Regulations Issued on Continuity of Interest Rule for Corporate Reorganizations

The IRS issued final and proposed regulations (T.D. 9565 and REG-124627-11) on the continuity of interest (COI) requirement in Sec. 368 corporate reorganizations.

To qualify for nonrecognition treatment in a corporate reorganization, one of the requirements that must be met is COI, specifically how that requirement is met in the period between the date a binding contract is signed and the transaction is closed. Earlier regulations (T.D. 9225) provided that, to determine whether a proprietary interest in the target corporation is preserved, the consideration to be exchanged for the proprietary interest in the target corporation under a contract to effect the potential reorganization is valued on the last business day before the first date the contract is a binding contract (the pre-signing date) if the contract provides for fixed consideration (the signing date rule).

In 2007, the IRS issued temporary and proposed regulations (T.D. 9316 and REG-146247-06) adopting the signing date rule, but modifying the definition of fixed consideration to provide that consideration is fixed only if the contract specifies the number of the issuing corporation’s shares to be exchanged for all or each proprietary interest in the target corporation. The 2007 regulations also provided that modification of the sales contract resulted in a new signing date, but liberalized the rules by providing that the issuance of additional shares or a decrease in the money or other property delivered to the target’s shareholders would not trigger a new signing date. In addition, the regulations permitted shareholders to receive nonstock contingent consideration as long as the target shareholders remained subject to the economic benefits and burdens of owning the issuing corporation as of the signing date.

The newly issued final regulations adopt the 2007 regulations, while also clarifying that a contract can provide for fixed consideration even if it provides for a shareholder election to receive a number of shares of stock in the issuing corporation, money or other property (or some combination of those three things), in exchange for the shareholder’s proprietary interests in the target corporation.

The application of the signing date rule would be expanded in the new proposed regulations, issued in coordination with T.D. 9565. The proposed rules would allow a reorganization contract to provide that the amount of consideration will vary as the value of the issuing corporation’s stock declines between the pre-signing date value and some lower value provided for in the contract (the floor price), but not below the floor price. If the closing date value is less than the floor price, the target shareholders have been subjected to the economic fortunes of owning the stock as if they had had a contract requiring fixed consideration. The proposed regulations therefore permit COI to be determined as if the consideration that would have been delivered at the floor price were issued and valued at the floor price. A similar rule would apply if the value of the issuing corporation’s stock rises.

The proposed rules would also permit the use of an average value for the issuing corporation’s stock if it is based upon issuing corporation stock values after the signing date and before the closing date and the binding contract uses the average price, so computed, in determining the number of shares of each class of stock of the issuing corporation, the amount of money, and the other property to be exchanged for all the proprietary interests in the target corporation, or to be exchanged for each proprietary interest in the target corporation.

The final regulations are generally effective December 19, 2011. The proposed regulations will apply generally to transactions occurring on or after publication as final regulations in the Federal Register.