[Federal Register Volume 63, Number 18 (Wednesday, January 28, 1998)]
[Rules and Regulations]
[Pages 4183-4185]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-1818]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 8761]
RIN 1545-AV80
Continuity of Interest
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Temporary regulations.
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SUMMARY: This document contains temporary regulations providing
guidance regarding satisfaction of the continuity of interest
requirement for corporate reorganizations. The temporary regulations
affect corporations and their shareholders. Final regulations published
elsewhere in this issue of the Federal Register also provide guidance
regarding satisfaction of the continuity of interest requirement for
corporate reorganizations. These temporary regulations amplify the
final regulations. The text of these temporary regulations also serves
as the text of proposed regulations published elsewhere in this issue
of the Federal Register.
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: Phoebe Bennett, (202) 622-7750 (not a
toll-free number).
SUPPLEMENTARY INFORMATION: This document contains amendments to the
Income Tax Regulations (26 CFR part 1) under section 368. These
temporary regulations provide that, in determining whether the
continuity of interest requirement for corporate reorganizations is
satisfied with respect to a potential reorganization, a proprietary
interest in the target corporation is not preserved if, in connection
with a potential reorganization, it is redeemed or acquired by a person
related to the target corporation, or to the extent that, prior to and
in connection with a potential reorganization, an extraordinary
distribution is made with respect to it.
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 requirement. Many written
comments were received in response to this notice of proposed
rulemaking. A public hearing on the proposed regulations was held on
May 7, 1997. After consideration of all comments, the regulations
proposed by REG-252231-96 are adopted as final regulations, and
published elsewhere in this issue of the Federal Register. These
temporary regulations supplement the final regulations.
Explanation of Provisions
Final regulations published elsewhere in this issue of the Federal
Register provide that in determining whether the continuity of interest
(COI) requirement for corporate reorganizations is satisfied,
dispositions of stock of the target corporation (T) by a T shareholder
generally are not taken into account.
Redemptions of T Stock or Extraordinary Distributions With Respect to T
Stock
Commentators requested guidance on the circumstances under which a
redemption by T of its stock would adversely affect satisfaction of the
COI requirement.
Some commentators suggested that the IRS and Treasury Department
adopt an approach that would identify either the issuing corporation
(P) or T as the source of the funds for the redemption. If, in
connection with an acquisition of T, the facts and circumstances
indicate that P did not directly or indirectly furnish funds used by T
to redeem T shareholders, these commentators suggested that
satisfaction of the COI requirement should not be adversely affected.
In many transactions, however, such a tracing approach would be
extremely difficult to administer. For example, if P acquired the
assets, rather than the stock, of T or if T redeemed stock for a note,
it would be unclear in many circumstances whether in substance T or P
assets were used to fund the redemption or to repay the note.
Another commentator suggested that redemptions by T in connection
with a potential reorganization should adversely affect satisfaction of
the COI requirement because the effect on COI is the same as if P had
furnished the redemption consideration in the transaction. The
temporary regulations generally adopt this approach because it reflects
that T and P will be combined economically and because of the
difficulties of administering a tracing approach, as previously
described.
Treatment of stock redeemed by T as proprietary interests that are
not preserved in the reorganization also accords the same tax result to
transactions that reach the same result by different steps. For
example, T could merge into P for a combination of consideration, of
which 30 percent is P stock and 70 percent is a P promissory note.
Conversely, T could issue its promissory note to redeem 70 percent of
the T stock and then P would assume the T note in the merger, in which
the
[[Page 4184]]
remaining T shareholders receive solely P stock. From the perspective
of P, T, and the T shareholders, these two transactions are
substantively identical, and the COI requirement is not satisfied in
the first transaction. The temporary regulations provide that the
second transaction likewise does not satisfy the COI requirement.
In addition, this approach corresponds with the rule of the final
regulations that a proprietary interest in T is not preserved if, in
connection with the potential reorganization, P stock furnished in
exchange for a proprietary interest in T in the potential
reorganization is redeemed. Because the final regulations do not
inquire, in the case of a subsequent P redemption, whether the source
of consideration furnished in the redemption was former T assets or
historic P assets, the temporary regulations similarly do not make an
inquiry in the case of a prior T redemption. Instead, for purposes of
the COI requirement, the temporary regulations treat T and P as a
combined economic enterprise. In an asset acquisition, this approach
avoids the difficult process of identifying the source of payments as
between T and P.
Commentators have suggested that this approach is inconsistent with
authorities which hold that redemptions of stock of the target
corporation with assets of the target corporation do not violate the
solely-for-voting-stock requirement applicable to section 368(a)(1)(B)
reorganizations. See, e.g., Rev. Rul. 55-440 (1955-2 C.B. 226). None of
these authorities address the effect on continuity of interest of such
redemptions. For the reasons stated above, the temporary regulations
take such redemptions into account for continuity purposes.
The temporary regulations provide that a proprietary interest in T
is not preserved if, in connection with a potential reorganization, it
is redeemed or to the extent that, prior to and in connection with a
potential reorganization, an extraordinary distribution is made with
respect to it. An extraordinary distribution with respect to T stock,
followed by a sale of the remaining T stock to P, has the same effect
on the value of the proprietary interest in T as a pro rata redemption
by T followed by a sale of the outstanding T stock to P.
The temporary regulations do not provide guidance on the
determination of whether a distribution will be treated as an
extraordinary distribution, except that the rules of section 1059 do
not apply for this purpose. The IRS and Treasury Department invite
comments on whether the regulations should provide more specific
guidance in this area.
