law for nonvoting preferred stock which must be ignored for purposes of section 382. The new exception is limited to nonvoting stock which has fixed and preferred dividends and does not participate in corporate growth to any significant extent, has redemption and liquidation rights which do not exceed paid-in capital or par value (except for a reasonable redemption premium), and is not convertible into another class of stock.

The Act also defines "participating stock" to mean stock (including common stock) which represents an interest in the corporate earnings and assets not limited to a stated amount of money or property or percentage of paid-in capital or par value, or by any similar formula. The reorganization rules will thus not be fully satisfied by giving loss company shareholders only conventional preferrred stock (whether voting or nonvoting),29

The new rules require the Service to determine by regulation whether a variety of instruments (however denoted) which may be difficult to classify under general definitions are to be considered stock or participating stock for purposes of this provision. For this purpose, the Service will deal by regulation with conversion and call rights, rights in earnings and assets, priorities and preferences, and similar factors (including collateral agreements and "puts" back to the issuing company) in determining whether or not a particular instrument will be treated as "stock" or as "participating stock."30 The Libson Shops doctrine.-In Libson Shops, Inc. v. Koehler, 353 U.S. 382 (1957), the Supreme Court, in a case decided under the 1939 Code, adopted an approach to the loss carryover area under which loss carryovers would basically follow the specific business activities which gave rise to the losses. Some uncertainty existed after this decision as to whether the business continuity approach represents a separate, nonstatutory test for determining carryovers of net operating losses. As a result of the changes made by the Act, Congress intends that the so-called Libson Shops test should have no application to determining net operating loss carryovers after stock purchases or reorganizations to tax years governed by the new rules. However, Congress intends that no inference should be drawn concerning the applicability or

29 As indicated earlier, section 382 is applied in effect by reference to the lesser percentage of participating stock or of all stock retained by former owners of a loss company. Under section 382(a), for example, if a loss company recapitalizes by freezing the bulk (e.g., 95 percent) of its current value into voting preferred stock, and the balance into common stock which the owners then sell to outsiders, the latters' purchase may cause a reduction in carryovers. Although the common (participating) stock represents only 5 percent of the company's current value, it also represents 100 percent of its future value. Since the former owners retained no share in this future value, the company's loss carryovers will be eliminated entirely.

30 Under some circumstances, fully participating preferred stock may properly be treated as participating stock in light of the practical economic effect of its preferential right to earnings.

Under this delegation, the Service can also deal with contingent share reorganizations and with non voting preferred stock which obtains voting rights only if and when certain events occur (such as missing a stated number of dividends). The delegation will also permit the Service, on appropriate facts, to ignore stock held as security for a loan to the corporation (see regulation sec. 1.305-3(e), example (14)), or stock held in escrow (see Glover Packing Co. of Texas v. U.S., 328 F. 2d 342 (Ct. Cl. 1964). This delegation also gives the Service specific authority under section 382 to treat convertible preferred stock or bonds, warrants and other options as equivalent to the underlying stock where appropriate to prevent manipulations of stock structures designed to circumvent the basic policies underlying section 382.

nonapplicability of theLibson Shops case in determining net operating loss carryovers to tax years governed by prior law.31

The general tax avoidance test.-Congress did not change the basic provisions of section 269 of the Code. Congress believes, however, that section 269 should not be applied to disallow net operating loss carryovers in situations where part or all of a loss carryover is permitted under the specific rules of section 382, unless a device or scheme to circumvent the purpose of the carryover restrictions appears to be present.32 Congress also concluded that this general disallowance provision should be retained for transactions not expressly within the fixed rules of section 382. Section 269 is retained, for example, to deal with "built-in-loss" transactions, other post-acquisition losses, acquisitions expressly excepted from section 382, and other exchanges or transfers which are apparent devices to exploit continuing gaps in the technical rules for tax avoidance purposes.

Effective date

In order to allow a reasonable time for the Internal Revenue Service to issue regulations under the new rules, the Act delays the effective date of the new rules generally for one year. The new rules apply to reorganizations pursuant to plans adopted by one or more of the parties on or after January 1, 1978. A reorganization plan will be considered adopted on the date the board of directors adopts the plan or recommends its adoption to the shareholders, or on the date the shareholders approve the plan, whichever is earlier. If the new limitations affect a reorganization occurring in 1978, net operating loss carryovers to 1977 from earlier years will not be affected by the new rules, but carryovers of operating losses to 1978 and later years may be limited. A loss occurring in 1977 (or in a fiscal year ending in 1978) may also be limited as a carryover to 1978 (or to a fiscal year ending in 1979) and later years.

