The Solely for Voting Stock Requirement in Certain Corporate Reorganizations

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-115086-98]

RIN 1545-AW55

The Solely for Voting Stock Requirement in Certain Corporate

Reorganizations

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 relating to the

solely for voting stock requirement in certain corporate

reorganizations under section 368(a)(1)(C) of the Internal Revenue

Code. The proposed regulations provide that prior ownership of a

portion of a target corporation's stock by an acquiring corporation

generally will not prevent the solely for voting stock requirement in a

``C'' reorganization of the target corporation and the acquiring

corporation from being satisfied. This document also provides notice of

a public hearing on these proposed regulations.

DATES: Written comments must be received by September 13, 1999.

Requests to speak and outlines of topics to be discussed at the hearing

scheduled for October 5, 1999, must be received by September 13, 1999.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-115086-98), room

5226, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, DC 20044. Submissions may be hand delivered Monday through

Friday between the hours of 8 a.m. and 5 p.m. to CC:DOM:CORP:R (REG-

115086-98), 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/tax_regs/

regslist.html. The public hearing will be held in Room 2615, Internal

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

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Marnie

Rapaport, (202) 622-7550; concerning submissions of comments, the

hearing, and/or to be placed on the building access list to attend the

hearing, Guy R. Traynor, (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

A. General Information

This document contains proposed amendments to the Income Tax

Regulations (26 CFR part 1) under section 368(a)(1)(C) relating to the

definition of a ``C'' reorganization. A ``C'' reorganization is

described as the acquisition by one corporation of substantially all of

the properties of a target corporation in exchange solely for voting

stock of the acquiring corporation (or solely for voting stock of its

parent). See section 368(a)(1)(C). The use of money or other property

will not prevent an exchange from qualifying under section 368(a)(1)(C)

if at least 80 percent of the gross fair market value of all of the

property of the target corporation is acquired for voting stock (the

so-called boot relaxation rule). See section 368(a)(2)(B). The proposed

regulations provide that prior ownership of a portion of a target

corporation's stock by an acquiring corporation generally will not

prevent the solely for voting stock requirement in a ``C''

reorganization of the target corporation and the acquiring corporation

from being satisfied. These regulations propose to reverse the IRS's

longstanding position that the acquisition of assets of a partially

controlled subsidiary does not qualify as a tax-free reorganization

under section 368(a)(1)(C).

B. The Bausch & Lomb Doctrine

The IRS's position that the acquisition of assets of a partially

controlled subsidiary does not qualify as a tax-free reorganization

under section 368(a)(1)(C) is articulated in Rev. Rul. 54-396 (1954-2

C.B. 147). This position subsequently was sustained in litigation in

Bausch & Lomb Optical Co. v. Commissioner, 30 T.C. 602 (1958), aff'd,

267 F.2d 75 (2d Cir.), cert. denied, 361 U.S. 835 (1959) (the Bausch &

Lomb doctrine). In Rev. Rul. 54-396, a parent corporation owning 79

percent of the stock of a subsidiary as the result of a prior unrelated

cash purchase acquires all of the assets of the subsidiary in exchange

for a block of the parent's voting stock. The block of the parent's

stock that has been transferred to the subsidiary is then distributed

in liquidation pro rata to its shareholders. The ruling concludes that

the transaction does not qualify as a ``C'' reorganization under the

1939 Internal Revenue Code, but rather is a taxable liquidation of the

subsidiary. The rationale of the revenue ruling is that the acquisition

violates the solely for voting stock requirement, because the parent

corporation acquires only 21 percent of the subsidiary's assets in

exchange for the parent's voting stock, while the remaining 79 percent

of the subsidiary's assets is acquired as a liquidating distribution in

exchange for the previously held stock of the subsidiary.

In Bausch & Lomb (which had nearly identical facts to Rev. Rul. 54-

396), the parent corporation, Bausch & Lomb, owned 79.9 percent of the

stock of Riggs Optical Company. In order to acquire the assets of

Riggs, Bausch & Lomb exchanged shares of its voting stock for all of

the Riggs assets. Pursuant to a prearranged plan, Riggs subsequently

was dissolved and distributed its only asset, the Bausch & Lomb shares,

pro rata to its shareholders. The Tax Court and the Second Circuit

Court of Appeals sustained the Commissioner's contention that the

acquisition of the Riggs assets and the dissolution of Riggs should be

viewed together as part of a single plan, and that the surrender by

Bausch & Lomb of its Riggs stock constituted nonstock consideration in

violation of the ``C'' reorganization requirements.

C. The Solely for Voting Stock Requirement

The ``C'' reorganization first appeared in 1921 when a tax-free

reorganization was defined as a merger or consolidation ``including the

acquisition by one corporation * * * of substantially all of the

properties of another corporation.'' Revenue Act of 1921, section

202(c)(2), 42 Stat. 227, 230. The statutory language failed to limit

the type of permissible consideration, arguably allowing an acquisition

for cash to qualify as a merger.

