We have not attempted in our report or the proposed amendments to deal with the problem of effective dates of the proposed statutory changes. In general, we believe that statutory changes should be made prospective only. Except in the limited areas where it is expressly stated otherwise, nothing contained in our report or the proposed amendments is intended to constitute an expression of views or to give rise to an inference as to the proper interpretation of existing law.

In submitting our report, we desire to express our appreciation of the helpful cooperation we received from the staff of the Joint Committee on Internal Revenue Taxation, the Treasury Department and the Internal Revenue Service, representatives of which attended many of our meetings for the purpose of supplying information. We wish also to acknowledge our indebtedness to the American Law Institute and the coordinating committee of the Institute and the American Bar Association Section of Taxation for their helpful studies and reports with respect to matters dealt with in subchapter C, and to members of certain committees of the American Bar Association Section of Taxation, the Association of the Bar of the City of New York and the American Institute of Certified Public Accountants for their unofficial informal suggestions. Finally, we wish to express our gratitude to Mr. Edwin S. Cohen, one of our members, who, as counsel to our group, assumed a heavier than normal share of the burden in connection with the preparation of our report and the proposed amendments, to Mr. Fred M. Ringel who contributed helpful assistance, to Mr. Lincoln Arnold who advised us in connection with drafting problems and to Mr. Arnold C. Johnson of the staff of the Joint Committee on Internal Revenue Taxation who served as our secretary.

Respectfully submitted.

REPORT OF THE ADVISORY GROUP ON

SUBCHAPTER C

To Accompany

SUBCHAPTER C ADVISORY GROUP PROPOSED
AMENDMENTS

The first section of the proposed amendments eliminates the necessity of referring to the Internal Revenue Code of 1954 each time a change is proposed with respect to such code. Whenever an amendment is expressed in terms of an amendment to or repeal of a section or other provision, the reference is to a provision of the Internal Revenue Code of 1954.

SECTION 2. DISTRIBUTIONS OF PROPERTY

AMENDMENTS OF SECTION 301

Under section 301 (b) (1) (B), the amount of a distribution in prop) erty (other than money) to a corporate shareholder is the lesser of (ie the fair market value of the property, or (ii) the adjusted basis of the property in the hands of the distributing corporation, increased in thamount of gain to the distributing corporation recognized under subsection (b) or (c) of section 311. This provision applies not only in determining the amount of the dividend received by a corporate shareholder but also, in case the distribution is not out of earnings and profits, in determining the amount of the reduction in the basis of the shareholder's stock or the amount of any capital gain resulting from the distribution. In the ordinary case of a distribution in kind, the existing provisions carry out the basic policy of the statute, but technical amendments are needed with respect to certain fringe problems. (a) The statute does not specifically deal with the effect upon a corporate distributee of a distribution consisting of stock, or rights to stock, of the distributing corporation in cases in which under section 305 (b) the distribution is not excluded from gross income.

The advisory group believes that the statute should be amended to provide specifically that the rule of section 301 (b) (1) (B) (ii), limiting the amount of the distribution in the hands of corporate distributees to the adjusted basis of property in the hands of the distributing corporation, shall not apply to distributions of stock, or rights to acquire stock, of the distributing corporation which under section 305 (b) are taxable dividends.

(b) A comparable problem arises if a corporation distributes its obligations to a corporate shareholder. It might be argued that the distributing corporation has no tax basis in its own obligations, and therefore the amount of the distribution under section 301 (b) (1) (B) (ii) is zero.

The advisory group recommends that the statute be amended to provide that in the case of the distribution of obligations of the distributing company, the amount of the distribution (to a corporate shareholder) shall be the fair market value of the obligations, or the principal amount of the obligations, whichever is the lesser.

(c) Clause (ii) of section 301 (b) (1) (B) provides for increasing the adjusted basis of the distributed property by the amount of gain recognized "under subsection (b) or (c) of section 311", relating to distribution of appreciated LIFO inventory and distribution of property subject to a liability in excess of its adjusted basis. No provision is made for an increase in the adjusted basis where gain is recognized under section 453 (d) to the distributing corporation on the distribution of an installment obligation.

The advisory group recommends that clause (ii) of section 301 (b) (1) (B) be amended to provide for an increase in the adjusted basis in any case where gain is recognized to the distributing corporation upon the distribution of the property.

(d) The question has been raised as to whether section 301 (b) (1) (B) should be amended so that it would apply only if a dividendsreceived deduction is allowed with respect to the distribution in kind. The advisory group does not believe that the statute should be so limited. If property which has appreciated in value is distributed by a corporation which has no earnings or profits, the present statute properly prevents a step-up in tax basis (e. g., for depreciation deductions) at the expense of only a capital-gains tax or merely a reduction in the basis of the stock in respect to which the distribution was received. However, there are some cases involving foreign corporations where the advisory group believes that the amount of a distribution in kind should be determined without regard to the adjusted basis of the property.

The first case involves distributions by certain foreign corporations. In many cases it is most difficult, if not impossible, for the taxpayer or the Government to obtain information from the foreign corporation as to the adjusted basis (as defined in our tax laws) of the property distributed. It is believed that the adjusted basis of property should not enter into the determination of the amount of distribution by a foreign corporation unless its dividends qualify for a dividends-received deduction under section 245. To so qualify, the foreign corporation must be engaged in trade or business within the United States and have derived a major part of its gross income from United States sources, and it will, of course, be filing Federal income-tax returns.

