Continuity of Interest in Transfer of Target Assets After Qualified Stock Purchase of Target

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[CO-62-94]

RIN 1545-AT15

Continuity of Interest in Transfer of Target Assets After

Qualified Stock Purchase of Target

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

-----------------------------------------------------------------------

SUMMARY: This document contains proposed regulations relating to the

income tax treatment of the transfer of target assets to the purchasing

corporation or another member of the same affiliated group as the

purchasing corporation (the transferee) after a qualified stock

purchase (QSP) of target stock, if a section 338 election is not made.

These regulations provide guidance to parties to such transfers and

their shareholders. This document also provides notice of a public

hearing on these proposed regulations.

DATES: Written comments and outlines of topics to be discussed at the

public hearing scheduled for June 7, 1995, must be received by May 19,

1995.

ADDRESSES: Send submissions to: CC:CORP:T:R (CO-62-94), room 5228,

Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,

DC 20044. In the alternative, submissions may be hand delivered between

the hours of 8 a.m. and 5 p.m. to: CC:CORP:T:R (CO-62-94), Courier's

Desk, Internal Revenue Service, 1111 Constitution Avenue NW.,

Washington, DC. The public hearing will be held in room 3313, Internal

Revenue Building, 1111 Constitution Avenue NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,

William Alexander, (202) 622-7780; concerning the submissions and

requests for a hearing, Christina Vasquez, (202) 622-7180 (not toll-

free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document proposes guidance as to the treatment of transfers of

target assets to another corporation after a qualified stock purchase

of target stock, if a section 338 election is not made for the target.

It addresses the effect of section 338 on the result in Yoc Heating v.

Commissioner and similar cases.

Under Sec. 1.368-1(b), for a transfer of assets to be pursuant to a

reorganization within the meaning of section 368, there must be a

continuity of interest in the target's business enterprise on the part

of those persons who, directly or indirectly, were the owners of the

enterprise prior to the reorganization.

In Yoc Heating v. Commissioner, 61 T.C. 168 (1973), a corporation

bought 85 percent of a target corporation's stock for cash and notes.

As part of the same plan, the target subsequently transferred its

assets to a newly formed subsidiary of the purchaser and dissolved. The

purchaser received additional stock of its subsidiary in exchange for

the purchaser's target stock and the minority shareholders received

cash in exchange for their target stock.

The Tax Court, viewing the stock purchase and asset acquisition as

an integrated transaction in which the purchaser acquired all of the

target's assets for cash and notes, held there was insufficient

continuity of interest to qualify the asset transfer as a

reorganization under section 368 because the shareholders of the target

before the stock purchase received no stock in the acquiring entity. As

a result, the subsidiary received a cost basis in the target's assets.

In addition to Yoc Heating, there are other cases in which courts

have denied reorganization treatment and have given the transferee a

stepped-up basis in the target's assets following the purchase of the

target's stock and the merger of the target into the purchaser or a

related corporation. See, e.g., Russell v. Commissioner, 832 F.2d 349

(6th Cir. 1987), aff'g Cannonsburg Skiing Corp. v. Commissioner, T.C.

Memo 1986-150 (corporation purchased target stock and then target

merged into purchaser); Security Industrial Insurance Co. v. United

States, 702 F.2d 1234 (5th Cir. 1983) (corporation purchased stock of

targets and then targets merged into purchaser, which then transferred

the target assets to a subsidiary of the purchaser); South Bay

Corporation v. Commissioner, 345 F.2d 698 (2d Cir. 1965) (individual

purchased stock in two targets and then targets merged into a third

corporation owned by the individual); Superior Coach of Florida

[[Page 9310]] v. Commissioner, 80 T.C. 895 (1983) (individual purchased

target stock and then target merged into another corporation controlled

by the individual); Estate of McWhorter v. Commissioner, 69 T.C. 650

(1978), aff'd, 590 F.2d 340 (8th Cir. 1978) (corporation purchased

target stock and then target merged into purchaser); and Kass v.

