Continuity of Interest requirement for corporate reorganizations

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8783] RIN 1545-AW45

TITLE: Continuity of Interest requirement for corporate
reorganizations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Amendment to final regulations.

SUMMARY: This document amends final regulations providing guidance
regarding satisfaction of the continuity of interest requirement for
corporate reorganizations. The amendment to the final regulations
affects corporations and their shareholders.

This amendment to the final regulations is necessary to provide
clarification regarding an example illustrating a relationship
created in connection with a potential reorganization.

DATES: Effective date: This amendment is effective September 23,
1998.

Applicability date: This amendment 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
(subject to customary conditions) binding on January 28, 1998, and
at all times thereafter.

FOR FURTHER INFORMATION CONTACT: Phoebe Bennett, (202) 622-7750 (not
a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On January 28, 1998, the IRS published final regulations
(REG-252231-96) in the Federal Register (63 FR 4174) relating to the
continuity of interest (COI) requirement.

Explanation of Provisions The final COI regulation provides that
acquisitions of target (T) stock for cash by a corporation related
to the issuing corporation (P) generally do not preserve continuity
of interest.

See §1.368-1(e)(2). Two corporations are related if they are members
of the same affiliated group as defined in section 1504, or if a
purchase of P stock by another corporation would be treated as a
distribution in redemption of P stock under section 304(a)(2). See
§1.368-1(e)(3). A corporation will be treated as related to another
corporation if such relationship exists immediately before or
immediately after the acquisition of T stock, or if the relationship
is created in connection with the potential reorganization. See
§1.368-1(e)(3)(ii). Thus, a purchase by a corporation that was not
initially related to P, but purchased T stock and became related to
P in the potential reorganization, would not preserve continuity to
the extent of the purchase.

Section 1.368-1(e)(6), Example 2 was intended to illustrate this
principle. In the example, 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 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. The example shows that X is related to P because
X becomes affiliated with P in the merger.

Section 1.338-2(c)(3) provides that, by virtue of section 338, COI
is satisfied for certain persons if, following a qualified stock
purchase (QSP) of T by the purchasing corporation, the purchasing
corporation or a member of the purchasing corporation's affiliated
group acquired the T assets.

Commentators have questioned whether §1.338-2(c)(3) applies to the
transaction described in Example 2. It is not intended that these
final regulations provide guidance under section 338. To avoid any
such implication, Example 2 is amended so that X's acquisition of
A's T stock is not a QSP.

In addition, the amendment to the final regulation illustrates the
proper application of the related party rule that treats two
corporations as related if a purchase of P stock by another
corporation would be treated as a distribution in redemption of P
stock under section 304(a)(2). See §1.368- 1(e)(3)(i). Commentators
have questioned why, in Example 2, X is not already related to P
under the section 304(a)(2) rule even before the merger, because X
owned more than 50 percent of the P stock. Section 304(a)(2)
requires that the issuing corporation control the acquiring
corporation (within the meaning of section 304(c)). In Example 2, P
is the issuing corporation and X is the acquiring corporation. X is
not related to P under section.4 304(a)(2) because P does not
control X; instead, X controls P. A sentence is added to Example 2
to illustrate this point.

Applicability Date

The amendment to these final regulations 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
(subject to customary conditions) binding on January 28, 1998, and
at all times thereafter.

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 these
regulations do 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 author of this amendment to the final 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 its 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. In §1.368-1, paragraph (e)(6) Example 2 is revised to read
as follows:

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

* * * * *

(e) * * *

(6) * * *

Example 2. Relationship created in connection with potential
reorganization. Corporation X owns 60 percent of the stock of P and
30 percent of the stock of T. A owns the remaining 70 percent of the
stock of T. X buys A's T stock for cash in a transaction which is
not a qualified stock purchase within the meaning of section 338. T
then merges into P. In the merger, X exchanges all of its T stock
for additional stock of P.

As a result of the issuance of the additional stock to X in the
merger, X's ownership interest in P increases from 60 to 80 percent
of the stock of P. X is not a person related to P under paragraph
(e)(3)(i)(B) of this section, because a purchase of stock of P by X
would not be treated as a distribution in redemption of the stock of
P under section 304(a)(2). However, 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.

* * * * *

Michael P. Dolan
Deputy Commissioner of Internal Revenue
Approved: September 14, 1998
Donald C. Lubick
Assistant Secretary of the Treasury

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