This is a series based on questions from the AICPA tax certificate of educational achievement (CEA) courses.
Small Business Tax
Q. To ensure that a corporate merger will be treated as a tax-free reorganization by the Internal Revenue Service, how should the continuity of interest requirement be measured under the new regulations that have been proposed by the Treasury Department?
A. To qualify as a tax-free reorganization, a merger transaction must meet various statutory and regulatory requirements. One, under Treasury regulations section 1.368-1(b), is known as the continuity of interest requirement. The current regulations require that the acquired companys shareholders have a continuing and substantial proprietary interest as shareholders in the acquiring company. Historically, two primary tests have been applied to determine whether the continuity of interest rules are satisfied.
PASSING THE TWO TESTS
The first test looks at how much of the consideration the acquired companys shareholders receive is in the form of stock; the IRS position is that at least 50% must be stock (revenue procedure 77-31, 1977-2 CB 568). The courts, however, have allowed lessgoing as low as 38%to find continuity of interest. In John A. Nelson Co. v. Helvering (296 U.S. 374 ), the court said 38% nonparticipating preferred stock was adequate to establish continuity.
Once a company is acquired, a second test is how long its shareholders have held the stock they received in the reorganization. The IRS position historically has been that continuity of interest can be thwarted by post-transaction sales if there is a preconceived plan or arrangement to dispose of the acquiring companys stock (revenue ruling 66-23, 1966-1 CB 67). The courts have adopted this view when a shareholder intends to dispose of his or her stock as soon as possible after the reorganization (see McDonalds Restaurants of Ill., Inc. v. Commr , 688 F.2d 520 [7th Cir. 1982] and Robert A. Penrod , 88 TC 1415 ).
This second test has resulted in significant litigation and uncertainty in structuring reorganization transactions. In an effort to simplify transaction structuring, the IRS has proposed new regulations that would all but do away with continuity of interest problems.
WHAT THE IRS PROPOSES
The basic premise of the proposed regulations is that continuity of interest would be measured almost solely by reference to the consideration furnished by the acquiring company. As long as the portion of consideration composed of stock is substantial (50% or more, according to the IRS), post-transaction sales would be disregardedsubject to a few exceptions. The proposed regulations appear to eliminate the need to analyze post-transaction dispositions under the so-called step transaction doctrine.
Example . Anderson owns all of the stock of Orbit. Primo, Inc., acquires Orbit by merger. The merger agreement says Anderson will receive 50% Primo stock and 50% cash for her interest in Orbit. Immediately after the mergerunder the terms of a plan that existed before the mergerAnderson sells her Primo stock to Barton, who is unrelated to Primo. This transaction satisfies the continuity of interest requirement under the proposed regulations (proposed Treasury regulations section 1.368-1(c)(3), example 1).
Under the proposed regulations, the exception is for transactions in which the acquirer or its affiliates have a plan or intention to reacquire for cash some or all of the stock given in the merger. The subsequent reacquisition would be combined with the reorganization and the determination of whether continuity is satisfied would be made after taking into account the post-transaction redemption.
Example . Anderson owns all of the stock of Orbit. Primo acquires Orbit by a merger in which Anderson receives 50% Primo stock and 50% cash for her interest. Under a binding agreement, Anderson agrees to sell the Primo stock back to Primo for cash. Under these circumstances, continuity of interest is not satisfied and the merger would not be tax-free. The same result would occur if Anderson sold her stock to an affiliate of Primo.
The proposed regulations would apply only to transactions occurring after the regulations are final; they would not apply to transactions closing after the regulations are final under an agreement entered into before the regulations were final. It is curious that such a pro-taxpayer regulation would apply only prospectively. If the IRS is going to make such a fundamental change to its position, it should do so for all transactions that are still potentially subject to challenge, regardless of when they close.
EXCHANGE OF OPTIONS AND WARRANTS
It is worth noting that the IRS also proposed changes to its rules on the treatment of the exchange of options and warrants in a reorganization. The regulations currently provide that exchanging options and warrants is not tax-free under Internal Revenue Code section 354 (although, based on the facts, the exchange may not be taxable under IRC section 1001). The proposed regulations would treat options and warrants just like stock. This change also is prospective, effective only after the date the regulations are published in final form.
BRYAN E. BLOOM is a tax attorney with WRH Partners in
Morristown, New Jersey, and an adjunct professor at Fairleigh
Dickinson University. He is an author in the AICPA tax CEA series.