[Federal Register Volume 65, Number 170 (Thursday, August 31, 2000)]
[Rules and Regulations]
[Pages 52909-52912]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-22075]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8898]
RIN 1545-AV81


Continuity of Interest

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations providing guidance 
regarding the continuity of interest requirement for corporate 
reorganizations. The final regulations affect corporations and their 
shareholders. The final regulations provide that distributions and 
redemptions by a target corporation prior to a potential reorganization 
are taken into account for continuity of interest purposes to the 
extent that the consideration received by the target shareholder in the 
redemption or distribution is treated as other property or money under 
section 356 of the Internal Revenue Code, or to the extent that the 
consideration would be treated as other property or money if the target 
shareholder also had received stock of the issuing corporation in 
exchange for stock owned by the shareholder in the target corporation.

DATES: Effective Dates: These regulations are effective August 30, 
2000.
    Applicability Dates: For dates of applicability of these 
regulations, see the ``Effective Dates'' portion of the Supplementary 
Information of the preamble.

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

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information in these final regulations has been 
reviewed and, pending receipt and evaluation of public comments, 
approved by the Office of Management and Budget (OMB) under 44 U.S.C. 
3507 and assigned control number 1545-1691.
    The collection of information in these regulations is in 
Sec. 1.368-1(e)(7). The information is a private letter ruling request 
to apply the final regulations to a transaction in which a taxpayer has 
entered into a binding agreement on or after January 28, 1998 (the 
effective date of Sec. 1.368-1T), and before the effective date of the 
final regulations. This information will be used to ensure that all 
parties to the transaction take consistent positions for Federal tax 
purposes. The collection of information is elective. If Sec. 1.368-1T 
would apply to a transaction, but the taxpayer would prefer to apply 
the final regulations, the taxpayer may elect to submit the 
information. The likely respondents are businesses or other for-profit 
institutions.
    Comments concerning the collection of information should be sent to 
the Office of Management and Budget, Attn: Desk Officer for the 
Department of Treasury, Office of Information and Regulatory Affairs, 
Washington, DC 20503, with copies to the Internal Revenue Service, 
Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC 20224. 
Any such comments should be submitted not later than October 30, 2000.
    Comments are specifically requested concerning:
    (a) Whether the collection of information is necessary for the 
proper performance of the functioning of the Internal Revenue Service, 
including whether the information will have practical utility;
    (b) The accuracy of the estimated burden associated with the 
collection of information (see below);
    (c) How the quality, utility, and clarity of the information 
requested may be enhanced;
    (d) How the burden of complying with the collection of information 
may be minimized, including through the application of automated 
collection techniques or other forms of information technology; and
    (e) Estimates of capital or start-up costs, and costs of operation, 
maintenance, and purchase of services to provide information. Estimated 
total annual reporting burden: 1,500 hours. The annual burden per 
respondent

[[Page 52910]]

varies from 50 to 200 hours, depending on individual circumstances, 
with an estimated average of 150 hours. Estimated number of 
respondents: 10. Estimated frequency of responses: Once.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the OMB.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    On January 28, 1998, the Treasury Department and IRS published 
final regulations on the continuity of interest (COI) requirement for 
potential corporate reorganizations, which permitted former target 
corporation (T) shareholders to sell stock in the issuing corporation 
(P) without causing the potential reorganization to fail to satisfy the 
COI requirement (63 FR 4174). Additionally, the IRS and Treasury 
Department published temporary and proposed regulations (the Temporary 
Regulations) in the Federal Register at 63 FR 4183 and 63 FR 4204, 
respectively, relating to redemptions of, and extraordinary 
distributions on, T stock prior to certain otherwise qualifying 
reorganizations.
    The Treasury Department and IRS received written comments in 
response to the proposed regulations. A public hearing on the proposed 
regulations was held on May 26, 1998. After consideration of all 
comments, Sec. 1.368-1T, published at 63 FR 4183, is removed. Section 
1.368-1(e) is amended by this Treasury decision.

Explanation of Provisions

    The Internal Revenue Code provides general nonrecognition treatment 
for reorganization transactions specifically described in section 368. 
In addition to complying with the statutory requirements and certain 
other requirements, a transaction generally must satisfy the COI 
requirement. The purpose of the COI requirement is to prevent 
transactions that resemble sales from qualifying for nonrecognition of 
gain or loss available to corporate reorganizations. COI requires that 
in substance a substantial part of the value of the proprietary 
interests in T be preserved in the reorganization. These final 
regulations address the effect on COI of prereorganization redemptions 
and distributions.

