Measuring COI under the binding contract rules.

Final Regs. Sec. 1.368-1(e) (TD 9225, 9/15/05) allows taxpayers some flexibility in measuring continuity of interest (COI) for transactions entered into under a binding contract after Sept. 16, 2005. Under the "binding contract" rule, taxpayers are permitted to measure COI in a tax-free reorganization by reference to the value of the acquirer's stock as of the day immediately preceding the day the parties enter

into a binding contract to proceed with the transaction, as opposed to immediately before the closing date. This alternative is beneficial for preserving the COI requirement in situations in which the value of acquirer stock falls between the definitive agreement date and the closing date. While the requirements to use the binding contract rule are rigid, the resulting benefit is the assurance that the COI requirement will be met.

Background

The COI requirement for tax-free reorganizations is set forth in Regs. Sec. 1.368-1(e)(1); it provides that a substantial part of the value of the proprietary interests in the target corporation must be preserved in the reorganization. COI is generally measured by reference to the portion of the acquirer stock used as consideration in the transaction, as this represents a continued proprietary interest on the part of the target shareholders in the reorganized corporation. While different forms of tax-free reorganizations require varying levels of COI, satisfying the appropriate level is imperative if the transaction is to qualify as a tax-free reorganization.

Normally, COI is measured as of the date the reorganization transaction is closed. On that date, the portion of the total consideration paid to the target by the acquirer is measured to determine whether the COI requirements are met. The value of the target stock used as consideration is measured immediately before the transaction is dosed.

This rule can present a problem, if the overall value of the consideration to be paid to the target shareholders is fixed in the definitive agreement, and the value of the acquirer stock falls between the date of the definitive agreement and the dosing date. In this scenario, the acquirer must contribute additional consideration to make up for the decline in its stock value. This additional consideration would consist of additional acquirer stock or additional nonstock consideration (i.e., cash or other property). If nonstock consideration is used, the COI requirement could be jeopardized if the new mix of consideration does not contain the required portion of acquirer stock.

The Binding Contract Rule

Regs. Sec. 1.368-1(e)(2) provides an alternative to the general measurement rules described above for determining COI. This rule, called the "binding contract" rule, offers assurance that the COI requirement will be met, by allowing taxpayers to measure for COI as of the day immediately preceding the day the binding contract is executed, rather than measuring immediately before the transaction closes. By changing this measurement date, the value of the acquirer stock is known and, thus, the measurement can be determined with certainty. However, as discussed below, this guarantee comes at a price--lost flexibility in modifying the negotiated consideration.

Definition: Under Regs. Sec. 1.368-1(e) (2) (ii) (A), a "binding contract" is an instrument enforceable under applicable laws against the parties to it. Certain conditions to enforceability are permitted for items such as regulatory agency approval and satisfaction of customary conditions (such as due diligence results and adequate representations). In addition, further modifications to the agreement are permitted to allow for the negotiation of insubstantial terms.

Modifications: However, under Kegs. Sec. 1.368-1(e)(2)(ii)(B), any modification of an otherwise binding contract that relates to the amount or type of consideration to be paid to the target shareholders will generally establish a new binding contract date and a new date for measuring COI, unless: (1) the sole effect of the modification is to increase the shares of acquirer stock to be used as consideration in the transaction; and (2) absent the modification, the COI requirement would have been met had the transaction closed on the modification date.

Fixed consideration: A fundamental condition to using the binding contract rule is that the contract must provide for fixed consideration. For this purpose, Regs. Sec. 1.368-1(e) (2) (iii) (A) states that a contract provides for fixed consideration if it provides the:

1. Number of shares of each class of acquirer stock, the amount of money and the other property to be exchanged for all of the target stock (in the aggregate), or for each share of target stock;

2. Percentage of the number of shares of each class of target stock, or the percentage (by value) of the target stock, to be exchanged for acquirer stock, provided that the target stock to be exchanged for acquirer stock and the target stock to be exchanged for cash or other property each represent an economically reasonable exchange; or

3. Percentage of each share of target stock to be exchanged for acquirer stock, provided that the portion of each share of target stock to be exchanged for acquirer stock and the portion of each share of target stock to be exchanged for cash or other property each represent an economically reasonable exchange.

