number of small entities. 
This certification is based on the fact that these regulations provide 
clarifying guidance of existing law and do not create additional 
obligations for, or impose an economic impact on small entities. 
Accordingly, a Regulatory Flexibility Analysis under the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to 
section 7805(f) of the Code, this notice of proposed rulemaking will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. All comments will be available for public inspection and copying. 
If a public hearing is scheduled, notice of the date, time, and place 
for the public hearing will be published in the Federal Register.

Drafting Information

    The principal authors of these regulations are Theresa M. Kolish 
and Rebecca O. Burch of the Office of Associate Chief Counsel 
(Corporate). Other personnel from offices of the IRS and Treasury 
Department participated in their development.

Availability of IRS Documents

    IRS revenue rulings, procedures, and notices cited in this preamble 
are made available by the Superintendent of Documents, U.S. Government 
Printing Office, Washington, DC 20402.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR Part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read, 
in part, as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.301-2 is added to read as follows:


Sec.  1.301-2  Application to basis.

    (a) Application to basis. That portion of a distribution which is 
not a dividend shall be applied pro rata, on a share-by-share basis, to 
reduce the adjusted basis of each share of stock held by the 
shareholder within the class of stock upon which the distribution is 
made. The following example illustrates this paragraph (a):

    Example. (i) Facts. Corporation X, a calendar year taxpayer, has 
only common stock outstanding. A, an individual, owns all 100 
shares; 25 were acquired on Date 1 for $25 (Block 1) and 75 were 
acquired on Date

[[Page 3514]]

2 for $175 (Block 2). On December 31, when Corporation X had 
earnings and profits of $100, it made a $3 distribution on each 
share of common stock.
    (ii) Analysis. A is treated as receiving $75 of the distribution 
on block 1 and $225 on block 2. On Block 1, A will have a $25 
dividend under section 301(c)(1), a $25 return of capital under 
section 301(c)(2) and a $25 gain under section 301(c)(3). On Block 
2, A will have a $75 dividend under section 301(c)(1), a $150 return 
of capital under section 301(c)(2) and will have a remaining basis 
of $25 in the shares of block 2.

    (b) Effective/applicability date. This section applies to 
transactions that occur after the date these regulations are published 
as final regulations in the Federal Register.


Sec.  1.302-2  [Amended]

    Par. 3. In Sec.  1.302-2, paragraph (c) is removed and reserved.
    Par. 4. Section 1.302-5 is added to read as follows:


Sec.  1.302-5  Redemptions under section 302(d).