In the case of purchases of stock of a loss company and other acquisitions subject to new sec. 382(a), the new rules take effect for taxable years of a loss corporation beginning after June 30, 1978.

31 Congress does not intend the changes in section 382 to affect the "continuity of business enterprise" requirement which the courts and the Service have long established as a condition for basic nonrecognition treatment of a corporate reorganization (see sec. 1.368-1(b) of the regulations).

Congress also does not intend to deprive the Service of other weapons to attack transactions in which the benefits of loss carryovers are improperly transferred in ways other than by transfers of stock, or transactions where section 382 is otherwise satisfied (in whole or part). For example, the new rules do not affect the principles of substance over form, step transaction (see, e.g., the examples in regulations sec. 1.382 (b)-1 (c), corporate entity, assignment of income. or the rules of Code sections 482 or 704 (b) (relating to allocations). Nor do the new rules prevent the Service, in appropriate cases, from challenging situations where a loss company pays more than fair market value for stock or assets of another company.

For example, section 269 could still apply to a case where the capital structure of a company is arranged principally to avoid a "control" relationship under section 382, or where a permanent interest by former owners of a loss company is diluted for tax avoidance purposes. Thus, if a proft company buys less than all the stock of a loss company and then transfers in a short-term income asset such as certain kinds of royalties or an installment note receivable (or liquidates the loss company into a company which owns such assets), section 289 might still be invoked if the after-tax benefits to the new exceed the price paid for the loss company's stock and if the company remains a shell after the last payment on the receivable is received.

Owner

However, the "lookback" period under these rules may include earlier taxable years. The earliest lookback point, however, is January 1, 1978. For example, section 382 (a) as amended will take effect for a calendar year corporation during calendar 1979. The first "lookback" period for a calendar year corporation under the new rules will be a transitional 24-month period from December 31, 1979, back to January 1, 1979, and then back to January 1, 1978. When the new rules become fully effective, the lookback period will cover three years, so that for a corporation whose taxable year ends on December 31, 1980, reference will be made back to the first day of that year and then back to January 1, 1979, and then to January 1, 1978.

In this example, the prior rules of section 382 (a) will govern the allowance of loss carryovers of the company to its calendar years 1977 and 1978. The new rules will govern loss carryovers from 1978 and earlier years to 1979 and later years. Although the new rules will thus not actually limit carryovers in this example until 1979, the new limitations may affect loss carryovers to 1979 from earlier years, as well as carryovers from 1979 to later years. Also, changes in stock ownership occurring during 1978 will be taken into account as part of the lookback period from December 31, 1979, for purposes of testing loss carryovers to 1979 and later years. This means that changes in the stock ownership of a calendar year loss company during 1978 will be taken into account in applying former section 382(a) at the end of 1978 and also in applying new section 382 (a) at the end of 1979 and 1980 as part of the lookback period from the end of each of those years.33

For a fiscal year corporation whose taxable year begins, for example, on July 1, the rules of prior section 382 (a) will govern loss carryovers to fiscal 1977 and 1978. The new rules will govern loss carryovers to fiscal 1979, and for this purpose changes in stock ownership measured by reference back to stock ownership on July 1, 1978, and on January 1, 1978, will be taken into account.34

The statements above concerning the relationship between the new section 382 rules and section 269 of present law and the Libson Shops case are intended to operate initially with respect to the first taxable year to which carryovers are governed by the new rules of section 382.

Revenue effect

It is estimated that, when fully effective in 1978 and later years, the provision will increase budget receipts in light of the reduced off

32 For a calendar year company, changes in its stock ownership during 1978 will thus be taken into account under the "old" rules in testing loss carryovers to 1978. The same ownership changes will also be taken into account under the new rules in testing carryovers to 1979 and later years. If no change in the stock ownership of a calendar year company occurs during 1978, new section 382 (a) will not reduce its loss carryovers to 1979 (unless ownership changes occur in 1979). If changes in stock ownership do occur during 1978. those changes may reduce (under the new rules) a carryover of prior losses to 1979 and later years. This reduction of carryovers to 1979 and later years may occur even if the old rules (applied at the end of 1978) did not limit carryovers to 1978.

