Continuity of Interest

DEPARTMENT OF THE TREASURY

26 CFR Part 1

[REG-252231-96]

RIN 1545-AU72

Continuity of Interest

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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SUMMARY: This document contains proposed regulations providing that the

continuity of shareholder interest requirement for corporate

reorganizations is satisfied if the

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acquiring corporation furnishes consideration which represents a

proprietary interest in the affairs of the acquiring corporation and

such consideration represents a substantial part of the value of the

stock or properties transferred. Dispositions of stock of the acquiring

corporation by a former target shareholder generally are not taken into

account in determining whether continuity of shareholder interest has

been satisfied. This document also provides notice of a public hearing

on these proposed regulations.

DATES: Comments must be received by March 24, 1997. Requests to speak

and outlines of topics to be discussed at the public hearing scheduled

for Wednesday, May 7, 1997 must be received by Wednesday, April 16,

1997.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-252231-96), 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:DOM:CORP:R (REG-

252231-96), Courier's Desk, Internal Revenue Service, 1111 Constitution

Avenue NW., Washington, DC. Alternatively, taxpayers may submit

comments electronically via the Internet by selecting the ``Tax Regs''

option on the IRS Home Page, or by submitting comments directly to the

IRS Internet site at http://www.irs.ustreas.gov/prod/tax__regs/

comments.html. The public hearing will be held in the Auditorium,

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

DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Phoebe

Bennett, (202) 622-7750; concerning submissions and the hearing,

Christina Vasquez, (202) 622-6808 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: This document contains proposed amendments

to the Income Tax Regulations (26 CFR part 1) under section 368. The

proposed regulations provide that the continuity of shareholder

interest (COSI) requirement is satisfied if the acquiring corporation

furnishes consideration which represents a proprietary interest in the

affairs of the acquiring corporation and such consideration represents

a substantial part of the value of the stock or properties transferred.

Background

The Internal Revenue Code of 1986 (Code) provides general

nonrecognition treatment for reorganizations specifically described in

section 368 of the Code. Literal compliance with the statutory

requirements is not sufficient for nonrecognition. For example, to

qualify as a reorganization the COSI requirement must also be

satisfied.

The early statutory definitions of reorganizations did not specify

the type of consideration required for a transaction to qualify as a

reorganization. As a result, a transaction may have satisfied the

literal definition of a reorganization even if the transaction

resembled a sale. To prevent such transactions from qualifying as

reorganizations, the COSI requirement was established by the courts to

ensure that the consideration furnished by the acquiring corporation

represented a proprietary interest in the affairs of the acquiring

corporation and that such consideration represented a substantial part

of the value of the stock or properties transferred. See Helvering v.

Minnesota Tea Co., 296 U.S. 378 (1935); Pinellas Ice & Cold Storage Co.

v. Commissioner, 287 U.S. 462 (1933); Cortland Specialty Co. v.

Commissioner, 60 F.2d 937 (2d Cir. 1932), cert. denied 288 U.S. 599

(1933). ``Reorganization, merger and consolidation are words indicating

corporate readjustments of existing interests. They all differ

fundamentally from a sale where the vendor corporation parts with its

interest for cash and receives nothing more.'' Cortland, 60 F.2d at

939.

The cases that gave rise to the COSI requirement did not involve

situations in which shareholders of the target corporation disposed of

stock consideration from the acquiring corporation after having

received it. In those cases, the relevant inquiry was whether the

acquiring corporation furnished the proper type of consideration in the

reorganization. Over the years, issues have arisen regarding whether

the COSI requirement is satisfied if the target shareholders, as

contemplated at the time of the reorganization, subsequently dispose of

the stock received from the acquiring corporation. Compare McDonald's

Restaurants of Illinois, Inc. v. Commissioner, 688 F.2d 520 (7th Cir.

1982), rev'g McDonald's of Zion v. Commissioner, 76 T.C. 972 (1981),

with Penrod v. Commissioner, 88 T.C. 1415 (1987). Various bar

associations have asked the Treasury Department and the IRS to provide

guidance to clarify existing law and reduce uncertainty in applying

COSI principles in the context of postreorganization sales. See New

York State Bar Association Tax Section, Postreorganization Continuity

of Interest, reprinted in 73 Tax Notes 481 (1996); Committee on

Taxation of Corporations of the Association of the Bar of the City of

New York, Postreorganization Transactions and Continuity of Shareholder

Interest, reprinted in 72 Tax Notes 1401 (1996).