    (a) In general--(1) Share-by-share basis reduction. In any case in 
which an amount received in redemption of stock (as defined in section 
317(b)) is treated as a distribution to which section 301 applies, that 
portion of a distribution that is not a dividend shall be applied to 
reduce the adjusted basis of each share held by the redeemed 
shareholder (as defined in paragraph (b) of this section) in the 
redeemed class (as defined in paragraph (b) of this section). Such 
reduction shall be applied pro rata, on a share-by-share basis, to all 
shares of the redeemed class held by the redeemed shareholder. Gain, if 
any, on a share shall be determined under section 301(c)(3).
    (2) Deemed recapitalization. Except as provided in paragraph (a)(3) 
of this section, immediately following the reduction of basis as 
provided in section 301(c)(2) and paragraph (a)(1) of this section, all 
shares of the redeemed class, including the redeemed shares, held by 
the redeemed shareholder will be treated as surrendered in a 
reorganization described in section 368(a)(1)(E) in exchange for the 
number of shares of the redeemed class directly held by the redeemed 
shareholder after the redemption. The basis of the shares deemed 
received in the reorganization described in section 368(a)(1)(E) will 
be determined under the rules of section 358 and Sec.  1.358-2.
    (3) Redemption of all shares of redeemed class--(i) Remaining basis 
treated as loss. If all the shares of the redeemed class held by the 
redeemed shareholder are redeemed, an amount equal to the basis of the 
redeemed stock, after adjusting such basis to reflect the application 
of section 301(c)(2) as provided in paragraph (a)(1) of this section, 
will be treated as a loss on a disposition of the redeemed stock on the 
date of the redemption. Such loss is taken into account on the 
inclusion date as defined in paragraph (b) of this section.
    (ii) Attributes of loss. Notwithstanding that a loss described in 
paragraph (a)(3)(i) of this section may be deferred and taken into 
account on a date later than the date of the redemption, the attributes 
(for example, character and source) of such loss are determined on the 
date of the redemption that gave rise to such loss.
    (b) Definitions--(1) Redeemed shareholder. Except as provided in 
paragraph (c) of this section, the term redeemed shareholder means the 
person whose stock is redeemed in a transaction. If the redeemed 
shareholder is a corporation, and the assets of the redeemed 
shareholder are acquired in a transaction described in section 381(a) 
(other than transactions described in paragraph (b)(4)(ii) of this 
section), the acquiring corporation (within the meaning of section 381) 
thereafter is treated as the redeemed shareholder.
    (2) Redeemed class. With respect to a shareholder whose stock has 
been redeemed, the term redeemed class means all of the shares of that 
class held by the redeemed shareholder. For this purpose, a class is 
defined with respect to economic rights to distributions rather than 
the labels attached to shares or rights with respect to corporate 
governance.
    (3) Redeeming corporation. The term redeeming corporation means the 
corporation that issued the stock that is redeemed.
    (4) Inclusion date--(i) Definition. The term inclusion date means 
the earlier of--
    (A) The first date on which the redeemed shareholder would satisfy 
the criteria of section 302(b)(1), (2), or (3), if the facts and 
circumstances that exist at the end of such day had existed immediately 
after the redemption; or
    (B) The first date on which all classes of stock of the redeeming 
corporation become worthless within the meaning of section 165(g). 
Solely for purposes of this paragraph, if the assets of the redeeming 
corporation (or its successor) are acquired by another corporation in a 
transaction described in section 381(a), the inclusion date for the 
redeemed shareholder is determined by treating all of the facts and 
circumstances that exist at the end of the day that includes the 
section 381 transaction (including the acquisition of the assets of the 
redeeming corporation or its successor) as existing immediately after 
the redemption. A successor for this purpose means a corporation that 
acquires the assets of the redeeming corporation in a transaction to 
which section 381(a) applies.
    (ii) Special rules for corporate shareholders. If the redeemed 
shareholder is a corporation, the inclusion date includes the date such 
corporation has disposed of all of its assets in a transaction in which 
all gain and loss with respect to its assets is recognized in whole, 
and the corporation ceases to exist for tax purposes. If the redeemed 
shareholder is a foreign corporation, the inclusion date includes the 
date such corporation transfers its assets to a domestic corporation in 
either a liquidation described in section 332 or a reorganization 
described in section 368(a)(1) to which section 381 applies. If the 
redeemed shareholder is a foreign corporation that is not a controlled 
foreign corporation within the meaning of section 957(a) on the date of 
the redemption, the inclusion date includes the date such corporation 
transfers its assets to a controlled foreign corporation in a 
liquidation described in section 332 or a reorganization described in 
section 368(a)(1) to which section 381 applies.
    (c) Rules for special shareholders--(1) Redeemed shareholder is a 
partnership. [Reserved]
    (2) Redeemed shareholder is an S corporation. [Reserved]
    (3) Redeemed shareholder is an estate or trust. [Reserved]
    (d) Operating rules for treatment of loss attributable to basis of 
redeemed stock--
    (1) Treatment as a deferred loss. Any loss attributable to the 
basis of redeemed stock under paragraph (a) of this section that has 
not been permitted to be taken into account under such section shall be 
treated as a deferred loss. The character of the deferred loss as 
ordinary or capital is determined at the time of the redemption.
    (2) Effect of loss attributable to basis of redeemed stock on 
earnings and profits. If the redeemed shareholder is a corporation, any 
deferred loss attributable to the basis of redeemed stock is not 
reflected in such corporation's earnings and profits before it is taken 
into account pursuant to the rules of paragraph (a)(3) of this section. 
See, for example, Sec. Sec.  1.312-6(a) and 1.312-7.
    (e) Examples. For the purposes of the examples in this section, 
Corporations X, Y and Z are domestic corporations

[[Page 3515]]

that file U.S. tax returns on a calendar-year basis. The examples are 
as follows:

