[Federal Register Volume 63, Number 184 (Wednesday, September 23, 1998)]
[Rules and Regulations]
[Pages 50757-50759]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-25444]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8783]
RIN 1545-AW45


Continuity of Interest Requirement for Corporate Reorganizations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Amendment to final regulations.

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[[Page 50758]]

SUMMARY: This document amends final regulations providing guidance 
regarding satisfaction of the continuity of interest requirement for 
corporate reorganizations. The amendment to the final regulations 
affects corporations and their shareholders. This amendment to the 
final regulations is necessary to provide clarification regarding an 
example illustrating the relationship created in connection with 
potential reorganization.

DATES: Effective date: This amendment is effective September 23, 1998.
    Applicability date: This amendment 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.

FOR FURTHER INFORMATION CONTACT: Phoebe Bennett, (202) 622-7750 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    On January 28, 1998, the IRS published final regulations (REG-
252231-96) in the Federal Register (63 FR 4174) relating to the 
continuity of interest (COI) requirement.

Explanation of Provisions

    The final COI regulation provides that acquisitions of target (T) 
stock for cash by a corporation related to the issuing corporation (P) 
generally do not preserve continuity of interest. See Sec. 1.368-
1(e)(2). Two corporations are related if they are members of the same 
affiliated group as defined in section 1504, or if a purchase of P 
stock by another corporation would be treated as a distribution in 
redemption of P stock under section 304(a)(2). See Sec. 1.368-1(e)(3). 
A corporation will be treated as related to another corporation if such 
relationship exists immediately before or immediately after the 
acquisition of T stock, or if the relationship is created in connection 
with the potential reorganization. See Sec. 1.368-1(e)(3)(ii). Thus, a 
purchase by a corporation that was not initially related to P, but 
purchased T stock and became related to P in the potential 
reorganization, would not preserve continuity to the extent of the 
purchase.
    Section 1.368-1(e)(6), Example 2 was intended to illustrate this 
principle. In the example, 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 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. The example shows that X is related to P because X becomes 
affiliated with P in the merger.
    Section 1.338-2(c)(3) provides that, by virtue of section 338, COI 
is satisfied for certain persons if, following a qualified stock 
purchase (QSP) of T by the purchasing corporation, the purchasing 
corporation or a member of the purchasing corporation s affiliated 
group acquired the T assets. Commentators have questioned whether 
Sec. 1.338-2(c)(3) applies to the transaction described in Example 2. 
It is not intended that these final regulations provide guidance under 
section 338. To avoid any such implication, Example 2 is amended so 
that X's acquisition of A's T stock is not a QSP.
    In addition, the amendment to the final regulation illustrates the 
proper application of the related party rule that treats two 
corporations as related if a purchase of P stock by another corporation 
would be treated as a distribution in redemption of P stock under 
section 304(a)(2). See Sec. 1.368-1(e)(3)(i). Commentators have 
questioned why, in Example 2, X is not already related to P under the 
section 304(a)(2) rule even before the merger, because X owned more 
than 50 percent of the P stock. Section 304(a)(2) requires that the 
issuing corporation control the acquiring corporation (within the 
meaning of section 304(c)). In Example 2, P is the issuing corporation 
and X is the acquiring corporation. X is not related to P under section 
304(a)(2) because P does not control X; instead, X controls P. A 
sentence is added to Example 2 to illustrate this point.

Applicability Date

    The amendment to these final regulations 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.

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 these regulations do 
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 author of this amendment to the final 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 its 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. In Sec. 1.368-1, paragraph (e)(6) Example 2 is revised to 
read as follows:


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

* * * * *
    (e) * * *
    (6) * * *

    Example 2. Relationship created in connection with potential 
reorganization. Corporation X owns 60 percent of the stock of P and 
30 percent of the stock of T. A owns the remaining 70 percent of the 
stock of T. X buys A s T stock for cash in a transaction which is 
not a qualified stock purchase within the meaning of section 338. T 
then merges into P. In the merger, X exchanges all of its T stock 
for additional stock of P. As a result of the issuance of the 
additional stock to X in the merger, X s ownership interest in P 
increases from 60 to 80 percent of the stock of P. X is not a person 
related to P under paragraph (e)(3)(i)(B) of this section, because a 
purchase of stock of P by X would not be treated as a distribution 
in redemption of the stock of P under section 304(a)(2). However, 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

[[Page 50759]]

the proprietary interest in T is not preserved. See paragraph (e)(2) 
of this section.
* * * * *
Michael P. Dolan,
Deputy Commissioner of Internal Revenue.

    Approved: September 14, 1998.
Donald C. Lubick,
Assistant Secretary of the Treasury.
[FR Doc. 98-25444 Filed 9-22-98; 8:45 am]
BILLING CODE 4830-01-U