[Federal Register Volume 60, Number 208 (Friday, October 27, 1995)]
[Rules and Regulations]
[Pages 54942-54944]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-26739]



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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8626]
RIN 1545-AT15


Continuity of Interest in Transfer of Target Assets After 
Qualified Stock Purchase of Target

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document prescribes final regulations under section 338 
of the Internal Revenue Code regarding the transfer of target assets to 
the purchasing corporation or another member of the same affiliated 
group as the purchasing corporation 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.

DATES: These regulations are effective October 27, 1995.
    These regulations are applicable to transfers of target assets that 
occur on or after October 26, 1995.

FOR FURTHER INFORMATION CONTACT: Steven M. Flanagan at (202) 622-7790 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Explanation of Provisions

Background

    This document contains final regulations under section 338 that 
govern the treatment of an intragroup merger or similar transaction 
following a QSP of target stock, if a section 338 election is not made 
for the target.
    Section 338 provides that, if a corporation makes a 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. Under 
section 338(i), the 

[[Page 54943]]
IRS and Treasury are authorized to prescribe such regulations as may be 
necessary or appropriate to carry out the purposes of section 338.
    On February 17, 1995, proposed regulations under section 338 were 
published in the Federal Register (60 FR 9309). The proposed rules are 
based on the conclusion that the result in Yoc Heating v. Commissioner, 
61 T.C. 168 (1973), is inconsistent with the legislative intent behind 
section 338 when there is a QSP of target stock.

Public Comments and the Final Regulations

    The IRS received comments from the public on the proposed 
regulations, and a public hearing was held on June 7, 1995. 
Commentators generally support the proposed regulations. Accordingly, 
the final regulations adopt the proposed regulations with minor 
technical changes. The principal comments on the proposed regulations 
are discussed below.
    Treatment of minority shareholders. The proposed regulations 
generally treat the purchasing corporation's target stock acquired in 
the QSP as an interest on the part of a person who is an owner of the 
target's business enterprise prior to the transfer that can be 
continued in a reorganization. Thus, if the purchasing corporation 
purchases the bulk of the stock of a target corporation in a QSP and 
subsequently merges the target into a subsidiary of the purchasing 
corporation in exchange for the subsidiary's stock, the continuity of 
interest requirement is treated as satisfied. However, this treatment 
does not extend to minority shareholders of the target whose stock is 
not acquired by the purchasing corporation.
    Several commentators argue that the proposed regulations are 
inconsistent because they provide tax-free treatment to the purchasing 
corporation, but not minority shareholders who are the true historic 
owners of the target. Therefore, they suggest that the proposed 
regulations are contrary to traditional notions of shareholder 
continuity, and that the final regulations should extend tax-free 
treatment to minority shareholders who exchange their target stock for 
stock in the acquiring entity.
    The final regulations do not adopt this suggestion. The legislative 
history of section 338 indicates a congressional intent to repeal the 
Kimbell-Diamond doctrine and protect the exclusivity of the section 338 
election for obtaining a cost rather than a carryover basis in the 
target's assets after a QSP. See H.R. Conf. Rep. No. 760, 97th Cong., 
2d Sess. 467, 536 (1982), 1982-2 C.B. 600, 632. The regulations apply 
the reorganization rules to the target corporation and purchasing group 
because the IRS and Treasury believe it is the simplest and most 
effective means of achieving this intent, as they provide a pre-
existing set of rules with well-understood consequences.
    The legislative history does not indicate any intention to provide 
reorganization treatment for all purposes to exchanges of stock 
incident to asset transfers after QSPs. Under general income tax rules, 
an exchange of shares is only accorded reorganization treatment if the 
continuity of interest requirement is satisfied with respect to the 
target shareholders generally. This requirement is not satisfied if the 
acquisition of the target in a QSP and the merger of the target into 
the purchasing corporation's subsidiary are pursuant to an integrated 
transaction in which the owner of the majority stake in the target 
receives solely cash. See, e.g., Yoc Heating, 61 T.C. 168; Kass v. 
Commissioner, 60 T.C. 218 (1973), aff'd, 491 F.2d 749 (3d Cir. 1974). 
Thus, extension of reorganization treatment to the minority 
shareholders in this case would inappropriately alter general 
reorganization principles, and would not be grounded in the policies of 
section 338.
    Scope of minority shareholder exclusion provision. One commentator 
suggests that if the final regulations continue to deny reorganization 
treatment to the preexisting minority shareholders, the exclusion 
should expressly apply to both the continuity of interest and control 
rules, rather than only the continuity of interest rule (as proposed). 
The final regulations adopt the commentator's suggestion by moving the 
minority shareholder exclusion to the scope section. This change is 
intended to clarify that the minority shareholder exclusion applies to 
any transaction that qualifies as a tax-free reorganization by 
operation of these regulations.
    Effect of section 338(h)(8). Section 338(h)(8) provides that stock 
and asset acquisitions made by members of the same affiliated group 
shall be treated as made by one corporation. One commentator suggests 
that the final regulations should specifically provide that section 
338(h)(8) does not apply in determining whether the merger of target 
qualifies as a reorganization. Otherwise, the commentator contends, a 
transaction in which target ``sprinkles'' its assets among several 
members of the purchasing corporation's affiliated group would qualify 
as a reorganization, because section 338(h)(8) treats the purchasing 
corporation and its affiliates as one corporation.
    The final regulations do not adopt this suggestion because section 
338(h) (including section 338(h)(8)), by its terms, only applies for 
purposes of section 338 (e.g., determining whether a transaction 
qualifies as a QSP). The final regulations only modify the continuity 
of interest and control requirements for reorganizations, and any 
transaction in which the target ``sprinkles'' its assets among several 
purchasing corporation affiliates would likely fail other 
reorganization requirements.
    Guidance regarding mergers after a section 338 election. The 
Preamble to the proposed regulations requests comments on whether 
guidance is necessary on the proper treatment of post-QSP mergers if a 
section 338 election is made for target. Because this request did not 
receive a strong response, the IRS and Treasury have decided not to 
provide such guidance in this document.

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 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), the notice of proposed 
rulemaking preceding these regulations was 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 Steven M. Flanagan, 
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.

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 * * *


[[Page 54944]]

    Par. 2. Section 1.338-0 is amended by adding contents entries for 
Sec. 1.338-2(c)(3) in numerical order 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. 
Notwithstanding the rules of this paragraph (c)(3), section 354(a) (and 
so much of section 356 as relates to section 354) cannot 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 as determined without 
regard to this paragraph (c)(3).
    (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.
    (iii) Control requirement. By virtue of section 338, the 
acquisition of target stock in the qualified stock purchase will not 
prevent the purchasing corporation from qualifying 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 cannot apply to K's exchange 
of T stock for X stock in the merger of T into X unless the transfer 
of T's assets is pursuant to a reorganization as determined without 
regard to Sec. 1.338-2(c)(3). 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 October 26, 1995.
* * * * *
Margaret Milner Richardson,
Commissioner of Internal Revenue.

    Approved: October 3, 1995.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 95-26739 Filed 10-26-95; 8:45 am]
BILLING CODE 4830-01-U