A section 355 distribution of controlled corporation stock by T
will preserve a proprietary interest in T, except to the extent that
the T shareholders receive other property or money to which section
356(a) applies or the distribution is extraordinary in amount and is a
distribution of property or money to which section 356(b) applies.
Related Person Rule
In determining whether the COI requirement is satisfied,
dispositions of T stock to persons that are not related to T or P are
disregarded. The final regulations provide that a proprietary interest
in T is not preserved if, in connection with a potential
reorganization, a person related 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. Consistent with the final regulations, the temporary
regulations provide that a proprietary interest in T is not preserved
if, prior to and in connection with a potential reorganization, a
person related to T acquires T stock with consideration other than T
stock or P stock.
Definition of Related Person of T
The final regulations include as related persons any corporation
that is a member of the affiliated group, within the meaning of section
1504, of which P is a member, and any corporation whose purchase of P
stock would be treated as a redemption of that stock under section
304(a)(2). The section 1504 test was adopted because the IRS and
Treasury Department were concerned that acquisitions of T stock or P
stock by P affiliated corporations were no different in substance than
acquisitions or redemptions by P. This concern does not generally
extend to members of T's affiliated group that are not also considered
related to T under section 304(a)(2) because such corporations are T
shareholders participating in the potential reorganization along with
the other shareholders of the target corporation. The temporary
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 Sec. 1.1502-
80(b)).
Effect on Other Authorities
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, or as to the
characterization of a related transaction. See, e.g., Sec. 1.301-1(1).
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
temporary regulations.
Effective Date
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.
Special Analyses
It has been determined that these temporary regulations are 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 temporary regulations and, because the
temporary 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.
Drafting Information
The principal author of these regulations is Phoebe Bennett of the
Office of the Assistant Chief Counsel (Corporate), IRS. However, other
personnel from the IRS and Treasury Department participated in their
development.
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:
[[Page 4185]]
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 1.368-1T is added to read as follows:
Sec. 1.368-1T Purpose and scope of exception of reorganization
exchanges (temporary).
(a) through (e)(1)(i) [Reserved] For further guidance see
Sec. 1.368-1(a) through (e)(1)(i).
(e)(1)(ii)(A) General rule. A proprietary interest in the target
corporation (other than one held by the acquiring corporation) is not
preserved if, prior to and in connection with a potential
reorganization, it is redeemed or to the extent that, prior to and in
connection with a potential reorganization, an extraordinary
distribution is made with respect to it. The determination of whether a
distribution with respect to stock of the target corporation is an
extraordinary distribution for purposes of this paragraph (e)(1)(ii)
will be made on the basis of all of the facts and circumstances, but
the treatment of the distribution under section 1059 (relating to
extraordinary dividends) will not be taken into account.
(B) Exception. Paragraph (e)(1)(ii)(A) of this section does not
apply to a distribution of stock by the target corporation to which
section 355(a) (or so much of section 356 as relates to section 355)
applies, except to the extent that--
(1) The target corporation shareholders receive other property or
money to which section 356(a) applies; or
(2) The distribution is extraordinary in amount and is a
distribution of property or money to which section 356(b) applies.
(2)(i) [Reserved] For further guidance, see Sec. 1.368-1(e)(2)(i).
(ii) A proprietary interest in the target corporation is not
preserved if, prior to and in connection with a potential
reorganization, a person related (as defined in Sec. 1.368-1(e)(3)
determined without regard to Sec. 1.368-1(e)(3)(i)(A)) to the target
corporation acquires stock of the target corporation, with
consideration other than stock of either the target corporation or the
issuing corporation.
(e)(3) through (e)(6) Example 9. [Reserved] For further guidance,
see Sec. 1.368-1(e)(3) through (e)(6) Example 9.
(e)(6) Example 10. Acquisition of target corporation stock
before merger. (i) Redemption by target corporation. A owns 85
percent and B owns 15 percent of the stock of T. The fair market
value of T is $100x. Neither A nor B own stock of P. Prior to and in
connection with the merger of T into P, T redeems A's T stock for
$85x and issues to A its promissory note in exchange for the stock.
At the time of the merger T has a value of $15x, after giving effect
to the redemption of its stock. In the merger, B receives solely P
stock. The continuity of interest requirement is not satisfied
because T redeemed A's stock, and a substantial part of the value of
the proprietary interest in T is not preserved. See paragraph
(e)(1)(ii)(A) of this section.
(ii) Purchase by person related to target corporation. The facts
are the same as paragraph (i) of this Example 10, except that X, T's
wholly owned subsidiary, acquires A's T stock prior to and in
connection with the merger for cash of $85x. Under paragraph
(e)(2)(ii) of this section and Sec. 1.368-1(e)(3)(i)(B), X's
acquisition of A's T stock is an acquisition by a related person.
The continuity of interest requirement is not satisfied, because X
acquired T stock, 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)(ii) of this section.
Example 11. Extraordinary distribution before merger. A owns all
of the stock of T. The fair market value of T is $100x. Prior to and
in connection with the merger of T into P, T pays A an extraordinary
distribution of an $85x note. T merges into P, and A receives solely
P stock. P assumes T's obligation on the note. The continuity of
interest requirement is not satisfied, because T paid A an
extraordinary distribution, and a substantial part of the value of
the proprietary interest in T is not preserved. See paragraph
(e)(1)(ii)(A) of this section.
(f) Effective date. This section 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.
Michael P. Dolan,
Deputy Commissioner of Internal Revenue.
Approved: January 12, 1998.
Donald C. Lubick,
Acting Assistant Secretary of the Treasury.
[FR Doc. 98-1818 Filed 1-23-98; 12:15 pm]
BILLING CODE 4830-01-U
