(b) In the case of a redemption of nonparticipating stock from the original recipient thereof, the tax will not apply if and to the extent that the participating stock in respect of which the nonparticipating stock was issued is simultaneously redeemed. It is possible, as heretofore noted, that a corporation may have outstanding nothing but nonparticipating stock. The effect of Section 309 in such a situation might be to make impossible any revision of an existing corporation's capital structure by way of stock redemption for ten years without incurring the 85% tax. Our Committee's recommendation on this point is covered in subsection (f), infra.

(c) "If the transfer is in redemption of nonparticipating stock issued for securities or property (or which takes the place of nonparticipating stock which was issued for securities or property) to the extent of 105 percent of the fair market value of such property.”

(i) It is believed that the omission of the words "securities or" immediately before the final word of this sentence is unintentional since it produces the anomalous result of treating securities exchanged for stock as if they had no value at the time of the exchange. The 85% tax would then be imposed on any part of the redemption price of the stock in excess of 105% of whatever cash or other property, if any, had been used with the securities to acquire the stock. Since such result was presumably not intended, addition of the omitted words is recommended.

(ii) This exception suggests that there is no intention to tax redemptions of nonparticipating stock originally issued for a fair consideration if the redemption price is not set in such a manner as to serve as a device to siphon off earnings. Nevertheless, the tax will apply to any redemption to the extent that the redemption price exceeds 105% of the amount paid for the stock, even though such redemption price was established for bona fide business reasons having nothing to do with tax avoidance. Redemption premiums in excess of 5% are not uncom mon, and there are many non-redeemable preferred stocks which can be recapitalized only by paying a substantial premium. It is suggested, therefore, that the allowable redemption premium be increased.

(iii) As heretofore suggested bail-outs comparable to those effected under existing law by use of preferred stock may under

the bill be accomplished through the medium of non-voting participating stock with redemption provisions. Such a stock should either be included in the definition of nonparticipating stock in Section 312 so that its redemption would be subject to the tax provided in Section 309 or its redemption should be made taxable as a dividend by an appropriate exception in Section 302. (d) The tax will not apply if the transfer is treated under Section 302(b) as a distribution not in redemption of stock. This exemption is ambiguous. Section 302(b) provides that any distribution in redemption will be treated as a distribution under Section 301 unless one of the provisions of Section 302 (a) is applicable. Section 302(a)(1) provides that a distribution in redemption of stock will be treated as a distribution in full or part payment in exchange for such stock if the Section 309 transfer tax is applicable thereto. It is not believed that such a circle of cross-references is desirable. Qualifying amendments are recommended.

(e) Finally, the tax will not apply if the transfer in redemption qualifies under Section 303. No comment on this paragraph appears

necessary.

(f) Section 309 (c) provides that for the purpose of determining liability for the 85% tax nonparticipating stock will be deemed to have been issued on its actual date of issuance or January 1, 1954, whichever is later. The effect of this provision will be to impose the new tax on transfers in redemption of stock issued long before such tax was ever proposed and whose redemption provisions were adopted for completely bona fide reasons. Moreover, the provision is discriminatory against all pre-1954 issues. By its use of a 10-year period beyond which a redemption of nonparticipating stock will in no event be subject to the 85% tax, the Ways and Means Committee appears to have indicated its belief that the possibility of bail-outs after such a period is negligible. If this will be true of new issues it should certainly also be true with respect to those already in existence. Furthermore the problem of proving the value of property paid in for stock as far back as the nineteenth century will prove most burdensome. Accordingly, it is recommended that the tax provided in Section 309 be applicable only as to a redemption of stock within 10 years of its actual date of issuance, and that subsection (c) thereof be deleted from the bill.

(g) It is not believed that the tax law should penalize corporations for redeeming issues of nonparticipating stock already in existence where the manner of issuance is not likely to have been connected with tax avoidance motives. Therefore, with respect to all of such existing nonparticipating stock issued for money, property or securities (or which takes the place of nonparticipating stock so issued) and not originally issued as a stock dividend or in connection with a recapitalization or mere rearrangement of capital structure, it is recommended that an appropriate exemption be added to Section 309 which would permit the redemption of these issues at any time without giving rise to the 85% tax.

(2) Section 310 of the bill deals with the effect of corporate distributions upon the earnings and profits of the distributing corporation.

