[Federal Register Volume 63, Number 18 (Wednesday, January 28, 1998)]
[Rules and Regulations]
[Pages 4174-4183]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-1819]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8760]
RIN 1545-AU72 and 1545-AU73


Continuity of Interest and Continuity of Business Enterprise

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations providing guidance 
regarding satisfaction of the continuity of interest and continuity of 
business enterprise requirements for corporate reorganizations. The 
final regulations affect corporations and their shareholders.

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: Regarding Sec. 1.368-1(e) (continuity 
of interest) Secs. 1.338-2 and 1.368-1 (a) and (b): Phoebe Bennett, 
(202) 622-7750 (not a toll-free number); regarding Sec. 1.368-1(d) 
(continuity of business enterprise) and, Secs. 1.368-1 (a) and (b), 
1.368-2(k): Marlene Peake Oppenheim, (202) 622-7750 (not a toll free 
number).

SUPPLEMENTARY INFORMATION:

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 (COI) requirement (proposed COI 
regulations). On January 3, 1997, the IRS published a notice of 
proposed rulemaking (REG-252233-96) in the Federal Register (62 FR 
36101) (proposed COBE regulations) relating to (1) the continuity of 
business enterprise (COBE) requirement; and (2) transfers of acquired 
assets or stock following certain otherwise qualifying reorganizations 
(remote continuity of interest). Many written comments were received in 
response to these notices of proposed rulemaking. A public hearing on 
both proposed regulations was held on May 7, 1997. After consideration 
of all comments, the regulations proposed by REG-252231-96 and REG-
252233-96 are adopted as revised by this

[[Page 4175]]

Treasury decision, along with temporary regulations and proposed 
regulations cross-referencing the temporary regulations regarding COI 
published elsewhere in this issue of the Federal Register.

Explanation of Provisions

    The Internal Revenue Code of 1986 provides general nonrecognition 
treatment for reorganizations specifically described in section 368. In 
addition to complying with the statutory requirements and certain other 
requirements, a transaction generally must satisfy the continuity of 
interest requirement and the continuity of business enterprise 
requirement.

A. Continuity of Interest

    The purpose of the continuity of interest requirement is to prevent 
transactions that resemble sales from qualifying for nonrecognition of 
gain or loss available to corporate reorganizations. The final 
regulations provide that the COI requirement is satisfied if in 
substance a substantial part of the value of the proprietary interest 
in the target corporation (T) is preserved in the reorganization. A 
proprietary interest in T is preserved if, in a potential 
reorganization, it is exchanged for a proprietary interest in the 
issuing corporation (P), it is exchanged by the acquiring corporation 
for a direct interest in the T enterprise, or it otherwise continues as 
a proprietary interest in T. The issuing corporation means the 
acquiring corporation (as the term is used in section 368(a)), except 
that, in determining whether a reorganization qualifies as a triangular 
reorganization (as defined in Sec. 1.358-6(b)(2)), the issuing 
corporation means the corporation in control of the acquiring 
corporation. However, a proprietary interest in T is not preserved if, 
in connection with the potential reorganization, it is acquired by P 
for consideration other than P stock, or P stock furnished in exchange 
for a proprietary interest in T if the potential reorganization is 
redeemed. All facts and circumstances must be considered in determining 
whether, in substance, a proprietary interest in T is preserved.
Rationale for the COI Regulations
    The proposed and final regulations permit former T shareholders to 
sell P stock received in a potential reorganization to third parties 
without causing the reorganization to fail to satisfy the COI 
requirement. Some commentators have questioned whether the regulations 
are consistent with existing authorities.
    The COI requirement was applied first to reorganization provisions 
that did not specify that P exchange a proprietary interest in P for a 
proprietary interest in T. Supreme Court cases imposed the COI 
requirement to further Congressional intent that tax-free status be 
accorded only to transactions where P exchanges a substantial 
proprietary interest in P for a proprietary interest in T held by the T 
shareholders rather than to transactions resembling sales. See LeTulle 
v. Scofield, 308 U.S. 415 (1940); Helvering v. Minnesota Tea Co., 296 
U.S. 378 (1935); Pinellas Ice & Cold Storage Co. v. Commissioner, 287 
U.S. 462 (1933). See also Cortland Specialty Co. v. Commissioner, 60 
F.2d 937 (2d Cir. 1932), cert. denied 288 U.S. 599 (1933).
    None of the Supreme Court cases establishing the COI requirement 
addressed the issue of whether sales by former T shareholders of P 
stock received in exchange for T stock in the potential reorganization 
cause the COI requirement to fail to be satisfied. Since then, however, 
some courts have premised decisions on the assumption that sales of P 
stock received in exchange for T stock in the potential reorganization 
may cause the COI requirement to fail to be satisfied. McDonald's 
Restaurants of Illinois, Inc. v. Commissioner, 688 F.2d 520 (7th Cir. 
1982); Penrod v. Commissioner, 88 T.C. 1415 (1987); Heintz v. 
Commissioner, 25 T.C. 132 (1955), nonacq., 1958-2 C.B. 9; Estate of 
Elizabeth Christian v. Commissioner, 57 T.C.M. (CCH) 1231 (1989). The 
apparent focus of these cases is on whether the T shareholders intended 
on the date of the potential reorganization to sell their P stock and 
the degree, if any, to which P facilitates the sale. Based on an 
intensive inquiry into nearly identical facts, some of these cases held 
that as a result of the subsequent sale the potential reorganization 
did not satisfy the COI requirement; others held that satisfaction of 
the COI requirement was not adversely affected by the subsequent sale. 
The IRS and Treasury Department have concluded that the law as 
reflected in these cases does not further the principles of 
reorganization treatment and is difficult for both taxpayers and the 
IRS to apply consistently.
    Therefore, consistent with Congressional intent and the Supreme 
Court precedent which distinguishes between sales and reorganizations, 
the final regulations focus the COI requirement generally on exchanges 
between the T shareholders and P. Under this approach, sales of P stock 
by former T shareholders generally are disregarded.
    The final regulations will greatly enhance administrability in this 
area by both taxpayers and the government. The regulations will prevent 
``whipsaw'' of the government, such as where the former T shareholders 
treat the transaction as a tax-free reorganization, and P later 
disavows reorganization treatment to step up its basis in the T assets 
based on the position that sales of P stock by the former T 
shareholders did not satisfy the COI requirement. See, e.g., McDonald's 
Restaurants, supra. In addition, this approach will prevent unilateral 
sales of P stock by former majority T shareholders from adversely 
affecting the section 354 nonrecognition treatment expected by former 
minority T shareholders.
Dispositions of T Stock
    The proposed COI regulations do not specifically address the effect 
upon COI of dispositions of T stock prior to a potential 
reorganization, but ask for comments on that issue. The IRS and 
Treasury Department believe that issues concerning the COI requirement 
raised by dispositions of T stock before a potential reorganization 
correspond to those raised by subsequent dispositions of P stock 
furnished in exchange for T stock in the potential reorganization. As 
requested by commentators, the final regulations apply the rationale of 
the proposed COI regulations to transactions occurring both prior to 
and after a potential reorganization. Cf. J.E. Seagram Corp. v. 
Commissioner, 104 T.C. 75 (1995) (sales of T stock prior to a potential 
reorganization do not affect COI if not part of the plan of 
reorganization). The final regulations provide that, for COI purposes, 
a mere disposition of T stock prior to a potential reorganization to 
persons not related to P is disregarded and a mere disposition of P 
stock received in a potential reorganization to persons not related to 
P is disregarded. But see Sec. 1.368-1T(e)(1)(ii)(A) and (B).
    In soliciting comments on the effect upon COI of dispositions of T 
stock prior to a potential reorganization, the preamble to the proposed 
COI regulations specifically requests comments on King Enterprises, 
Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969) (COI requirement 
satisfied where, pursuant to a plan, P acquires the T stock for 51 
percent P stock and 49 percent debt and cash, and T merges upstream 
into P), and Yoc Heating Corp. v. Commissioner, 61 T.C. 168 (1973) (COI 
requirement not satisfied where, pursuant to a plan, P acquires 85 
percent of the T stock for cash and notes, and T merges into P's newly 
formed subsidiary with minority

