Proposed section 368 regulations (remote continuity-of-interest doctrine). (Tax Executive Institute's comments submitted to IRS on April 30, 1997).

On April 30, 1997, Tax Executives Institute submitted the following comments to the Internal Revenue Service on proposed regulations under section 368, which would significantly relax the "remote" continuity-of-interest doctrine for certain tax-free reorganizations. The comments were prepared under the aegis of TEI's Federal Tax Committee, whose chair is David L. Klausman of Westinghouse Electric Corporation. Philip C. Cohen of Unilever United States Inc. and David A. Heywood of Union Pacific Corp. contributed materially to the preparation of the submission.

On January 2, 1997, the Internal Revenue Service issued proposed regulations under section 368 that would significantly relax the "remote" continuity-of-interest doctrine for certain tax-free reorganizations. The proposed regulations (REG-252233-96) were published in the Federal Register on January 3, 1997 (62 Fed. Reg. 361), and in the Internal Revenue Bulletin (1997-9 I.R.B. 19).(1) The proposed regulations would also modify the rules relating to the continuity of business enterprise doctrine. A public hearing on the proposed rules is scheduled for May 7, 1997. Tax Executives Institute is pleased to submit the following comments on the proposed regulations.

Background

Tax Executives Institute is the principal association of business tax executives in North America. The Institute's more than 5,000 members represent 2,800 of the largest companies in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and the government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.

TEI members are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations relating to the remote continuity-of-interest doctrine in certain tax-free reorganizations.

Overview of Proposed

Regulations

As noted in the preamble, Congress has amended section 368 a number of times, beginning in 1954, to ameliorate the effects of the remote continuity-of-interest doctrine. In the case of transactions otherwise qualifying as tax-free reorganizations under section 368(a)(1)(A), (B), (C), or (G) (meeting the requirements of sections 354(b)(1)(a) and (B)), section 368(a)(2)(c) permits the acquiring corporation to transfer the acquired assets or stock to a corporation "controlled" by the acquiring corporation. Changes have also been made to permit various forms of triangular reorganizations where the stock of a corporation in "control" of the acquiring corporation is employed to effect the acquisitive reorganization. In each instance, "control," which is determined by reference to section 368(c), is defined as the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of all other classes of stock.

For transactions otherwise qualifying as tax-free reorganizations under section 368(a)(1)(A), (B), (C), or (G), the proposed regulations would change the continuity-of-interest requirements in current Treas. Reg. [sections] 1.368-1(b) and, in addition, permit transfers beyond those explicitly permitted by section 368(a)(2)(C). Corresponding changes would be made to the continuity-of-business enterprise requirements in current Treas. Reg. [sections] 1.368-1(d).

Under carefully prescribed conditions, the proposed regulations would permit the acquiring corporation to transfer the acquired assets or stock to a partnership. In addition, the corporations to which such transfers may be made would be expanded to include any member of the "qualified group." Prop. Reg. [sections] 1.368-1(d)(5)(iii) defines the "qualified group" as one or more chains of corporations connected through direct stock ownership, where each link in the chain of corporations to the "issuing corporation" satisfies the control requirement in section 368(c). Prop. Reg. [sections] 1.368-1(d)(5)(iv) defines the "issuing corporation" as the acquiring corporation (as that term is used in section 368), except in those transactions where use of the stock of a corporation in control of the acquiring corporation is permitted. Where stock in the controlling corporation is used to acquire a target corporation's stock or assets, the controlling corporation would be the "issuing corporation."

In general, the Treasury Department and IRS are to be commended for proposing significant changes restricting the "emote continuity" doctrine. TEI recommends, however, that the Treasury and IRS go further. For the reasons set forth below, the proposed regulations should be amended in two respects before they are finalized. First, the types of permissible transfers of assets or stock should be expanded to include transfers to any member of an affiliated group filing consolidated returns, whether or not that member meets the "control" requirement in section 368(c). Second, the changes should be made effective retroactively, at least on an elective basis.

Should the Uncertain Scope

of Judicial Doctrines 

Underpinning the "Remote"

Continuity-of-Interest

Doctrine Be Given Continued

Deference?