Explanation of Proposed Regulations

The proposed regulations provide that the COSI requirement is

satisfied if the acquiring corporation furnishes consideration in the

reorganization that represents a proprietary interest in the affairs of

the acquiring corporation and such consideration represents a

substantial part of the value of the stock or properties transferred.

Dispositions of stock of the acquiring corporation by a former target

shareholder generally are not taken into account in determining whether

COSI has been satisfied. However, the proposed regulations emphasize

that all facts and circumstances must be considered in determining

whether the acquiring corporation has in substance furnished the

required consideration. For example, if the acquiring corporation or a

related party (within the meaning of section 707(b)(1) or section

267(b) (without regard to section 267(e))) purchases the acquiring

corporation stock shortly after the reorganization, all of the facts

and circumstances may indicate that the transaction should be properly

recast to treat the acquiring corporation as furnishing cash in the

reorganization, in which case the reorganization would not satisfy the

COSI requirement. This approach refocuses the COSI requirement on its

initial purpose of ensuring that the acquiring corporation furnishes

the proper type of consideration and also promotes simplicity and

administrability in applying the COSI requirement.

Effect on Other Authorities

The proposed regulations do not specifically address the effect on

COSI of dispositions of target stock before a transaction potentially

qualifying as a reorganization. See, e.g., King Enterprises, Inc. v.

United States, 418 F.2d 511 (Ct. Cl. 1969); J.E. Seagram Corp. v.

Commissioner, 104 T.C. 75 (1995); Superior Coach of Florida, Inc. v.

Commissioner, 80 T.C. 895 (1983); Yoc Heating Corp. v. Commissioner, 61

T.C. 168 (1973). The Treasury Department and IRS are studying this

question and also the role of the COSI requirement in section

368(a)(1)(D) reorganizations and section 355 transactions. See

Sec. 1.355-2(c). The Treasury Department and IRS solicit comments on

these issues.

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Effect on Other Documents

The IRS will modify or obsolete publications as necessary to

conform with this regulation as of the date of publication in the

Federal Register of the final regulations. See, e.g., Rev. Proc. 86-42

(1986-2 C.B. 722); Rev. Proc. 77-37 (1977-2 C.B. 568). The IRS solicits

comments as to whether other publications should be modified or

obsoleted.

Proposed Effective Date

The revisions and additions in the proposed regulations apply to

transactions occurring after these regulations are published as final

regulations in the Federal Register, except that they shall not apply

to any transactions occurring pursuant to a written agreement which is

(subject to customary conditions) binding on or before these

regulations are published as final regulations in 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 also has been determined

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

chapter 5) does not apply to these regulations, and because the

regulation does not impose a collection of information on small

entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not

apply. 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 Public Hearing

Before these proposed regulations are adopted as final regulations,

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

and eight copies) or comments transmitted via Internet that are

submitted timely to the IRS. All comments will be available for public

inspection and copying.

A public hearing has been scheduled at 10 a.m. on Wednesday, May 7,

1997, in the Auditorium, Internal Revenue Service, 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

request to speak by Wednesday, April 16, 1997, and submit an outline of

the topics to be discussed and the time to be devoted to each topic by

Wednesday, April 16, 1997.

A period of 10 minutes will be allotted 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 Phoebe Bennett of the

Office of the Assistant Chief Counsel (Corporate), IRS. However, other

personnel from the IRS and Treasury Department participated in their

development.

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 1.368-1 is amended by:

1. Revising the third sentence of paragraph (b).

2. Adding two sentences between the fourth and fifth sentences of

paragraph (b).

3. Adding paragraph (e).

The revisions and additions read as follows:

Sec. 1.368-1 Purpose and scope of exception of reorganization

exchanges.

* * * * *

(b) * * * Requisite to a reorganization under the Code are a

continuity of the business enterprise under the modified corporate

form, and (except as provided in section 368(a)(1)(D)) a continuity of

shareholder interest. * * * The continuity of shareholder interest

requirement is described in paragraph (e) of this section. The third

and fifth sentences of this paragraph apply to transactions occurring

after these regulations are published as final regulations in the

Federal Register, except that they shall not apply to any transactions

occurring pursuant to a written agreement which is (subject to

customary conditions) binding on or before these regulations are

published as final regulations in the Federal Register. * * *

* * * * *

(e) Continuity of shareholder interest--(1) General rule. The

purpose of the continuity of shareholder interest requirement is to

prevent transactions that resemble sales from qualifying for

nonrecognition of gain or loss available to corporate reorganizations.