[[Page 4176]]

shareholders receiving cash). Consistent with these cases, where the 
step transaction doctrine applies to link T stock purchases with later 
acquisitions of T, the final regulations provide that a proprietary 
interest in T is not preserved if, in connection with the potential 
reorganization, it is acquired by P for consideration other than P 
stock. Whether a stock acquisition is made in connection with a 
potential reorganization will be determined based on the facts and 
circumstances of each case. See generally Sec. 1.368-1(a). This 
regulation does not address the effect, if any, of section 338 on 
corporate transactions (except for conforming changes to Sec. 1.338-
2(c)(3)). See generally Sec. 1.338-2(c)(3) (certain tax effects of a 
qualified stock purchase without a section 338 election on the post-
acquisition elimination of T).
Related Person Rule
    The proposed COI regulations provide that ``[i]n determining 
whether [COI is satisfied], 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 267(b) (without regard to section 267(e))) to 
redeem or acquire the consideration provided in the reorganization.'' 
The final regulations provide a more specific rule that a proprietary 
interest in T is not preserved if, in connection with a potential 
reorganization, a person related (as defined below) 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. The IRS and Treasury Department believe, 
however, that certain related party acquisitions preserve a proprietary 
interest in T and therefore, the rule includes an exception to the 
related party rule. Under this exception, a proprietary interest in T 
is preserved to the extent those persons who were the direct or 
indirect owners of T prior to the potential reorganization maintain a 
direct or indirect proprietary interest in P. See, e.g., Rev. Rul. 84-
30 (1984-1 C.B. 114).
    Commentators stated that the proposed COI regulations' rule, which 
employs sections 707(b)(1) and 267(b) to define persons related to P, 
is too broad. In response, the final regulations adopt a narrower 
related person definition which has two components in order to address 
two separate concerns.
    First, the IRS and Treasury Department were concerned that 
acquisitions of T or P stock by a member of P's affiliated group were 
no different in substance from an acquisition or redemption by P, 
because of the existence of various provisions in the Code that permit 
members to transfer funds to other members without significant tax 
consequences. Accordingly, Sec. 1.368-1(e)(3)(i)(A) includes as related 
persons corporations that are members of the same affiliated group 
under section 1504, without regard to the exceptions in section 
1504(b).
    Second, because the final regulations take into account whether, in 
substance, P has redeemed the stock it exchanged for T stock in the 
potential reorganization, the final 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)).
    Because the final regulations focus generally on the consideration 
P exchanges, related persons do not include individual or other 
noncorporate shareholders. Thus, the IRS will no longer apply the 
holdings of South Bay Corporation v. Commissioner, 345 F.2d 698 (2d 
Cir. 1965), and Superior Coach of Florida, Inc. v. Commissioner, 80 
T.C. 895 (1983), to transactions governed by these regulations.
T Stock Not Acquired in Connection With a Potential Reorganization
    Commentators requested clarification of whether P must actually 
furnish stock to T shareholders that own T stock which was not acquired 
in connection with a potential reorganization. The final regulations 
provide that a proprietary interest in T is preserved if it is 
exchanged by the acquiring corporation (which may or may not also be P) 
for a direct interest in the T enterprise, or otherwise continues as a 
proprietary interest in T.
Redemptions of T Stock or Extraordinary Distributions With Respect to T 
Stock
    In addition to the final regulations, the IRS and Treasury 
Department are contemporaneously issuing temporary regulations and 
proposed regulations cross-referencing the temporary regulations 
published elsewhere in this issue of the Federal Register with the same 
effective date as these final regulations. The temporary and proposed 
regulations provide that a proprietary interest in T is not preserved 
if, in connection with a potential reorganization, it is redeemed or 
acquired by a person related to T, or to the extent that, prior to and 
in connection with a potential reorganization, an extraordinary 
distribution is made with respect to it.
Transactions Following a Qualified Stock Purchase
    As stated above, these final regulations focus the COI requirement 
generally on exchanges between the T shareholders and P. Accordingly, 
the language of Sec. 1.338-2(c)(3) is conformed to these final COI 
regulations to treat the stock of T acquired by the purchasing 
corporation in the qualified stock purchase as though it was not 
acquired in connection with the transfer of the T assets.
Effect on Other Authorities
    The IRS and Treasury Department continue to study the role of the 
COI requirement in section 368(a)(1)(D) reorganizations and section 355 
transactions. Therefore, these final COI regulations do not apply to 
section 368(a)(1)(D) reorganizations and section 355 transactions. See 
Sec. 1.355-2(c).
    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, for example, whether P has 
issued solely voting stock for purposes of section 368(a)(1)(B) or (C).
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 
regulations.
    Rev. Rul. 66-23 (1966-1 C.B. 67) is hereby obsoleted because it 
indicates that a plan or arrangement in connection with a potential 
reorganization for disposition of stock to unrelated persons does not 
satisfy the COI requirement.

