Stock repurchase plans and COI.

An essential element of a tax-free reorganization is that there must be continuity of proprietary interest (COI) in the acquiring company. The purpose of this rule is to distinguish a taxable sale from a tax-free reorganization. Minnesota Tea Co., 296 US 378 (1935), and Pinellas Ice & Cold Storage Co., 287 US 462 (1933), established the principle that, to be a reorganization, the target shareholders must acquire an interest in an acquiring company that is "definite and material" and represents a substantial part of the transferred property's value. Thus, the COI requirement relates to the type of consideration received, the amount of qualifying consideration received and how long the target shareholders must retain the interest.

Interestingly, the Supreme Court never decided how long the target company shareholders were required to hold the interest they received, and the law on this issue is not clear. The courts have disagreed whether a reorganization occurred if shareholders had a pre-existing intention to dispose of the stock they received; compare McDonald's Restaurants of Illinois, Inc., 688 F2d 520 (7th Cir. 1982), and Penrod, 88 TC 1415 (1987). In Rev. Rul. 66-23, the IRS held that the receipt of stock subject to a court order to dispose of it within seven years satisfied the COI requirement, because the shareholders had complete discretion and control over the shares during the interim.

To bring certainty to the COI requirement and to prevent a buyer and seller from adopting inconsistent positions, the Service amended the reorganization regulations in 1998. In general, Regs. Sec. 1.368-1(e)(1)(i) now provides that the disposition of target stock prior to a reorganization or the disposition of the acquirer's stock after a reorganization, except to the acquiring corporation or related persons, will be disregarded. Rev. Rul. 66-23 was also declared obsolete.

Today, companies frequently have programs in which they repurchase their shares in the market from time to time. The existence of a repurchase program raises many questions when a company wants to engage in a tax-free reorganization. It is highly likely that the company will repurchase shares that it just issued in the reorganization. The Service considered a stock repurchase program in Regs. Sec. 1.3681 (e)(6), Example 8, which states that the repurchase program "was not created or modified in connection with the acquisition" and that the acquiring corporation purchased only a minor percentage of its stock in the market. The regulation concludes that the repurchase program does not violate the COI requirement, because "it was not in connection with the merger." While the example concludes that a repurchase plan will not invalidate a reorganization, it left many unanswered questions about the operation of a repurchase program.

The IRS issued much-needed clarification in Rev. Rul. 99-58. In the ruling, the acquiring company, whose stock was widely held and publicly traded, had a stock repurchase plan in effect before engaging in a reorganization. Because it was concerned about the dilution resulting from the issuance of additional shares in the reorganization, it amended the repurchase plan to increase the number of shares it would repurchase to include the number of shares issued in the reorganization. However, the number of shares repurchased would not exceed the number of shares outstanding before the merger. The repurchases were made by a broker on the open market. Because of the mechanics of an open-market transaction, a purchaser and seller of a share do not know the other's identity.

Rev. Rul. 99-58 considered whether the repurchase plan violated the COI requirement, because the acquiring company might repurchase shares that had been issued to a target shareholder. The ruling concluded that the repurchase of shares on the open market through a broker has no effect on the COI requirement. This was based on the fact that there was no understanding between the acquiring company and the target shareholders that their holding of the acquiring company's stock would be transitory. In addition, because the purchases were in the market, the program did not favor participation by the target shareholders. Further, because of the market purchases, the Service rejected the notion of tracing the seller and purchaser.

This ruling clarifies the regulations in several important aspects. First, the acquiring company is not restricted to repurchasing a small percentage of its stock, but can repurchase the number of shares issued in the reorganization. Further, it can amend an existing plan to increase the number of shares to be repurchased. Previously, the regulations applied only to an existing plan.

The ruling does not state whether a company can adopt a repurchase plan at the time of (or after) a reorganization, and whether there is any limit on the number of shares that can be repurchased. In comments at the annual meeting of the Tax Section of the New York State Bar Association on Jan. 25, 2000, a Treasury representative stated the repurchase plan could be a newly adopted plan. Further, he indicated that the company could not repurchase more shares than were outstanding before the reorganization, because this would establish that some of the shares issued in the reorganization were reacquired by the company.

FROM LAWRENCE H. COHEN, J.D., LL.M., NEW YORK, NY, AND LORIN D. LUCHS, CPA, J.D., LL.M, WASHINGTON, DC