Continuity of shareholder interest requires that the acquiring

corporation furnish consideration representing a proprietary interest

in the affairs of the acquiring corporation and that such consideration

represents a substantial part of the value of the stock or properties

transferred. In determining whether the acquiring corporation has

furnished such consideration, all facts and circumstances must be

considered, including any plan or arrangement for the acquiring

corporation or its successor corporation (or a person related to the

acquiring corporation or its successor corporation within the meaning

of section 707(b)(1) or section 267(b) (without regard to section

267(e))) to redeem or acquire the consideration provided in the

reorganization. Thus, for example, if based on all the facts and

circumstances the acquiring corporation has furnished solely cash, the

continuity of shareholder interest requirement is not satisfied.

(2) Triangular reorganizations. For purposes of this paragraph (e),

in the case of a triangular reorganization described in Sec. 1.358-

6(b), the continuity of shareholder interest requirement will be

applied with reference to the stock of the corporation which is in

control of the acquiring corporation (in a forward triangular merger)

or in control of the merged corporation (in a reverse triangular

merger).

(3) Examples. The following examples illustrate the application of

this paragraph (e):

Example 1. A owns all of the stock of T. T merges into P. In the

merger, A receives stock of P having a fair market value of $50x and

cash of $50x. Immediately after the merger, and pursuant to a

preexisting binding contract negotiated by A, A sells all of the

stock of P received by A in the merger to B, a party not related to

P. The transaction satisfies the continuity of shareholder interest

requirement because A received stock of P representing a substantial

part of the value of the total consideration transferred in the

acquisition.

Example 2. A owns 80 percent of the stock of T and none of the

stock of P, which is widely held. T merges into P. In the merger, A

receives stock of P. In addition, A obtains registration rights

pursuant to an agreement with P to register the P stock and sells

such stock shortly after the acquisition in the open market. The

transaction satisfies the continuity of shareholder interest

requirement.

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Example 3. A owns 80 percent of the stock of T and none of the

stock of P. T merges into P. In the merger, A receives stock of P.

In addition, A arranges with an independent investment banker to

hedge the risk of loss on the P stock received in the merger.

Neither P nor a party related to P enters directly or indirectly

into the hedging transaction. The transaction satisfies the

continuity of shareholder interest requirement.

Example 4. A owns 80 percent of the stock of T and none of the

stock of P. T merges into P. In the merger, A receives stock of P

but with an agreement that it will be redeemed shortly by P.

Pursuant to the agreement, shortly after the merger P redeems all of

the stock of P received by A in the merger for cash. Under all of

the facts and circumstances, the cash is treated as furnished by P

in the merger, so that the merger does not satisfy the continuity of

shareholder interest requirement. The result is the same if S, P's

wholly owned subsidiary, buys all of the stock of P received by A in

the merger for cash. The result is also the same if pursuant to a

plan between P, its investment banker, and A, P's investment banker

buys all of the stock of P received by A in the merger for cash and,

shortly thereafter, P redeems the stock held by the investment

banker for cash.

(4) Effective date. Paragraph (e) applies to transactions occurring

after these regulations are published as final regulations in the

Federal Register, except that it shall not apply to any transactions

occurring pursuant to a written agreement which is (subject to

customary conditions) binding on or before these regulations are

published as final regulations in the Federal Register.

Par. 3. In Sec. 1.368-2, paragraph (a) is amended by removing the

second sentence and adding two new sentences in its place to read as

follows:

Sec. 1.368-2 Definition of terms.

(a) * * * The term does not embrace the mere purchase by one

corporation of the properties of another corporation. The preceding

sentence applies to transactions occurring after these regulations are

published as final regulations in the Federal Register, except that it

shall not apply to any transactions occurring pursuant to a written

agreement which is (subject to customary conditions) binding on or

before these regulations are published as final regulations in the

Federal Register. * * *

* * * * *

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 96-32120 Filed 12-20-96; 8:45 am]

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