The other case involves distributions in kind to a foreign corporation not engaged in trade or business within the United States. If the distribution is taxable as a dividend, the fair market value of the property should be the amount subjected to tax, for the basis of that property in the hands of the foreign corporation has no Federal tax consequences. However, if the foreign corporation receiving the dividend is engaged in trade or business within the United States, and therefore entitled to the dividends-received deduction, then, for the protection of the revenues, the existing rule of section 301 (b) (1) (B) should apply to the distribution.

The advisory group therefore recommends that section 301 (b) (B) be amended so that it will not apply to distributions to foreign corporations not engaged in trade or business in the United States,

or to distributions from a foreign corporation unless a dividends-received deduction is allowable with respect to the distribution (or would be allowable if there were earnings and profits to cover the distribution).

(e) Conforming amendments are made to section 301 (d), which provides the rules for determining the basis of property received in distributions in kind.

SECTION 3. DISTRIBUTIONS IN REDEMPTION OF STOCKAMENDMENT OF SECTION 302

A. RECOMMENDATIONS FOR STATUTORY CHANGES

Corporations having no earrings and profits.-The advisory group recommends that section 302 (b) (1) be amended to provide specifically that the fact that the corporation has no earnings and profits will not require the application of section 302 (b) (1). This is stated to be the intention of Congress in the 1954 Senate Finance Committee Report, and the regulations so provide (Regulations, sec. 1.302-2). However, there is doubt that the present statute literally carries out this intention. The matter is of significance in the case of a deficit corporation in determining

(a) whether the distribution is to be governed by section 301 (c) (2) and (3) (in which event the amount of the distribution will be applied against the shareholder's total basis for all his stock in the corporation and only the excess will be taxed as gain) or by section 302 (a) (in which event the shareholder will realize gain or loss measured by the difference between the amount of the distribution and the basis of the stock redeemed); and

(b) whether if the shareholder is a corporation, and the distribution is made in kind, the provisions of sections 301 (b) (1) (B) and 301 (d) (2) will apply, limiting the amount of the distribution to the lower of the fair market value or the basis of the property distributed.

The recommended amendment will insure that the fact that the corporation has insufficient earnings and profits will not require the application of section 302 (b) (1).

Redemptions of stock owned by partnerships.-Under present law, in the case of redemption of stock owned by a partnership, section 318 (a) (2) (A) provides that the partnership shall be deemed to own all the stock owned by each of the partners. Thus in determining whether a redemption of stock owned by the partnership complies with the substantial disproportionality test of section 302 (b)‍(2), stock owned individually by any partner must be taken into account. The redemption of all the stock owned by the partnership may result in dividend treatment to all the partners, even to those who own no stock individually, merely because one or more of the partners individually own stock in the corporation.

With respect to the rule in present section 318 (a) (2) (A) the advisory group is recommending an amendment to limit attribution from a partner to a partnership to those cases in which the partner has at least a 5-percent interest in the partnership. The advisory group has concluded that the minimum percentage in section 318 may not be

safely increased beyond 5 percent because the rules of section 318 apply in a number of parts of subchapter C, other than section 302, where a further increase would be inadvisable. However, for purposes of section 302 the 5-percent minimum will not serve to eliminate inequity involved in according dividend treatment to some partners merely because one of their partners, having a partnership interest greater than 5 percent, owns stock in the redeeming corporation.

Accordingly, the advisory group recommends that a specific provision be inserted in section 302 (b) (2) (D) requiring that the disproportionality test be applied separately for each partner, as though the stock owned by the partnership had been distributed to the partners immediately prior to the redemption and the stock redeemed had been redeemed in the hands of each partner. In this manner those partners who own stock individually may have dividend treatment on the redemption while others have capital gain treatment. For example, if the ABCD partnership, in which each of 4 partners has a one-fourth interest, owns 500 of the outstanding 1,000 shares of a corporation, and partner A individually owns the remaining 500 shares, redemption of all the stock owned by the partnership will result under 302 (b) (2) (D) in capital gain treatment to partners B, C, and D, but not to partner A. This is because the interest of B, C, and D in the corporation will each be reduced from 12% percent to 0, while A's total interest will be increased from 62% percent to 100 percent. For a discussion of the changes recommended with respect to attribution of stock ownership in connection with redemption of shares individually owned by persons who are members of a partnership, see the comments under Section 11: Constructive Ownership of Stock-Amendment of Section 318.

a

Corporations having two classes of voting stock. The advisory group recommends that section 302 (b) (2) (E) be added to the statute to provide that where there is more than one class of voting stock the determination of the ratio of voting stock owned before and after the redemption is to be made in accordance with the combined voting power of all classes of stock entitled to vote. While it is believed that this is the rule under present law, it is felt that a clarifying amendment is advisable to eliminate a question of construction.

Time for testing application of section 302 (b) (2).—The advisory group recommends that section 302 (b) (2) (F) be added to the statute to deal specifically with the manner of determining whether the application of the 80 percent substantial disproportionality test of section 302 (b) (2) has been met in cases in which the redemption price is payable in installments. Where all the shares to be redeemed are turned in at the time of the initial payment, there are technically no shares turned in at the time the subsequent payments are received. It is thought advisable to provide specifically that the subsequent installments qualify for capital gain treatment if the 80 percent substantial disproportionality test is met at the time the shares are surrendered.

Redemptions of preferred stock. The advisory group recommends that section 302 (b) (5) be added to the statute to provide that section 302 (a) shall apply to a redemption of preferred stock if the shareholder owns less than one percent of the common stock and voting stock in the company after the redemption. This change is made primarily for the purpose of assuring capital-gain treatment auto