Continuity of Interest & Continuity of Business Enterprise

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8760] RIN 1545-AU72 and
1545-AU73

TITLE: Continuity of Interest and Continuity of Business Enterprise

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations providing guidance
regarding satisfaction of the continuity of interest and continuity
of business enterprise requirements for corporate reorganizations.
The final regulations affect corporations and their shareholders.

DATES: These regulations are effective January 28, 1998.

Applicability: These regulations apply to transactions occurring
after January 28, 1998, except that they do not apply to any
transaction occurring pursuant to a written agreement which is
(subject to customary conditions) binding on January 28, 1998, and
at all times thereafter.

FOR FURTHER INFORMATION CONTACT: Regarding §1.368-1(e) (continuity
of interest), §§1.338-2 and 1.368-1(a) and (b):

Phoebe Bennett, (202) 622-7750 (not a toll-free number); regarding
§1.368-1(d) (continuity of business enterprise), §§1.368-1(a) and
(b), and 1.368-2(k): Marlene Peake Oppenheim, (202) 622-7750 (not a
toll free number).

SUPPLEMENTARY INFORMATION:

Background

On December 23, 1996, the IRS published a notice of proposed
rulemaking (REG-252231-96) in the Federal Register (61 FR 67512)
relating to the continuity of interest (COI) requirement (proposed
COI regulations). On January 3, 1997, the IRS published a notice of
proposed rulemaking (REG-252233-96) in the Federal Register (62 FR
36101) (proposed COBE regulations) relating to (1) the continuity of
business enterprise (COBE) requirement; and (2) transfers of
acquired assets or stock following certain otherwise qualifying
reorganizations (remote continuity of interest). Many written
comments were received in response to these notices of proposed
rulemaking. A public hearing on both proposed regulations was held
on May 7, 1997.

After consideration of all comments, the regulations proposed by
REG-252231-96 and REG-252233-96 are adopted as revised by this
Treasury decision, along with temporary regulations and proposed
regulations cross-referencing the temporary regulations regarding
COI published elsewhere in this issue of the Federal Register.

Explanation of Provisions

The Internal Revenue Code of 1986 provides general nonrecognition
treatment for reorganizations specifically described in section 368.
In addition to complying with the statutory requirements and certain
other requirements, a transaction generally must satisfy the
continuity of interest requirement and the continuity of business
enterprise requirement.

A. Continuity of Interest

The purpose of the continuity of interest requirement is to prevent
transactions that resemble sales from qualifying for nonrecognition
of gain or loss available to corporate reorganizations. The final
regulations provide that the COI requirement is satisfied if in
substance a substantial part of the value of the proprietary
interest in the target corporation (T) is preserved in the
reorganization. A proprietary interest in T is preserved if, in a
potential reorganization, it is exchanged for a proprietary interest
in the issuing corporation (P), it is exchanged by the acquiring
corporation for a direct interest in the T enterprise, or it
otherwise continues as a proprietary interest in T. The issuing
corporation means the acquiring corporation (as the term is used in
section 368(a)), except that, in determining whether a
reorganization qualifies as a triangular reorganization (as defined
in §1.358-6(b)(2)), the issuing corporation means the corporation in
control of the acquiring corporation. However, a proprietary
interest in T is not preserved if, in connection with the potential
reorganization, it is acquired by P for consideration other than P
stock, or P stock furnished in exchange for a proprietary interest
in T in the potential reorganization is redeemed. All facts and
circumstances must be considered in determining whether, in
substance, a proprietary interest in T is preserved.

Rationale for the COI regulations

The proposed and final regulations permit former T shareholders to
sell P stock received in a potential reorganization to third parties
without causing the reorganization to fail to satisfy the COI
requirement. Some commentators have questioned whether the
regulations are consistent with existing authorities.

The COI requirement was applied first to reorganization provisions
that did not specify that P exchange a proprietary interest in P for
a proprietary interest in T. Supreme Court cases imposed the COI
requirement to further Congressional intent that tax-free status be
accorded only to transactions where P exchanges a substantial
proprietary interest in P for a proprietary interest in T held by
the T shareholders rather than to transactions resembling sales. See
LeTulle v. Scofield, 308 U.S. 415 (1940); Helvering v. Minnesota Tea
Co., 296 U.S. 378 (1935); Pinellas Ice & Cold Storage Co. v.
Commissioner, 287 U.S. 462 (1933). See also Cortland Specialty Co.
v. Commissioner, 60 F.2d 937 (2d Cir. 1932), cert. denied 288 U.S.
599 (1933).

None of the Supreme Court cases establishing the COI requirement
addressed the issue of whether sales by former T shareholders of P
stock received in exchange for T stock in the potential
reorganization cause the COI requirement to fail to be satisfied.
Since then, however, some courts have premised decisions on the
assumption that sales of P stock received in exchange for T stock in
the potential reorganization may cause the COI requirement to fail
to be satisfied. McDonald's Restaurants of Illinois, Inc. v.
Commissioner, 688 F.2d 520 (7th Cir. 1982); Penrod v. Commissioner,
88 T.C. 1415 (1987); Heintz v. Commissioner, 25 T.C. 132 (1955),
nonacq., 1958-2 C.B. 9; Estate of Elizabeth Christian v.
Commissioner, 57 T.C.M. (CCH) 1231 (1989). The apparent focus of
these cases is on whether the T shareholders intended on the date of
the potential reorganization to sell their P stock and the degree,
if any, to which P facilitates the sale. Based on an intensive
inquiry into nearly identical facts, some of these cases held that
as a result of the subsequent sale the potential reorganization did
not satisfy the COI requirement; others held that satisfaction of
the COI requirement was not adversely affected by the subsequent
sale. The IRS and Treasury Department have concluded that the law as
reflected in these cases does not further the principles of
reorganization treatment and is difficult for both taxpayers and the
IRS to apply consistently.

Therefore, consistent with Congressional intent and the Supreme
Court precedent which distinguishes between sales and
reorganizations, the final regulations focus the COI requirement
generally on exchanges between the T shareholders and P. Under this
approach, sales of P stock by former T shareholders generally are
disregarded.

The final regulations will greatly enhance administrability in this
area by both taxpayers and the government. The regulations will
prevent "whipsaw" of the government, such as where the former T
shareholders treat the transaction as a tax-free reorganization, and
P later disavows reorganization treatment to step up its basis in
the T assets based on the position that sales of P stock by the
former T shareholders did not satisfy the COI requirement. See,
e.g., McDonald's Restaurants, supra. In addition, this approach will
prevent unilateral sales of P stock by former majority T
shareholders from adversely affecting the section 354 nonrecognition
treatment expected by former minority T shareholders.

Dispositions of T stock

The proposed COI regulations do not specifically address the effect
upon COI of dispositions of T stock prior to a potential
reorganization, but ask for comments on that issue. The IRS and
Treasury Department believe that issues concerning the COI
requirement raised by dispositions of T stock before a potential
reorganization correspond to those raised by subsequent dispositions
of P stock furnished in exchange for T stock in the potential
reorganization. As requested by commentators, the final regulations
apply the rationale of the proposed COI regulations to transactions
occurring both prior to and after a potential reorganization. Cf.
J.E. Seagram Corp. v.