    Example 1. (i) Facts. A and B, husband and wife, each own 100 
shares (50 percent) of the common stock of Corporation X which they 
hold as a capital asset. On Date 1, A acquired 50 shares for $100 
(block 1) and 50 shares on Date 2 for $200 (block 2). On December 
31, Corporation X, which has no current or accumulated earnings and 
profits, redeems all of A's block 2 shares for $300. Under section 
302(d), the redemption proceeds are treated under section 301 as a 
recovery of basis.
    (ii) Analysis. Under this section, immediately before the 
redemption, the distribution of property is applied on a pro rata, 
share-by-share basis with respect to each of the shares in the 
redeemed class held directly by A, the redeemed shareholder. 
Accordingly, A will have a $50 capital gain on block 1 ($150-100) 
under section 301(c)(3) and $50 of basis remaining on block 2 ($150-
200). To reflect the actual number of shares held by A after the 
redemption, A's shares in the redeemed class, including the shares 
actually surrendered, will be treated as exchanged in a 
recapitalization under section 368(a)(1)(E). The basis in A's 
recapitalized shares will be determined under Sec.  1.358-2. 
Accordingly, A will have 25 shares with a zero basis (attributable 
to block 1) and 25 shares with a basis of $50 (attributable to block 
2).
    Example 2. (i) Facts. The facts are the same as in Example 1, 
except that, Corporation X, on the following December 31, when it 
has no current or accumulated earnings and profits, redeems all of 
A's remaining 50 shares for $40. A does not file an agreement 
described in section 302(c)(2)(A)(iii) waiving family attribution 
under section 318.
    (ii) Analysis. Since A is treated under section 318(a)(1) as 
owning B's shares, the redemption is described in section 302(d) and 
is treated as a distribution to which section 301 applies. As in 
Example 1, immediately before the redemption, the distribution is 
applied on a pro rata, share-by-share basis with respect to each of 
the shares in the redeemed class held by A. Accordingly, A 
recognizes a $20 gain and a $30 loss. The $30 deferred loss under 
Sec.  1.302-5(a)(3) may be taken into account by A on the inclusion 
date (see Sec.  1.302-5(a)(3)(ii)).
    Example 3. (i) Facts. Corporation X has both common and 
preferred stock outstanding. A, an individual, has 100 shares of 
common stock with a basis of $100 and 100 shares of preferred stock 
with a basis of $200. The 100 shares of common stock represent 
voting control of Corporation X. Corporation X, when it has no 
current or accumulated earnings and profits, redeems all of A's 
preferred stock for $150. Section 302(d) applies to the redemption, 
and therefore the distribution is treated as a distribution of 
property to which section 301 applies.
    (ii) Analysis. If Corporation X had declared a distribution 
under section 301 with respect to the redeemed preferred stock, the 
distribution would have been limited to the shares of common stock. 
Therefore, the only basis recovered under section 301(c)(2) is the 
basis of A's preferred stock. A has $50 in excess basis after the 
redemption of all its preferred stock which will not shift to the 
common stock held by A. Under Sec.  1.302-5(a)(3), the excess basis 
will be treated as a deferred loss until the inclusion date.
    Example 4. (i) Facts. Corporation Z has 100 shares of stock 
outstanding, 50 shares of which are owned by each of A and his son, 
B. A's basis in each of his shares of Corporation Z stock is $1. In 
Year 1, Corporation Z redeems all of A's shares of Corporation Z 
stock for $200. A does not file an agreement described in section 
302(c)(2)(A)(iii) waiving family attribution under section 318. At 
the end of Year 1, Corporation Z has current and accumulated 
earnings and profits in excess of $200. Section 302(d) applies to 
the redemption, and therefore the distribution is treated as a 
distribution to which section 301 applies. A recognizes dividend 
income of $200. In Year 6, Corporation Y, a publicly traded 
corporation acquires all of Corporation Z's assets in exchange 
solely for voting stock in a reorganization described in section 
368(a)(1)(C). In the reorganization, B surrenders his shares of 
Corporation Z stock which, at the time of the reorganization have an 
aggregate fair market value of $200, and receives in exchange 5,000 
shares of common stock of Corporation Y representing less than one 
percent of the fair market value of all the stock of Y.
    (ii) Analysis. Under this section, an amount equal to A's basis 
in the redeemed stock after the Year 1 redemption, $50, is treated 
as a deferred loss on a disposition of the redeemed stock on the 
date of the redemption. Under paragraph (b)(3) of this section, 
solely for purposes of determining whether a particular date on or 
after the date of the reorganization is the inclusion date, 
Corporation Y, the acquiring corporation, is treated as the 
redeeming corporation. If the facts and circumstances that exist at 
the end of the day of the reorganization had existed on the date of 
the redemption, the redemption would have been treated as a 
distribution in part or full payment in exchange for the redeemed 
stock pursuant to section 302(a). Therefore, the date of the 
reorganization is the inclusion date and A is permitted to take into 
account the deferred loss of $50 attributable to his basis in the 
redeemed stock in Year 6.