Commissioner, 60 T.C. 218 (1973), aff'd, 491 F.2d 749 (3d Cir. 1974)

(corporation purchased target stock and then target merged into

purchaser).

The Yoc Heating court's analysis of the transaction as, in

substance, a taxable asset acquisition by the subsidiary is consistent

with generally applied federal income tax principles. For example, in

Kimbell-Diamond Milling Co. v. Commissioner, 14 T.C. 74 (1950), aff'd

per curiam, 187 F.2d 718 (5th Cir.), cert. denied, 342 U.S. 827 (1951),

an acquiring corporation's purchase of a target corporation's stock

followed by the liquidation of the target was treated for federal

income tax purposes as, in substance, a direct purchase of the target's

assets by the acquiring corporation. The Tax Court's characterization

in Kimbell-Diamond was based on a finding that the acquiring

corporation intended to obtain the target's assets rather than its

stock. As a result, the acquiring corporation's basis in the target's

assets was determined by reference to the purchase price of the

target's stock.

In 1954, Congress codified principles derived from Kimbell-Diamond

by enacting former section 334(b)(2) of the Internal Revenue Code of

1954, which created an objective test that permitted a stock purchase

followed by liquidation of the target to be treated as an asset

acquisition. S. Rep. No. 1622, 83d Cong., 2d Sess. 257 (1954).

In 1982, Congress repealed section 334(b)(2) and replaced it with

section 338, which provides that, if a corporation makes a qualified

stock purchase (QSP) of the stock of a target, the purchasing

corporation may elect to have the target treated as having sold all of

its assets at the close of the acquisition date in a single transaction

and as a new corporation that purchased all such assets at the

beginning of the following day. Section 338 was ``intended to replace

any nonstatutory treatment of a stock purchase as an asset purchase

under the Kimbell-Diamond doctrine.'' H.R. Conf. Rep. No. 760, 97th

Cong., 2d Sess. 467, 536 (1982), 1982-2 C.B. 600, 632.

Under section 338(i), the IRS and Treasury are authorized to

prescribe such regulations as may be necessary or appropriate to carry

out the purposes of section 338. The IRS and Treasury believe that the

result in Yoc Heating is inconsistent with the legislative intent

behind section 338. As a result of the enactment of section 338, an

intragroup merger or similar transaction following a QSP generally

should not be treated as part of an overall asset acquisition. The

qualified stock purchase must be accorded its intended effect. Cf. Rev.

Rul. 90-95, 1990-2 C.B. 67 (applying sections 332 and 334 to a merger

of the target into the purchasing corporation following a QSP). If a

section 338 election is not made, in a subsequent intragroup merger or

similar transaction, the target assets generally should preserve their

historic basis maintained in the qualified stock purchase. The IRS and

Treasury believe that applying the reorganization rules to the target

and purchasing group in mergers and similar transactions following a

QSP is the simplest and most effective means of achieving the

congressional intent in repealing the Kimbell-Diamond doctrine.

Explanation of Provisions

Proposed Sec. 1.338-2(c)(3) applies to the transfer of target

assets to the purchasing corporation or another member of the same

affiliated group as the purchasing corporation (the transferee)

following a QSP of target stock, if the purchasing corporation does not

make a section 338 election for the target.

As noted above, for the transfer of target assets to be pursuant to

a reorganization within the meaning of section 368, there must be a

continuity of interest in the target's business enterprise on the part

of those persons who, directly or indirectly, were the owners of the

enterprise prior to the reorganization. See Sec. 1.368-1(b). The

proposed regulations generally provide that, by virtue of the

application of section 338, the purchasing corporation's target stock

acquired in the QSP represents an interest on the part of a person who

was an owner of the target's business enterprise prior to the transfer

that can be continued in a reorganization for the purpose of

determining whether the continuity of interest requirement is

satisfied. A corollary provision enables the transfer to satisfy the

requirements for an acquisitive reorganization under section

368(a)(1)(D).