B. Continuity of Business Enterprise

    The COBE requirement is fundamental to the notion that tax-free 
reorganizations merely readjust continuing interests in property. In 
Sec. 1.368-1(d), as effective prior to these final regulations, COBE 
generally required the acquiring corporation to either continue a 
significant historic T business or use a significant portion of T's 
historic business assets in a business. However, a valid reorganization 
may qualify as tax-free even if the acquiring corporation does

[[Page 4177]]

not directly carry on the historic T business or use the historic T 
assets in a business. See section 368(a)(2)(C). See also Rev. Rul. 68-
261 (1968-1 C.B. 147); Rev. Rul. 81-247 (1981-1 C.B. 87).
    Consistent with the view that the acquiring corporation need not 
directly conduct the T business or use the T assets, the final 
regulations provide rules under which, in an otherwise qualifying 
corporate reorganization, the assets and the businesses of the members 
of a qualified group of corporations are treated as assets and 
businesses of the issuing corporation. Accordingly, in the final 
regulations, COBE requires that the issuing corporation either continue 
T's historic business or use a significant portion of T's historic 
business assets in a business.
    A qualified group is one or more chains of corporations connected 
through stock ownership with the issuing corporation, but only if the 
issuing corporation owns directly stock meeting the requirements of 
section 368(c) in at least one of the corporations, and stock meeting 
the requirements of section 368(c) in each of the corporations is owned 
directly by one of the other corporations.
    The judicial continuity of interest doctrine historically included 
a concept commonly known as remote continuity of interest. Commonly 
viewed as arising out of Groman v. Commissioner, 302 U.S. 82 (1937), 
and Helvering v. Bashford, 302 U.S. 454 (1938), remote continuity of 
interest focuses on the link between the T shareholders and the former 
T business assets following the reorganization. In Sec. 1.368-1(d), as 
effective prior to these final regulations, COBE focuses on the 
continuation of T's business, or the use of T's business assets, by the 
acquiring corporation. Section 1.368-1(d), as revised herein, expands 
this concept by treating the issuing corporation as conducting a T 
business or owning T business assets if these activities are conducted 
by a member of the qualified group or, in certain cases, by a 
partnership that has a member of the qualified group as a partner.
    The proposed COBE regulations separately address COBE (Sec. 1.368-
1(d)) and remote continuity of interest (Sec. 1.368-1(f)). The IRS and 
Treasury Department believe the COBE requirements adequately address 
the issues raised in Groman and Bashford and their progeny. Thus, these 
final regulations do not separately articulate rules addressing remote 
continuity of interest.
Definition of the Qualified Group
    The proposed COBE regulations define the qualified group using a 
control test based on section 368(c). The IRS and Treasury Department 
received comments suggesting the replacement of the section 368(c) 
definition of control by the affiliated group definition of control 
stated in section 1504, without regard to section 1504(b). However, 
because section 368 generally determines control by reference to 
section 368(c), the final regulations retain the approach of the 
proposed COBE regulations.
Rules for Aggregation of Interests in Historic T Assets and Businesses 
Held in Partnership Solution
    In determining whether COBE is satisfied, the proposed COBE 
regulations aggregate the interests of the members of a qualified 
group. In addition, the proposed COBE regulations attribute a business 
of a partnership to a corporate transferor partner if the partner has a 
sufficient nexus with that partnership business. However, the proposed 
COBE regulations only consider the transferor partner's interest in the 
partnership business, and do not aggregate this interest with interests 
in the partnership held by other members of the qualified group.
    In response to comments requesting a partnership aggregation rule, 
the final regulations, through a system of attribution, aggregate the 
interests in a partnership business held by all the members of a 
qualified group. The final regulations provide rules under which a 
corporate partner may be treated as holding assets of a business of a 
partnership. Additionally, P is treated as holding all the assets, and 
conducting all the businesses of its qualified group. Furthermore, in 
certain circumstances, P will be treated as conducting a business of a 
partnership. Once the relevant T businesses and T assets are attributed 
to P, COBE is tested under the general rule of the final COBE 
regulations. See Sec. 1.368-1(d)(1).
    The proposed COBE regulations do not discuss tiered partnerships. 
In response to comments, the final regulations provide guidance on this 
issue. See Sec. 1.368-1(d)(5), Example 12.

C. Transfers of Assets or Stock to Controlled Corporations as Part of a 
Plan of Reorganization

    The proposed COBE regulations are limited in their application to 
COBE and remote continuity of interest. The rules of the proposed COBE 
regulations provide that for certain reorganizations, transfers of 
acquired assets or stock among members of the qualified group, and in 
certain cases, transfers of acquired assets to partnerships, do not 
disqualify a transaction from satisfying the COBE and remote continuity 
of interest requirements. The preamble to the proposed COBE regulations 
states that these rules do not address any other issues concerning the 
qualification of a transaction as a reorganization.
    Comments suggest that the proposed COBE regulations are ambiguous 
as they could be interpreted to mean that a transfer of stock or assets 
to a qualified group member after an otherwise tax-free reorganization 
would be given independent significance and the step transaction 
doctrine would not apply. Under such an interpretation, the potential 
reorganization would not be recast as a taxable acquisition or another 
type of reorganization. To eliminate this ambiguity, Sec. 1.368-1(a) of 
the final regulations provides that, in determining whether a 
transaction qualifies as a reorganization under section 368(a), the 
transaction must be evaluated under relevant provisions of law, 
including the step transaction doctrine. Section 1.368-1(d) of the 
final regulations is limited to a discussion of the COBE requirement, 
and does not address satisfaction of the explicit statutory 
requirements of a reorganization, which is the subject of Sec. 1.368-2. 
However, Sec. 1.368-2(k) of the final regulations does provide guidance 
in this regard, extending the application of section 368(a)(2)(C) to 
certain successive transfers.
    Section 1.368-2(k) of the final regulations states that a 
transaction otherwise qualifying under section 368(a)(1) (A), (B), (C), 
or (G) (where the requirements of sections 354(b)(1) (A) and (B) are 
met) shall not be disqualified by reason of the fact that part or all 
of the acquired assets or stock acquired in the transaction are 
transferred or successively transferred to one or more corporations 
controlled in each transfer by the transferor corporation. Control is 
defined under section 368(c). The final regulations also provide a rule 
for transfers of assets following a reorganization qualifying under 
section 368(a)(1)(A) by reason of section 368(a)(2)(E). No inference is 
to be drawn as to whether transactions not described in Sec. 1.368-2(k) 
otherwise qualify as reorganizations.
    The final regulations also provide that, if a transaction otherwise 
qualifies as a reorganization, a corporation remains a party to the 
reorganization even though stock or assets acquired in the 
reorganization are transferred in a transaction described in 
Sec. 1.368-2(k).

[[Page 4178]]

See Sec. 1.368-2(f). Furthermore, if a transaction otherwise qualifies 
as a reorganization, a corporation shall not cease to be a party to the 
reorganization solely because acquired assets are transferred to a 
partnership in which the transferor is a partner if the COBE 
requirement is satisfied.
Section 368(a)(1)(D), 368(a)(1)(F), and 355 Transactions
    The proposed COBE regulations, applying only to the COBE and remote 
continuity of interest requirements, are limited to transactions 
otherwise qualifying for reorganization treatment under section 
368(a)(1) (A), (B), (C), or (G) (where the requirements of sections 
354(b)(1) (A) and (B) are met). The IRS and Treasury Department 
received comments stating that the final regulations should apply to 
reorganizations qualifying under section 368(a)(1) (D) or (F) or to 
transactions qualifying under section 355.
    The final regulations do not limit the application of Sec. 1.368-
1(d) to the transactions enumerated in section 368(a)(2)(C). The COBE 
provisions in the final regulations apply to all reorganizations for 
which COBE is relevant.
    Section 1.368-2(k)(1) of the final regulations, however, is limited 
in its application to the transactions described in section 
368(a)(2)(C), and does not apply in determining whether a 
reorganization qualifies under section 368(a)(1)(D), section 
368(a)(1)(F), or section 355. The IRS and Treasury Department believe 
that further study is needed prior to extending Sec. 1.368-2(k)(1) to 
one or more of these provisions.

