Regulations offer flexibility in meeting COI requirement.

Final regulations under Sec. 368, issued in September 2005, provide taxpayers flexibility in satisfying the continuity of interest (COI) requirement for certain corporate reorganizations. These COI regulations are designed to prevent changes in market value from causing an otherwise tax-free transaction to become a taxable transaction in which the target shareholders are subject, by reason of a binding contract, to the economic fortunes of the issuing corporation as of the date the binding contract is entered into by the relevant parties. The final COI regulations also provide insight, through examples, into acceptable COI limits.

How Much Stock?

COI, as described in Regs. Sec. 1.368-1 (e), generally requires the target shareholders in a reorganization to receive a proprietary interest in the issuing corporation in exchange for their shares in the target. This regulatory requirement focuses on the type of consideration received by the target shareholders. To satisfy the COI requirement, a significant portion of the consideration received by the target shareholders should consist of instruments that carry the required degree of proprietary interest, such as stock of the issuing corporation. The COI requirement is applied in the aggregate so that some target shareholders may receive solely issuing corporation stock and other shareholders may receive solely cash.

To date, there has been no mandatory requirement prescribed by Congress or Treasury as to the minimum amount of issuing corporation stock that must be received by the target shareholders to satisfy the COI requirement. Nevertheless the IRS, for advance ruling purposes, has required for many years that at least 50% of the consideration received by the target shareholders must be issuing corporation stock; see e.g., Rev. Procs. 77-37 and 86-42. Despite the fact that the Supreme Court in Nelson, 296 US 374 (1935), found COI to be satisfied when 38% of the consideration was issuing corporation stock, many tax practitioners were reluctant to issue tax opinions on acquisitive transactions that involved less than 50% COI.

An example set forth in the final COI regulations provides a welcomed clarification to lower acceptable COI limits. In Regs. Sec. 1.368-1(e)(2)(v), Example (6), the IRS acknowledges the COI requirement is satisfied for an acquisitive transaction if at least 40% of the target stock is exchanged for issuing corporation stock. The preamble to the final regulations clarifies that the 40% COI safe harbor is applicable to all reorganizations, not just to reorganizations involving fluctuations in value. It appears the IRS has quickly adopted this lower COI limit for advance ruling purposes, by accepting a taxpayer's representation for a statutory merger under Sec. 368(a) that at least 40% of the proprietary interest in the target will be exchanged for issuing corporation stock; see e.g., Letter Ruling 200610007.

Although the final COI regulations provide for a 40% COI safe harbor, the regulations do not specify a minimum level of propriety interest that must be issued to satisfy the COI requirement. An example in the proposed regulations provided COI was not satisfied when the issuing corporation stock was less than 30% of the total consideration provided to target shareholders in the transaction. This example has been deleted from the final COI regulations.

Changes in Market Value

Prior to the final COI regulations, no clear guidance existed as to whether fluctuations in value that take place during the period between the binding contract date and the effective date of the reorganization affect COI. Due to fluctuations in value, it is possible that a percentage of the stock consideration, if measured based solely on the effective date, could be substantially less than the prescribed stock amount set forth in the binding contract, Regs. Sec. 1.368-1(e)(2)(ii) answers this uncertainty by adopting the approach, if certain conditions are satisfied, of ignoring any market fluctuations in value subsequent to the binding contract date for purposes of testing COI.

Regs. Sec. 1.368-1(e)(2)(i) provides that in determining whether a proprietary interest in the target is preserved, the consideration to be exchanged pursuant to a contract is valued on the last business day before the first date on which such contract is a binding contract, but only if such contract provides for fixed consideration. Valuation is permitted at a point in time other than the closing price of the issuing corporation stock on the last business day before the binding contract is signed. Thus, valuations using an average of the high and low trading price of that day should be acceptable, as well as the closing price of the issuing corporation stock on the relevant exchange in situations of a single trade. This provides taxpayers some flexibility in determining the appropriate values.

Fixed Consideration

The final COI regulations apply only to reorganizations having "fixed consideration" defined as consideration in contracts that represent a (1) fixed number of shares of issuing corporation stock, the amount of money and "other property" being exchanged for the target corporation stock, or (2) fixed percentage of shares, or value of target stock, being exchanged for issuing corporation stock. Further, a contract that permits target shareholders to elect to receive either issuing corporation stock or other property (including money) is treated as having fixed consideration if the contract provides either the (1) minimum number of shares of issuing corporation stock and the maximum amount of money and other property to be exchanged for target stock or (2) minimum percentage of the number of target shares or value being exchanged for issuing corporation stock.

Under these final COI regulations, a contract with a "proration" mechanism providing for the issuing corporation's stock and cash amounts to be prorated, if necessary, so that 40% of the total consideration is in the form of issuing corporation stock and 60% is in cash, should satisfy the COI requirement, even if the amount of issuing corporation stock issued in the transaction is based on a market value occurring after the binding contract date.

FROM MARYANN D'ANGELO, CPA, J.D., LL.M., WASHINGTON, DC