Commissioner, 104 T.C. 75 (1995) (sales of T stock prior to a
potential reorganization do not affect COI if not part of the plan
of reorganization). The final regulations provide that, for COI
purposes, a mere disposition of T stock prior to a potential
reorganization to persons not related to P is disregarded and a mere
disposition of P stock received in a potential reorganization to
persons not related to P is disregarded. But see §1.368-1T(e)(1)(ii)
(A) and (B).

In soliciting comments on the effect upon COI of dispositions of T
stock prior to a potential reorganization, the preamble to the
proposed COI regulations specifically requests comments on King
Enterprises, Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969) (COI
requirement satisfied where, pursuant to a plan, P acquires the T
stock for 51 percent P stock and 49 percent debt and cash, and T
merges upstream into P), and Yoc Heating Corp. v. Commissioner, 61
T.C. 168 (1973) (COI requirement not satisfied where, pursuant to a
plan, P acquires 85 percent of the T stock for cash and notes, and T
merges into P's newly formed subsidiary with minority shareholders
receiving cash). Consistent with these cases, where the step
transaction doctrine applies to link T stock purchases with later
acquisitions of T, the final regulations provide that a proprietary
interest in T is not preserved if, in connection with the potential
reorganization, it is acquired by P for consideration other than P
stock. Whether a stock acquisition is made in connection with a
potential reorganization will be determined based on the facts and
circumstances of each case.

See generally §1.368-1(a). This regulation does not address the
effect, if any, of section 338 on corporate transactions (except for
conforming changes to §1.338-2(c)(3)). See generally §1.338-2(c)(3)
(certain tax effects of a qualified stock purchase without a section
338 election on the post-acquisition elimination of T).

Related person rule

The proposed COI regulations provide that "[i]n determining whether
[COI is satisfied], 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 267(b) (without regard to section 267(e))) to
redeem or acquire the consideration provided in the reorganization."
The final regulations provide a more specific rule that a
proprietary interest in T is not preserved if, in connection with a
potential reorganization, a person related (as defined below) to P
acquires, with consideration other than a proprietary interest in P,
T stock or P stock furnished in exchange for a proprietary interest
in T in the potential reorganization. The IRS and Treasury
Department believe, however, that certain related party acquisitions
preserve a proprietary interest in T and therefore, the rule
includes an exception to the related party rule. Under this
exception, a proprietary interest in T is preserved to the extent
those persons who were the direct or indirect owners of T prior to
the potential reorganization maintain a direct or indirect
proprietary interest in P. See, e.g., Rev. Rul. 84-30 (1984-1 C.B.
114).

Commentators stated that the proposed COI regulations' rule, which
employs sections 707(b)(1) and 267(b) to define persons related to
P, is too broad. In response, the final regulations adopt a narrower
related person definition which has two components in order to
address two separate concerns.

First, the IRS and Treasury Department were concerned that
acquisitions of T or P stock by a member of P's affiliated group
were no different in substance from an acquisition or redemption by
P, because of the existence of various provisions in the Code that
permit members to transfer funds to other members without
significant tax consequences. Accordingly, §1.368-1(e)(3)(i)(A)
includes as related persons corporations that are members of the
same affiliated group under section 1504, without regard to the
exceptions in section 1504(b).

Second, because the final regulations take into account whether, in
substance, P has redeemed the stock it exchanged for T stock in the
potential reorganization, the final regulations treat two
corporations as related persons if a purchase of the stock of one
corporation by another corporation would be treated as a
distribution in redemption of the stock of the first corporation
under section 304(a)(2) (determined without regard to
§1.1502-80(b)).

Because the final regulations focus generally on the consideration P
exchanges, related persons do not include individual or other
noncorporate shareholders. Thus, the IRS will no longer apply the
holdings of South Bay Corporation v. Commissioner, 345 F.2d 698 (2d
Cir. 1965), and Superior Coach of Florida, Inc. v. Commissioner, 80
T.C. 895 (1983), to transactions governed by these regulations.

T stock not acquired in connection with a potential reorganization

Commentators requested clarification of whether P must actually
furnish stock to T shareholders that own T stock which was not
acquired in connection with a potential reorganization.

The final regulations provide that a proprietary interest in T is
preserved if it is exchanged by the acquiring corporation (which may
or may not also be P) for a direct interest in the T enterprise, or
otherwise continues as a proprietary interest in T.

Redemptions of T stock or extraordinary distributions with respect
to T stock

In addition to the final regulations, the IRS and Treasury
Department are contemporaneously issuing temporary regulations and
proposed regulations cross-referencing the temporary regulations
published elsewhere in this issue of the Federal Register with the
same effective date as these final regulations.

The temporary and proposed regulations provide that a proprietary
interest in T is not preserved if, in connection with a potential
reorganization, it is redeemed or acquired by a person related to T,
or to the extent that, prior to and in connection with a potential
reorganization, an extraordinary distribution is made with respect
to it.

Transactions following a qualified stock purchase As stated above,
these final regulations focus the COI requirement generally on
exchanges between the T shareholders and P. Accordingly, the
language of §1.338-2(c)(3) is conformed to these final COI
regulations to treat the stock of T acquired by the purchasing
corporation in the qualified stock purchase as though it was not
acquired in connection with the transfer of the T assets.

Effect on other authorities

The IRS and Treasury Department continue to study the role of the
COI requirement in section 368(a)(1)(D) reorganizations and section
355 transactions. Therefore, these final COI regulations do not
apply to section 368(a)(1)(D) reorganizations and section 355
transactions. See §1.355-2(c).

These COI regulations apply solely for purposes of determining
whether the COI requirement is satisfied. No inference should be
drawn from any provision of this regulation as to whether other
reorganization requirements are satisfied, for example, whether P
has issued solely voting stock for purposes of section 368(a)(1)(B)
or (C).

Effect on other documents

Rev. Proc. 77-37 (1977-2 C.B. 568) and Rev. Proc. 86-42 (1986-2 C.B.
722) will be modified to the extent inconsistent with these
regulations.

Rev. Rul. 66-23 (1966-1 C.B. 67) is hereby obsoleted because it
indicates that a plan or arrangement in connection with a potential
reorganization for disposition of stock to unrelated persons does
not satisfy the COI requirement.

B. Continuity of Business Enterprise

The COBE requirement is fundamental to the notion that tax-free
reorganizations merely readjust continuing interests in property. In
§1.368-1(d), as effective prior to these final regulations, COBE
generally required the acquiring corporation to either continue a
significant historic T business or use a significant portion of T's
historic business assets in a business. However, a valid
reorganization may qualify as tax-free even if the acquiring
corporation does not directly carry on the historic T business or
use the historic T assets in a business. See section 368(a)(2)(C).
See also Rev. Rul. 68-261 (1968-1 C.B. 147); Rev. Rul. 81-247
(1981-1 C.B. 87).

