IRS Finalizes COI Regs.

• Author: Weinberger, Mark

Effective Aug. 31, 2000, the Service issued final regulations (TD 8898) on the effect of pre-reorganization transactions on the continuity-of-interest (COI) requirement for corporate reorganizations. The regulations finalize the proposed and temporary regulations published on Jan. 28, 1998 (TD 8761).

Background

Under the temporary regulations, a proprietary interest in a target was not preserved if the interest were redeemed or an extraordinary distribution made on target stock prior to (and in connection with) a potential reorganization. Under this rule, continuity is adversely affected by pre-acquisition distributions made when (1) a regulated investment company (RIC) or real estate investment trust (REIT) acquires a corporation (which must distribute all non-RIC or non-REIT earnings and profits), (2) a C corporation acquires an S corporation (which commonly distributes its accumulated adjustments account (AAA)) or 0) there is an acquisition of a controlled foreign corporation (which commonly distributes its previously taxed income account on its subpart F income).

Commentators argued that the temporary regulations were too broad and should instead have been based on the "solely for voting stock" requirement: Pre-reorganization redemptions and extraordinary distributions by a target should not be taken into account for COI purposes, unless an acquiring corporation directly or indirectly furnishes the consideration for the redemption or distribution.

Sec. 356 Rule

The final regulations replace the temporary regulations' "in connection with" language with a Sec. 356 test, providing that a proprietary interest in a target is not preserved to the extent that consideration received before a reorganization in a redemption of (or distribution on) the target stock is treated as other property or money under Sec. 356 (or would be so treated if the target shareholder had also received acquiring stock in exchange for target stock). The fiction is necessary because Sec. 356 generally does not apply to a target shareholder unless he receives acquiring stock; see Rev. Rul. 74-515. To determine whether the COI requirement is satisfied, each target shareholder is treated as receiving some acquiring stock solely for purposes of applying the Sec. 356 COI test, but apparently not for any other purpose.

Unfortunately, Sec. 356 is somewhat unclear, which will make the Sec. 356 test of the final regulations difficult to apply with certainty for...