(a) Section 310(a) provides generally that a distribution of securities or other property will result in a reduction of earnings and profits by the amount of money, the principal amount of securities and the adjusted basis of other property distributed. This resolves a conflict in the courts in respect of the effect on earnings and profits of dividends in kind. According to the House Report at page A94, the amount of a distribution in kind which is taxable as a dividend is limited to the lesser of the distributing corporation's earnings and profits or the fair market value of the property distributed. Thus, if a corporation has property with an adjusted basis of $100 and a fair market value of $150 and distributes such property to its stockholders at a time when its earnings and profits amount to $120, the amount taxable as a dividend to the shareholder will be $120; the remaining $30 will be applied to reduce the basis of the stockholder's shares. This result is contrary to that suggested by the American Law Institute [2 FED. INC. TAX STAT. X §507(b) (8) (Feb. 1954 Draft)] and adopts the holding in Estate of Ida S. Godley, 19 T. C. No. 124 (1953) (now on appeal 3d Cir.).

In the example given above, by reducing earnings and profits by no more than the basis of the property distributed ($100) the bill in effect provides for future dividend taxation of the $20 excess of earnings and profits over such basis. This amount, however, will already have been taxed to the shareholder when the property was

distributed to him. To eliminate this inequity it is suggested that in such cases earnings and profits be reduced by the amount taxable as a dividend.

(b) Section 310 (c) provides that distributions considered to be in redemption of stock (other than nonparticipating stock issued for property) shall reduce earnings and profits by an amount having the same ratio to earnings and profits immediately prior to the transaction which the adjusted basis of the assets distributed bears to the adjusted basis of all assets immediately prior to the distribution. It has already been pointed out that it will be possible under the bill for a stockholder to sell part of his stock to outsiders and turn the balance in for redemption without the realization of a dividend by either the retiring stockholder or his successors in control. (See Section I-C(1)(c) (iii), supra.) In such an event it would seem proper to provide that the redemption would result in no decrease in earnings and profits. The addition of such a rule to Section 310 is accordingly recommended.

II.

CORPORATE LIQUIDATIONS

A. Revisions of Existing Law

The provisions of the bill with respect to corporate liquidations embody substantial departures from the pattern of existing law in the following respects:

The unrealized appreciation in the value of corporate property distributed in liquidation is not taxed to the shareholder at the time of liquidation. It is intended that a parent corporation will in general receive the benefit of the cost of the stock of a subsidiary either as the basis of assets received on liquidation or through a loss recognized on liquidation. The collapsible corporation problem is attacked by perpetuating the corporation's basis of particular types of assets rather than by treating the gain on sale or liquidation as ordinary income. Corporations are permitted to sell their assets in connection with a liquidation without incurring the second tax involved in Commissioner v. Court Holding Company, 324 U. S. 331 (1945). A partial liquidation is limited to a distribution in connection with a complete termination of one of several separate businesses carried on by the corporation.

B. Definitions

(1) PARTIAL LIQUIDATIONS

(a) Section 336(a) limits a partial liquidation to a distribution "attributable to the complete termination" of a separately operated business of the corporation. It is not clear whether the business must be terminated merely as to the distributing corporation, or whether the stockholder-distributee and the purchaser of the assets are also precluded from continuing the activity. Compare the definition of "complete termination of the business of the employer" in Section 401 (b) (2) (B).

(b) Section 336(a)(2) requires that for at least five years prior to the partial liquidation, separate books and records of the business terminated must have been kept "by the distributing corporation" and the business must have been operated separately from the other business of "the corporation". Our Committee recommends that the term "corporation" be enlarged to include predecessors in tax-free acquisitions.

(2) INVENTORY ASSETS

To meet the problem of the collapsible corporation, the bill provides a carry-over of the corporation's basis of certain assets "which, under normal circumstances, would not be distributed in kind to shareholders." These comprise inventory, property held for sale to customers in the ordinary course of business, "rights to income", and, where held less than five years, real property and depreciable property, used in the trade or business.

(a) Rights to income. The House Report at page A113 cites as an example of "rights to income" a contract calling for a certain percentage of the profits of a business. It is the stated intention that all rights to future income shall, for this purpose, be considered susceptible of valuation.

Our Committee believes that this subsection is indefinite, will prove troublesome to interpret and will involve burdensome valuation problems. It does not appear, for example, that "rights to income" should include unmatured coupons attached to a bond, future dividends on stock, or a percentage of profits to be paid for future services.