Consistent with the view that the acquiring corporation need not
directly conduct the T business or use the T assets, the final
regulations provide rules under which, in an otherwise qualifying
corporate reorganization, the assets and the businesses of the
members of a qualified group of corporations are treated as assets
and businesses of the issuing corporation.

Accordingly, in the final regulations, COBE requires that the
issuing corporation either continue T's historic business or use a
significant portion of T's historic business assets in a business.

A qualified group is one or more chains of corporations connected
through stock ownership with the issuing corporation, but only if
the issuing corporation owns directly stock meeting the requirements
of section 368(c) in at least one of the corporations, and stock
meeting the requirements of section 368(c) in each of the
corporations is owned directly by one of the other corporations.

The judicial continuity of interest doctrine historically included a
concept commonly known as remote continuity of interest. Commonly
viewed as arising out of Groman v.

Commissioner, 302 U.S. 82 (1937), and Helvering v. Bashford, 302
U.S. 454 (1938), remote continuity of interest focuses on the link
between the T shareholders and the former T business assets
following the reorganization. In §1.368-1(d), as effective prior to
these final regulations, COBE focuses on the continuation of T's
business, or the use of T's business assets, by the acquiring
corporation. Section 1.368-1(d), as revised herein, expands this
concept by treating the issuing corporation as conducting a T
business or owning T business assets if these activities are
conducted by a member of the qualified group or, in certain cases,
by a partnership that has a member of the qualified group as a
partner.

The proposed COBE regulations separately address COBE (§1.368-1(d))
and remote continuity of interest (§1.368-1(f)).

The IRS and Treasury Department believe the COBE requirements
adequately address the issues raised in Groman and Bashford and
their progeny. Thus, these final regulations do not separately
articulate rules addressing remote continuity of interest.

Definition of the qualified group

The proposed COBE regulations define the qualified group using a
control test based on section 368(c). The IRS and Treasury
Department received comments suggesting the replacement of the
section 368(c) definition of control by the affiliated group
definition of control stated in section 1504, without regard to
section 1504(b). However, because section 368 generally determines
control by reference to section 368(c), the final regulations retain
the approach of the proposed COBE regulations.

Rules for aggregation of interests in historic T assets and
businesses held in partnership solution

In determining whether COBE is satisfied, the proposed COBE
regulations aggregate the interests of the members of a qualified
group. In addition, the proposed COBE regulations attribute a
business of a partnership to a corporate transferor partner if the
partner has a sufficient nexus with that partnership business.
However, the proposed COBE regulations only consider the transferor
partner's interest in the partnership business, and do not aggregate
this interest with interests in the partnership held by other
members of the qualified group.

In response to comments requesting a partnership aggregation rule,
the final regulations, through a system of attribution, aggregate
the interests in a partnership business held by all the members of a
qualified group. The final regulations provide rules under which a
corporate partner may be treated as holding assets of a business of
a partnership. Additionally, P is treated as holding all the assets,
and conducting all the businesses of its qualified group.
Furthermore, in certain circumstances, P will be treated as
conducting a business of a partnership. Once the relevant T
businesses and T assets are attributed to P, COBE is tested under
the general rule of the final COBE regulations. See §1.368-1(d)(1).

The proposed COBE regulations do not discuss tiered partnerships. In
response to comments, the final regulations provide guidance on this
issue. See §1.368-1(d)(5), Example 12.

C. Transfers of Assets or Stock to Controlled Corporations as Part
of a Plan of Reorganization

The proposed COBE regulations are limited in their application to
COBE and remote continuity of interest. The rules of the proposed
COBE regulations provide that for certain reorganizations, transfers
of acquired assets or stock among members of the qualified group,
and in certain cases, transfers of acquired assets to partnerships,
do not disqualify a transaction from satisfying the COBE and remote
continuity of interest requirements. The preamble to the proposed
COBE regulations states that these rules do not address any other
issues concerning the qualification of a transaction as a
reorganization.

Comments suggest that the proposed COBE regulations are ambiguous as
they could be interpreted to mean that a transfer of stock or assets
to a qualified group member after an otherwise tax-free
reorganization would be given independent significance and the step
transaction doctrine would not apply. Under such an interpretation,
the potential reorganization would not be recast as a taxable
acquisition or another type of reorganization. To eliminate this
ambiguity, §1.368-1(a) of the final regulations provides that, in
determining whether a transaction qualifies as a reorganization
under section 368(a), the transaction must be evaluated under
relevant provisions of law, including the step transaction doctrine.
Section 1.368-1(d) of the final regulations is limited to a
discussion of the COBE requirement, and does not address
satisfaction of the explicit statutory requirements of a
reorganization, which is the subject of §1.368-2. However,
§1.368-2(k) of the final regulations does provide guidance in this
regard, extending the application of section 368(a)(2)(C) to certain
successive transfers.

Section 1.368-2(k) of the final regulations states that a
transaction otherwise qualifying under section 368(a)(1)(A), (B),
(C), or (G) (where the requirements of sections 354(b)(1)(A) and (B)
are met) shall not be disqualified by reason of the fact that part
or all of the acquired assets or stock acquired in the transaction
are transferred or successively transferred to one or more
corporations controlled in each transfer by the transferor
corporation. Control is defined under section 368(c). The final
regulations also provide a rule for transfers of assets following a
reorganization qualifying under section 368(a)(1)(A) by reason of
section 368(a)(2)(E). No inference is to be drawn as to whether
transactions not described in §1.368-2(k) otherwise qualify as
reorganizations.

The final regulations also provide that, if a transaction otherwise
qualifies as a reorganization, a corporation remains a party to the
reorganization even though stock or assets acquired in the
reorganization are transferred in a transaction described in
§1.368-2(k). See §1.368-2(f). Furthermore, if a transaction
otherwise qualifies as a reorganization, a corporation shall not
cease to be a party to the reorganization solely because acquired
assets are transferred to a partnership in which the transferor is a
partner if the COBE requirement is satisfied.

Section 368(a)(1)(D), 368(a)(1)(F), and 355 transactions The
proposed COBE regulations, applying only to the COBE and remote
continuity of interest requirements, are limited to transactions
otherwise qualifying for reorganization treatment under section
368(a)(1)(A), (B), (C), or (G) (where the requirements of sections
354(b)(1)(A) and (B) are met). The IRS and Treasury Department
received comments stating that the final regulations should apply to
reorganizations qualifying under section 368(a)(1)(D) or (F) or to
transactions qualifying under section 355.

The final regulations do not limit the application of §1.368-1(d) to
the transactions enumerated in section 368(a)(2)(C). The COBE
provisions in the final regulations apply to all reorganizations for
which COBE is relevant.