Similar principles also apply to fiscal year companies.

34 For a fiscal year corporation whose taxable year begins before July 1, the rules of prior section 382(a) will govern loss carryovers to fiscal 1977, 1978 and 1979. The new rules will govern loss carryovers to fiscal 1980, and for this purpose changes in stock ownership measured by reference back to stock ownership on the first day of fiscal 1980 and 1979 and on January 1, 1978, will be taken into account.

set of past losses against current profits. However, the amount of the revenue increase is considered indeterminate because the amount of the reduction in the use of carryovers depends on the relative sizes of the companies involved and also because some acquisitions of loss companies by profitable companis may not be made.

7. Small Commercial Fishing Vessel Construction Reserves (sec. 807 of the Act and sec. 607 of the Merchant Marine Act)

Prior law

Under prior law, domestic shipping vessels had to weigh at least 5 net tons in order to be eligible for the capital construction fund (under which the tax on shipping income can be deferred if placed in a capital construction fund for future use in obtaining additional ships).

Reasons for change

In reviewing the operation of the capital construction fund, Congress was concerned that the 5-ton limitation discriminated unfavorably against small shipowners, especially those engaged in small scale commercial fishing. Accordingly, Congress concluded that a lower weight limitation would better achieve the general goal of revitalizing the U.S. commercial fleet.

Explanation of provision

The Act permits a commercial fishing vessel which is under 5 net tons, but not under 2 net tons, to be an eligible vessel under the capital construction fund (sec. 607 of the Merchant Marine Act, 46 U.S.C. 1177), if the vessel is constructed (or reconstructed) in the United States, is owned by a citizen of the United States, has a home port in the United States, and is operated in the commercial fisheries of the United States.

Effective date

The provision is effective upon the date of enactment (October 4, 1976).

Revenue effect

It is estimated that this provision will reduce revenues by less than $5 million a year.

H. SMALL BUSINESS PROVISIONS

1. Extension of Certain Corporate Income Tax Rate Reductions (Sec. 901 of the Act and secs. 11 and 821 of the Code)

Prior law

Prior to the 1975 Tax Reduction Act, corporate income was subject to a 22-percent normal tax and a 26-percent surtax (for a total tax rate of 48 percent). However, the first $25,000 of corporate income was exempt from the surtax. As a result, the first $25,000 of corporate income was taxed at a 22-percent rate and the income in excess of $25,000 was taxed at a 48-percent rate.

In the Tax Reduction Act of 1975, the surtax exemption was increased to $50,000 and the normal tax was reduced to 20 percent on the initial $25,000 of taxable income. This resulted in a 20-percent rate on the first $25,000 of income, a 22-percent rate on the next $25,000 of income, and a 48-percent rate on income in excess of $50,000. These changes were extended by the Revenue Adjustment Act of 1975 through June 30, 1976.

Reasons for change

The temporary changes in the corporate surtax exemption provided by the 1975 Tax Reduction Act were adopted for two reasons: First, to grant tax relief to small businesses which are not likely to derive substantial benefits from the liberalizations in the investment credit because they are not capital intensive; and second, to provide temporary tax relief to small business as part of a program of tax reduction designed to help sustain the economy and promote economic recovery. These reasons for increasing the surtax exemption and lowering the normal corporate tax rate continue to apply in the current economic situation.

The changes in the surtax exemption and the normal corporate tax rate made in the 1975 Tax Reduction Act did not apply to mutual insurance companies, because of a technical oversight [resulting from the fact that mutual insurance companies' tax rates are determined under a different section of the Code (sec. 821)].

Explanation of provision

The Act extends the increase in the surtax exemption and the reduction in the normal tax rates through December 31, 1977, and applies these changes to mutual insurance companies.

Effective date

These provisions make the changes in corporate tax rates and the increase in the surtax exemption applicable in the case of all taxable years ending after December 31, 1975 and before January 1, 1978. They are made applicable to mutual insurance companies for taxable years ending after December 31, 1974 and before January 1, 1978.