[Federal Register Volume 60, Number 33 (Friday, February 17, 1995)] [Proposed Rules] [Pages 9309-9312] From the Federal Register Online via the Government Publishing Office [www.gpo.gov] [FR Doc No: 95-3771] ======================================================================= ----------------------------------------------------------------------- DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1 [CO-62-94] RIN 1545-AT15 Continuity of Interest in Transfer of Target Assets After Qualified Stock Purchase of Target AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Notice of proposed rulemaking and notice of public hearing. ----------------------------------------------------------------------- SUMMARY: This document contains proposed regulations relating to the income tax treatment of the transfer of target assets to the purchasing corporation or another member of the same affiliated group as the purchasing corporation (the transferee) after a qualified stock purchase (QSP) of target stock, if a section 338 election is not made. These regulations provide guidance to parties to such transfers and their shareholders. This document also provides notice of a public hearing on these proposed regulations. DATES: Written comments and outlines of topics to be discussed at the public hearing scheduled for June 7, 1995, must be received by May 19, 1995. ADDRESSES: Send submissions to: CC:CORP:T:R (CO-62-94), room 5228, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. In the alternative, submissions may be hand delivered between the hours of 8 a.m. and 5 p.m. to: CC:CORP:T:R (CO-62-94), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW., Washington, DC. The public hearing will be held in room 3313, Internal Revenue Building, 1111 Constitution Avenue NW., Washington, DC. FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, William Alexander, (202) 622-7780; concerning the submissions and requests for a hearing, Christina Vasquez, (202) 622-7180 (not toll- free numbers). SUPPLEMENTARY INFORMATION: Background This document proposes guidance as to the treatment of transfers of target assets to another corporation after a qualified stock purchase of target stock, if a section 338 election is not made for the target. It addresses the effect of section 338 on the result in Yoc Heating v. Commissioner and similar cases. Under Sec. 1.368-1(b), for a transfer of assets to be pursuant to a reorganization within the meaning of section 368, there must be a continuity of interest in the target's business enterprise on the part of those persons who, directly or indirectly, were the owners of the enterprise prior to the reorganization. In Yoc Heating v. Commissioner, 61 T.C. 168 (1973), a corporation bought 85 percent of a target corporation's stock for cash and notes. As part of the same plan, the target subsequently transferred its assets to a newly formed subsidiary of the purchaser and dissolved. The purchaser received additional stock of its subsidiary in exchange for the purchaser's target stock and the minority shareholders received cash in exchange for their target stock. The Tax Court, viewing the stock purchase and asset acquisition as an integrated transaction in which the purchaser acquired all of the target's assets for cash and notes, held there was insufficient continuity of interest to qualify the asset transfer as a reorganization under section 368 because the shareholders of the target before the stock purchase received no stock in the acquiring entity. As a result, the subsidiary received a cost basis in the target's assets. In addition to Yoc Heating, there are other cases in which courts have denied reorganization treatment and have given the transferee a stepped-up basis in the target's assets following the purchase of the target's stock and the merger of the target into the purchaser or a related corporation. See, e.g., Russell v. Commissioner, 832 F.2d 349 (6th Cir. 1987), aff'g Cannonsburg Skiing Corp. v. Commissioner, T.C. Memo 1986-150 (corporation purchased target stock and then target merged into purchaser); Security Industrial Insurance Co. v. United States, 702 F.2d 1234 (5th Cir. 1983) (corporation purchased stock of targets and then targets merged into purchaser, which then transferred the target assets to a subsidiary of the purchaser); South Bay Corporation v. Commissioner, 345 F.2d 698 (2d Cir. 1965) (individual purchased stock in two targets and then targets merged into a third corporation owned by the individual); Superior Coach of Florida [[Page 9310]] v. Commissioner, 80 T.C. 895 (1983) (individual purchased target stock and then target merged into another corporation controlled by the individual); Estate of McWhorter v. Commissioner, 69 T.C. 650 (1978), aff'd, 590 F.2d 340 (8th Cir. 1978) (corporation purchased target stock and then target merged into purchaser); and Kass v. Commissioner, 60 T.C. 218 (1973), aff'd, 491 F.2d 749 (3d Cir. 1974) (corporation purchased target stock and then target merged into purchaser). The Yoc Heating court's analysis of the transaction as, in substance, a taxable asset acquisition by the subsidiary is consistent with generally applied federal income tax principles. For example, in Kimbell-Diamond Milling Co. v. Commissioner, 14 T.C. 74 (1950), aff'd per curiam, 187 F.2d 718 (5th Cir.), cert. denied, 342 U.S. 827 (1951), an acquiring corporation's purchase of a target corporation's stock followed by the liquidation of the target was treated for federal income tax purposes as, in substance, a direct purchase of the target's assets by the acquiring corporation. The Tax Court's characterization in Kimbell-Diamond was based on a finding that the acquiring corporation intended to obtain the target's assets rather than its stock. As a result, the acquiring corporation's basis in the target's assets was determined by reference to the purchase price of the target's stock. In 1954, Congress codified principles derived from Kimbell-Diamond by enacting former section 334(b)(2) of the Internal Revenue Code of 1954, which created an objective test that permitted a stock purchase followed by