Treasury recently finalized regulations, effective for transactions occurring after December 12, 2008, for applying the continuity-of-interest (COI) requirement to insolvent corporations (T.D. 9434). These regulations expand the Sec. 368(a) (1)(G) COI provisions by providing that stock issued to a creditor in reorganizations both inside and outside bankruptcy proceedings will generally represent qualifying consideration when determining whether the reorganization satisfies the COI requirement.
COI is both a regulatory and a judicial requirement. The requirement first appeared in its current form in Cortland Specialty Co., 60 F.2d 937 (2d Cir. 1932), cert. denied, 288 U.S. 599 (1932), where the Second Circuit explained the purpose of Section 203 of the Revenue Act of 1926, a precursor to Sec. 368, in terms very similar to the current regulations. Cortland was followed shortly thereafter by two U.S. Supreme Court decisions that further explained the requirement. In the pre–Sec. 368 reorganization decision, Pinellas Ice & Cold Storage Co., 287 U.S. 462 (1933), the Court, citing Cortland, held that target shareholders must acquire an interest in the acquirer for the merger to qualify as a reorganization because, without receipt of such interest, the transaction was in substance a sale. In Helvering v. Minnesota Tea Co., 296 U.S. 378 (1935), the Court went a step further than it had in Pinellas, holding not only that a continuing interest is required, but also that such interest must be substantial compared with the interest exchanged. This position is perhaps the first mention of the necessary degree of continuity in a reorganization.
The current regulatory continuity requirement adopts the judicial language, stating that the reorganization provisions under Sec. 368 are intended to apply only to reorganizations, “which effect only a readjustment of continuing interest in property under modified corporate forms” (Regs. Sec. 1.368-1(b)). Further defining the requirement, the regulations go on to state:
A proprietary interest in the target corporation is preserved if, in a potential reorganization, it is exchanged for a proprietary interest in the issuing corporation (as defined in [Regs. Sec. 1.368-1(b)]), it is exchanged by the acquiring corporation for a direct interest in the target corporation enterprise, or it otherwise continues as a proprietary interest in the target corporation. [Regs. Sec. 1.368-1(e)(1)(i)]
In a bankruptcy workout of an insolvent corporation, the historic debtor corporation’s shareholders are often eliminated in the workout. As such, barring special rules to the contrary, many bankruptcy reorganizations under Sec. 368(a) (1)(G) would fail the COI requirement. In the case of an insolvent corporation in bankruptcy, the Supreme Court held that the debtor corporation’s creditors became the proprietors for purposes of determining COI (Helvering v. Alabama Asphaltic Limestone Co., 315 U.S. 179 (1942)).
In March 2005, Treasury issued proposed regulations to address when and to what extent creditors of a corporation would be treated as proprietors in determining COI in a potential reorganization (REG-163314-03). The proposed regulations provided that creditors of an insolvent target corporation not in a title 11 (bankruptcy) or similar case could be treated as holding a proprietary interest in the corporation (Prop. Regs. Sec. 1.368-1(e)(6)). The proposed regulations also provided specific guidance on how to quantify the proprietary interest of the target corporation so that taxpayers could determine whether the COI requirement was met (Prop. Regs. Sec. 1.368-1(e)(6)(ii)).
In order to facilitate the rehabilitation of troubled corporations, Congress expanded the application of the G reorganization rules (transfer of assets to another corporation in a bankruptcy or similar case under a qualified plan) to reorganizations of insolvent corporations outside bankruptcy. The final regulations adopt the rules proposed for creditors of an insolvent target corporation outside a title 11 or similar case in Regs. Sec. 1.368-1(e) (6) with only minor modifications and clarifications (T.D. 9434).
Temp. Regs. Modify Application of the Hot Stock Rule
Under Regs. Sec. 1.368-1(e)(6)(i), a creditor’s claim against a target corporation may represent a proprietary interest if the target is in a title 11 or similar bankruptcy case or if the target is insolvent immediately prior to the reorganization. Under the new rules, senior and junior creditors are viewed differently, although each type of creditor may receive qualifying stock in exchange for their claims (see Regs. Sec. 1.368-1(e)(6)(ii)).
For a claim of the most senior class of creditors and any equal class of creditor receiving a non–de minimis proprietary interest in the issuing corporation, the value of the proprietary interest in the target corporation represented by the creditor’s liability is described by the following equation:
V = C ×
V is the value of the proprietary interest in the target corporation represented by the claim. C represents the fair market value (FMV) of the senior creditor’s claim. P represents the aggregate FMV of proprietary interests received (i.e., the value of stock received in the aggregate by senior creditors). M + O represents the aggregate sum of the money and other consideration (including the proprietary interests in the issuing corporation) received by the senior creditors (Regs. Sec. 1.368-1(e)(6)(ii)(A)). By contrast, for claims of junior classes of creditors receiving stock, the value of the proprietary interest in the target organization is the FMV of the junior creditor’s claim (Regs. Sec. 1.368-1(e)(6)(ii)(B)).
Example 1: T, an insolvent corporation, has two senior creditors (A and B), each with a $200 claim. In a nonbankruptcy reorganization, A receives $50 in stock of P, the issuing (i.e., acquiring) corporation, and $150 in cash, while B receives $200 in cash.
Applying the above equation, $25 of each creditor’s claim represents a proprietary interest [$200 × 50 ÷ (50 + 350) = $25], and the aggregate consideration allocated to the proprietary interests is $50 ($25 of stock received by A plus $25 of cash received by B). COI in the reorganization is 50%, calculated by dividing the $25 value of the stock allocated as a proprietary interest by the $50 of aggregate consideration allocated to the proprietary interests of the creditors.
Example 2: Under the same facts as Example 1, assume that T also had a junior creditor with a claim with an FMV of $100. The creditor received $65 in cash and $35 in P stock.
COI in the reorganization is 40%, calculated by comparing the aggregate $60 value of the stock allocated as proprietary interests to the senior and junior creditors ($60 = $25 deemed received by A and $35 received by T) to the $150 of aggregate consideration allocated to the proprietary interests of the creditors ($25 of stock received by A, $25 of cash received by B, and the entire $100 claim of the junior creditor).
As with past economic downturns, many corporations are facing debt workouts and restructurings. The final regulations provide insolvent debtor corporations with the same favorable COI rules as corporations in bankruptcy and thereby provide greater flexibility to corporations looking to restructure debt. However, the broadening of the rules could also make it more difficult for creditors to recognize a loss in a workout because receipt of stock in a qualified reorganization is covered by Sec. 354, which defers the recognition of gain or loss (although a taxable event will occur under Sec. 354(a)(2)(B) to the extent the stock received is attributable to accrued interest). Also worthy of note is that while the regulations may expand the ability to qualify a workout as a reorganization, they do not eliminate the amount or defer the timing of cancellation of indebtedness income that the corporation may recognize through the application of Sec. 108(e)(8).
Mindy Cozewith is director, National Tax, at RSM McGladrey, Inc., in New York City.
Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.
For additional information about these items, contact Ms. Cozewith at (908) 233-2577 or firstname.lastname@example.org.