Getting back to basics - proposed continuity regulations.

• Author: Boyer, Mark W.

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.

COSI

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...