Effective Date

    The amendments to 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. Commentators requested that the effective date be changed 
to allow these regulations to apply to transactions occurring on or 
before January 28, 1998. The IRS and Treasury Department believe that 
adopting an earlier effective date increases the likelihood that T, P, 
and each of the former T shareholders would report the transaction 
inconsistently (in some cases using hindsight), and would reduce 
administrability of the regulation. No inference should be drawn from 
any provision of this regulation as to application of the COI or COBE 
requirements to transactions occurring on or before January 28, 1998.

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 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, the notices 
of proposed rulemaking preceding these regulations were submitted to 
the Chief Counsel for Advocacy of the Small Business Administration for 
comment on their impact on small business.

Drafting Information

    The principal authors of these regulations are Phoebe Bennett, 
regarding Sec. 1.368-1(e) (continuity of interest), and Marlene Peake 
Oppenheim, regarding Sec. 1.368-1(d) (continuity of business 
enterprise) and Sec. 1.368-2(k), both 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:

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 1.338-2 is amended:
    1. By revising paragraph (c)(3)(ii).
    2. In paragraph (c)(3)(iv) example, by revising the first sentence 
of paragraph (B).
    The revisions read as follows:


Sec. 1.338-2  Miscellaneous issues under section 338.

* * * * *
    (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) and (e) is satisfied on the transfer of assets from 
target to the transferee, the purchasing corporation's target stock 
acquired in the qualified stock purchase shall be treated as though it 
was not acquired in connection with the transfer of target assets.
* * * * *
    (iv) Example. * * *
    (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 shall be treated as though it was not 
acquired in connection with the transfer of T assets to X. * * *
* * * * *
    Par. 3. Section 1.368-1 is amended by:
    1. Adding three sentences immediately following the first sentence 
of paragraph (a).
    2. Removing the third sentence and adding four sentences in its 
place to paragraph (b).
    3. Removing paragraph (d)(1).
    4. Redesignating paragraphs (d)(2), (d)(3), and (d)(4) as 
paragraphs (d)(1), (d)(2), and (d)(3), respectively.
    5. Removing the first sentence of newly designated paragraph (d)(1) 
and adding two sentences in its place.
    6. Adding new paragraph (d)(4).
    7. Paragraph (d)(5) is amended by:
    a. Adding two sentences to the end of paragraph (d)(5) introductory 
text.
    b. Removing the parentheses around the numbers in the paragraph 
headings for Example (1) through Example (5).
    c. Adding Example 6 through Example 12.
    8. Adding paragraph (e).
    The additions and revisions read as follows:


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

    (a) * * * In determining whether a transaction qualifies as a 
reorganization under section 368(a), the transaction must be evaluated 
under relevant provisions of law, including the step transaction 
doctrine. But see Secs. 1.368-2 (f) and (k) and 1.338-2(c)(3). The 
preceding two sentences 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 binding on January 28, 1998, 
and at all times thereafter. * * *
    (b) * * * Requisite to a reorganization under the Internal Revenue 
Code are a continuity of the business enterprise through the issuing 
corporation under the modified corporate form as described in paragraph 
(d) of this

[[Page 4179]]