Notwithstanding the general rule above, the proposed regulations

provide that sections 354, 355, 356 and 358 do not apply to any person

other than the purchasing corporation or another member of the same

affiliated group as the purchasing corporation unless the transfer of

target assets is pursuant to a reorganization under generally

applicable rules without regard to the provisions of the proposed

regulations. The legislative history of section 338 does not indicate

any intent to eliminate the continuity of interest requirement

generally and allow reorganization treatment to shareholders receiving

stock in acquisitions where the overall consideration does not preserve

continuity of interest. The rules provided in the proposed regulations

reconcile Congress' concerns in enacting section 338 with general

reorganization principles.

The IRS and Treasury request comments on the proposed rules,

including, particularly, comments regarding the collateral consequences

of treating the transaction as a reorganization to the target and to

the purchasing corporation and its affiliates, but not to persons

unaffiliated with the purchasing corporation. The IRS and Treasury also

solicit comments as to whether guidance is needed as to the proper

treatment of post-QSP mergers and similar transactions if a section 338

election is made for the target.

Proposed Effective Date

Section 1.338-2(c)(3) is proposed to be effective for transfers of

target assets occurring on or after the date final regulations are

filed with the Office of the Federal Register.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It has also been determined

that section 553(b) of the Administrative Procedure Act (5 U.S.C.

chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do

not apply to these regulations, and, therefore, a Regulatory

Flexibility Analysis is not required. Pursuant to section 7805(f) of

the Internal Revenue 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 Requests for a Public Hearing

Before this proposed regulation is adopted as a final regulation,

consideration will be given to any written comments (a signed original

and eight (8) copies) that are submitted timely to the IRS. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for June 7, 1995, at 10 a.m. in

room [[Page 9311]] 3313, Internal Revenue Building, 1111 Constitution

Avenue NW, Washington, DC. Because of access restrictions, visitors

will not be admitted beyond the Internal Revenue Building lobby more

than 15 minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons that wish to present oral comments at the hearing must

submit written comments by May 19, 1995, and submit an outline of the

topics to be discussed and the time to be devoted to each topic (signed

original and eight (8) copies) by May 19, 1995.

A period of 10 minutes will be allocated to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these regulations is William Galanis,

Office of Assistant Chief Counsel (Corporate), Internal Revenue

Service. However, other personnel from the IRS and Treasury Department

participated in their development.

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 1.338-0 is amended by adding entries for

Sec. 1.338-2(c)(3) to read as follows:

Sec. 1.338-0 Outline of topics.

* * * * *

Sec. 1.338-2 Miscellaneous issues under section 338.

* * * * *

(c)* * *

(3) Consequences of post-acquisition elimination of target.

(i) Scope.

(ii) Continuity of interest.

(iii) Control requirement.

(iv) Example.

(v) Effective date.

* * * * *

Par. 3. Section 1.338-2 is amended by adding paragraph (c)(3) to

read as follows:

Sec. 1.338-2 Miscellaneous issues under section 338.

* * * * *

(c) * * *

(3) Consequences of post-acquisition elimination of target--(i)

Scope. The rules of this paragraph (c)(3) apply to the transfer of

target assets to the purchasing corporation (or another member of the

same affiliated group as the purchasing corporation) (the transferee)

following a qualified stock purchase of target stock, if the purchasing

corporation does not make a section 338 election for target.

(ii) Continuity of interest. By virtue of section 338, in

determining whether the continuity of interest requirement of

Sec. 1.368-1(b) is satisfied on the transfer of assets from target to

the transferee, the purchasing corporation's target stock acquired in

the qualified stock purchase represents an interest on the part of a

person who was an owner of the target's business enterprise prior to

the transfer that can be continued in a reorganization. Notwithstanding

the preceding sentence, sections 354, 355, 356 and 358 do not apply to

any person other than the purchasing corporation or another member of

the same affiliated group as the purchasing corporation unless the

transfer is pursuant to a reorganization under generally applicable

rules without regard to this paragraph (c)(3)(ii).