The remote continuity-of-interest doctrine emanates from two Supreme Court decisions: Groman v. Commissioner, 302 U.S. 82 (1937), and Helvering v. Bashford, 302 U.S. 454 (1938). As explained in the preamble, the cases are read as holding that if T transfers its assets to an acquiring corporation (P) in exchange for stock of the corporation controlling P (as in Groman), or if P acquires the T assets but pursuant to the plan of reorganization transfers them to a controlled subsidiary (as in Bashford), the continuity-of-interest doctrine is not satisfied.

Those decisions, however, represent a shaky foundation for an elusive, yet pervasive, doctrine that permeates the Internal Revenue Code's reorganization provisions. Leading commentators have criticized the decisions and characterized the Court's reasoning in both cases as "opaque" and "obscure." See, e.g., B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders [para.] 12.21[31 (6th ed. 1994), and Ferguson & Ginsburg, Triangular Reorganizations, 28 Tax L. Rev. 159, 161 (1973). At least one commentator has recommended that the remote continuity doctrine be abandoned completely. See Levere, Remote Continuity of Interest: The Problem Persists, 49 Tax Lawyer 795, 796 (1996). Indeed, the Internal Revenue Service itself has even rejected, or at least limited the application of, Groman and Bashford in one instance.(2) As a result, TEI questions whether the doctrine should be given continued deference, and, if it is retained, whether its application should limit post-reorganization transfers among members of an affiliated group filing consolidated returns.

Under the "remote" continuity-of-interest doctrine as described in the preamble, "stock consideration received by the target corporation's (T) shareholders does not provide continuity unless the target assets or stock are ultimately held by the corporation that issued the stock."(3) Absent such continuity, the transaction cannot qualify as a tax-free reorganization. The degree of reliance placed on Groman and Bashford to support the remote continuity doctrine, however, seems misplaced. Moreover, contrary to the implication in the preamble, the transactions involved in both cases qualified as tax-free reorganizations.(4)

Stated differently, while the results in Groman and Bashford may be justified by their facts, TEI does not believe the decisions support the broadly enunciated "remote continuity" doctrine articulated in the preamble. In addition, that articulation seems to ignore the effect of subsequent case law that clarified the scope of Groman and Bashford. See Campbell v. Commissioner, 15 T.C. 312 (1950) (acq. 1951-1 C.B. 1). In Campbell, the corporation that acquired the stock of the target corporation in exchange for its own stock transferred the target stock to a subsidiary on the day following the acquisition. Notwithstanding that transfer, the Tax Court held that the transaction qualified as a tax-free reorganization since the transfer was not a part of the "plan" of reorganization. See 15 T.C. at 319.

By its acquiescence in Campbell, the IRS has signaled its acceptance of that decision as a proper interpretation of the Internal Revenue Code. Consequently, it is reasonable to conclude that the continuity required to achieve a tax-free reorganization is lacking only where the corporation that issues the stock transfers the acquired assets or stock as a part of the plan of reorganization. In our view, this interpretation of the remote continuity doctrine would cause much less uncertainty than the expansive interpretation set forth in the preamble. Based on the facts in the decisions in Groman and Bashford, the IRS should limit the application of the remote continuity doctrine to situations where split consideration is employed because that is the only time, at least from the standpoint of the target shareholders, that the subsequent transfer of assets or stock is necessarily a part of the plan of reorganization.

Broader Definition of

"Control"

While complete abandonment of the remote continuity doctrine may not be possible, we believe that the proposed regulations can be improved -- and the operation of the remote continuity-of-interest doctrine narrowed further -- by adopting a different standard of "control." In the preamble, the Treasury and IRS invite comments on whether the "qualified group" should be defined other than by reference to the section 368(c) test. TEI recommends that the definition of the "qualified group" in Prop. Reg. [sections] 1.368-1(d)(5)(iii) be revised to include any member of the affiliated group filing a consolidated income tax return.

For purposes of determining which corporations are eligible to file consolidated income tax returns, the members of an affiliated group of corporations are defined by section 1504(a) differently from the "control" requirement in section 368(c).(5) Section 1504(a)(2) requires ownership of at least 80 percent of the total voting power of the stock of a corporation and at least 80 percent of the total value of its stock for such corporation to be a member of an affiliated group. In addition, section 1504(a)(4) specifically excludes from the ownership requirement non-voting preferred stock.