Section 1.368-2(k)(1) of the final regulations, however, is limited
in its application to the transactions described in section 368(a)
(2)(C), and does not apply in determining whether a reorganization
qualifies under section 368(a)(1)(D), section 368(a)(1)(F), or
section 355. The IRS and Treasury Department believe that further
study is needed prior to extending §1.368-2(k)(1) to one or more of
these provisions.

Effective Date

The amendments to these regulations apply to transactions occurring
after January 28, 1998, except that they do not apply to any
transaction occurring pursuant to a written agreement which is
(subject to customary conditions) binding on January 28, 1998, and
at all times thereafter. Commentators requested that the effective
date be changed to allow these regulations to apply to transactions
occurring on or before January 28, 1998. The IRS and Treasury
Department believe that adopting an earlier effective date increases
the likelihood that T, P, and each of the former T shareholders
would report the transaction inconsistently (in some cases using
hindsight), and would reduce administrability of the regulation. No
inference should be drawn from any provision of this regulation as
to application of the COI or COBE requirements to transactions
occurring on or before January 28, 1998.

Special Analyses

It has been determined that this Treasury decision 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,
the notices of proposed rulemaking preceding these regulations were
submitted to the Chief Counsel for Advocacy of the Small Business
Administration for comment on their impact on small business.

Drafting Information

The principal authors of these regulations are Phoebe Bennett,
regarding §1.368-1(e) (continuity of interest), and Marlene Peake
Oppenheim, regarding §1.368-1(d) (continuity of business enterprise)
and §1.368-2(k), both of the Office of the Assistant Chief Counsel
(Corporate), IRS. 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.

Adoption of Amendments to the Regulations Accordingly, 26 CFR part 1
is 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 1.338-2 is amended:

1. By revising paragraph (c)(3)(ii).

2. In paragraph (c)(3)(iv) Example by revising the first sentence of
paragraph (B).

The revisions read as follows:

§1.338-2 Miscellaneous issues under section 338.

* * * * *

(c) * * *

(3) * * *

(ii) Continuity of interest. By virtue of section 338, in
determining whether the continuity of interest requirement of
§1.368-1(b) and (e) is satisfied on the transfer of assets from
target to the transferee, the purchasing corporation's target stock
acquired in the qualified stock purchase shall be treated as though
it was not acquired in connection with the transfer of target
assets.

* * * * *

(iv) Example. * * *

(B) Status of transfer as a reorganization. By virtue of section
338, for the purpose of determining whether the continuity of
interest requirement of §1.368-1(b) is satisfied, P's T stock
acquired in the qualified stock purchase shall be treated as though
it was not acquired in connection with the transfer of T assets to
X. * * *

* * * * *

Par. 3. Section 1.368-1 is amended by:

1. Adding three sentences immediately following the first sentence
of paragraph (a).

2. Removing the third sentence and adding four sentences in its
place to paragraph (b).

3. Removing paragraph (d)(1).

4. Redesignating paragraphs (d)(2), (d)(3), and (d)(4) as paragraphs
(d)(1), (d)(2), and (d)(3), respectively.

5. Removing the first sentence of newly designated paragraph (d)(1)
and adding two sentences in its place.

6. Adding new paragraph (d)(4).

7. Paragraph (d)(5) is amended by:

a. Adding two sentences to the end of paragraph (d)(5) introductory
text.

b. Removing the parentheses around the numbers in the paragraph
headings for Example (1) through Example (5).

c. Adding Example 6 through Example 12.

8. Adding paragraph (e).

The additions and revisions read as follows:

§1.368-1 Purpose and scope of exception of reorganization exchanges.

(a) * * * In determining whether a transaction qualifies as a
reorganization under section 368(a), the transaction must be
evaluated under relevant provisions of law, including the step
transaction doctrine. But see §§1.368-2(f) and (k) and 1.338-2(c)
(3). The preceding two sentences apply to transactions occurring
after January 28, 1998, except that they do not apply to any
transaction occurring pursuant to a written agreement which is
binding on January 28, 1998, and at all times thereafter.

* * *

(b) * * * Requisite to a reorganization under the Internal Revenue
Code are a continuity of the business enterprise through the issuing
corporation under the modified corporate form as described in
paragraph (d) of this section, and (except as provided in section
368(a)(1)(D)) a continuity of interest as described in paragraph (e)
of this section. (For rules regarding the continuity of interest
requirement under section 355, see §1.355-2(c).) For purposes of
this section, the term issuing corporation means the acquiring
corporation (as that term is used in section 368(a)), except that,
in determining whether a reorganization qualifies as a triangular
reorganization (as defined in §1.358-6(b)(2)), the issuing
corporation means the corporation in control of the acquiring
corporation. The preceding three sentences apply to transactions
occurring after January 28, 1998, except that they do not apply to
any transaction occurring pursuant to a written agreement which is
binding on January 28, 1998, and at all times thereafter. * * *

* * * * *

(d) Continuity of business enterprise--(1) General rule.

Continuity of business enterprise (COBE) requires that the issuing
corporation (P), as defined in paragraph (b) of this section, either
continue the target corporation's (T's) historic business or use a
significant portion of T's historic business assets in a business.
The preceding sentence applies to transactions occurring after
January 28, 1998, except that it does not apply to any transaction
occurring pursuant to a written agreement which is binding on
January 28, 1998, and at all times thereafter.

* * *

* * * * *

(4) Acquired assets or stock held by members of the qualified group
or partnerships. The following rules apply in determining whether
the COBE requirement of paragraph (d)(1) of this section is
satisfied:

(i) Businesses and assets of members of a qualified group.

The issuing corporation is treated as holding all of the businesses
and assets of all of the members of the qualified group, as defined
in paragraph (d)(4)(ii) of this section.

(ii) Qualified group. A qualified group is one or more chains of
corporations connected through stock ownership with the issuing
corporation, but only if the issuing corporation owns directly stock
meeting the requirements of section 368(c) in at least one other
corporation, and stock meeting the requirements of section 368(c) in
each of the corporations (except the issuing corporation) is owned
directly by one of the other corporations.

(iii) Partnerships--(A) Partnership assets. Each partner of a
partnership will be treated as owning the T business assets used in
a business of the partnership in accordance with that partner's
interest in the partnership.

(B) Partnership businesses. The issuing corporation will be treated
as conducting a business of a partnership if --

(1) Members of the qualified group, in the aggregate, own an
interest in the partnership representing a significant interest in
that partnership business; or

(2) One or more members of the qualified group have active and
substantial management functions as a partner with respect to that
partnership business.

(C) Conduct of the historic T business in a partnership. If a
significant historic T business is conducted in a partnership, the
fact that P is treated as conducting such T business under paragraph
(d)(4)(iii)(B) of this section tends to establish the requisite
continuity, but is not alone sufficient.

(iv) Effective date. This paragraph (d)(4) applies to transactions
occurring after January 28, 1998, except that it does not apply to
any transaction occurring pursuant to a written agreement which is
binding on January 28, 1998, and at all times thereafter.

