[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