As a result of section 368(c)'s definition of "control," a corporation with a class of non-voting preferred stock (or bonds that might be reclassified as equity) held by unrelated parties, no matter how small the share of the total equity, would not qualify as a member of the "qualified group" under the proposed regulations. Conversely, where different classes of stock had unequal voting rights, it would be possible for a corporation to be a member of the "qualified group" even though 80 percent of its voting power represents a far smaller share of its total value. TEI's recommended change of using section 1504(a) would avoid anomalous results in such cases. Incorporating the affiliated group control test would also address so-called diamond ownership structures, i.e., a situation where the target assets or stock are subsequently held by a member of an affiliated group (S3) that is owned equally by two other subsidiaries (S1) and (S2) that in turn are completely owned by P.

Moreover, including all the members of an affiliated group within the definition of the "qualified group" would be consistent with the policy direction underlying the recent changes to the consolidated return regulations. The intercompany transaction regulations, among other consolidated return regulation projects, attempt to achieve the same tax results that would obtain from treating the members of an affiliated group as divisions of a single corporation. See T.D. 8597, 1995-2 C.B. 147. Transferring acquired assets or stock from one division to another within a single corporation raises no continuity-of-interest issue, remote or otherwise. We believe that the proposed regulations would be improved by permitting similar transfers between members of affiliated groups filing consolidated returns.

As an added benefit, TEI's recommended change would ease the administrative burden of determining which corporations are members of the "qualified group." Taxpayers and revenue agents alike would know the members of their affiliated groups because the information on the eligibility of the members to join in the consolidated return filing is part of the core tax return information. Conversely, taxpayers and agents rarely determine which members of the group are under "control" within the meaning of section 368(c).

Finally, TEI does not believe that the recommended change is inconsistent with the policy underlying the reorganization provisions. In public remarks on the proposed regulations, representatives from the IRS's Office of Chief Counsel have commented that the IRS may not have the authority to adopt a definition of "control" that varies from the section 368 definition. Declining to change the definition of "qualified group" to include all affiliated group members should not, however, be laid to a lack of statutory authority. Implicit within the changes underlying the proposed regulations is a conclusion that the IRS's authority is not limited by section 368(a)(2)(C). Specifically, a transfer of assets or stock to a subsidiary of a controlling corporation where its stock is used by the acquiring corporation is clearly not contemplated by the express requirements of section 368(a)(2)(C). Nonetheless, in permitting such a transaction to qualify for tax-free treatment, the proposed regulations reach a sensible result that does not contravene the policy of the statute. Hence, we believe that the IRS is not precluded from adopting the section 1504(a) control test in order to define the "qualified group" in Prop. Reg. [sections] 1.368-1(d)(5)(iii).

In the event the IRS concludes otherwise, we urge that it promulgate regulations under section 1502 that permit the post-reorganization transfer of assets to any other member of the affiliated group. Pursuant to the grant of legislative authority under section 1502, there should be no question of the IRS's authority to issue regulations incorporating a different definition of control.

Effective Date of Regulations

Except for transactions occurring pursuant to binding written contracts entered into prior thereto, the regulations will be effective for transactions occurring after the date of adoption. The preamble provides no explanation of why the revised rules should be applied on a wholly prospective basis.

Prior to enactment of changes last year, section 7805(b) was generally applied to give retroactive effect to new regulations, except where sound policy or administrative arguments supported adoption of prospective-only rules. For interpretative regulations in respect of statutory changes after July 30, 1996, the general rule is that regulations are generally prospective unless one of the exceptions under section 7805(b) applies. Because the effect of the proposed regulations is to clarify statutes existing at the date of enactment of revised section 7805(b), we believe the proposed regulations can and should be applied retroactively, either as a general matter or on a taxpayer-by-taxpayer elective basis. Between those two alternatives for retroactive treatment, we believe the better approach is to apply the new rules retroactively and permit an election for acquiring or controlling corporations to elect under "old" rules relating to remote continuity of interest.

The purpose of the proposed regulations is to relax restrictive rules that might otherwise deny tax-free status to reorganization transactions. By providing explicit rules that reduce the uncertainty surrounding the nebulous scope of the longstanding, judicially created remote continuity-of-interest doctrine, the effect of the proposed rules is generally taxpayer-favorable. Hence, the proposed rules represent a clarification of existing statutes at July 30, 1996, and are not, in our view, subject to the 1996 legislative changes limiting the IRS's authority to issue retroactive regulations. Viewed in this light, the absence of an explanation in the preamble for not making the changes retroactive is puzzling.