liquidation of the target to be treated as an asset acquisition. S. Rep. No. 1622, 83d Cong., 2d Sess. 257 (1954). In 1982, Congress repealed section 334(b)(2) and replaced it with section 338, which provides that, if a corporation makes a qualified stock purchase (QSP) of the stock of a target, the purchasing corporation may elect to have the target treated as having sold all of its assets at the close of the acquisition date in a single transaction and as a new corporation that purchased all such assets at the beginning of the following day. Section 338 was ``intended to replace any nonstatutory treatment of a stock purchase as an asset purchase under the Kimbell-Diamond doctrine.'' H.R. Conf. Rep. No. 760, 97th Cong., 2d Sess. 467, 536 (1982), 1982-2 C.B. 600, 632. Under section 338(i), the IRS and Treasury are authorized to prescribe such regulations as may be necessary or appropriate to carry out the purposes of section 338. The IRS and Treasury believe that the result in Yoc Heating is inconsistent with the legislative intent behind section 338. As a result of the enactment of section 338, an intragroup merger or similar transaction following a QSP generally should not be treated as part of an overall asset acquisition. The qualified stock purchase must be accorded its intended effect. Cf. Rev. Rul. 90-95, 1990-2 C.B. 67 (applying sections 332 and 334 to a merger of the target into the purchasing corporation following a QSP). If a section 338 election is not made, in a subsequent intragroup merger or similar transaction, the target assets generally should preserve their historic basis maintained in the qualified stock purchase. The IRS and Treasury believe that applying the reorganization rules to the target and purchasing group in mergers and similar transactions following a QSP is the simplest and most effective means of achieving the congressional intent in repealing the Kimbell-Diamond doctrine. Explanation of Provisions Proposed Sec. 1.338-2(c)(3) applies to the transfer of target assets to the purchasing corporation or another member of the same affiliated group as the purchasing corporation (the transferee) following a QSP of target stock, if the purchasing corporation does not make a section 338 election for the target. As noted above, for the transfer of target assets to be pursuant to a reorganization within the meaning of section 368, there must be a continuity of interest in the target's business enterprise on the part of those persons who, directly or indirectly, were the owners of the enterprise prior to the reorganization. See Sec. 1.368-1(b). The proposed regulations generally provide that, by virtue of the application of section 338, the purchasing corporation's target stock acquired in the QSP represents an interest on the part of a person who was an owner of the target's business enterprise prior to the transfer that can be continued in a reorganization for the purpose of determining whether the continuity of interest requirement is satisfied. A corollary provision enables the transfer to satisfy the requirements for an acquisitive reorganization under section 368(a)(1)(D). Notwithstanding the general rule above, the proposed regulations provide that sections 354, 355, 356 and 358 do not apply to any person other than the purchasing corporation or another member of the same affiliated group as the purchasing corporation unless the transfer of target assets is pursuant to a reorganization under generally applicable rules without regard to the provisions of the proposed regulations. The legislative history of section 338 does not indicate any intent to eliminate the continuity of interest requirement generally and allow reorganization treatment to shareholders receiving stock in acquisitions where the overall consideration does not preserve continuity of interest. The rules provided in the proposed regulations reconcile Congress' concerns in enacting section 338 with general reorganization principles. The IRS and Treasury request comments on the proposed rules, including, particularly, comments regarding the collateral consequences of treating the transaction as a reorganization to the target and to the purchasing corporation and its affiliates, but not to persons unaffiliated with the purchasing corporation. The IRS and Treasury also solicit comments as to whether guidance is needed as to the proper treatment of post-QSP mergers and similar transactions if a section 338 election is made for the target. Proposed Effective Date Section 1.338-2(c)(3) is proposed to be effective for transfers of target assets occurring on or after the date final regulations are filed with the Office of the Federal Register. Special Analyses It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business. Comments and Requests for a Public Hearing Before this proposed regulation is adopted as a final regulation, consideration will be given to any written comments (a signed original and eight (8) copies) that are submitted timely to the IRS. All comments will be available for public inspection and copying. A public hearing has been scheduled for June 7, 1995, at 10 a.m. in room [[Page 9311]] 3313, Internal Revenue Building, 1111 Constitution Avenue NW, Washington, DC. Because of access restrictions, visitors will not be admitted beyond the Internal Revenue Building lobby more than 15 minutes before the hearing starts. The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons that wish to present oral comments at the hearing must submit written comments by May 19, 1995, and submit an outline of the topics to be discussed and the time to be devoted to each topic (signed original and eight (8) copies) by May 19, 1995. A period of 10 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 William Galanis, Office of Assistant Chief Counsel (Corporate), Internal Revenue Service. 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. 