section, and (except as provided in section 368(a)(1)(D)) a continuity 
of interest as described in paragraph (e) of this section. (For rules 
regarding the continuity of interest requirement under section 355, see 
Sec. 1.355-2(c).) For purposes of this section, the term issuing 
corporation means the acquiring corporation (as that term is used in 
section 368(a)), except that, in determining whether a reorganization 
qualifies as a triangular reorganization (as defined in Sec. 1.358-
6(b)(2)), the issuing corporation means the corporation in control of 
the acquiring corporation. The preceding three sentences 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 binding on January 28, 1998, and at all times thereafter. * * 
*
* * * * *
    (d) Continuity of business enterprise--(1) General rule. Continuity 
of business enterprise (COBE) requires that the issuing corporation 
(P), as defined in paragraph (b) of this section, either continue the 
target corporation's (T's) historic business or use a significant 
portion of T's historic business assets in a business. The preceding 
sentence 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 binding on January 28, 1998, and at all 
times thereafter. * * *
* * * * *
    (4) Acquired assets or stock held by members of the qualified group 
or partnerships. The following rules apply in determining whether the 
COBE requirement of paragraph (d)(1) of this section is satisfied:
    (i) Businesses and assets of members of a qualified group. The 
issuing corporation is treated as holding all of the businesses and 
assets of all of the members of the qualified group, as defined in 
paragraph (d)(4)(ii) of this section.
    (ii) Qualified group. A qualified group is one or more chains of 
corporations connected through stock ownership with the issuing 
corporation, but only if the issuing corporation owns directly stock 
meeting the requirements of section 368(c) in at least one other 
corporation, and stock meeting the requirements of section 368(c) in 
each of the corporations (except the issuing corporation) is owned 
directly by one of the other corporations.
    (iii) Partnerships--(A) Partnership assets. Each partner of a 
partnership will be treated as owning the T business assets used in a 
business of the partnership in accordance with that partner's interest 
in the partnership.
    (B) Partnership businesses. The issuing corporation will be treated 
as conducting a business of a partnership if --
    (1) Members of the qualified group, in the aggregate, own an 
interest in the partnership representing a significant interest in that 
partnership business; or
    (2) One or more members of the qualified group have active and 
substantial management functions as a partner with respect to that 
partnership business.
    (C) Conduct of the historic T business in a partnership. If a 
significant historic T business is conducted in a partnership, the fact 
that P is treated as conducting such T business under paragraph 
(d)(4)(iii)(B) of this section tends to establish the requisite 
continuity, but is not alone sufficient.
    (iv) Effective date. This paragraph (d)(4) 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 binding 
on January 28, 1998, and at all times thereafter.
    (5) * * * All corporations have only one class of stock 
outstanding. The preceding sentence and paragraph (d)(5) Example 6 
through Example 12 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 binding on January 28, 1998, 
and at all times thereafter.
* * * * *
    Example 6. Use of a significant portion of T's historic business 
assets by the qualified group. (i) Facts. T operates an auto parts 
distributorship. P owns 80 percent of the stock of a holding company 
(HC). HC owns 80 percent of the stock of ten subsidiaries, S-1 
through S-10. S-1 through S-10 each separately operate a full 
service gas station. Pursuant to a plan of reorganization, T merges 
into P and the T shareholders receive solely P stock. As part of the 
plan of reorganization, P transfers T's assets to HC, which in turn 
transfers some of the T assets to each of the ten subsidiaries. No 
one subsidiary receives a significant portion of T's historic 
business assets. Each of the subsidiaries will use the T assets in 
the operation of its full service gas station. No P subsidiary will 
be an auto parts distributor.
    (ii) Continuity of business enterprise. Under paragraph 
(d)(4)(i) of this section, P is treated as conducting the ten gas 
station businesses of S-1 through S-10 and as holding the historic T 
assets used in those businesses. P is treated as holding all the 
assets and conducting the businesses of all of the members of the 
qualified group, which includes S-1 through S-10 (paragraphs 
(d)(4)(i) and (ii) of this section). No member of the qualified 
group continues T's historic distributorship business. However, 
subsidiaries S-1 through S-10 continue to use the historic T assets 
in a business. Even though no one corporation of the qualified group 
is using a significant portion of T's historic business assets in a 
business, the COBE requirement of paragraph (d)(1) of this section 
is satisfied because, in the aggregate, the qualified group is using 
a significant portion of T's historic business assets in a business.
    Example 7. Continuation of the historic T business in a 
partnership satisfies continuity of business enterprise. (i) Facts. 
T manufactures ski boots. P owns all of the stock of S-1. S-1 owns 
all of the stock of S-2, and S-2 owns all of the stock of S-3. T 
merges into P and the T shareholders receive consideration 
consisting of P stock and cash. The T ski boot business is to be 
continued and expanded. In anticipation of this expansion, P 
transfers all of the T assets to S-1, S-1 transfers all of the T 
assets to S-2, and S-2 transfers all of the T assets to S-3. S-3 and 
X (an unrelated party) form a new partnership (PRS). As part of the 
plan of reorganization, S-3 transfers all the T assets to PRS, and 
S-3, in its capacity as a partner, performs active and substantial 
management functions for the PRS ski boot business, including making 
significant business decisions and regularly participating in the 
overall supervision, direction, and control of the employees of the 
ski boot business. S-3 receives a 20 percent interest in PRS. X 
transfers cash in exchange for an 80 percent interest in PRS.
    (ii) Continuity of business enterprise. Under paragraph 
(d)(4)(iii)(B)(2) of this section, P is treated as conducting T's 
historic business because S-3 performs active and substantial 
management functions for the ski boot business in S-3's capacity as 
a partner. P is treated as holding all the assets and conducting the 
businesses of all of the members of the qualified group, which 
includes S-3 (paragraphs (d)(4)(i) and (ii) of this section). The 
COBE requirement of paragraph (d)(1) of this section is satisfied.
    Example 8. Continuation of the historic T business in a 
partnership does not satisfy continuity of business enterprise. (i) 
Facts. The facts are the same as Example 7 except that S-3 transfers 
the historic T business to PRS in exchange for a 1 percent interest 
in PRS.
    (ii) Continuity of business enterprise. Under paragraph 
(d)(4)(iii)(B)(2) of this section, P is treated as conducting T's 
historic business because S-3 performs active and substantial 
management functions for the ski boot business in S-3's capacity as 
a partner. The fact that a significant historic T business is 
conducted in PRS, and P is treated as conducting such T business 
under (d)(4)(iii)(B) tends to establish the requisite continuity, 
but is not alone sufficient (paragraph (d)(4)(iii)(C) of this 
section). The COBE requirement of paragraph (d)(1) of this section 
is not satisfied.
    Example 9. Continuation of the T historic business in a 
partnership satisfies continuity of business enterprise. (i) Facts. 
The facts are the same as Example 7 except that S-3 transfers the 
historic T business to PRS in

[[Page 4180]]

exchange for a 33\1/3\ percent interest in PRS, and no member of P's 
qualified group performs active and substantial management functions 
for the ski boot business operated in PRS.
    (ii) Continuity of business enterprise. Under paragraph 
(d)(4)(iii)(B)(1) of this section, P is treated as conducting T's 
historic business because S-3 owns an interest in the partnership 
representing a significant interest in that partnership business. P 
is treated as holding all the assets and conducting the businesses 
of all of the members of the qualified group, which includes S-3 
(paragraphs (d)(4)(i) and (ii) of this section). The COBE 
requirement of paragraph (d)(1) of this section is satisfied.
    Example 10. Use of T's historic business assets in a partnership 
business. (i) Facts. T is a fabric distributor. P owns all of the 
stock of S-1. T merges into P and the T shareholders receive solely 
P stock. S-1 and X (an unrelated party) own interests in a 
partnership (PRS). As part of the plan of reorganization, P 
transfers all of the T assets to S-1, and S-1 transfers all the T 
assets to PRS, increasing S-1's percentage interest in PRS from 5 to 
33\1/3\ percent. After the transfer, X owns the remaining 66\2/3\ 
percent interest in PRS. Almost all of the T assets consist of T's 
large inventory of fabric, which PRS uses to manufacture sportswear. 
All of the T assets are used in the sportswear business. No member 
of P's qualified group performs active and substantial management 
functions for the sportswear business operated in PRS.
    (ii) Continuity of business enterprise. Under paragraph 
(d)(4)(iii)(A) of this section, S-1 is treated as owning 33\1/3\ 
percent of the T assets used in the PRS sportswear manufacturing 
business. Under paragraph (d)(4)(iii)(B)(1) of this section, P is 
treated as conducting the sportswear manufacturing business because 
S-1 owns an interest in the partnership representing a significant 
interest in that partnership business. P is treated as holding all 
the assets and conducting the businesses of all of the members of 
the qualified group, which includes S-1 (paragraphs (d)(4)(i) and 
(ii) of this section). The COBE requirement of paragraph (d)(1) of 
this section is satisfied.
    Example 11. Aggregation of partnership interests among members 
of the qualified group: use of T's historic business assets in a 
partnership business. (i) Facts. The facts are the same as Example 
10, except that S-1 transfers all the T assets to PRS, and P and X 
each transfer cash to PRS in exchange for partnership interests. 
After the transfers, P owns 11 percent, S-1 owns 22\1/3\ percent, 
and X owns 66\2/3\ percent of PRS.
    (ii) Continuity of business enterprise. Under paragraph 
(d)(4)(iii)(B)(1) of this section, P is treated as conducting the 
sportswear manufacturing business because members of the qualified 
group, in the aggregate, own an interest in the partnership 
representing a significant interest in that business. P is treated 
as owning 11 percent of the assets directly, and S-1 is treated as 
owning 22\1/3\ percent of the assets, used in the PRS sportswear 
business (paragraph (d)(4)(iii)(A) of this section). P is treated as 
holding all the assets of all of the members of the qualified group, 
which includes S-1, and thus in the aggregate, P is treated as 
owning 33\1/3\ of the T assets (paragraphs (d)(4)(i) and (ii) of 
this section). The COBE requirement of paragraph (d)(1) of this 
section is satisfied because P is treated as using a significant 
portion of T's historic business assets in its sportswear 
manufacturing business.
    Example 12. Tiered partnerships: use of T's historic business 
assets in a partnership business. (i) Facts. T owns and manages a 
commercial office building in state Z. Pursuant to a plan of 
reorganization, T merges into P, solely in exchange for P stock, 
which is distributed to the T shareholders. P transfers all of the T 
assets to a partnership, PRS-1, which owns and operates television 
stations nationwide. After the transfer, P owns a 50 percent 
interest in PRS-1. P does not have active and substantial management 
functions as a partner with respect to the PRS-1 business. X, not a 
member of P's qualified group, owns the remaining 50 percent 
interest in PRS-1. PRS-1, in an effort to expand its state Z 
television operation, enters into a joint venture with U, an 
unrelated party. As part of the plan of reorganization, PRS-1 
transfers all the T assets and its state Z television station to 
PRS-2, in exchange for a 75 percent partnership interest. U 
contributes cash to PRS-2 in exchange for a 25 percent partnership 
interest and oversees the management of the state Z television 
operation. PRS-1 does not actively and substantially manage PRS-2's 
business. PRS-2's state Z operations are moved into the acquired T 
office building. All of the assets that P acquired from T are used 
in PRS-2's business.
    (ii) Continuity of business enterprise. Under paragraph 
(d)(4)(iii)(A) of this section, PRS-1 is treated as owning 75 
percent of the T assets used in PRS-2's business. P, in turn, is 
treated as owning 50 percent of PRS-1's interest the T assets. Thus, 
P is treated as owning 37\1/2\ percent (50 percent x 75 percent) of 
the T assets used in the PRS-2 business. Under paragraph 
(d)(4)(iii)(B)(1) of this section, P is treated as conducting PRS-
2's business, the operation of the state Z television station, and 
under paragraph (d)(4)(iii)(A) of this section, P is treated as 
using 37\1/2\ percent of the historic T business assets in that 
business. The COBE requirement of paragraph (d)(1) of this section 
is satisfied because P is treated as using a significant portion of 
T's historic business assets in its television business.