Inasmuch as there are numerous ways for acquiring corporations to ensure that they have structured a taxable asset or stock purchase, it is difficult to conceive of circumstances where taxpayers would, prior to adoption of the proposed rules, have purposely structured a reorganization transaction that fails the remote continuity requirements. There are much more straightforward ways for taxpayers to ensure taxable transactions. As a result, it is unlikely any taxpayer has relied on a post-reorganization asset or stock drop down to convert a reorganization into a taxable purchase.(6)

Of equal importance, taxpayers that desired reorganization treatment likely did not report reorganization transactions as taxable, notwithstanding that unanticipated business exigencies may have arisen soon after a reorganization that compelled the acquiring corporation to transfer the acquired assets or stock to another member of the "qualified group" (however defined). In such a case, an acquiring corporation would likely invoke the Campbell decision as a shield in order to prevent such a transfer from being integrated with the prior reorganization and disqualifying tax-free status. In order to eliminate needless audit controversies, taxpayers faced with such circumstances would likely welcome a retroactive effective date treatment or would make an election to apply the regulations retroactively. Hence, making the proposed rules retroactive or permitting taxpayers to elect retroactive treatment would minimize confusion and reduce uncertainty by limiting the potential application of the integrated transaction argument and confirm taxpayers' anticipated and reported result.

Finally, before issuing the proposed rules, the IRS and Treasury likely concluded that the current remote continuity-of-interest rules operate either as an obstacle that knowledgeable taxpayers can safely avoid off as a trap for the unwary. Specifically, any taxpayer knowingly failing the current proscription against post-reorganization asset or stock drop downs is likely relying on Campbell. Alternatively, a knowledgeable taxpayer may have postponed the drop-down transaction until the reorganization was "old and cold." Should the regulations be made final on a prospective only basis, generally only ill-informed taxpayers that inadvertently or unknowingly transferred assets or stock within the affiliated group will be exposed to a potential audit adjustment. TEI sees no policy or administrative reason why such taxpayers should be subject to requirements that the IRS has determined are unnecessary in order to effectuate future reorganizations. As a result, we do not see what policy interest is served by making the less restrictive rules prospective only.

Since there does not seem to be a legitimate reliance interest on the part of either taxpayers or the government that should prevent the proposed changes from being given retroactive effect, we urge the government to make the changes retroactive generally and permit that rare (perhaps nonexistent) taxpayer that is adversely affected by the retroactive change to opt out of the retroactive regime.

Conclusion

TEI is pleased to have the opportunity to present its views on the subject of the proposed regulations relating to remote continuity-of-interest doctrine for certain tax-free reorganizations. These comments were prepared under the aegis of TEI's Federal Tax Committee whose chair is David L. Klausman. If you have any questions concerning these comments, please call either Mr. Klausman of Westinghouse Electric Corporation at [phone], or Jeffery P. Rasmussen of the Institute's professional tax staff at [phone].

(1) For simplicity's sake, the proposed regulations are referred to as the "proposed regulations"; specific provisions are cited as "Prop. Reg. [sections]." References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Bulletin.

(2) See Rev. Rul. 64-73, 1964-1 C.B. 142.

(3) Preamble, 1997-9 I.R.B. at 19.

(4) In both cases, shareholders of the target corporation received (i) stock in the corporation that ultimately received the transferred assets and (ii) stock in the corporation in control of the transferee. The only issue decided in either case was that the stock of the controlling corporation did not qualify for nonrecognition treatment. Hence, Groman and Bashford may be read narrowly as involving a recharacterization of a portion of the split stock consideration as taxable boot.

(5) Prior to the Tax Reform Act of 1986, section 332(b)(1) employed the same definition of "control" as that used in section 368(c) to determine which corporations were eligible for complete liquidation treatment under section 332. As a technical correction to the Tax Reform Act of 1984, section 1804(e)(6) of the 1986 Act adopted the current version of section 332(b)(1), which determines such eligibility by reference to section 1504(a)(2).

(6) In such cases, taxpayers would likely prefer to avoid the uncertainty that the IRS might attempt to assert the Campbell decision as a sword to defeat the taxpayer's attempt to fail the remote continuity test.