[Federal Register Volume 61, Number 247 (Monday, December 23, 1996)]
[Proposed Rules]
[Pages 67512-67515]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-32120]


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DEPARTMENT OF THE TREASURY
26 CFR Part 1

[REG-252231-96]
RIN 1545-AU72


Continuity of Interest

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations providing that the 
continuity of shareholder interest requirement for corporate 
reorganizations is satisfied if the

[[Page 67513]]

acquiring corporation furnishes consideration which represents a 
proprietary interest in the affairs of the acquiring corporation and 
such consideration represents a substantial part of the value of the 
stock or properties transferred. Dispositions of stock of the acquiring 
corporation by a former target shareholder generally are not taken into 
account in determining whether continuity of shareholder interest has 
been satisfied. This document also provides notice of a public hearing 
on these proposed regulations.

DATES: Comments must be received by March 24, 1997. Requests to speak 
and outlines of topics to be discussed at the public hearing scheduled 
for Wednesday, May 7, 1997 must be received by Wednesday, April 16, 
1997.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-252231-96), 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:DOM:CORP:R (REG-
252231-96), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue NW., Washington, DC. Alternatively, taxpayers may submit 
comments electronically via the Internet by selecting the ``Tax Regs'' 
option on the IRS Home Page, or by submitting comments directly to the 
IRS Internet site at http://www.irs.ustreas.gov/prod/tax__regs/
comments.html. The public hearing will be held in the Auditorium, 
Internal Revenue Building, 1111 Constitution Avenue NW., Washington, 
DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Phoebe 
Bennett, (202) 622-7750; concerning submissions and the hearing, 
Christina Vasquez, (202) 622-6808 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: This document contains proposed amendments 
to the Income Tax Regulations (26 CFR part 1) under section 368. The 
proposed regulations provide that the continuity of shareholder 
interest (COSI) requirement is satisfied if the acquiring corporation 
furnishes consideration which represents a proprietary interest in the 
affairs of the acquiring corporation and such consideration represents 
a substantial part of the value of the stock or properties transferred.

Background

    The Internal Revenue Code of 1986 (Code) provides general 
nonrecognition treatment for reorganizations specifically described in 
section 368 of the Code. Literal compliance with the statutory 
requirements is not sufficient for nonrecognition. For example, to 
qualify as a reorganization the COSI requirement must also be 
satisfied.
    The early statutory definitions of reorganizations did not specify 
the type of consideration required for a transaction to qualify as a 
reorganization. As a result, a transaction may have satisfied the 
literal definition of a reorganization even if the transaction 
resembled a sale. To prevent such transactions from qualifying as 
reorganizations, the COSI requirement was established by the courts to 
ensure that the consideration furnished by the acquiring corporation 
represented a proprietary interest in the affairs of the acquiring 
corporation and that such consideration represented a substantial part 
of the value of the stock or properties transferred. See Helvering v. 
Minnesota Tea Co., 296 U.S. 378 (1935); Pinellas Ice & Cold Storage Co. 
v. Commissioner, 287 U.S. 462 (1933); Cortland Specialty Co. v. 
Commissioner, 60 F.2d 937 (2d Cir. 1932), cert. denied 288 U.S. 599 
(1933). ``Reorganization, merger and consolidation are words indicating 
corporate readjustments of existing interests. They all differ 
fundamentally from a sale where the vendor corporation parts with its 
interest for cash and receives nothing more.'' Cortland, 60 F.2d at 
939.
    The cases that gave rise to the COSI requirement did not involve 
situations in which shareholders of the target corporation disposed of 
stock consideration from the acquiring corporation after having 
received it. In those cases, the relevant inquiry was whether the 
acquiring corporation furnished the proper type of consideration in the 
reorganization. Over the years, issues have arisen regarding whether 
the COSI requirement is satisfied if the target shareholders, as 
contemplated at the time of the reorganization, subsequently dispose of 
the stock received from the acquiring corporation. Compare McDonald's 
Restaurants of Illinois, Inc. v. Commissioner, 688 F.2d 520 (7th Cir. 
1982), rev'g McDonald's of Zion v. Commissioner, 76 T.C. 972 (1981), 
with Penrod v. Commissioner, 88 T.C. 1415 (1987). Various bar 
associations have asked the Treasury Department and the IRS to provide 
guidance to clarify existing law and reduce uncertainty in applying 
COSI principles in the context of postreorganization sales. See New 
York State Bar Association Tax Section, Postreorganization Continuity 
of Interest, reprinted in 73 Tax Notes 481 (1996); Committee on 
Taxation of Corporations of the Association of the Bar of the City of 
New York, Postreorganization Transactions and Continuity of Shareholder 
Interest, reprinted in 72 Tax Notes 1401 (1996).