    (e) Continuity of interest--(1) General rule. (i) The purpose of 
the continuity of interest requirement is to prevent transactions that 
resemble sales from qualifying for nonrecognition of gain or loss 
available to corporate reorganizations. Continuity of interest requires 
that in substance a substantial part of the value of the proprietary 
interests in the target corporation be preserved in the reorganization. 
A proprietary interest in the target corporation is preserved if, in a 
potential reorganization, it is exchanged for a proprietary interest in 
the issuing corporation (as defined in paragraph (b) of this section), 
it is exchanged by the acquiring corporation for a direct interest in 
the target corporation enterprise, or it otherwise continues as a 
proprietary interest in the target corporation. However, a proprietary 
interest in the target corporation is not preserved if, in connection 
with the potential reorganization, it is acquired by the issuing 
corporation for consideration other than stock of the issuing 
corporation, or stock of the issuing corporation furnished in exchange 
for a proprietary interest in the target corporation in the potential 
reorganization is redeemed. All facts and circumstances must be 
considered in determining whether, in substance, a proprietary interest 
in the target corporation is preserved. For purposes of the continuity 
of interest requirement, a mere disposition of stock of the target 
corporation prior to a potential reorganization to persons not related 
(as defined in paragraph (e)(3) of this section determined without 
regard to paragraph (e)(3)(i)(A) of this section) to the target 
corporation or to persons not related (as defined in paragraph (e)(3) 
of this section) to the issuing corporation is disregarded and a mere 
disposition of stock of the issuing corporation received in a potential 
reorganization to persons not related (as defined in paragraph (e)(3) 
of this section) to the issuing corporation is disregarded.
    (ii) [Reserved] For further guidance see Sec. 1.368-1T(e)(1)(ii)(A) 
and (B).
    (2) Related person acquisitions. (i) A proprietary interest in the 
target corporation is not preserved if, in connection with a potential 
reorganization, a person related (as defined in paragraph (e)(3) of 
this section) to the issuing corporation acquires, with consideration 
other than a proprietary interest in the issuing corporation, stock of 
the target corporation or stock of the issuing corporation furnished in 
exchange for a proprietary interest in the target corporation in the 
potential reorganization, except to the extent those persons who were 
the direct or indirect owners of the target corporation prior to the 
potential reorganization maintain a direct or indirect proprietary 
interest in the issuing corporation.
    (ii) [Reserved] For further guidance see Sec. 1.368-1T(e)(2)(ii).
    (3) Definition of related person--(i) In general. For purposes of 
this paragraph (e), two corporations are related persons if either--
    (A) The corporations are members of the same affiliated group as 
defined in

[[Page 4181]]

section 1504 (determined without regard to section 1504(b)); or
    (B) 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)).
    (ii) Special rules. The following rules apply solely for purposes 
of this paragraph (e)(3):
    (A) A corporation will be treated as related to another corporation 
if such relationship exists immediately before or immediately after the 
acquisition of the stock involved.
    (B) A corporation, other than the target corporation or a person 
related (as defined in paragraph (e)(3) of this section determined 
without regard to paragraph (e)(3)(i)(A) of this section) to the target 
corporation, will be treated as related to the issuing corporation if 
the relationship is created in connection with the potential 
reorganization.
    (4) Acquisitions by partnerships. For purposes of this paragraph 
(e), each partner of a partnership will be treated as owning or 
acquiring any stock owned or acquired, as the case may be, by the 
partnership in accordance with that partner's interest in the 
partnership. If a partner is treated as acquiring any stock by reason 
of the application of this paragraph (e)(4), the partner is also 
treated as having furnished its share of any consideration furnished by 
the partnership to acquire the stock in accordance with that partner's 
interest in the partnership.
    (5) Successors and predecessors. For purposes of this paragraph 
(e), any reference to the issuing corporation or the target corporation 
includes a reference to any successor or predecessor of such 
corporation, except that the target corporation is not treated as a 
predecessor of the issuing corporation and the issuing corporation is 
not treated as a successor of the target corporation.
    (6) Examples. For purposes of the examples in this paragraph 
(e)(6), P is the issuing corporation, T is the target corporation, S is 
a wholly owned subsidiary of P, all corporations have only one class of 
stock outstanding, A and B are individuals, PRS is a partnership, all 
reorganization requirements other than the continuity of interest 
requirement are satisfied, and the transaction is not otherwise subject 
to recharacterization. The following examples illustrate the 
application of this paragraph (e):

