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Getting back to basics - proposed continuity regulations.

The IRS recently issued proposed regulations under Sec. 368 on the continuity-of-shareholder-interest (COSI) and continuity-of-business-enterprise (COBE) requirements. These are proposed to be effective on the date final regulations are published in the Federal Register.


The COSI requirement for tax-free reorganizations has been developed by the courts; see Cortland Specialty Co., 60 F2d 937 (2d Cir. 1932), Pinellas Ice & Cold Storage Co., 287 US 462 (1933), and Nelson, 296 US 374 (1935). Generally, the courts have required target corporation shareholders to maintain a continuing interest in the target corporation through a significant proprietary interest in the acquiring corporation. Early decisions focused on the consideration received in the transaction, while later decisions considered the impact of pre-reorganization dispositions (Yoc Heating, 61 TC 168 (1973)). Soon, the IRS began to focus on the target shareholder's post-reorganization intent; see Rev. Procs. 77-37 and 86-42. As a result, actions of one or more shareholders in disposing of the acquirer's stock could affect the tax treatment of all the other target shareholders.

Under the proposed regulations, the focus would return to the form of consideration issued by the acquiring corporation. Under the proposed rules, COSI would be satisfied if the acquiring corporation furnishes consideration in the reorganization that represents a proprietary interest in its (or its parent's) affairs. The consideration must represent a "substantial" portion of the value of the stock or properties transferred. "Substantial" has not been defined in the regulations, but might be deemed to be as low as one-third (as in Nelson, supra) or one-half (as required by Rev. Procs. 77-37 and 86-42).

Generally, under the proposed regulations, dispositions after the reorganization by the target shareholders would not be taken into account; however, all the facts and circumstances would have to be considered. For instance, the subsequent redemption of target shareholders by an acquiring corporation or a party related to the acquiring corporation as part of a pre-arranged plan would prevent the COSI requirement from being satisfied. The proposed regulations do not consider pre-reorganization transactions or continuity requirements for reorganizations under Sec. 368(a)(1)(d) or transactions under Sec. 355. The Service has taken a more expansive view of continuity in "D" reorganizations in certain letter rulings; see, e.g., Letter Ruling 9111055.


Another judicial requirement of reorganizations was established by the Supreme Court in Groman, 302 US 82 (1937), and Bashford, 302 US 454 (1938), and became known as the "remote continuity of interest" doctrine. This doctrine required the newly acquired stock or assets to be directly held by the corpora6on that issued the consideration. Later, the doctrine was modified by legislation that allowed the acquirer to transfer the stock or assets to its subsidiary (Sec. 368(a)(2)(C)), or to permit forward and reverse triangular mergers (Sec. 368(a)(2)(d) and (E)). Absent a statutory exception to this judicial requirement, the IRS continued to impose a COBE test on all taxfree reorganizations; see GCM 35117, in which the Service held that the transfer of assets to a partnership after a type "A" reorganization violated the remote continuity doctrine.

The proposed regulations would use the current requirements under Regs. Sec. 1. 368-1 (d), which generally provide that COBE is satisfied when the acquiring corporation continues the target's historic business or uses a significant portion of the target's historic business in a trade or business. The proposed regulations provide that continuity would not be violated if the acquirer transfers the target's assets or stock to a member of a qualified group (i.e., one or more chains of corporations connected through stock ownership with the issuing corporation). The issuing corporation must directly own at least 80% of the voting stock and 80% of each class of nonvoting stock in at least one other corporation; all other corporations in the chain must also satisfy these requirements. To qualify for the 80% test, no attribution of stock among the corporations is allowed.

Also, the proposed regulation would treat a partnership as an aggregation of its partners and not as a separate entity. Therefore, when assets are transferred to a partnership after a reorganization, the COBE requirement would not be violated if the transferor has active and substantial management functions as a partner or a significant interest in the partnership. All facts and circumstances would have to be considered in a transfer of assets to a partnership.

Application of Regulations

Under the proposed continuity regulations, the cashing out of the target shareholders would be substantially simpler. Not only would a pre-arranged disposition of the acquirer's stock to parties other than the acquiring corporation be allowed, but (as noted in Example 3 of the proposed regulations) the target shareholders would be allowed to hedge their risk of loss and still satisfy the continuity requirement. Therefore, if the target shareholders could not immediately dispose of their stock, they could enter into hedging transactions to prevent any downside risk in the acquirer's stock or use the stock as collateral for a loan to monetize their investment.

In certain cases, it is advantageous for a corporation to fad the qualifications for a tax-free reorganization (e.g., purchase for tax and pooling for financial statement purposes). Under the proposed regulations, failing the judicial doctrines would become slightly more difficult. For instance, under the remote continuity requirement, the transfer of assets to a partnership wholly owned by an affiliated group causes the reorganization to fail and become a taxable asset purchase; under the proposed regulations, this would not be possible.


The COSI proposed regulations should be welcomed as an effort to return the focus to the consideration issued in the transaction, thereby eliminating the subjectivity related to the pre- or post-reorganization analysis. The COBE proposed regulations would provide flexibility to the acquiring corporation as to the manner in which it holds acquired assets, albeit at the cost of reduced flexibility in structuring a taxable versus nontaxable acquisition.
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Author:Prettyman, James H.
Publication:The Tax Adviser
Date:Jul 1, 1997
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