Explanation of Proposed Regulations

    The proposed regulations provide that the COSI requirement is 
satisfied if the acquiring corporation furnishes consideration in the 
reorganization that represents a proprietary interest in the affairs of 
the acquiring corporation and such consideration represents a 
substantial part of the value of the stock or properties transferred. 
Dispositions of stock of the acquiring corporation by a former target 
shareholder generally are not taken into account in determining whether 
COSI has been satisfied. However, the proposed regulations emphasize 
that all facts and circumstances must be considered in determining 
whether the acquiring corporation has in substance furnished the 
required consideration. For example, if the acquiring corporation or a 
related party (within the meaning of section 707(b)(1) or section 
267(b) (without regard to section 267(e))) purchases the acquiring 
corporation stock shortly after the reorganization, all of the facts 
and circumstances may indicate that the transaction should be properly 
recast to treat the acquiring corporation as furnishing cash in the 
reorganization, in which case the reorganization would not satisfy the 
COSI requirement. This approach refocuses the COSI requirement on its 
initial purpose of ensuring that the acquiring corporation furnishes 
the proper type of consideration and also promotes simplicity and 
administrability in applying the COSI requirement.

Effect on Other Authorities

    The proposed regulations do not specifically address the effect on 
COSI of dispositions of target stock before a transaction potentially 
qualifying as a reorganization. See, e.g., King Enterprises, Inc. v. 
United States, 418 F.2d 511 (Ct. Cl. 1969); J.E. Seagram Corp. v. 
Commissioner, 104 T.C. 75 (1995); Superior Coach of Florida, Inc. v. 
Commissioner, 80 T.C. 895 (1983); Yoc Heating Corp. v. Commissioner, 61 
T.C. 168 (1973). The Treasury Department and IRS are studying this 
question and also the role of the COSI requirement in section 
368(a)(1)(D) reorganizations and section 355 transactions. See 
Sec. 1.355-2(c). The Treasury Department and IRS solicit comments on 
these issues.

[[Page 67514]]

Effect on Other Documents

    The IRS will modify or obsolete publications as necessary to 
conform with this regulation as of the date of publication in the 
Federal Register of the final regulations. See, e.g., Rev. Proc. 86-42 
(1986-2 C.B. 722); Rev. Proc. 77-37 (1977-2 C.B. 568). The IRS solicits 
comments as to whether other publications should be modified or 
obsoleted.

Proposed Effective Date

    The revisions and additions in the proposed regulations apply to 
transactions occurring after these regulations are published as final 
regulations in the Federal Register, except that they shall not apply 
to any transactions occurring pursuant to a written agreement which is 
(subject to customary conditions) binding on or before these 
regulations are published as final regulations in 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 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, 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 Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight copies) or comments transmitted via Internet that are 
submitted timely to the IRS. All comments will be available for public 
inspection and copying.
    A public hearing has been scheduled at 10 a.m. on Wednesday, May 7, 
1997, in the Auditorium, Internal Revenue Service, 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 
request to speak by Wednesday, April 16, 1997, and submit an outline of 
the topics to be discussed and the time to be devoted to each topic by 
Wednesday, April 16, 1997.
    A period of 10 minutes will be allotted 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 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.