    (f) Effective/applicability date. This section applies to 
transactions that occur after the date these regulations are published 
as final regulations in the Federal Register.
    Par. 5. Section 1.304-1 is revised to read as follows:


Sec.  1.304-1  In general.

    (a) In general. Section 304 is applicable where a shareholder sells 
stock of one corporation to a related corporation as defined in section 
304. Sales to which section 304 is applicable shall be treated as 
redemptions subject to sections 302 and 303.
    (b) Effective/applicability date. This section applies to 
transactions that occur after the date these regulations are published 
as final regulations in the Federal Register.
    Par. 6. Section 1.304-2 is amended by revising paragraphs (a) and 
(c), and adding paragraph (d) to read as follows:


Sec.  1.304-2  Acquisition by related corporation (other than a 
subsidiary).

    (a) In general (1) If a corporation (the acquiring corporation), in 
return for property, acquires the stock of another corporation (the 
issuing corporation) from one or more persons, and such person or 
persons from whom the stock was acquired were in control of both such 
corporations, then such property shall be treated as received in 
redemption of the common stock of the acquiring corporation. As to each 
person transferring stock, the amount received shall be treated as a 
distribution to which section 301 applies, if section 302(a) or 303 
does not apply. For the amount constituting a dividend in such cases, 
see Sec.  1.304-6.
    (2) Section 302(b). In applying section 302(b), reference shall be 
made to the ownership of stock in the issuing corporation and not to 
the ownership of the acquiring corporation (except for the purposes of 
applying section 318(a)). Section 318(a) shall be applied without 
regard to the 50 percent limitation contained in section 318(a)(2)(C) 
and (3)(C).
    (3) Section 302(d). If, pursuant to section 302(d), section 301 
applies to the property received in redemption of the common stock of 
the acquiring corporation pursuant to paragraph (a)(1) of this section, 
the transferor and the acquiring corporation shall be treated, for all 
Federal income tax purposes, in the same manner as if the transferor 
had transferred the stock of the issuing corporation to the acquiring 
corporation in exchange for the common stock of the acquiring 
corporation in a transaction to which section 351 applies, and then the 
acquiring corporation had redeemed the common stock it was treated as 
issuing in an exchange for property. Accordingly, the acquiring 
corporation's basis in the stock of the issuing corporation is 
determined under section 362, and, under section 358, the transferor's 
basis in the common stock of the acquiring corporation deemed issued to 
the transferor in the deemed section 351 transaction is equal to the 
transferors basis in the stock of the issuing corporation it 
surrendered.
    (4) Basis of redeemed shares. To the extent that section 301(c)(2) 
applies to the redemption of the common stock of the acquiring 
corporation issued in the deemed section 351 exchange, the amount 
distributed in such redemption

[[Page 3516]]

shall be applied to reduce the adjusted basis of each share of common 
stock directly held or deemed held by the transferor on a pro rata, 
share-by-share basis. See Sec.  1.302-5(a).
    (5) Sale or exchange treatment. If section 301 does not apply to 
the property treated as received in redemption of the common stock of 
the acquiring corporation pursuant to paragraph (a)(1) of this section, 
the property received by the transferor shall be treated as received in 
a distribution in full payment in exchange for such common stock of the 
acquiring corporation under section 302(a). The basis and the holding 
period of the common stock of the acquiring corporation that is treated 
as redeemed will be the same as the basis and holding period of the 
stock of the issuing corporation actually surrendered. The acquiring 
corporation shall take a cost basis in the stock of the issuing 
corporation that it acquires under section 1012.
* * * * *
    (c) Examples. For purposes of the examples in this section, each of 
corporation is a domestic corporation that files a U.S. tax return on a 
calendar-year basis and in each instance the fair market value of the 
issuing corporation stock is in excess of its adjusted basis. The 
principles of this section are illustrated by the following examples:

    Example 1. (i) Facts. Corporation X and Corporation Y each has 
100 shares of common stock outstanding. A, an individual, owns one-
half of the stock of each corporation, B owns one-half of the stock 
of Corporation X, and C owns one-half of the stock of Corporation Y. 
A, B, and C are unrelated. A sells 30 shares of the stock of 
Corporation X, which have an adjusted basis of $10, to Corporation Y 
for $50.
    (ii) Analysis. Section 304(a)(1) applies to A's sale of 30 
shares of Corporation X stock to Corporation Y because A controls 
both Corporation X and Corporation Y within the meaning of section 
304(c), and Corporation Y acquires the 30 shares of Corporation X 
stock from A in exchange for property ($50 of cash). Pursuant to 
section 304(a)(1), the cash received by A is treated as a redemption 
of the stock of Corporation Y. Because before the sale A owns 50 
percent of the stock of Corporation X and after the sale A owns only 
35 percent of such stock (20 shares directly and 15 constructively 
because one-half of the 30 shares owned by Corporation Y are 
attributed to A), the redemption is substantially disproportionate 
as to A pursuant to the provisions of section 302(b)(2). A, 
therefore, recognizes a gain of $40 ($50 minus $10). If the stock 
surrendered is a capital asset, such gain is long-term or short-term 
capital gain depending on the period of time that A held such stock. 
A's basis in the stock of Corporation Y is not changed as a result 
of the sale. Under section 1012, the basis that Corporation Y takes 
in the acquired stock of Corporation X is its cost of $50.
    Example 2. (i) Facts. Corporation X and Corporation Y each has 
200 shares of common stock outstanding, all of which are owned by H, 
an individual. H has a basis $100 in his Corporation X stock and $30 
in his Corporation Y stock. Corporation X has $40 and Corporation Y 
has $20 of current and accumulated earnings and profits. H sells his 
200 shares of Corporation X stock to Corporation Y for $150 at a 
time when Corporation Y stock also has a fair market value of $150.
    (ii) Analysis. Section 304(a)(1) applies to H's sale of his 200 
shares of Corporation X stock to Corporation Y because H controls 
both Corporation X and Corporation Y within the meaning of section 
304(c), and Corporation Y acquires the 200 shares of Corporation X 
stock from H in exchange for property. Pursuant to section 
304(a)(1), the cash received by H is treated as a redemption of the 
stock of Corporation Y. Because before the sale H directly owns 100 
percent of Corporation X and after the sale H is treated as owning 
100 percent of Corporation X, section 302(a) does not apply to the 
deemed redemption distribution. Under section 302(d), the proceeds 
of the deemed redemption are treated as a distribution to which 
section 301 applies. Therefore, H is treated as transferring the 
Corporation X stock to Corporation Y in exchange for Corporation Y 
common stock in a transaction to which section 351(a) applies. 
Corporation Y's basis in the Corporation X stock acquired is $100 
under section 362(a), the same basis that H had in the Corporation X 
stock surrendered. H takes a basis of $100 in the Corporation Y 
common stock H is treated as receiving in the deemed section 351 
exchange. Corporation Y is then treated as redeeming such 
Corporation Y common stock from H for $150 in a transaction to which 
section 301 applies. H is treated as receiving a dividend of $60 
($20 from the current and accumulated earnings and profits of 
Corporation Y and then $40 from the current and accumulated earnings 
and profits of Corporation X) (see section 304(b)). Under Sec.  
1.302-5, the remaining $90 of the distribution will be applied to 
and reduce the basis of each share of Corporation Y stock held by H. 
Accordingly, H will have no gain on the shares deemed received in 