(5) * * * All corporations have only one class of stock outstanding.
The preceding sentence and paragraph (d)(5) Example 6 through
Example 12 apply to transactions occurring after January 28, 1998,
except that they do not apply to any transaction occurring pursuant
to a written agreement which is binding on January 28, 1998, and at
all times thereafter.

* * * * *

Example 6. Use of a significant portion of T's historic business
assets by the qualified group. (i) Facts. T operates an auto parts
distributorship. P owns 80 percent of the stock of a holding company
(HC). HC owns 80 percent of the stock of ten subsidiaries, S-1
through S-10. S-1 through S-10 each separately operate a full
service gas station. Pursuant to a plan of reorganization, T merges
into P and the T shareholders receive solely P stock. As part of the
plan of reorganization, P transfers T's assets to HC, which in turn
transfers some of the T assets to each of the ten subsidiaries. No
one subsidiary receives a significant portion of T's historic
business assets.

Each of the subsidiaries will use the T assets in the operation of
its full service gas station. No P subsidiary will be an auto parts
distributor.

(ii) Continuity of business enterprise. Under paragraph (d)(4)(i) of
this section, P is treated as conducting the ten gas station
businesses of S-1 through S-10 and as holding the historic T assets
used in those businesses. P is treated as holding all the assets and
conducting the businesses of all of the members of the qualified
group, which includes S-1 through S-10 (paragraphs (d)(4)(i) and
(ii) of this section). No member of the qualified group continues
T's historic distributorship business. However, subsidiaries S-1
through S-10 continue to use the historic T assets in a business.
Even though no one corporation of the qualified group is using a
significant portion of T's historic business assets in a business,
the COBE requirement of paragraph (d)(1) of this section is
satisfied because, in the aggregate, the qualified group is using a
significant portion of T's historic business assets in a business.

Example 7. Continuation of the historic T business in a partnership
satisfies continuity of business enterprise. (i) Facts. T
manufactures ski boots. P owns all of the stock of S-1. S-1 owns all
of the stock of S-2, and S-2 owns all of the stock of S-3. T merges
into P and the T shareholders receive consideration consisting of P
stock and cash. The T ski boot business is to be continued and
expanded. In anticipation of this expansion, P transfers all of the
T assets to S-1, S-1 transfers all of the T assets to S-2, and S-2
transfers all of the T assets to S-3. S-3 and X (an unrelated party)
form a new partnership (PRS). As part of the plan of reorganization,
S-3 transfers all the T assets to PRS, and S-3, in its capacity as a
partner, performs active and substantial management functions for
the PRS ski boot business, including making significant business
decisions and regularly participating in the overall supervision,
direction, and control of the employees of the ski boot business.

S-3 receives a 20 percent interest in PRS. X transfers cash in
exchange for an 80 percent interest in PRS.

(ii) Continuity of business enterprise. Under paragraph (d)(4)(iii)
(B)(2) of this section, P is treated as conducting T's historic
business because S-3 performs active and substantial management
functions for the ski boot business in S-3's capacity as a partner.
P is treated as holding all the assets and conducting the businesses
of all of the members of the qualified group, which includes S-3
(paragraphs (d)(4)(i) and (ii) of this section). The COBE
requirement of paragraph (d)(1) of this section is satisfied.

Example 8. Continuation of the historic T business in a partnership
does not satisfy continuity of business enterprise.

(i) Facts. The facts are the same as Example 7 except that S-3
transfers the historic T business to PRS in exchange for a 1 percent
interest in PRS.

(ii) Continuity of business enterprise. Under paragraph (d)(4)(iii)
(B)(2) of this section, P is treated as conducting T's historic
business because S-3 performs active and substantial management
functions for the ski boot business in S-3's capacity as a partner.
The fact that a significant historic T business is conducted in PRS,
and P is treated as conducting such T business under (d)(4)(iii)(B)
tends to establish the requisite continuity, but is not alone
sufficient (paragraph (d)(4)(iii)(C) of this section). The COBE
requirement of paragraph (d)(1) of this section is not satisfied.

Example 9. Continuation of the T historic business in a partnership
satisfies continuity of business enterprise. (i) Facts. The facts
are the same as Example 7 except that S-3 transfers the historic T
business to PRS in exchange for a 33 1/3 percent interest in PRS,
and no member of P's qualified group performs active and substantial
management functions for the ski boot business operated in PRS.

(ii) Continuity of business enterprise. Under paragraph (d)(4)(iii)
(B)(1) of this section, P is treated as conducting T's historic
business because S-3 owns an interest in the partnership
representing a significant interest in that partnership business. P
is treated as holding all the assets and conducting the businesses
of all of the members of the qualified group, which includes S-3
(paragraphs (d)(4)(i) and (ii) of this section). The COBE
requirement of paragraph (d)(1) of this section is satisfied.

Example 10. Use of T's historic business assets in a partnership
business. (i) Facts. T is a fabric distributor. P owns all of the
stock of S-1. T merges into P and the T shareholders receive solely
P stock. S-1 and X (an unrelated party) own interests in a
partnership (PRS). As part of the plan of reorganization, P
transfers all of the T assets to S-1, and S-1 transfers all the T
assets to PRS, increasing S-1's percentage interest in PRS from 5 to
33 1/3 percent. After the transfer, X owns the remaining 66 2/3
percent interest in PRS.

Almost all of the T assets consist of T's large inventory of fabric,
which PRS uses to manufacture sportswear. All of the T assets are
used in the sportswear business. No member of P's qualified group
performs active and substantial management functions for the
sportswear business operated in PRS.

(ii) Continuity of business enterprise. Under paragraph (d)(4)(iii)
(A) of this section, S-1 is treated as owning 33 1/3 percent of the
T assets used in the PRS sportswear manufacturing business. Under
paragraph (d)(4)(iii)(B)(1) of this section, P is treated as
conducting the sportswear manufacturing business because S-1 owns an
interest in the partnership representing a significant interest in
that partnership business. P is treated as holding all the assets
and conducting the businesses of all of the members of the qualified
group, which includes S-1 (paragraphs (d)(4)(i) and (ii) of this
section). The COBE requirement of paragraph (d)(1) of this section
is satisfied.

Example 11. Aggregation of partnership interests among members of
the qualified group: use of T's historic business assets in a
partnership business. (i) Facts. The facts are the same as Example
10, except that S-1 transfers all the T assets to PRS, and P and X
each transfer cash to PRS in exchange for partnership interests.
After the transfers, P owns 11 percent, S-1 owns 22 1/3 percent, and
X owns 66 2/3 percent of PRS.

(ii) Continuity of business enterprise. Under paragraph (d)(4)(iii)
(B)(1) of this section, P is treated as conducting the sportswear
manufacturing business because members of the qualified group, in
the aggregate, own an interest in the partnership representing a
significant interest in that business.

