Stock repurchase plans and COI.

• Author: Cohen, Lawrence H.
• Position: Continuity of shareholder interest

An essential element of a tax-free reorganization is that there must be continuity of proprietary interest (COI) in the acquiring company. The purpose of this rule is to distinguish a taxable sale from a tax-free reorganization. Minnesota Tea Co., 296 US 378 (1935), and Pinellas Ice & Cold Storage Co., 287 US 462 (1933), established the principle that, to be a reorganization, the target shareholders must acquire an interest in an acquiring company that is "definite and material" and represents a substantial part of the transferred property's value. Thus, the COI requirement relates to the type of consideration received, the amount of qualifying consideration received and how long the target shareholders must retain the interest.

Interestingly, the Supreme Court never decided how long the target company shareholders were required to hold the interest they received, and the law on this issue is not clear. The courts have disagreed whether a reorganization occurred if shareholders had a pre-existing intention to dispose of the stock they received; compare McDonald's Restaurants of Illinois, Inc., 688 F2d 520 (7th Cir. 1982), and Penrod, 88 TC 1415 (1987). In Rev. Rul. 66-23, the IRS held that the receipt of stock subject to a court order to dispose of it within seven years satisfied the COI requirement, because the shareholders had complete discretion and control over the shares during the interim.

To bring certainty to the COI requirement and to prevent a buyer and seller from adopting inconsistent positions, the Service amended the reorganization regulations in 1998. In general, Regs. Sec. 1.368-1(e)(1)(i) now provides that the disposition of target stock prior to a reorganization or the disposition of the acquirer's stock after a reorganization, except to the acquiring corporation or related persons, will be disregarded. Rev. Rul. 66-23 was also declared obsolete.

Today, companies frequently have programs in which they repurchase their shares in the market from time to time. The existence of a repurchase program raises many questions when a company wants to engage in a tax-free reorganization. It is highly likely that the company will repurchase shares that it just issued in the reorganization. The Service considered a stock repurchase program in Regs. Sec. 1.3681 (e)(6), Example 8, which states that the repurchase program "was not created or modified in connection with the acquisition" and that the acquiring corporation purchased only a...