Continuity of Interest

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8761] RIN 1545-AV80

TITLE: Continuity of Interest

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

SUMMARY: This document contains temporary regulations providing
guidance regarding satisfaction of the continuity of interest
requirement for corporate reorganizations. The temporary regulations
affect corporations and their shareholders. Final regulations
published elsewhere in this issue of the Federal Register also
provide guidance regarding satisfaction of the continuity of
interest requirement for corporate reorganizations.

These temporary regulations amplify the final regulations. The text
of these temporary regulations also serves as the text of proposed
regulations published elsewhere in this issue of the Federal
Register.

DATES: These regulations are effective January 28, 1998.

Applicability: These regulations apply to transactions occurring
after January 28, 1998, except that they do not apply to any
transaction occurring pursuant to a written agreement which is
(subject to customary conditions) binding on January 28, 1998, and
at all times thereafter.

FOR FURTHER INFORMATION CONTACT: Phoebe Bennett, (202) 622-7750.(not
a toll-free number).

SUPPLEMENTARY INFORMATION:

This document contains amendments to the Income Tax Regulations (26
CFR part 1) under section 368. These temporary regulations provide
that, in determining whether the continuity of interest requirement
for corporate reorganizations is satisfied with respect to a
potential reorganization, a proprietary interest in the target
corporation is not preserved if, in connection with a potential
reorganization, it is redeemed or acquired by a person related to
the target corporation, or to the extent that, prior to and in
connection with a potential reorganization, an extraordinary
distribution is made with respect to it.

Background

On December 23, 1996, the IRS published a notice of proposed
rulemaking (REG-252231-96) in the Federal Register (61 FR 67512)
relating to the continuity of interest requirement. Many written
comments were received in response to this notice of proposed
rulemaking. A public hearing on the proposed regulations was held on
May 7, 1997. After consideration of all comments, the regulations
proposed by REG-252231-96 are adopted as final regulations, and
published elsewhere in this issue of the Federal Register. These
temporary regulations supplement the final regulations.

Explanation of Provisions Final regulations published elsewhere in
this issue of the Federal Register provide that in determining
whether the.continuity of interest (COI) requirement for corporate
reorganizations is satisfied, dispositions of stock of the target
corporation (T) by a T shareholder generally are not taken into
account.

Redemptions of T Stock or Extraordinary Distributions with Respect
to T Stock Commentators requested guidance on the circumstances
under which a redemption by T of its stock would adversely affect
satisfaction of the COI requirement.

Some commentators suggested that the IRS and Treasury Department
adopt an approach that would identify either the issuing corporation
(P) or T as the source of the funds for the redemption. If, in
connection with an acquisition of T, the facts and circumstances
indicate that P did not directly or indirectly furnish funds used by
T to redeem T shareholders, these commentators suggested that
satisfaction of the COI requirement should not be adversely
affected. In many transactions, however, such a tracing approach
would be extremely difficult to administer. For example, if P
acquired the assets, rather than the stock, of T or if T redeemed
stock for a note, it would be unclear in many circumstances whether
in substance T or P assets were used to fund the redemption or to
repay the note.

Another commentator suggested that redemptions by T in connection
with a potential reorganization should adversely affect satisfaction
of the COI requirement because the effect on COI is the same as if P
had furnished the redemption consideration in the transaction. The
temporary regulations.generally adopt this approach because it
reflects that T and P will be combined economically and because of
the difficulties of administering a tracing approach, as previously
described.

Treatment of stock redeemed by T as proprietary interests that are
not preserved in the reorganization also accords the same tax result
to transactions that reach the same result by different steps. For
example, T could merge into P for a combination of consideration, of
which 30 percent is P stock and 70 percent is a P promissory note.
Conversely, T could issue its promissory note to redeem 70 percent
of the T stock and then P would assume the T note in the merger, in
which the remaining T shareholders receive solely P stock. From the
perspective of P, T, and the T shareholders, these two transactions
are substantively identical, and the COI requirement is not
satisfied in the first transaction. The temporary regulations
provide that the second transaction likewise does not satisfy the
COI requirement.

In addition, this approach corresponds with the rule of the final
regulations that a proprietary interest in T is not preserved if, in
connection with the potential reorganization, P stock furnished in
exchange for a proprietary interest in T in the potential
reorganization is redeemed. Because the final regulations do not
inquire, in the case of a subsequent P redemption, whether the
source of consideration furnished in the redemption was former T
assets or historic P assets, the temporary regulations similarly do
not make an inquiry in the case of a prior T redemption. Instead,
for purposes of the COI.requirement, the temporary regulations treat
T and P as a combined economic enterprise. In an asset acquisition,
this approach avoids the difficult process of identifying the source
of payments as between T and P.