In 1934, Congress restricted the permissible consideration in an

acquisition of a target's stock or assets (in other than a statutory

merger or consolidation) to voting stock. Revenue Act of 1934, section

112(g)(1), 48 Stat. 680, 705. The stated purpose for this limitation

was to ``remove the danger that taxable sales [could] be cast into the

form of a reorganization.'' See H.R. Rep. No. 704, 73d Cong., 2d Sess.

12-14 (1934), 1939-1 C.B. (Part 2) 554, 563-565; S. Rep. No. 558, 73d

Cong., 2d Sess. 16-17 (1934), 1939-1 C.B. (Part 2) 586, 598-599.

D. Reasons for Change

The legislative history of the ``C'' reorganization provisions

provides that the purpose of the solely for voting

[[Page 31771]]

stock requirement in section 368(a)(1)(C) is to prevent transactions

that resemble sales from qualifying for nonrecognition of gain or loss

available to corporate reorganizations. The IRS and Treasury Department

have concluded that a transaction in which the acquiring corporation

converts an indirect ownership interest in assets to a direct interest

in those assets does not resemble a sale and, thus, have concluded that

Congress did not intend to disqualify a transaction from qualifying

under section 368(a)(1)(C) merely because the acquiring corporation has

prior ownership of a portion of a target corporation's stock. Because

the judicial doctrine of continuity of interest arose from similar

concerns, the regulations under Sec. 1.368-1(e)(1)(i) reach a similar

conclusion with respect to the continuity of interest doctrine.

Moreover, the taxable treatment of the ``upstream'' ``C''

reorganization under the Bausch & Lomb doctrine contrasts with the tax-

free treatment of the ``upstream'' ``A'' reorganization under section

368(a)(1)(A). See also Rev. Rul. 57-278 (1957-1 C.B. 124) (Bausch &

Lomb does not apply to an asset acquisition by a newly formed

corporation in exchange for its parent's stock, even though prior to

the acquisition the parent already owned 72 percent of the transferor's

stock). In the ``upstream'' ``A'' reorganization, the indirect interest

of the parent in the assets of its subsidiary (i.e., the target

corporation) is converted into a direct interest in the subsidiary's

assets. An exchange is deemed to occur for purposes of section 354 even

if, in form, one does not occur. The IRS and Treasury Department have

concluded that the ``upstream'' reorganization under section

368(a)(1)(C) (i.e., the Bausch & Lomb transaction) should not be

treated differently from the ``upstream'' ``A'' reorganization solely

because the acquiring corporation already owns stock in the target

corporation. Accordingly, the IRS and Treasury Department have

concluded that the Bausch & Lomb doctrine does not further the

principles of reorganization treatment.

Explanation of Provisions

The proposed regulations provide that preexisting ownership of a

portion of a target corporation's stock by an acquiring corporation

generally will not prevent the solely for voting stock requirement in a

``C'' reorganization from being satisfied. If the boot relaxation rule

applies, the sum of (i) the money or other property that is distributed

in pursuance of the plan of reorganization to the shareholders of the

target corporation other than the acquiring corporation and to the

creditors of the target corporation pursuant to section 361(b)(3), and

(ii) the assumption of all the liabilities of the target corporation

(including liabilities to which the properties of the target

corporation are subject), cannot exceed 20 percent of the value of all

of the properties of the target corporation. In this regard, the

proposed regulations provide that if, in connection with a potential

``C'' reorganization of a target corporation into an acquiring

corporation, the acquiring corporation acquires the target

corporation's stock for consideration other than its own voting stock

(or voting stock of a corporation in control of the acquiring

corporation if such stock is used in the acquisition of the target

corporation's properties), whether from a shareholder of the target

corporation or from the target corporation itself, such consideration

will be treated as money or other property exchanged by the acquiring

corporation for the target corporation's assets. Accordingly, the

requirements of section 368(a)(1)(C) will not be satisfied unless the

transaction can qualify under the boot relaxation rule of section

368(a)(2)(B). The determination of whether there has been an

acquisition in connection with a potential ``C'' reorganization of a

target corporation's stock for consideration other than an acquiring

corporation's own voting stock (or voting stock of a corporation in

control of the acquiring corporation if such stock is used in the

acquisition of the target corporation's properties) will be made on the

basis of all of the facts and circumstances.

Rev. Rul. 54-396 (1954-2 C.B. 147) will become obsolete when the

proposed regulations are issued in final form.

The regulations are proposed to apply to transactions occurring

after the date that a Treasury decision adopting these rules is

published in the Federal Register, except that they do not apply to any

transactions occurring pursuant to a written agreement which is

(subject to customary conditions) binding on the date the regulations

are published as final regulations in the Federal Register, and at all

times thereafter.

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 proposed regulations and, because

the proposed regulations do not impose a collection of information on

small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6)

does not apply. Therefore, a Regulatory Flexibility Analysis is not

required. Pursuant to section 7805(f) of the Internal Revenue Code,

these regulations 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 (8) copies) that are timely submitted to the IRS. The IRS and

Treasury request comments on the clarity of the proposed rule and how

it may be made easier to understand. All comments will be available for

public inspection and copying.