the section 351 exchange which have a $100 basis, but will have a 
$15 gain on the Corporation Y shares with a $30 basis. After the 
redemption transaction, all of H's shares in Corporation Y, 
including the deemed shares that are redeemed, are treated as 
exchanged in a recapitalization described in section 368(a)(1)(E). 
The basis of the redeemed shares and the shares actually outstanding 
in Corporation Y are allocated pursuant to Sec.  1.358-2(a). 
Accordingly, of H's 200 shares in Corporation Y common stock, 100 
will have a basis of $55, and 100 will have a zero basis.
    Example 3. (i) Facts. Corporation W acquired all of the 
outstanding stock of Corporation X stock for $75 (100 shares of 
common) and then acquired all of the outstanding stock of 
Corporation Y (50 shares of common stock for $75 and 50 shares of 
common stock for $100). Only corporation Y has current or 
accumulated earnings and profits ($100). Corporation W sells all the 
shares in Corporation X to Corporation Y for $300. At the time of 
the transaction, the Corporation X and Corporation Y stock have the 
same fair market value.
    (ii) Analysis. Section 304(a)(1) applies to Corporation W's sale 
of Corporation X to Corporation Y because Corporation W is in 
control of both Corporation X and Corporation Y within the meaning 
of section 304(c), and Corporation Y acquires the Corporation X 
stock in exchange for property. Because before the sale Corporation 
W owns 100 percent of Corporation X, and after the sale is treated 
as owning 100 percent of Corporation X, section 302(a) does not 
apply to the deemed redemption distribution. Under section 302(d), 
the proceeds of the deemed redemption are treated as a distribution 
to which section 301 applies. Section 1059(e)(1)(A)(iii) also 
applies. Corporation W is treated as transferring the Corporation X 
stock to Corporation Y in exchange for Corporation Y common stock in 
a transaction to which section 351(a) applies. Corporation Y's basis 
in the Corporation X stock is $75 under section 362(a), the same 
basis that Corporation W had in the stock it surrendered. 
Corporation W takes a $75 basis in the Corporation Y common stock it 
is deemed to receive in the deemed section 351 transaction. 
Corporation Y is then treated as redeeming such Corporation Y common 
stock from Corporation W for $300. In a redemption to which section 
301 applies, Corporation W is treated as receiving a dividend of 
$100 (from the current and accumulated earnings and profits of 
Corporation Y) (see section 304(b)). Under section 1059, the $100 
dividend is treated as an extraordinary dividend which, under the 
flush language of section 1059(e)(1)(A)(iii), reduces only the basis 
of the stock deemed redeemed, which has a basis of $75. Accordingly, 
Corporation W recognizes a $25 gain. Under Sec.  1.302-5, the 
remaining $200 of the distribution is applied to reduce the basis of 
the Corporation Y stock held by Corporation W on a pro rata, share-
by-share basis, including the basis in the shares deemed redeemed. 
Accordingly, $100 is allocated to the Corporation Y stock that 
Corporation W deemed received in the section 351 transaction that 
now has a zero basis after the application of section 1059 and the 
remaining $100 is allocated to Corporation W's other two blocks of 
Corporation Y stock. Corporation W has a total gain of $125 on the 
Corporation Y stock deemed received and redeemed; and $25 and $50, 
respectively, of remaining basis in the other 2 blocks of 
corporation Y shares. After the redemption transaction, all of 
Corporation W's shares in corporation Y, including the deemed shares 
that are redeemed, are treated as exchanged in a recapitalization 
described in section 368(a)(1)(E). As a result, corporation W will 
have 100 shares in corporation Y, 50 shares will have a zero basis, 
25 shares will have a $25 basis, and 25 shares will have a $50 
basis.

