Regulations offer flexibility in meeting COI requirement.

• Author: D'Angelo, Maryann
• Position: Continuity of interest

Final regulations under Sec. 368, issued in September 2005, provide taxpayers flexibility in satisfying the continuity of interest (COI) requirement for certain corporate reorganizations. These COI regulations are designed to prevent changes in market value from causing an otherwise tax-free transaction to become a taxable transaction in which the target shareholders are subject, by reason of a binding contract, to the economic fortunes of the issuing corporation as of the date the binding contract is entered into by the relevant parties. The final COI regulations also provide insight, through examples, into acceptable COI limits.

How Much Stock?

COI, as described in Regs. Sec. 1.368-1 (e), generally requires the target shareholders in a reorganization to receive a proprietary interest in the issuing corporation in exchange for their shares in the target. This regulatory requirement focuses on the type of consideration received by the target shareholders. To satisfy the COI requirement, a significant portion of the consideration received by the target shareholders should consist of instruments that carry the required degree of proprietary interest, such as stock of the issuing corporation. The COI requirement is applied in the aggregate so that some target shareholders may receive solely issuing corporation stock and other shareholders may receive solely cash.

To date, there has been no mandatory requirement prescribed by Congress or Treasury as to the minimum amount of issuing corporation stock that must be received by the target shareholders to satisfy the COI requirement. Nevertheless the IRS, for advance ruling purposes, has required for many years that at least 50% of the consideration received by the target shareholders must be issuing corporation stock; see e.g., Rev. Procs. 77-37 and 86-42. Despite the fact that the Supreme Court in Nelson, 296 US 374 (1935), found COI to be satisfied when 38% of the consideration was issuing corporation stock, many tax practitioners were reluctant to issue tax opinions on acquisitive transactions that involved less than 50% COI.

An example set forth in the final COI regulations provides a welcomed clarification to lower acceptable COI limits. In Regs. Sec. 1.368-1(e)(2)(v), Example (6), the IRS acknowledges the COI requirement is satisfied for an acquisitive transaction if at least 40% of the target stock is exchanged for issuing corporation stock. The preamble to the final regulations clarifies...