P is treated as owning 11 percent of the assets directly, and S-1 is
treated as owning 22 1/3 percent of the assets, used in the PRS
sportswear business (paragraph (d)(4)(iii)(A) of this section). P is
treated as holding all the assets of all of the members of the
qualified group, which includes S-1, and thus in the aggregate, P is
treated as owning 33 1/3 of the T assets (paragraph (d)(4)(i) and
(ii) of this section). The COBE requirement of paragraph (d)(1) of
this section is satisfied because P is treated as using a
significant portion of T's historic business assets in its
sportswear manufacturing business.

Example 12. Tiered partnerships: use of T's historic business assets
in a partnership business. (i) Facts. T owns and manages a
commercial office building in state Z. Pursuant to a plan of
reorganization, T merges into P, solely in exchange for P stock,
which is distributed to the T shareholders. P transfers all of the T
assets to a partnership, PRS-1, which owns and operates television
stations nationwide. After the transfer, P owns a 50 percent
interest in PRS-1. P does not have active and substantial management
functions as a partner with respect to the PRS-1 business. X, not a
member of P's qualified group, owns the remaining 50 percent
interest in PRS-1. PRS-1, in an effort to expand its state Z
television operation, enters into a joint venture with U, an
unrelated party. As part of the plan of reorganization, PRS-1
transfers all the T assets and its state Z television station to
PRS-2, in exchange for a 75 percent partnership interest. U
contributes cash to PRS-2 in exchange for a 25 percent partnership
interest and oversees the management of the state Z television
operation. PRS-1 does not actively and substantially manage PRS-2's
business. PRS-2's state Z operations are moved into the acquired T
office building. All of the assets that P acquired from T are used
in PRS-2's business.

(ii) Continuity of business enterprise. Under paragraph (d)(4)(iii)
(A) of this section, PRS-1 is treated as owning 75 percent of the T
assets used in PRS-2's business. P, in turn, is treated as owning 50
percent of PRS-1's interest the T assets.

Thus, P is treated as owning 371/2 percent (50 percent x 75 percent)
of the T assets used in the PRS-2 business. Under paragraph (d)(4)
(iii)(B)(1) of this section, P is treated as conducting PRS-2's
business, the operation of the state Z television station, and under
paragraph (d)(4)(iii)(A) of this section, P is treated as using
371/2 percent of the historic T business assets in that business.
The COBE requirement of paragraph (d)(1) of this section is
satisfied because P is treated as using a significant portion of T's
historic business assets in its television business.

(e) Continuity of interest--(1) General rule. (i) The purpose of the
continuity of interest requirement is to prevent transactions that
resemble sales from qualifying for nonrecognition of gain or loss
available to corporate reorganizations. Continuity of interest
requires that in substance a substantial part of the value of the
proprietary interests in the target corporation be preserved in the
reorganization. A proprietary interest in the target corporation is
preserved if, in a potential reorganization, it is exchanged for a
proprietary interest in the issuing corporation (as defined in
paragraph (b) of this section), it is exchanged by the acquiring
corporation for a direct interest in the target corporation
enterprise, or it otherwise continues as a proprietary interest in
the target corporation. However, a proprietary interest in the
target corporation is not preserved if, in connection with the
potential reorganization, it is acquired by the issuing corporation
for consideration other than stock of the issuing corporation, or
stock of the issuing corporation furnished in exchange for a
proprietary interest in the target corporation in the potential
reorganization is redeemed. All facts and circumstances must be
considered in determining whether, in substance, a proprietary
interest in the target corporation is preserved. For purposes of the
continuity of interest requirement, a mere disposition of stock of
the target corporation prior to a potential reorganization to
persons not related (as defined in paragraph (e)(3) of this section
determined without regard to paragraph (e)(3)(i)(A) of this section)
to the target corporation or to persons not related (as defined in
paragraph (e)(3) of this section) to the issuing corporation is
disregarded and a mere disposition of stock of the issuing
corporation received in a potential reorganization to persons not
related (as defined in paragraph (e)(3) of this section) to the
issuing corporation is disregarded.

(ii) [Reserved] For further guidance see §1.368-1T(e)(1)(ii)(A) and
(B).

(2) Related person acquisitions. (i) A proprietary interest in the
target corporation is not preserved if, in connection with a
potential reorganization, a person related (as defined in paragraph
(e)(3) of this section) to the issuing corporation acquires, with
consideration other than a proprietary interest in the issuing
corporation, stock of the target corporation or stock of the issuing
corporation furnished in exchange for a proprietary interest in the
target corporation in the potential reorganization, except to the
extent those persons who were the direct or indirect owners of the
target corporation prior to the potential reorganization maintain a
direct or indirect proprietary interest in the issuing corporation.

(ii) [Reserved] For further guidance see §1.368-1T(e)(2)(ii).

(3) Definition of related person--(i) In general. For purposes of
this paragraph (e), two corporations are related persons if either--

(A) The corporations are members of the same affiliated group as
defined in section 1504 (determined without regard to section
1504(b)); or

(B) A purchase of the stock of one corporation by another
corporation would be treated as a distribution in redemption of the
stock of the first corporation under section 304(a)(2) (determined
without regard to §1.1502-80(b)).

(ii) Special rules. The following rules apply solely for purposes of
this paragraph (e)(3):

(A) A corporation will be treated as related to another corporation
if such relationship exists immediately before or immediately after
the acquisition of the stock involved.

(B) A corporation, other than the target corporation or a person
related (as defined in paragraph (e)(3) of this section determined
without regard to paragraph (e)(3)(i)(A) of this section) to the
target corporation, will be treated as related to the issuing
corporation if the relationship is created in connection with the
potential reorganization.

(4) Acquisitions by partnerships. For purposes of this paragraph
(e), each partner of a partnership will be treated as owning or
acquiring any stock owned or acquired, as the case may be, by the
partnership in accordance with that partner's interest in the
partnership. If a partner is treated as acquiring any stock by
reason of the application of this paragraph (e)(4), the partner is
also treated as having furnished its share of any consideration
furnished by the partnership to acquire the stock in accordance with
that partner's interest in the partnership.

(5) Successors and predecessors. For purposes of this paragraph (e),
any reference to the issuing corporation or the target corporation
includes a reference to any successor or predecessor of such
corporation, except that the target corporation is not treated as a
predecessor of the issuing corporation and the issuing corporation
is not treated as a successor of the target corporation.

(6) Examples. For purposes of the examples in this paragraph (e)(6),
P is the issuing corporation, T is the target corporation, S is a
wholly owned subsidiary of P, all corporations have only one class
of stock outstanding, A and B are individuals, PRS is a partnership,
all reorganization requirements other than the continuity of
interest requirement are satisfied, and the transaction is not
otherwise subject to recharacterization. The following examples
illustrate the application of this paragraph (e):

Example 1. Sale of stock to third party. (i) Sale of issuing
corporation stock after merger. A owns all of the stock of T. T
merges into P. In the merger, A receives P stock having a fair
market value of $50x and cash of $50x. Immediately after the merger,
and pursuant to a preexisting binding contract, A sells all of the P
stock received by A in the merger to B.