    (d) Effective/applicability date. This section applies to 
transactions that

[[Page 3517]]

occur after the date these regulations are published as final 
regulations in the Federal Register.
    Par. 7. Section 1.304-3 is amended by revising paragraph (a) and 
adding paragraph (c) to read as follows:


Sec.  1.304-3  Acquisition by a subsidiary.

    (a) In general. If a subsidiary, in return for property, acquires 
stock of its parent corporation from a shareholder of the parent 
corporation, the acquisition of such stock will be treated as if the 
parent corporation had redeemed its own stock in exchange for the 
property. For the purposes of this section, a corporation is a parent 
corporation if it meets the 50 percent ownership requirements of 
section 304(c). The determination of whether the amount received shall 
be treated as received in payment in exchange for the stock will be 
made by applying section 302(b) with reference to the stock of the 
issuing parent corporation, or by applying section 303.
* * * * *
    (c) Effective/applicability date. This section applies to 
transactions that occur after the date these regulations are published 
as final regulations in the Federal Register.
    Par. 8. Section 1.304-5 is amended by adding a sentence at the end 
of paragraph (a) and revising paragraph (c) to read as follows:


Sec.  1.304-5  Control.

    (a) * * * Specifically, section 318(a) will be applied by 
substituting ``5 percent'' for ``50 percent'' in section 318(a)(2)(C) 
and by substituting ``5 percent'' for ``50 percent'' in section 
318(a)(3)(C), except that if section 318(a)(3)(C) would not have 
applied but for this substitution, by considering a corporation as 
owning the stock (other than stock in such corporation) owned by or for 
any shareholder of such corporation in that proportion which the value 
of the stock which such shareholder owned in such corporation bears to 
the value of all stock in such corporation.
* * * * *
    (c) Effective/applicability date. This section applies to 
transactions that occur after the date these regulations are published 
as final regulations in the Federal Register.
    Par. 9. Section 1.351-2 is amended by redesignating paragraphs (b), 
(c), (d) and (e) as paragraphs (c), (d), (e) and (f), respectively and 
adding new paragraphs (b) and (g) to read as follows:


Sec.  1.351-2  Receipt of property.

* * * * *
    (b) To determine the amount of gain recognized under section 
351(b), the fair market value of each category of consideration 
received by each transferor is allocated to the properties transferred 
in proportion to each property's relative fair market value. The 
application of this paragraph (b) is illustrated by the following 
example:

    Example. C transfers $2,000 in exchange for 200 shares of stock. 
D transfers Asset I, Asset II, and Asset III in exchange for $100 
cash and 100 shares of stock. The exchange is subject to section 
351. At the time of the exchange, Asset I has a fair market value of 
$220 and a basis of $400, Asset II has a fair market value of $330 
and a basis of $200, and Asset III has a fair market value of $550 
and a basis of $250. No gain or loss is recognized to C. Gain, but 
not loss, is recognized by D. To determine the gain recognized by D 
under section 351(b), the fair market value of each category of 
consideration received is allocated to the properties transferred in 
proportion to the relative fair market values of the properties 
transferred. Asset I represents 20 percent of the total fair market 
value of assets transferred (220/1100), Asset II represents 30 
percent (330/1100), and Asset III represents 50 percent (550/1100). 
Under paragraph (b) of this section, the amount of gain recognized 
by D is determined by allocating a pro rata portion of each class of 
consideration received to each property transferred as follows: (A) 
$20 cash and 20 shares of stock to Asset I (20 percent of 100 shares 
of stock and 20 percent of $100 (B) $30 cash and 30 shares of stock 
to Asset II (30 percent of 100 shares of stock and 30 percent of 
$100); and (C) $50 cash and 50 shares of stock to Asset III (50 
percent of 100 shares of stock and 50 percent of $100). D realizes a 
loss of $180 on Asset I, none of which is recognized, a gain of $130 
on Asset II, $30 of which is recognized, and a gain of $300 on Asset 
III, $50 of which is recognized.
* * * * *
    (g) This section applies to exchanges that occur after the date 
these regulations are published as final regulations in the Federal 
Register, except for exchanges which occur pursuant to a written 
agreement that is binding on or before the date these regulations are 
published as final in the Federal Register. For exchanges that occur on 
or before the date that these regulations are published as final 
regulations in the Federal Register, see this section as contained in 
26 CFR part 1 revised April 1, for the year before these regulations 
are published as final regulations in the Federal Register.
    Par. 10. Section 1.354-1 is amended by:
    1. Revising the section heading.
    2. Redesignating paragraphs (d), (e) and (f) as paragraphs (e), (f) 
and (g), respectively.
    3. Adding new paragraphs (d) and (h).
    4. Adding Example 5 to the end of newly designated paragraph (e).
    The additions and revisions read as follows:


Sec.  1.354-1  Exchanges of stock, securities and other property in 
certain reorganizations.

* * * * *
    (d) Exchanges solely or partly for money or other property--(1) 
Determination of consideration for a share of stock or a security. In 
determining the consideration received for a share of stock or a 
security, except as otherwise provided in this paragraph (d)(1), a pro 
rata portion of any other property and money received shall be treated 
as received in exchange for each share of stock and security 
surrendered, based on the fair market value of such surrendered share 
of stock or security. However, to the extent the terms of the exchange 
specify the other property or money that is received in exchange for a 
particular share of stock or security surrendered or a particular class 
of stock or securiti