A public hearing has been scheduled for October 5, 1999, beginning

at 10:00 a.m. in Room 2615 of the Internal Revenue Building, 1111

Constitution Avenue, NW., Washington, DC. Due to building security

procedures, visitors must enter at the 10th Street entrance, located

between Constitution and Pennsylvania Avenues, NW. In addition, all

visitors must present photo identification to enter the building.

Because of access restrictions, visitors will not be admitted beyond

the immediate entrance area more than 15 minutes before the hearing

starts. For information about having your name placed on the building

access list to attend the hearing, see the FOR FURTHER INFORMATION

CONTACT section of this preamble.

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

wish to present oral comments at the hearing must request to speak, and

submit written comments and an outline of the topics to be discussed

and the time to be devoted to each topic (signed original and eight (8)

copies) by September 13, 1999. A period of ten 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

Marnie Rapaport of the Office of the Assistant Chief Counsel

(Corporate), IRS. However, other personnel from the IRS and Treasury

Department participated in their development.

[[Page 31772]]

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 1.368-2 is amended by adding paragraph (d)(4) to

read as follows:

Sec. 1.368-2 Definition of terms.

* * * * *

(d) * * *

(4) (i) For purposes of paragraphs (d)(1) and (2)(ii) of this

section, prior ownership of a portion of the stock of the target

corporation by an acquiring corporation will not by itself prevent the

solely for voting stock requirement of such paragraphs from being

satisfied. In a transaction in which the acquiring corporation has

prior ownership of a portion of the stock of the target corporation,

the requirement of paragraph (2)(ii) is satisfied only if the sum of

the money or other property that is distributed in pursuance of the

plan of reorganization to the shareholders of the target corporation

other than the acquiring corporation and to the creditors of the target

corporation pursuant to section 361(b)(3), and all of the liabilities

of the target corporation assumed by the acquiring corporation

(including liabilities to which the properties of the target

corporation are subject), does not exceed 20 percent of the value of

all of the properties of the target corporation. If, in connection with

a potential acquisition by an acquiring corporation of substantially

all of a target corporation's properties, the acquiring corporation

acquires the target corporation's stock for consideration other than

the acquiring corporation's own voting stock (or voting stock of a

corporation in control of the acquiring corporation if such stock is

used in the acquisition of the target corporation's properties),

whether from a shareholder of the target corporation or the target

corporation itself, such consideration is treated, for purposes of

paragraphs (d)(1) and (2) of this section, as money or other property

exchanged by the acquiring corporation for the target corporation's

properties. Accordingly, the transaction will not qualify under section

368(a)(1)(C) unless, treating such consideration as money or other

property, the requirements of section 368(a)(2)(B) and paragraph

(d)(2)(ii) of this section are met. The determination of whether there

has been an acquisition in connection with a potential reorganization

under section 368(a)(1)(C) of a target corporation's stock for

consideration other than an acquiring corporation's own voting stock

(or voting stock of a corporation in control of the acquiring

corporation if such stock is used in the acquisition of the target

corporation's properties) will be made on the basis of all of the facts

and circumstances.

(ii) The following examples illustrate the principles of this

paragraph (d)(4):

Example 1. Corporation P (P) holds 60 percent of the Corporation

T (T) stock that P purchased several years ago in an unrelated

transaction. T has 100 shares of stock outstanding. The other 40

percent of the T stock is owned by Corporation X (X), an unrelated

corporation. T has properties with a fair market value of $110 and

liabilities of $10. T transfers all of its properties to P. In

exchange, P assumes the $10 of liabilities, and transfers to T $30

of P voting stock and $10 of cash. T distributes the P voting stock

and $10 of cash to X and liquidates. The transaction satisfies the

solely for voting stock requirement of paragraph (d)(2)(ii) of this

section because the sum of $10 of cash paid to X and the assumption

by P of $10 of liabilities does not exceed 20% of the value of the

properties of T.

Example 2. The facts are the same as in Example 1 except that P

purchased the 60 shares of T for $60 in cash in connection with the

acquisition of T's assets. The transaction does not satisfy the

solely for voting stock requirement of paragraph (d)(2)(ii) of this

section because P is treated as having acquired all of the T assets

for consideration consisting of $70 of cash, $10 of liability

assumption and $30 of P voting stock, and the sum of $70 of cash and

the assumption by P of $10 of liabilities exceeds 20% of the value

of the properties of T.

(iii) This paragraph (d)(4) applies to transactions occurring after

the date these regulations are published as final regulations in the

Federal Register, except that this paragraph (d)(4) does not apply to

any transactions occurring pursuant to a written agreement which is

(subject to customary conditions) binding on the date the regulations

are published as final regulations in the Federal Register, and at all

times thereafter.

* * * * *

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

[FR Doc. 99-14889 Filed 6-11-99; 8:45 am]

BILLING CODE 4830-01-P