    Example 1. Sale of stock to third party. (i) Sale of issuing 
corporation stock after merger. A owns all of the stock of T. T 
merges into P. In the merger, A receives P stock having a fair 
market value of $50x and cash of $50x. Immediately after the merger, 
and pursuant to a preexisting binding contract, A sells all of the P 
stock received by A in the merger to B. Assume that there are no 
facts and circumstances indicating that the cash used by B to 
purchase A's P stock was in substance exchanged by P for T stock. 
Under paragraphs (e)(1) and (2) of this section, the sale to B is 
disregarded because B is not a person related to P within the 
meaning of paragraph (e)(3) of this section. Thus, the transaction 
satisfies the continuity of interest requirement because 50 percent 
of A's T stock was exchanged for P stock, preserving a substantial 
part of the value of the proprietary interest in T.
    (ii) Sale of target corporation stock before merger. The facts 
are the same as paragraph (i) of this Example 1, except that B buys 
A's T stock prior to the merger of T into P and then exchanges the T 
stock for P stock having a fair market value of $50x and cash of 
$50x. The sale by A is disregarded. The continuity of interest 
requirement is satisfied because B's T stock was exchanged for P 
stock, preserving a substantial part of the value of the proprietary 
interest in T.
    Example 2. Relationship created in connection with potential 
reorganization. A owns all of the stock of T. X, a corporation which 
owns 60 percent of the P stock and none of the T stock, buys A's T 
stock for cash prior to the merger of T into P. X exchanges the T 
stock solely for P stock in the merger which, when combined with X's 
prior ownership of P stock, constitutes 80 percent of the stock of 
P. X is a person related to P under paragraphs (e)(3)(i)(A) and 
(ii)(B) of this section, because X becomes affiliated with P in the 
merger. The continuity of interest requirement is not satisfied, 
because X acquired a proprietary interest in T 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) of 
this section.
    Example 3. Participation by issuing corporation in post-merger 
sale. A owns 80 percent of the T stock and none of the P stock, 
which is widely held. T merges into P. In the merger, A receives P 
stock. In addition, A obtains rights pursuant to an arrangement with 
P to have P register the P stock under the Securities Act of 1933, 
as amended. P registers A's stock, and A sells the stock shortly 
after the merger. No person who purchased the P stock from A is a 
person related to P within the meaning of paragraph (e)(3) of this 
section. Under paragraphs (e)(1) and (2) of this section, the sale 
of the P stock by A is disregarded because no person who purchased 
the P stock from A is a person related to P within the meaning of 
paragraph (e)(3) of this section. The transaction satisfies the 
continuity of interest requirement because A's T stock was exchanged 
for P stock, preserving a substantial part of the value of the 
proprietary interest in T.
    Example 4. Redemptions and purchases by issuing corporation or 
related persons. (i) Redemption by issuing corporation. A owns 100 
percent of the stock of T and none of the stock of P. T merges into 
S. In the merger, A receives P stock. In connection with the merger, 
P redeems all of the P stock received by A in the merger for cash. 
The continuity of interest requirement is not satisfied, because, in 
connection with the merger, P redeemed the stock exchanged for a 
proprietary interest in T, and a substantial part of the value of 
the proprietary interest in T is not preserved. See paragraph (e)(1) 
of this section.
    (ii) Purchase of target corporation stock by issuing 
corporation. The facts are the same as paragraph (i) of this Example 
4, except that, instead of P redeeming its stock, prior to and in 
connection with the merger of T into S, P purchases 90 percent of 
the T stock from A for cash. The continuity of interest requirement 
is not satisfied, because in connection with the merger, P acquired 
a proprietary interest in T 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)(1) of this section. However, see 
Sec. 1.338-2(c)(3) (which may change the result in this case by 
providing that, by virtue of section 338, continuity of interest is 
satisfied for certain parties after a qualified stock purchase).
    (iii) Purchase of issuing corporation stock by person related to 
issuing corporation. The facts are the same as paragraph (i) of this 
Example 4, except that, instead of P redeeming its stock, S buys all 
of the P stock received by A in the merger for cash. S is a person 
related to P under paragraphs (e)(3)(i)(A) and (B) of this section. 
The continuity of interest requirement is not satisfied, because S 
acquired P stock issued in the merger, and a substantial part of the 
value of the proprietary interest in T is not preserved. See 
paragraph (e)(2) of this section.
    Example 5. Redemption in substance by issuing corporation. A 
owns 100 percent of the stock of T and none of the stock of P. T 
merges into P. In the merger, A receives P stock. In connection with 
the merger, B buys all of the P stock received by A in the merger 
for cash. Shortly thereafter, in connection with the merger, P 
redeems the stock held by B for cash. Based on all the facts and 
circumstances, P in substance has exchanged solely cash for T stock 
in the merger. The continuity of interest requirement is not 
satisfied, because in substance P redeemed the stock exchanged for a 
proprietary interest in T, and a substantial part of the value of 
the proprietary interest in T is not preserved. See paragraph (e)(1) 
of this section.
    Example 6. Purchase of issuing corporation stock through 
partnership. A owns 100 percent of the stock of T and none of the 
stock of P. S is an 85 percent partner in PRS. The other 15 percent 
of PRS is owned by unrelated persons. T merges into P. In the 
merger, A receives P stock. In connection with the merger, PRS 
purchases all of the P stock received by A in the merger for cash. 
Under paragraph (e)(4) of this section, S, as an 85 percent partner 
of PRS, is treated as having acquired 85 percent of the P stock 
exchanged for A's T stock in the merger, and as having furnished 85 
percent of the cash paid by PRS to acquire the P stock. S is a 
person related to P under paragraphs

[[Page 4182]]

(e)(3)(i)(A) and (B) of this section. The continuity of interest 
requirement is not satisfied, because S is treated as acquiring 85 
percent of the P stock issued in the merger, and a substantial part 
of the value of the proprietary interest in T is not preserved. See 
paragraph (e)(2) of this section.
    Example 7. Exchange by acquiring corporation for direct 
interest. A owns 30 percent of the stock of T. P owns 70 percent of 
the stock of T, which was not acquired by P in connection with the 
acquisition of T's assets. T merges into P. A receives cash in the 
merger. The continuity of interest requirement is satisfied, because 
P's 70 percent proprietary interest in T is exchanged by P for a 
direct interest in the assets of the target corporation enterprise.
    Example 8. Effect of general stock repurchase program. T merges 
into P, a corporation whose stock is widely held and publicly traded 
and that has one class of common stock outstanding. In the merger, T 
shareholders receive common stock of P. Immediately after the 
merger, P repurchases a small percentage of its common stock in the 
open market as part of its ongoing stock repurchase program. The 
repurchase program was not created or modified in connection with 
the acquisition of T. Continuity of interest is satisfied, because 
based on all of the facts and circumstances, the redemption of a 
small percentage of the P stock does not affect the T shareholders' 
proprietary interest in T, because it was not in connection with the 
merger, and the value of the proprietary interest in T is preserved. 
See paragraph (e)(1) of this section.
    Example 9. Maintenance of direct or indirect interest in issuing 
corporation. X, a corporation, owns all of the stock of each of 
corporations P and Z. Z owns all of the stock of T. T merges into P. 
Z receives P stock in the merger. Immediately thereafter and in 
connection with the merger, Z distributes the P stock received in 
the merger to X. X is a person related to P under paragraph 
(e)(3)(i)(A) of this section. The continuity of interest requirement 
is satisfied, because X was an indirect owner of T prior to the 
merger who maintains a direct or indirect proprietary interest in P, 
preserving a substantial part of the value of the proprietary 
interest in T. See paragraph (e)(2) of this section.