Commentators have suggested that this approach is inconsistent with
authorities which hold that redemptions of stock of the target
corporation with assets of the target corporation do not violate the
solely-for-voting-stock requirement applicable to section 368(a)(1)
(B) reorganizations.

See, e.g., Rev. Rul. 55-440 (1955-2 C.B. 226). None of these
authorities address the effect on continuity of interest of such
redemptions. For the reasons stated above, the temporary regulations
take such redemptions into account for continuity purposes.

The temporary regulations provide that a proprietary interest in T
is not preserved if, in connection with a potential reorganization,
it is redeemed or to the extent that, prior to and in connection
with a potential reorganization, an extraordinary distribution is
made with respect to it. An extraordinary distribution with respect
to T stock, followed by a sale of the remaining T stock to P, has
the same effect on the value of the proprietary interest in T as a
pro rata redemption by T followed by a sale of the outstanding T
stock to P.

The temporary regulations do not provide guidance on the
determination of whether a distribution will be treated as an
extraordinary distribution, except that the rules of section 1059 do
not apply for this purpose. The IRS and Treasury Department.invite
comments on whether the regulations should provide more specific
guidance in this area.

A section 355 distribution of controlled corporation stock by T will
preserve a proprietary interest in T, except to the extent that the
T shareholders receive other property or money to which section
356(a) applies or the distribution is extraordinary in amount and is
a distribution of property or money to which section 356(b) applies.

Related Person Rule

In determining whether the COI requirement is satisfied,
dispositions of T stock to persons that are not related to T or P
are disregarded. The final regulations provide that a proprietary
interest in T is not preserved if, in connection with a potential
reorganization, a person related to P acquires, with consideration
other than a proprietary interest in P, T stock or P stock furnished
in exchange for a proprietary interest in T in the potential
reorganization. Consistent with the final regulations, the temporary
regulations provide that a proprietary interest in T is not
preserved if, prior to and in connection with a potential
reorganization, a person related to T acquires T stock with
consideration other than T stock or P stock.

Definition of Related Person of T

The final regulations include as related persons any corporation
that is a member of the affiliated group, within the meaning of
section 1504, of which P is a member, and any corporation whose
purchase of P stock would be treated as a redemption of that stock
under section 304(a)(2). The section.1504 test was adopted because
the IRS and Treasury Department were concerned that acquisitions of
T stock or P stock by P affiliated corporations were no different in
substance than acquisitions or redemptions by P. This concern does
not generally extend to members of T's affiliated group that are not
also considered related to T under section 304(a)(2) because such
corporations are T shareholders participating in the potential
reorganization along with the other shareholders of the target
corporation. The temporary regulations treat two corporations as
related persons if a purchase of the stock of one corporation by
another corporation would be treated as a distribution in redemption
of the stock of the first corporation under section 304(a)(2)
(determined without regard to �1.1502-80(b)).

Effect on Other Authorities

These COI regulations apply solely for purposes of determining
whether the COI requirement is satisfied. No inference should be
drawn from any provision of this regulation as to whether other
reorganization requirements are satisfied, or as to the
characterization of a related transaction. See, e.g., �1.301-1(l).

Effect on Other Documents

Rev. Proc. 77-37 (1977-2 C.B. 568) and Rev. Proc. 86-42 (1986-2 C.B.
722) will be modified to the extent inconsistent with these
temporary regulations.

Effective Date

These regulations apply to transactions occurring after January 28,
1998, except that they do not apply to any.transaction occurring
pursuant to a written agreement which is (subject to customary
conditions) binding on January 28, 1998, and at all times
thereafter.

Special Analyses

It has been determined that these temporary regulations are not a
significant regulatory action as defined in EO 12866.

Therefore, a regulatory assessment is not required. It also has been
determined that section 553(b) of the Administrative Procedure Act
(5 U.S.C. chapter 5) does not apply to these temporary regulations
and, because the temporary regulations do not impose a collection of
information on small entities, the Regulatory Flexibility Act (5
U.S.C. chapter 6) does not apply.

Therefore, a Regulatory Flexibility Analysis is not required.

Pursuant to section 7805(f) of the Internal Revenue Code, these
regulations will be submitted to the Chief Counsel for Advocacy of
the Small Business Administration for comment on its impact on small
business.