The Temporary Regulations

    The Temporary Regulations provide that a proprietary interest in T 
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.
    Several commentators argued that the Temporary Regulations are 
overly broad. Some suggested that the scope of the COI requirement 
should closely parallel the law regarding the ``solely for voting 
stock'' requirement for reorganizations under Sec. 368(a)(1)(B) and 
(C), because both the solely for voting stock requirement and the COI 
requirement arose out of similar concerns, i.e., to prevent 
transactions that resemble sales from qualifying for nonrecognition 
treatment available to corporate reorganizations. These commentators 
maintain that, similar to the solely for voting stock rule, 
prereorganization redemptions and extraordinary distributions by T 
should not be taken into account for COI purposes unless P directly or 
indirectly furnishes the consideration for the redemption or 
distribution. A rule that goes beyond this, they argue, converts the 
COI requirement into an asset continuity test, and thus overlaps with 
the continuity of business enterprise requirement (COBE) and the 
``substantially all the assets'' requirement for certain 
reorganizations.
    In addition, one commentator maintained that the Temporary 
Regulations provide inconsistent results by treating extraordinary 
distributions taxed as dividends under section 301 as the equivalent of 
sales proceeds for purposes of COI.
    Other commentators expressed concern that certain types of 
taxpayers, such as S corporations, are inappropriately adversely 
affected by the approach of the Temporary Regulations. The commentators 
noted that when an S corporation merges into a C corporation, it is 
common for the S corporation, in advance of the reorganization, to make 
distributions in the amount of its accumulated adjustments account 
(AAA). If large enough, such distributions may cause the potential 
reorganization to fail to qualify for tax-free treatment because the 
COI requirement is not satisfied under the Temporary Regulations. These 
commentators believe that this application of the COI rules in the 
Temporary Regulations to S corporation reorganizations is inconsistent 
with section 1371, which generally provides that subchapter C applies 
to an S corporation, except to the extent inconsistent with subchapter 
S, because the practice of making prereorganization AAA distributions 
makes it more difficult for S corporations than for C corporations to 
qualify for reorganization treatment. Similar concerns arise when a 
controlled foreign corporation (CFC) distributes income from its 
previously taxed income account with respect to its subpart F income 
(see section 959). Another commentator suggested that distributions 
made by a C corporation immediately prior to a merger with a Regulated 
Investment Company (RIC) or Real Estate Investment Trust (REIT) should 
not be treated as extraordinary distributions. Under Secs. 1.852-12 
(for RICs) and 1.857-11 (for REITs), a C corporation that merges into a 
RIC or REIT must distribute all non-RIC or non-REIT earnings and 
profits before the end of the RIC's or REIT's first taxable year. 
Consequently, a C corporation typically will distribute such earnings 
and profits prior to a merger with a RIC or REIT.
    After considering these comments, the purpose of the COI 
requirement, and the other existing protections that prevent 
transactions that resemble sales from qualifying for nonrecognition of 
gain or loss available to corporate reorganizations, the Treasury 
Department and IRS have concluded that the approach of the final 
regulations best reflects the purpose of the COI requirement. The 
regulations provide that a proprietary interest in T (other than one 
held by P) is not preserved to the extent that consideration received 
prior to a potential reorganization, either in a redemption of T stock 
or in a distribution with respect to T stock, is treated as other 
property or money received in the exchange for purposes of section 356 
or would be so treated if the T shareholder also had received stock of 
P in exchange for stock owned by the shareholder in T. In determining 
whether consideration is treated as other property or money under 
section 356 received in an exchange for a proprietary interest in T, 
taxpayers should consider all facts, circumstances, and relevant legal 
authorities.
    The regulations posit for COI purposes that each T shareholder 
receives some P stock in exchange for T stock. Section 356 generally 
does not apply to a T shareholder who does not receive any P stock in 
exchange for T stock in a reorganization. See Rev. Rul. 74-515 (1974-2 
C.B. 118). Solely for purposes of determining whether the COI 
requirement is satisfied, however, the regulations deem each T 
shareholder to have received some P stock in

[[Page 52911]]

exchange for T stock (without ascribing any value to that stock). The 
regulations thus use the same criterion for determining whether COI is 
satisfied, regardless of whether a T shareholder receives any P stock. 
These final regulations do not offer safe harbors or special rules for 
the transactions about which commentators expressed concern. Unlike the 
temporary regulations, however, the final regulations do not 
automatically take all prereorganization redemptions and extraordinary 
distributions in connection with the reorganization into account for 
COI purposes.

Stock Repurchase Programs

    Example 8 of Sec. 1.368-1(e)(6) illustrates the effect on COI of a 
general stock repurchase program. In the example, P repurchases a small 
percentage of its stock after a reorganization, as part of a 
preexisting stock repurchase program. COI is satisfied because the 
redemption of a small percentage of P stock was not in connection with 
the merger. In response to comments received, the IRS and Treasury 
Department issued further guidance on the effect of a stock repurchase 
program on COI in Rev. Rul. 99-58 (1999-52 I.R.B. 701). Because Example 
8 suggests a more restrictive approach to COI than was intended in this 
context, Example 8 is removed by this Treasury decision.

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.