    (7) Effective date. This paragraph (e) 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 binding 
on January 28, 1998, and at all times thereafter.
    Par. 4. Section 1.368-2 is amended by:
    1. Removing the second sentence of paragraph (a) and adding two 
sentences in its place.
    2. Removing the second sentence of paragraph (f) and adding four 
sentences in its place.
    3. Removing the second sentence in paragraph (j)(1).
    4. Revising paragraph (j)(3)(ii).
    5. Revising the first sentence in paragraph (j)(3)(iii).
    6. Adding paragraph (j)(3)(iv).
    7. Removing paragraph (j)(4).
    8. Redesignating paragraphs (j)(5), (j)(6), and (j)(7) as (j)(4), 
(j)(5), and (j)(6), respectively.
    9. Removing the parentheses around the numbers in the paragraph 
headings for Example (1) through Example (9) in newly designated 
paragraph (j)(6).
    10. Adding paragraph (k).
    The additions and revisions 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 January 28, 1998, 
except that it does not apply to any transaction occurring pursuant to 
a written agreement which is binding on January 28, 1998, and at all 
times thereafter. * * *
* * * * *
    (f) * * * If a transaction otherwise qualifies as a reorganization, 
a corporation remains a party to the reorganization even though stock 
or assets acquired in the reorganization are transferred in a 
transaction described in paragraph (k) of this section. If a 
transaction otherwise qualifies as a reorganization, a corporation 
shall not cease to be a party to the reorganization solely by reason of 
the fact that part or all of the assets acquired in the reorganization 
are transferred to a partnership in which the transferor is a partner 
if the continuity of business enterprise requirement is satisfied. See 
Sec. 1.368-1(d). The preceding three sentences 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 binding 
on January 28, 1998, and at all times thereafter. * * *
* * * * *
    (j) * * *
    (3) * * *
    (ii) Except as provided in paragraph (k)(2) of this section, the 
controlling corporation must control the surviving corporation 
immediately after the transaction.
    (iii) After the transaction, except as provided in paragraph (k)(2) 
of this section, the surviving corporation must hold substantially all 
of its own properties and substantially all of the properties of the 
merged corporation (other than stock of the controlling corporation 
distributed in the transaction). * * *
    (iv) Paragraphs (j)(3)(ii) and (iii) of this section 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 binding on January 28, 1998, and at all times thereafter.
* * * * *
    (k) Transfer of assets or stock in section 368(a)(1)(A), (B), (C), 
or (G) reorganizations--(1) General rule for transfers to controlled 
corporations. Except as otherwise provided in this section, a 
transaction otherwise qualifying under section 368(a)(1)(A), (B), (C), 
or (G) (where the requirements of sections 354(b)(1)(A) and (B) are 
met) shall not be disqualified by reason of the fact that part or all 
of the acquired assets or stock acquired in the transaction are 
transferred or successively transferred to one or more corporations 
controlled in each transfer by the transferor corporation. Control is 
defined under section 368(c).
    (2) Transfers following a reverse triangular merger. A transaction 
qualifying under section 368(a)(1)(A) by reason of the application of 
section 368(a)(2)(E) is not disqualified by reason of the fact that 
part or all of the stock of the surviving corporation is transferred or 
successively transferred to one or more corporations controlled in each 
transfer by the transferor corporation, or because part or all of the 
assets of the surviving corporation or the merged corporation are 
transferred or successively transferred to one or more corporations 
controlled in each transfer by the transferor corporation.
    (3) Examples. The following examples illustrate the application of 
this paragraph (k). P is the issuing corporation and T is the target 
corporation. P has only one class of stock outstanding. The examples 
are as follows:

    Example 1. Transfers of acquired assets to controlled 
corporations. (i) Facts. T operates a bakery which supplies 
delectable pastries and cookies to local retail stores. The 
acquiring corporate group produces a variety of baked goods for 
nationwide distribution. P owns 80 percent of the stock of S-1. 
Pursuant to a plan of reorganization, T transfers all of its assets 
to S-1 solely in exchange for P stock, which T distributes to its 
shareholders. S-1 owns 80 percent of the stock of S-2; S-2 owns 80 
percent of the stock of S-3, which also makes and supplies pastries 
and cookies. Pursuant to the plan of reorganization, S-1 transfers 
the T assets to S-2; S-2 transfers the T assets to S-3.
    (ii) Analysis. Under this paragraph (k), the transaction, 
otherwise qualifying as a reorganization under section 368(a)(1)(C), 
is not disqualified by reason of the fact of the successive 
transfers of all of the acquired assets from S-1 to S-2, and from S-
2 to S-3 because in each transfer, the transferee corporation is 
controlled by the transferor

[[Page 4183]]

corporation. Control is defined under section 368(c).
    Example 2. Transfers of acquired stock to controlled 
corporations. (i) Facts. The facts are the same as Example 1 except 
that S-1 acquires all of the T stock rather than the T assets, and 
as part of the plan of reorganization, S-1 transfers all of the T 
stock to S-2, and S-2 transfers all of the T stock to S-3.
    (ii) Analysis. Under this paragraph (k), the transaction, 
otherwise qualifying as a reorganization under section 368(a)(1)(B), 
is not disqualified by reason of the fact of the successive 
transfers of all of the acquired stock from S-1 to S-2, and from S-2 
to S-3 because in each transfer, the transferee corporation is 
controlled by the transferor corporation.
    Example 3. Transfers of acquired stock to partnerships. (i) 
Facts. The facts are the same as in Example 2. However, as part of 
the plan of reorganization, S-2 and S-3 form a new partnership, PRS. 
Immediately thereafter, S-3 transfers all of the T stock to PRS in 
exchange for an 80 percent partnership interest, and S-2 transfers 
cash to PRS in exchange for a 20 percent partnership interest.
    (ii) Analysis. This paragraph (k) describes the successive 
transfer of the T stock to S-3, but does not describe S-3's transfer 
of the T stock to PRS. Therefore, the characterization of this 
transaction must be determined under the relevant provisions of law, 
including the step transaction doctrine. See Sec. 1.368-1(a). The 
transaction fails to meet the control requirement of a 
reorganization described in section 368(a)(1)(B) because immediately 
after the acquisition of the T stock, the acquiring corporation does 
not have control of T.

    (4) This paragraph (k) 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 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. 98-1819 Filed 1-23-98; 12:15 pm]
BILLING CODE 4830-01-U