Target stock acquired in anticipation of merger counts toward the continuity-of-interest requirement for subsequent nontaxable reorganization.

Among the requirements for tax-free reorganization treatment is that there be a continuity of interest on the part of those persons who, directly or indirectly, were owners of the acquired corporation prior to the reorganization; see Regs. Sec. 1.368-1 (b). Courts have taken the position that those shareholders to be "counted" for continuity purposes are the target's historic shareholders, i.e., those persons who were the shareholders at the commencement of the plan of reorganization. When a reorganization is preceded by a series of ownership changes, it is often difficult to determine the identity of the "historic shareholders." In JE. Seagram Corp., 104 TC 75 (1995), the Tax Court applied a "step-into-the-shoes" rule to make that determination.

In June 1981, Seagram launched an unfriendly takeover of Conoco. Conoco then found a white knight," DuPont, which agreed to make a competing tender offer for Conoco stock. The agreement also provided that, if DuPont was able to acquire at least 51 % of the Conoco stock, Conoco would be merged into a Dupont subsidiary. Thereafter, DuPont would acquire any Conoco shares not acquired in the tender offer. The merger was subject to, among other conditions, approval by the shareholders of DuPont and Conoco.

By August, DuPont had acquired over 51% of the Conoco shares, while only 32% of the Conoco stock had been tendered to Seagram. At all times, Seagram and DuPont were acting independently of each other and pursuant to competing offers. On August 17, Seagram gave up on its takeover bid and tendered its Conoco shares for DuPont common stock. Pursuant to the Conoco/DuPont agreement, Conoco merged into a DuPont subsidiary on receiving shareholder approval. The Conoco shares not previously tendered were exchanged for DuPont shares pursuant to the merger.

In summary, DuPont first acquired 46% of the Conoco stock for cash and 15.3% of the Conoco stock for DuPont stock in the tender offer. DuPont then acquired 32.3% of Conoco stock from Seagram and the remaining 6.4% Conoco stock in the merger.

The Tax Court held that Seagram stepped into the shoes of 32% of the Conoco shareholders when Seagram acquired their stock for cash through the Seagram competing tender offer. There was no material distinction between Seagram's subsequent tender of the Conoco stock and a direct tender by the "old" Conoco shareholders themselves. Thus, the requirement of continuity was met because DuPont itself acquired 54% of the Conoco stock in exchange for DuPont stock.

This Tax Court decision establishes limits on the doctrine of historic shareholder" continuity of interest. Even through Seagram purchased its Conoco stock after DuPont, and Conoco had commenced its plan of reorganization, since Seagram was not part of that plan, it was viewed as a historic shareholder for purposes of that merger.

From Mark L. Yecies, J.D., and C.Y Wang, CPA, Washington, D.C.