Effect on Other Documents

    The following publications do not apply to the extent they are 
inconsistent with these regulations:

Rev. Proc. 77-37 (1977-2 C.B. 568)
Rev. Proc. 86-42 (1986-2 C.B. 722)

Effective Dates

    These regulations apply to transactions occurring after August 30, 
2000, unless the transaction occurs pursuant to a written agreement 
that is (subject to customary conditions) binding on that date and at 
all times thereafter. Taxpayers who entered into a binding agreement on 
or after January 28, 1998 (the date that the temporary and proposed 
regulations were filed with the Federal Register), and before August 
30, 2000, may request a private letter ruling permitting them to apply 
the final regulations to their transaction. A private letter ruling 
will not be issued unless the taxpayer establishes to the satisfaction 
of the IRS that there is not a significant risk of different parties to 
the transaction taking inconsistent positions, for U.S. tax purposes, 
with respect to the applicability of the final regulations to the 
transaction.

Special Analyses

    It has been determined that these regulations are not a significant 
regulatory action as defined in Executive Order 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 final regulations. It is hereby certified that 
the collection of information in these regulations will not have a 
significant economic impact on a substantial number of small entities. 
This certification is based on the fact that while the burden of making 
this collection of information may be significant when applicable, 
taxpayers will have to make this collection of information only if they 
are corporations or shareholders of corporations who are parties to a 
purported reorganization in which COI would not be preserved under the 
Temporary regulations. The IRS estimates that the number of taxpayers 
who will need to make this collection of information will be 10 or 
fewer. Therefore, a Regulatory Flexibility Analysis under the 
Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. 
Pursuant to section 7805(f) of the Code, these final regulations will 
be 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 these regulations is Marie Byrne of the 
Office of the Associate Chief Counsel (Corporate), IRS. However, other 
personnel from the IRS and Treasury Department participated in their 
development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.368-1 is amended by:
    1. Revising paragraph (e)(1)(ii).
    2. Removing paragraph (e)(2)(ii).
    3. Removing the paragraph designation (e)(2)(i).
    4. Removing Example 8 of paragraph (e)(6).
    5. Redesignating Example 9 of paragraph (e)(6) as Example 8.
    6. Adding new Example 9 to paragraph (e)(6).
    7. Adding three sentences to the end of paragraph (e)(7).
    The additions and revision read as follows:


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

* * * * *
    (e) * * * (1) * * *
    (ii) For purposes of paragraph (e)(1)(i) of this section, a 
proprietary interest in the target corporation (other than one held by 
the acquiring corporation) is not preserved to the extent that 
consideration received prior to a potential reorganization, either in a 
redemption of the target corporation stock or in a distribution with 
respect to the target corporation stock, is treated as other property 
or money received in the exchange for purposes of section 356, or would 
be so treated if the target shareholder also had received stock of the 
issuing corporation in exchange for stock owned by the shareholder in 
the target corporation.
* * * * *
    (6) * * *
    Example 9. Preacquisition redemption by target corporation. T 
has two shareholders, A and B. P expresses an interest in acquiring 
the stock of T. A does not wish to own P stock. T redeems A's shares 
in T in exchange for cash. No funds have been or will be provided by 
P for this purpose. P subsequently acquires all the outstanding 
stock of T from B solely in exchange for voting stock of P. The cash 
received by A in the prereorganization redemption is not treated as 
other property or money under section 356, and would not be so 
treated even if A had received some stock of P in exchange for his T 
stock. The prereorganization redemption by T does not affect 
continuity of interest, because B's proprietary interest in T is 
unaffected, and the value of the proprietary interest in T is 
preserved.

[[Page 52912]]

    (7) * * * Paragraph (e)(1)(ii) of this section, however, applies to 
transactions occurring after August 30, 2000, unless the transaction 
occurs pursuant to a written agreement that is (subject to customary 
conditions) binding on that date and at all times thereafter. Taxpayers 
who entered into a binding agreement on or after January 28, 1998, and 
before August 30, 2000, may request a private letter ruling permitting 
them to apply the final regulation to their transaction. A private 
letter ruling will not be issued unless the taxpayer establishes to the 
satisfaction of the IRS that there is not a significant risk of 
different parties to the transaction taking inconsistent positions, for 
Federal tax purposes, with respect to the applicability of the final 
regulations to the transaction.


Sec. 1.368-1T  [Removed]

    Par. 3. Section 1.368-1T is removed.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

    Par. 4. Section Sec. 602.101, paragraph (b) is amended by adding an 
entry to the table in numerical order to read as follows:


Sec. 602.101  OMB Control numbers.

* * * * *
    (b) * * *

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                                                             Current OMB
     CFR part or section where identified or described       control No.
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                  *        *        *        *        *
1.368-1...................................................     1545-1691
 
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Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

    Approved: August 23, 2000.
Jonathan Talisman,
Acting Assistant Secretary of the Treasury.
[FR Doc. 00-22075 Filed 8-30-00; 8:45 am]
BILLING CODE 4830-01-P