Assume that there are no facts and circumstances indicating that the
cash used by B to purchase A's P stock was in substance exchanged by
P for T stock. Under paragraphs (e)(1) and (2) of this section, the
sale to B is disregarded because B is not a person related to P
within the meaning of paragraph (e)(3) of this section. Thus, the
transaction satisfies the continuity of interest requirement because
50 percent of A's T stock was exchanged for P stock, preserving a
substantial part of the value of the proprietary interest in T.

(ii) Sale of target corporation stock before merger. The facts are
the same as paragraph (i) of this Example 1, except that B buys A's
T stock prior to the merger of T into P and then exchanges the T
stock for P stock having a fair market value of $50x and cash of
$50x. The sale by A is disregarded. The continuity of interest
requirement is satisfied because B's T stock was exchanged for P
stock, preserving a substantial part of the value of the proprietary
interest in T.

Example 2. Relationship created in connection with potential
reorganization. A owns all of the stock of T. X, a corporation which
owns 60 percent of the P stock and none of the T stock, buys A's T
stock for cash prior to the merger of T into P. X exchanges the T
stock solely for P stock in the merger which, when combined with X's
prior ownership of P stock, constitutes 80 percent of the stock of
P. X is a person related to P under paragraphs (e)(3)(i)(A) and (ii)
(B) of this section, because X becomes affiliated with P in the
merger. The continuity of interest requirement is not satisfied,
because X acquired a proprietary interest in T for consideration
other than P stock, and a substantial part of the value of the
proprietary interest in T is not preserved. See paragraph (e)(2) of
this section.

Example 3. Participation by issuing corporation in post-merger sale.
A owns 80 percent of the T stock and none of the P stock, which is
widely held. T merges into P. In the merger, A receives P stock. In
addition, A obtains rights pursuant to an arrangement with P to have
P register the P stock under the Securities Act of 1933, as amended.
P registers A's stock, and A sells the stock shortly after the
merger. No person who purchased the P stock from A is a person
related to P within the meaning of paragraph (e)(3) of this section.
Under paragraphs (e)(1) and (2) of this section, the sale of the P
stock by A is disregarded because no person who purchased the P
stock from A is a person related to P within the meaning of
paragraph (e)(3) of this section. The transaction satisfies the
continuity of interest requirement because A's T stock was exchanged
for P stock, preserving a substantial part of the value of the
proprietary interest in T.

Example 4. Redemptions and purchases by issuing corporation or
related persons. (i) Redemption by issuing corporation. A owns 100
percent of the stock of T and none of the stock of P. T merges into
S. In the merger, A receives P stock. In connection with the merger,
P redeems all of the P stock received by A in the merger for cash.
The continuity of interest requirement is not satisfied, because, in
connection with the merger, P redeemed the stock exchanged for a
proprietary interest in T, and a substantial part of the value of
the proprietary interest in T is not preserved. See paragraph (e)(1)
of this section.

(ii) Purchase of target corporation stock by issuing corporation.
The facts are the same as paragraph (i) of this Example 4, except
that, instead of P redeeming its stock, prior to and in connection
with the merger of T into S, P purchases 90 percent of the T stock
from A for cash. The continuity of interest requirement is not
satisfied, because in connection with the merger, P acquired a
proprietary interest in T for consideration other than P stock, and
a substantial part of the value of the proprietary interest in T is
not preserved. See paragraph (e)(1) of this section. However, see
§1.338-2(c)(3) (which may change the result in this case by
providing that, by virtue of section 338, continuity of interest is
satisfied for certain parties after a qualified stock purchase).

(iii) Purchase of issuing corporation stock by person related to
issuing corporation. The facts are the same as paragraph (i) of this
Example 4, except that, instead of P redeeming its stock, S buys all
of the P stock received by A in the merger for cash. S is a person
related to P under paragraphs (e)(3)(i)(A) and (B) of this section.
The continuity of interest requirement is not satisfied, because S
acquired P stock issued in the merger, and a substantial part of the
value of the proprietary interest in T is not preserved. See
paragraph (e)(2) of this section.

Example 5. Redemption in substance by issuing corporation.

A owns 100 percent of the stock of T and none of the stock of P.

T merges into P. In the merger, A receives P stock. In connection
with the merger, B buys all of the P stock received by A in the
merger for cash. Shortly thereafter, in connection with the merger,
P redeems the stock held by B for cash. Based on all the facts and
circumstances, P in substance has exchanged solely cash for T stock
in the merger. The continuity of interest requirement is not
satisfied, because in substance P redeemed the stock exchanged for a
proprietary interest in T, and a substantial part of the value of
the proprietary interest in T is not preserved. See paragraph (e)(1)
of this section.

Example 6. Purchase of issuing corporation stock through
partnership. A owns 100 percent of the stock of T and none of the
stock of P. S is an 85 percent partner in PRS. The other 15 percent
of PRS is owned by unrelated persons. T merges into P.

In the merger, A receives P stock. In connection with the merger,
PRS purchases all of the P stock received by A in the merger for
cash. Under paragraph (e)(4) of this section, S, as an 85 percent
partner of PRS, is treated as having acquired 85 percent of the P
stock exchanged for A's T stock in the merger, and as having
furnished 85 percent of the cash paid by PRS to acquire the P stock.
S is a person related to P under paragraphs (e)(3)(i)(A) and (B) of
this section. The continuity of interest requirement is not
satisfied, because S is treated as acquiring 85 percent of the P
stock issued in the merger, and a substantial part of the value of
the proprietary interest in T is not preserved. See paragraph (e)(2)
of this section.

Example 7. Exchange by acquiring corporation for direct interest. A
owns 30 percent of the stock of T. P owns 70 percent of the stock of
T, which was not acquired by P in connection with the acquisition of
T's assets. T merges into P.

A receives cash in the merger. The continuity of interest
requirement is satisfied, because P's 70 percent proprietary
interest in T is exchanged by P for a direct interest in the assets
of the target corporation enterprise.

Example 8. Effect of general stock repurchase program. T merges into
P, a corporation whose stock is widely held and publicly traded and
that has one class of common stock outstanding. In the merger, T
shareholders receive common stock of P. Immediately after the
merger, P repurchases a small percentage of its common stock in the
open market as part of its ongoing stock repurchase program. The
repurchase program was not created or modified in connection with
the acquisition of T.

Continuity of interest is satisfied, because based on all of the
facts and circumstances, the redemption of a small percentage of the
P stock does not affect the T shareholders' proprietary interest in
T, because it was not in connection with the merger, and the value
of the proprietary interest in T is preserved. See paragraph (e)(1)
of this section.

Example 9. Maintenance of direct or indirect interest in issuing
corporation. X, a corporation, owns all of the stock of each of
corporations P and Z. Z owns all of the stock of T. T merges into P.
Z receives P stock in the merger. Immediately thereafter and in
connection with the merger, Z distributes the P stock received in
the merger to X. X is a person related to P under paragraph (e)(3)
(i)(A) of this section. The continuity of interest requirement is
satisfied, because X was an indirect owner of T prior to the merger
who maintains a direct or indirect proprietary interest in P,
preserving a substantial part of the value of the proprietary
interest in T. See paragraph (e)(2) of this section.