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 1.338-0 is amended by adding entries for Sec. 1.338-2(c)(3) to read as follows: Sec. 1.338-0 Outline of topics. * * * * * Sec. 1.338-2 Miscellaneous issues under section 338. * * * * * (c)* * * (3) Consequences of post-acquisition elimination of target. (i) Scope. (ii) Continuity of interest. (iii) Control requirement. (iv) Example. (v) Effective date. * * * * * Par. 3. Section 1.338-2 is amended by adding paragraph (c)(3) to read as follows: Sec. 1.338-2 Miscellaneous issues under section 338. * * * * * (c) * * * (3) Consequences of post-acquisition elimination of target--(i) Scope. The rules of this paragraph (c)(3) apply to the transfer of target assets to the purchasing corporation (or another member of the same affiliated group as the purchasing corporation) (the transferee) following a qualified stock purchase of target stock, if the purchasing corporation does not make a section 338 election for target. (ii) Continuity of interest. By virtue of section 338, in determining whether the continuity of interest requirement of Sec. 1.368-1(b) is satisfied on the transfer of assets from target to the transferee, the purchasing corporation's target stock acquired in the qualified stock purchase represents an interest on the part of a person who was an owner of the target's business enterprise prior to the transfer that can be continued in a reorganization. Notwithstanding the preceding sentence, sections 354, 355, 356 and 358 do not apply to any person other than the purchasing corporation or another member of the same affiliated group as the purchasing corporation unless the transfer is pursuant to a reorganization under generally applicable rules without regard to this paragraph (c)(3)(ii). (iii) Control requirement. By virtue of section 338, the purchasing corporation is treated as a shareholder of the target transferor for the purpose of determining whether, immediately after the transfer of target assets, a shareholder of the transferor is in control of the corporation to which the assets are transferred within the meaning of section 368(a)(1)(D). (iv) Example. This paragraph (c)(3) is illustrated by the following example: Example. (A) Facts. P, T, and X are domestic corporations. T and X each operate a trade or business. A and K, individuals unrelated to P, own 85 and 15 percent, respectively, of the stock of T. P owns all of the stock of X. The total adjusted basis of T's property exceeds the sum of T's liabilities plus the amount of liabilities to which T's property is subject. P purchases all of A's T stock for cash in a qualified stock purchase. P does not make an election under section 338(g) with respect to its acquisition of T stock. Shortly after the acquisition date, and as part of the same plan, T merges under applicable state law into X in a transaction that, but for the question of continuity of interest, satisfies all the requirements of section 368(a)(1)(A). In the merger, all of T's assets are transferred to X. P and K receive X stock in exchange for their T stock. P intends to retain the stock of X indefinitely. (B) Status of transfer as a reorganization. By virtue of section 338, for the purpose of determining whether the continuity of interest requirement of Sec. 1.368-1(b) is satisfied, P's T stock acquired in the qualified stock purchase represents an interest on the part of a person who was an owner of T's business enterprise prior to the transfer that can be continued in a reorganization through P's continuing ownership of X. Thus, the continuity of interest requirement is satisfied and the merger of T into X is a reorganization within the meaning of section 368(a)(1)(A). Moreover, by virtue of section 338, the requirement of section 368(a)(1)(D) that a target shareholder control the transferee immediately after the transfer is satisfied because P controls X immediately after the transfer. In addition, all of T's assets are transferred to X in the merger and P and K receive the X stock exchanged therefor in pursuance of the plan of reorganization. Thus, the merger of T into X is also a reorganization within the meaning of section 368(a)(1)(D). (C) Treatment of T and X. Under section 361(a), T recognizes no gain or loss in the merger. Under section 362(b), X's basis in the assets received in the merger is the same as the basis of the assets in T's hands. X succeeds to and takes into account the items of T as provided in section 381. (D) Treatment of P. By virtue of section 338, the transfer of T assets to X is a reorganization. Pursuant to that reorganization, P exchanges its T stock solely for stock of X, a party to the reorganization. Because P is the purchasing corporation, section 354 applies to P's exchange of T stock for X stock in the merger of T into X. Thus, P recognizes no gain or loss on the exchange. Under section 358, P's basis in the X stock received in the exchange is the same as the basis of P's T stock exchanged therefor. (E) Treatment of K. Because K is not the purchasing corporation (or an affiliate thereof), section 354 does not apply to K's exchange of T stock for X stock in the merger of T into X unless the transfer is pursuant to a reorganization under generally applicable rules without regard to paragraph (c)(3)(ii) of this section. Under general income tax principles applicable to reorganizations, the continuity of interest requirement is not satisfied because P's stock purchase and the merger of T into X are pursuant to an integrated transaction in which A, the owner of 85 percent of the stock of T, received solely cash in exchange for A's T stock. See, e.g., Yoc Heating v. Commissioner, 61 T.C. 168 (1973); Kass v. Commissioner, 60 T.C. 218 (1973), aff'd, 491 F.2d 749 (3d Cir. 1974). Thus, the requisite continuity of interest under Sec. 1.368- 1(b) is lacking and section 354 does not apply to K's exchange of T stock for X stock. K recognizes gain or loss, if any, pursuant to section 1001(c) with respect to its T stock. (v) Effective date. The provisions of this paragraph (c)(3) are effective for transfers of target assets on or after the [[Page 9312]] date final regulations are filed with the Office of the Federal Register. * * * * * Margaret Milner Richardson, Commissioner of Internal Revenue. [FR Doc. 95-3771 Filed 2-16-95; 8:45 am] BILLING CODE 4830-01-P