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 1.368-1 is amended by:
    1. Revising the third sentence of paragraph (b).
    2. Adding two sentences between the fourth and fifth sentences of 
paragraph (b).
    3. Adding paragraph (e).
    The revisions and additions read as follows:


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

* * * * *
    (b) * * * Requisite to a reorganization under the Code are a 
continuity of the business enterprise under the modified corporate 
form, and (except as provided in section 368(a)(1)(D)) a continuity of 
shareholder interest. * * * The continuity of shareholder interest 
requirement is described in paragraph (e) of this section. The third 
and fifth sentences of this paragraph apply to transactions occurring 
after these regulations are published as final regulations in the 
Federal Register, except that they shall not apply to any transactions 
occurring pursuant to a written agreement which is (subject to 
customary conditions) binding on or before these regulations are 
published as final regulations in the Federal Register. * * *
* * * * *
    (e) Continuity of shareholder interest--(1) General rule. The 
purpose of the continuity of shareholder interest requirement is to 
prevent transactions that resemble sales from qualifying for 
nonrecognition of gain or loss available to corporate reorganizations. 
Continuity of shareholder interest requires that the acquiring 
corporation furnish consideration representing a proprietary interest 
in the affairs of the acquiring corporation and that such consideration 
represents a substantial part of the value of the stock or properties 
transferred. In determining whether the acquiring corporation has 
furnished such consideration, 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 section 267(b) (without regard to section 
267(e))) to redeem or acquire the consideration provided in the 
reorganization. Thus, for example, if based on all the facts and 
circumstances the acquiring corporation has furnished solely cash, the 
continuity of shareholder interest requirement is not satisfied.
    (2) Triangular reorganizations. For purposes of this paragraph (e), 
in the case of a triangular reorganization described in Sec. 1.358-
6(b), the continuity of shareholder interest requirement will be 
applied with reference to the stock of the corporation which is in 
control of the acquiring corporation (in a forward triangular merger) 
or in control of the merged corporation (in a reverse triangular 
merger).
    (3) Examples. The following examples illustrate the application of 
this paragraph (e):

    Example 1. A owns all of the stock of T. T merges into P. In the 
merger, A receives stock of P having a fair market value of $50x and 
cash of $50x. Immediately after the merger, and pursuant to a 
preexisting binding contract negotiated by A, A sells all of the 
stock of P received by A in the merger to B, a party not related to 
P. The transaction satisfies the continuity of shareholder interest 
requirement because A received stock of P representing a substantial 
part of the value of the total consideration transferred in the 
acquisition.
    Example 2. A owns 80 percent of the stock of T and none of the 
stock of P, which is widely held. T merges into P. In the merger, A 
receives stock of P. In addition, A obtains registration rights 
pursuant to an agreement with P to register the P stock and sells 
such stock shortly after the acquisition in the open market. The 
transaction satisfies the continuity of shareholder interest 
requirement.

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    Example 3. A owns 80 percent of the stock of T and none of the 
stock of P. T merges into P. In the merger, A receives stock of P. 
In addition, A arranges with an independent investment banker to 
hedge the risk of loss on the P stock received in the merger. 
Neither P nor a party related to P enters directly or indirectly 
into the hedging transaction. The transaction satisfies the 
continuity of shareholder interest requirement.
    Example 4. A owns 80 percent of the stock of T and none of the 
stock of P. T merges into P. In the merger, A receives stock of P 
but with an agreement that it will be redeemed shortly by P. 
Pursuant to the agreement, shortly after the merger P redeems all of 
the stock of P received by A in the merger for cash. Under all of 
the facts and circumstances, the cash is treated as furnished by P 
in the merger, so that the merger does not satisfy the continuity of 
shareholder interest requirement. The result is the same if S, P's 
wholly owned subsidiary, buys all of the stock of P received by A in 
the merger for cash. The result is also the same if pursuant to a 
plan between P, its investment banker, and A, P's investment banker 
buys all of the stock of P received by A in the merger for cash and, 
shortly thereafter, P redeems the stock held by the investment 
banker for cash.

    (4) Effective date. Paragraph (e) applies to transactions occurring 
after these regulations are published as final regulations in the 
Federal Register, except that it shall not apply to any transactions 
occurring pursuant to a written agreement which is (subject to 
customary conditions) binding on or before these regulations are 
published as final regulations in the Federal Register.
    Par. 3. In Sec. 1.368-2, paragraph (a) is amended by removing the 
second sentence and adding two new sentences in its place to read as 
follows:


Sec. 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 these regulations are 
published as final regulations in the Federal Register, except that it 
shall not apply to any transactions occurring pursuant to a written 
agreement which is (subject to customary conditions) binding on or 
before these regulations are published as final regulations in the 
Federal Register. * * *
* * * * *
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 96-32120 Filed 12-20-96; 8:45 am]
BILLING CODE 4830-01-P