(7) Effective date. This paragraph (e) applies to transactions
occurring after January 28, 1998, except that it does not apply to
any transaction occurring pursuant to a written agreement which is
binding on January 28, 1998, and at all times thereafter.

Par. 4. Section 1.368-2 is amended by:

1. Removing the second sentence of paragraph (a) and adding two
sentences in its place.

2. Removing the second sentence of paragraph (f) and adding four
sentences in its place.

3. Removing the second sentence in paragraph (j)(1).

4. Revising paragraph (j)(3)(ii).

5. Revising the first sentence in paragraph (j)(3)(iii).

6. Adding paragraph (j)(3)(iv).

7. Removing paragraph (j)(4).

8. Redesignating paragraphs (j)(5), (j)(6), and (j)(7) as (j)(4),
(j)(5), and (j)(6), respectively.

9. Removing the parentheses around the numbers in the paragraph
headings for Example (1) through Example (9) in newly designated
paragraph (j)(6).

10. Adding paragraph (k).

The additions and revisions read as follows: §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 January 28, 1998,
except that it does not apply to any transaction occurring pursuant
to a written agreement which is binding on January 28, 1998, and at
all times thereafter. * * *

* * * * *

(f) * * * If a transaction otherwise qualifies as a reorganization,
a corporation remains a party to the reorganization even though
stock or assets acquired in the reorganization are transferred in a
transaction described in paragraph (k) of this section. If a
transaction otherwise qualifies as a reorganization, a corporation
shall not cease to be a party to the reorganization solely by reason
of the fact that part or all of the assets acquired in the
reorganization are transferred to a partnership in which the
transferor is a partner if the continuity of business enterprise
requirement is satisfied. See §1.368-1(d). The preceding three
sentences apply to transactions occurring after January 28, 1998,
except that they do not apply to any transaction occurring pursuant
to a written agreement which is binding on January 28, 1998, and at
all times thereafter. * * *

* * * * *

(j) * * *

(3) * * *

(ii) Except as provided in paragraph (k)(2) of this section, the
controlling corporation must control the surviving corporation
immediately after the transaction.

(iii) After the transaction, except as provided in paragraph (k)(2)
of this section, the surviving corporation must hold substantially
all of its own properties and substantially all of the properties of
the merged corporation (other than stock of the controlling
corporation distributed in the transaction). * * *

(iv) Paragraphs (j)(3)(ii) and (iii) of this section apply to
transactions occurring after January 28, 1998, except that they do
not apply to any transaction occurring pursuant to a written
agreement which is binding on January 28, 1998, and at all times
thereafter.

* * * * *

(k) Transfer of assets or stock in section 368(a)(1)(A), (B), (C),
or (G) reorganizations--(1) General rule for transfers to controlled
corporations. Except as otherwise provided in this section, a
transaction otherwise qualifying under section 368(a)(1)(A), (B),
(C), or (G) (where the requirements of sections 354(b)(1)(A) and (B)
are met) shall not be disqualified by reason of the fact that part
or all of the acquired assets or stock acquired in the transaction
are transferred or successively transferred to one or more
corporations controlled in each transfer by the transferor
corporation. Control is defined under section 368(c).

(2) Transfers following a reverse triangular merger. A transaction
qualifying under section 368(a)(1)(A) by reason of the application
of section 368(a)(2)(E) is not disqualified by reason of the fact
that part or all of the stock of the surviving corporation is
transferred or successively transferred to one or more corporations
controlled in each transfer by the transferor corporation, or
because part or all of the assets of the surviving corporation or
the merged corporation are transferred or successively transferred
to one or more corporations controlled in each transfer by the
transferor corporation.

(3) Examples. The following examples illustrate the application of
this paragraph (k). P is the issuing corporation and T is the target
corporation. P has only one class of stock outstanding. The examples
are as follows:

Example 1. Transfers of acquired assets to controlled corporations.
(i) Facts. T operates a bakery which supplies delectable pastries
and cookies to local retail stores. The acquiring corporate group
produces a variety of baked goods for nationwide distribution. P
owns 80 percent of the stock of S-1.

Pursuant to a plan of reorganization, T transfers all of its assets
to S-1 solely in exchange for P stock, which T distributes to its
shareholders. S-1 owns 80 percent of the stock of S-2; S-2 owns 80
percent of the stock of S-3, which also makes and supplies pastries
and cookies. Pursuant to the plan of reorganization, S-1 transfers
the T assets to S-2; S-2 transfers the T assets to S-3.

(ii) Analysis. Under this paragraph (k), the transaction, otherwise
qualifying as a reorganization under section 368(a)(1)(C), is not
disqualified by reason of the fact of the successive transfers of
all of the acquired assets from S-1 to S-2, and from S-2 to S-3
because in each transfer, the transferee corporation is controlled
by the transferor corporation. Control is defined under section
368(c).

Example 2. Transfers of acquired stock to controlled corporations.
(i) Facts. The facts are the same as Example 1 except that S-1
acquires all of the T stock rather than the T assets, and as part of
the plan of reorganization, S-1 transfers all of the T stock to S-2,
and S-2 transfers all of the T stock to S-3.

(ii) Analysis. Under this paragraph (k), the transaction, otherwise
qualifying as a reorganization under section 368(a)(1)(B), is not
disqualified by reason of the fact of the successive transfers of
all of the acquired stock from S-1 to S-2, and from S-2 to S-3
because in each transfer, the transferee corporation is controlled
by the transferor corporation.

Example 3. Transfers of acquired stock to partnerships.

(i) Facts. The facts are the same as in Example 2. However, as part
of the plan of reorganization, S-2 and S-3 form a new partnership,
PRS. Immediately thereafter, S-3 transfers all of the T stock to PRS
in exchange for an 80 percent partnership interest, and S-2
transfers cash to PRS in exchange for a 20 percent partnership
interest.

(ii) Analysis. This paragraph (k) describes the successive transfer
of the T stock to S-3, but does not describe S-3's transfer of the T
stock to PRS. Therefore, the characterization of this transaction
must be determined under the relevant provisions of law, including
the step transaction doctrine. See §1.368-1(a). The transaction
fails to meet the control requirement of a reorganization described
in section 368(a)(1)(B) because immediately after the acquisition of
the T stock, the acquiring corporation does not have control of T.

(4) This paragraph (k) applies to transactions occurring after
January 28, 1998, except that it does not apply to any transaction
occurring pursuant to a written agreement which is binding on
January 28, 1998, and at all times thereafter.

Michael P. Dolan
Deputy Commissioner of Internal Revenue
Approved: January 12, 1998
Donald C. Lubick
Acting Assistant Secretary of the Treasury

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