Drafting Information

The principal author of these regulations is Phoebe Bennett of the
Office of the Assistant Chief Counsel (Corporate), IRS.

However, other personnel from the IRS and Treasury Department
participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations Accordingly, 26 CFR part 1
is amended as follows:

PART 1--INCOME TAXES.

Paragraph 1. The authority citation for part 1 continues to read in
part as follows:

Authority: 26 U.S.C. 7805. * * *

Par. 2. Section 1.368-1T is added to read as follows:

�1.368-1T Purpose and scope of exception of reorganization exchanges
(temporary).

(a) through (e)(1)(i) [Reserved] For further guidance see
�1.368-1(a) through (e)(1)(i).

(e)(1)(ii)(A) General rule. A proprietary interest in the target
corporation (other than one held by the acquiring corporation) is
not preserved if, prior to and in connection with a potential
reorganization, it is redeemed or to the extent that, prior to and
in connection with a potential reorganization, an extraordinary
distribution is made with respect to it. The determination of
whether a distribution with respect to stock of the target
corporation is an extraordinary distribution for purposes of this
paragraph (e)(1)(ii) will be made on the basis of all of the facts
and circumstances, but the treatment of the distribution under
section 1059 (relating to extraordinary dividends) will not be taken
into account.

(B) Exception. Paragraph (e)(1)(ii)(A) of this section does not
apply to a distribution of stock by the target corporation to which
section 355(a) (or so much of section 356 as relates to section 355)
applies, except to the extent that--

(1) The target corporation shareholders receive other property or
money to which section 356(a) applies; or

(2) The distribution is extraordinary in amount and is
a.distribution of property or money to which section 356(b) applies.

(2)(i) [Reserved] For further guidance, see �1.368-1(e)(2)(i).

(ii) A proprietary interest in the target corporation is not
preserved if, prior to and in connection with a potential
reorganization, a person related (as defined in �1.368-1(e)(3)
determined without regard to �1.368-1(e)(3)(i)(A)) to the target
corporation acquires stock of the target corporation, with
consideration other than stock of either the target corporation or
the issuing corporation.

(e)(3) through (e)(6) Example 9. [Reserved] For further guidance,
see �1.368-1(e)(3) through (e)(6) Example 9.

(e)(6) Example 10. Acquisition of target corporation stock before
merger. (i) Redemption by target corporation. A owns 85 percent and
B owns 15 percent of the stock of T. The fair market value of T is
$100x. Neither A nor B own stock of P. Prior to and in connection
with the merger of T into P, T redeems A's T stock for $85x and
issues to A its promissory note in exchange for the stock. At the
time of the merger T has a value of $15x, after giving effect to the
redemption of its stock. In the merger, B receives solely P stock.
The continuity of interest requirement is not satisfied because T
redeemed A's stock, and a substantial part of the value of the
proprietary interest in T is not preserved. See paragraph (e)(1)(ii)
(A) of this section.

(ii) Purchase by person related to target corporation. The facts are
the same as paragraph (i) of this Example 10, except that X, T's
wholly owned subsidiary, acquires A's T stock prior to and in
connection with the merger for cash of $85x. Under paragraph (e)(2)
(ii) of this section and �1.368-1(e)(3)(i)(B), X's acquisition of
A's T stock is an acquisition by a related person. The continuity of
interest requirement is not satisfied, because X acquired T stock,
for consideration other than P stock, and a substantial part of the
value of the proprietary interest in T is not preserved. See
paragraph (e)(2)(ii) of this section.

Example 11. Extraordinary distribution before merger. A owns all of
the stock of T. The fair market value of T is $100x.

Prior to and in connection with the merger of T into P, T pays A an
extraordinary distribution of an $85x note. T merges into P,.and A
receives solely P stock. P assumes T's obligation on the note. The
continuity of interest requirement is not satisfied, because T paid
A an extraordinary distribution, and a substantial part of the value
of the proprietary interest in T is not preserved. See paragraph (e)
(1)(ii)(A) of this section..(f) Effective date. This section applies
to transactions occurring after January 28, 1998, except that it
does not apply to any transaction occurring pursuant to a written
agreement which is (subject to customary conditions) binding on
January 28, 1998, and at all times thereafter.

Michael P. Dolan
Deputy Commissioner of Internal Revenue
Approved: January 12, 1998
Donald C. Lubick
Acting Assistant Secretary of the Treasury

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