Under Kegs. Sec. 1.368-1(e)(2) (iii)(B), a contract that permits the target shareholders to elect the portion of consideration they wish to receive in the form of acquirer stock and/or cash or other property can qualify under the fixed consideration rules discussed above if it provides the:

1. Minimum number of shares of each class of acquirer stock and the maximum amount of cash or other property to be exchanged for all of the target stock (in the aggregate); or

2. Minimum percentage of the number of shares of each class of target stock, or the minimum percentage (by value) of all of the target stock (in the aggregate), to be exchanged for acquirer stock, provided that the target stock to be exchanged for acquirer stock and the target stock to be exchanged for cash or other property each represent an economically reasonable exchange.

Contingent consideration: Regs. Sec. 1.368-1(e)(2)(iii)(C) states that contracts that provide for contingent consideration will generally not qualify under the binding contract rule. However, such contracts will not fail to qualify, if such contingent consideration consists solely of acquirer stock and the COI requirement would be met if none of the contingent consideration were paid to the target shareholders. This exception seems obvious, given that, under these restrictions, the contingent consideration could only increase the COI of the target shareholders.

Advantages

The benefits of applying the binding contract rule are most evident in situations in which the parties to the reorganization have agreed on a fixed amount of consideration and fixed the number of acquirer shares to be used in the total consideration. In this case, absent the binding contract rule, a sharp decline in the value of acquirer stock could result in a failure to meet the COI requirement, because the percentage of the total consideration represented by acquirer stock might not be sufficient.

By applying the binding contract rule, the parties can measure the COI requirement immediately before the definitive agreement is signed, thereby securing the qualification regardless of subsequent declines in the value of acquirer stock.

Example 1: On Jan. 1,2006, A Corp. enters into a binding contract to acquire T Corp. in a statutory merger. The transaction will qualify as an A reorganization, provided the COI requirement is met. The aggregate consideration to be paid to the T shareholders consists of a set number of A shares and a specified amount of cash, both of which are determined as of the definitive agreement date, are fixed and represent a total pool of consideration of equal stock/cash value (50% A stock and 50% cash). The value of A stock was $50 on Dec. 31, 2005, and $15 on Sept. 29, 2006. The transaction closes on Sept. 30, 2006.

If the binding contract rule does not apply to this transaction, the merger would not qualify as a tax-free reorganization because, absent the binding contract rule, the value of A stock used in the transaction would be measured as of Sept. 29, 2006. If this measurement date is used, the A stock's value represents only 23.08% of the total consideration ($15/$65), which would not likely meet the COI requirement.

However, given that the binding contract rule would likely apply, the transaction will qualify as a tax-free reorganization, because the COI requirement will be met. For purposes of measuring COI, the value of A's stock on Dec. 31, 2005 is used. Such stock value represents 50% of the total consideration, which is sufficient to meet the COI requirement.

Burdens

While the binding contract rule provides certainty as to the qualification of the transaction under the COI rules, the fixed consideration requirements may not be palatable to the target shareholders, for obvious reasons. By accepting a fixed consideration contract, the target shareholders bear the risk of loss for declines in the value of acquirer stock that occur before the transaction is closed. For this reason, corporate acquisitions are often structured with a set price, but the form of the consideration is allowed to fluctuate with changes in the value of acquirer stock.

Example 2: The facts are the same as in Example 1, except that the total consideration to be paid to T's shareholders is fixed as of the contract date; however, the stock and cash portions are permitted to fluctuate, so that the total value of consideration set at the contract date is delivered as of the dosing date.

The sharp decline in the A stock value must be rectified at closing by adding more consideration. The satisfaction of the COI requirement will depend on the portion of this shortfall that is satisfied with A stock, and the portion satisfied with cash or other property. If the shortfall is rectified entirely with cash, the transaction will fail the COI requirement. If the shortfall is rectified entirely with A stock, the COI requirement will be met, but the transaction will be more dilutive to the A shareholders. If the shortfall is satisfied with a combination of A stock and cash or other property, the COI measurements will have to be closely monitored and calculated.

Conclusion

The binding contract rule offers certainty and assurance that the COI requirement for a particular transaction will be met, regardless of subsequent declines in the value of acquirer stock. However, this assurance may carry a price to the target shareholders, if they must agree to a fixed level of consideration and a fixed number of shares of acquirer stock. By consenting to a fixed number of acquirer shares as a percent of the total consideration, the target shareholders bear the risk of loss from declines in the value of acquirer stock beginning with the definitive agreement date. In any event, the parties to a reorganization should consider the potential availability of the binding contract rule in negotiating the terms of a definitive agreement, especially if the acquirer stock's value is volatile.

FROM DAVID A. THORNTON, CPA, COLUMBUS, OH