IRS Finalizes COI Regs.

Effective Aug. 31, 2000, the Service issued final regulations (TD 8898) on the effect of pre-reorganization transactions on the continuity-of-interest (COI) requirement for corporate reorganizations. The regulations finalize the proposed and temporary regulations published on Jan. 28, 1998 (TD 8761).

Background

Under the temporary regulations, a proprietary interest in a target was not preserved if the interest were redeemed or an extraordinary distribution made on target stock prior to (and in connection with) a potential reorganization. Under this rule, continuity is adversely affected by pre-acquisition distributions made when (1) a regulated investment company (RIC) or real estate investment trust (REIT) acquires a corporation (which must distribute all non-RIC or non-REIT earnings and profits), (2) a C corporation acquires an S corporation (which commonly distributes its accumulated adjustments account (AAA)) or 0) there is an acquisition of a controlled foreign corporation (which commonly distributes its previously taxed income account on its subpart F income).

Commentators argued that the temporary regulations were too broad and should instead have been based on the "solely for voting stock" requirement: Pre-reorganization redemptions and extraordinary distributions by a target should not be taken into account for COI purposes, unless an acquiring corporation directly or indirectly furnishes the consideration for the redemption or distribution.

Sec. 356 Rule

The final regulations replace the temporary regulations' "in connection with" language with a Sec. 356 test, providing that a proprietary interest in a target is not preserved to the extent that consideration received before a reorganization in a redemption of (or distribution on) the target stock is treated as other property or money under Sec. 356 (or would be so treated if the target shareholder had also received acquiring stock in exchange for target stock). The fiction is necessary because Sec. 356 generally does not apply to a target shareholder unless he receives acquiring stock; see Rev. Rul. 74-515. To determine whether the COI requirement is satisfied, each target shareholder is treated as receiving some acquiring stock solely for purposes of applying the Sec. 356 COI test, but apparently not for any other purpose.

Unfortunately, Sec. 356 is somewhat unclear, which will make the Sec. 356 test of the final regulations difficult to apply with certainty for pre-reorganization redemptions or distributions. The final regulations do not elaborate on applying the test, other than to say, in the preamble, "taxpayers should consider all facts, circumstances, and relevant legal authorities."

The example illustrating the Sec. 356 rule provides that T has two shareholders, A and B. P wishes to acquire T stock. 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 T stock from B, solely in exchange for P voting stock. The cash received by A in the pre-reorganization redemption is not treated as other property or money under Sec. 356, and would not be so treated even if A had received some P stock in exchange for his T stock. The example concludes that the pre-reorganization redemption by T does not affect COI, because B's proprietary interest in T is unaffected and the value of the proprietary interest in T is preserved.

In a stock acquisition context, the solely-for-voting-stock authorities (such as Rev. Ruls. 75-360, 68-285 and 55-440 and McDonald, 52 TC 82 (1969)), are helpful in applying the Sec. 356 test. Care should be taken to ensure that the acquiring corporation does not indirectly provide the consideration provided by the target to redeem target stock or make distributions on it; see Waterman S.S. Corp., 430 F2d 1185 (5th Cir. 1970). In the asset acquisition context, the law is unclear; see Rev. Rul. 71-364, in which the distribution by a target of excess cash not needed to satisfy liabilities was part of a Sec. 356 exchange that did not violate the solely-for-voting-stock requirement for a C reorganization.

For Sec. 368(a)(2)(E) and other Sec. 368 reorganizations with a "substantially all" requirement, significant target stock redemptions would presumably violate the "substantially all" requirement.

Notably, however, the continuity-of-business enterprise (COBE) requirement applies to Sec. 368 reorganizations; see Rev. Rul. 81-92, applying the COBE requirement to B reorganizations, but also Rev. Rul. 82-34, holding that the COBE requirement did not apply to E recapitalizations. As a result, the COBE requirement must be taken into account in determining the size of the redemption and the nature of the assets distributed. Nonetheless, corporations may obtain loan proceeds to partially fund redemptions without violating the COBE requirement.

Moreover, as stated in the asset acquisition context, the application of the Sec. 356 test is somewhat unclear. However, certain factual situations indicate that the new regulations arguably reach interesting results in the context of B reorganizations.

Example: T is wholly owned by individual A, who wishes to receive substantial property from T prior to P's acquisition of T. If T is able to redeem 75% of A's stock prior to P's acquisition of the remaining 25% of the T stock, the final regulation appears to provide that the COI requirement for P's acquisition will be satisfied.

P's acquisition could qualify under Sec. 368 as a B reorganization. Arguably, A should have capital gain on the 75% redemption under Sec. 302(a) and (b)(2) if A's resulting interest in P is less than 50% (when the majority of the P stock is owned by persons unrelated to A). Sale treatment for A is based on Zenz v. Quinlivan, 213 F2d 914 (6th Cir. 1954) and Rev. Rul. 75-447 for Sec. 302 purposes; see McDonald. The step-transaction doctrine would allow A to compare his percentage ownership in T prior to the redemption with his constructive ownership in T (through P), if any, after P's acquisition, to calculate whether the redemption was substantially disproportionate under Sec. 302(b)(2) and thus whether Sec. 302(a) treats the redemption as a sale.

A would also appear to receive sale treatment for the redemption under Sec. 302(a) if instead A and his children owned the T stock and A was fully redeemed prior to P's acquisition of T, assuming the percentage of P stock owned by A's children was less than 50% (calculated after the acquisition by applying the Sec. 318 attribution rules). A would not need to waive the Sec. 302(b)(2) family attribution rules to obtain sale treatment.

Arguably, even if the funds used to redeem T's 75% stock interest were borrowed by T, the COI requirement would be satisfied if T used its own funds to repay the debt. This result might depend on proving that P had no plan or intention to directly or indirectly reimburse T for the cash used to redeem A's T stock, whether through paying T's debt or otherwise.

Additional Issues

The final regulations conform to Rev. Rul. 99-58, by removing the restrictive Example 8 of Regs. Sec. 1.368-1(e)(6). Rev. Rul. 99-58 provides that stock repurchase programs by the acquiring corporation would not necessarily affect COI, even if modified in connection with the reorganization.

In addition, the preamble to the final regulations states that the Sec. 368 checklists do not apply to the extent that the representations are inconsistent with the final COI regulations; see Rev. Procs. 77-37 and 86-42.

Effective Date

The final regulations apply to transactions occurring after Aug. 30, 2000, unless the transaction occurs pursuant to a written agreement binding on that date and at all times thereafter (subject to customary conditions). Taxpayers who entered into a binding agreement between Jan. 28, 1998 and Aug. 30, 2000 may request a letter ruling permitting them to apply the final regulations to their transaction. However, the IRS will not issue a ruling unless the taxpayer establishes there is no significant risk of different parties to the transaction taking inconsistent positions.

FROM NELSON CROUCH, WASHINGTON, DC