(iii) Control requirement. By virtue of section 338, the purchasing

corporation is treated as a shareholder of the target transferor for

the purpose of determining whether, immediately after the transfer of

target assets, a shareholder of the transferor is in control of the

corporation to which the assets are transferred within the meaning of

section 368(a)(1)(D).

(iv) Example. This paragraph (c)(3) is illustrated by the following

example:

Example. (A) Facts. P, T, and X are domestic corporations. T and

X each operate a trade or business. A and K, individuals unrelated

to P, own 85 and 15 percent, respectively, of the stock of T. P owns

all of the stock of X. The total adjusted basis of T's property

exceeds the sum of T's liabilities plus the amount of liabilities to

which T's property is subject. P purchases all of A's T stock for

cash in a qualified stock purchase. P does not make an election

under section 338(g) with respect to its acquisition of T stock.

Shortly after the acquisition date, and as part of the same plan, T

merges under applicable state law into X in a transaction that, but

for the question of continuity of interest, satisfies all the

requirements of section 368(a)(1)(A). In the merger, all of T's

assets are transferred to X. P and K receive X stock in exchange for

their T stock. P intends to retain the stock of X indefinitely.

(B) Status of transfer as a reorganization. By virtue of section

338, for the purpose of determining whether the continuity of

interest requirement of Sec. 1.368-1(b) is satisfied, P's T stock

acquired in the qualified stock purchase represents an interest on

the part of a person who was an owner of T's business enterprise

prior to the transfer that can be continued in a reorganization

through P's continuing ownership of X. Thus, the continuity of

interest requirement is satisfied and the merger of T into X is a

reorganization within the meaning of section 368(a)(1)(A). Moreover,

by virtue of section 338, the requirement of section 368(a)(1)(D)

that a target shareholder control the transferee immediately after

the transfer is satisfied because P controls X immediately after the

transfer. In addition, all of T's assets are transferred to X in the

merger and P and K receive the X stock exchanged therefor in

pursuance of the plan of reorganization. Thus, the merger of T into

X is also a reorganization within the meaning of section

368(a)(1)(D).

(C) Treatment of T and X. Under section 361(a), T recognizes no

gain or loss in the merger. Under section 362(b), X's basis in the

assets received in the merger is the same as the basis of the assets

in T's hands. X succeeds to and takes into account the items of T as

provided in section 381.

(D) Treatment of P. By virtue of section 338, the transfer of T

assets to X is a reorganization. Pursuant to that reorganization, P

exchanges its T stock solely for stock of X, a party to the

reorganization. Because P is the purchasing corporation, section 354

applies to P's exchange of T stock for X stock in the merger of T

into X. Thus, P recognizes no gain or loss on the exchange. Under

section 358, P's basis in the X stock received in the exchange is

the same as the basis of P's T stock exchanged therefor.

(E) Treatment of K. Because K is not the purchasing corporation

(or an affiliate thereof), section 354 does not apply to K's

exchange of T stock for X stock in the merger of T into X unless the

transfer is pursuant to a reorganization under generally applicable

rules without regard to paragraph (c)(3)(ii) of this section. Under

general income tax principles applicable to reorganizations, the

continuity of interest requirement is not satisfied because P's

stock purchase and the merger of T into X are pursuant to an

integrated transaction in which A, the owner of 85 percent of the

stock of T, received solely cash in exchange for A's T stock. See,

e.g., Yoc Heating v. Commissioner, 61 T.C. 168 (1973); Kass v.

Commissioner, 60 T.C. 218 (1973), aff'd, 491 F.2d 749 (3d Cir.

1974). Thus, the requisite continuity of interest under Sec. 1.368-

1(b) is lacking and section 354 does not apply to K's exchange of T

stock for X stock. K recognizes gain or loss, if any, pursuant to

section 1001(c) with respect to its T stock.

(v) Effective date. The provisions of this paragraph (c)(3) are

effective for transfers of target assets on or after the

[[Page 9312]] date final regulations are filed with the Office of the

Federal Register.

* * * * *

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 95-3771 Filed 2-16-95; 8:45 am]

BILLING CODE 4830-01-P