The following article is adapted from reprinted from the M&A Tax Report, Vol. 7, No. 9, April 1999, Panel Publishers, New York, NY.
STINGY CONTINUITY OF INTEREST RULINGS
By Robert W. Wood, San Francisco
For an acquisitive transaction to qualify as a reorganization it must satisfy the continuity of interest doctrine. This fundamental continuity requirement is satisfied if a substantial part of the value of the proprietary interests in the target corporation are preserved in the potential reorganization. A proprietary interest is so preserved if it is exchanged for a proprietary interest in the issuing corporation. Continuity of interest does not apply to the acquiring corporation or its shareholders. Thus, where necessary, the limits can be finessed by structuring the transaction as a reverse acquisition — make the acquiring corporation the corporation whose shareholders will be cashed out in what otherwise might be viewed as excessive numbers (see Rev. Rul. 70-223).
Moreover, a substantial part of such proprietary interests are considered preserved if 50% of the proprietary interests in the target are exchanged for interests in the issuing corporation. In Nelson v. Helvering, the Supreme Court found the requisite continuity of interest where the target's assets were transferred for preferred stock (38%) and cash (62%). Based on this now ancient and well-known case, most practitioners feel comfortable rendering opinions at continuity of interest levels of 40% and above.
Recently issued regulations (Reg. Sec. 1.368-1(e)) eliminate the venerable notions of historic shareholder continuity (under which only stock received by historical shareholders of the target counted for continuity of interest purposes). The new regulations also alter the scheme of post-merger continuity under which a pre-conceived plan or arrangement to dispose of the stock of the issuing corporation could cause that stock to be excluded in the computation of continuing equity. Still, the regulations do not ignore all pre- and post-transaction dealings in the stock of the target and the issuing corporation. Thus, pre-transaction disposals of stock, where the acquirer is the target or a person related to the target, will detract from continuity of interest, but only if such disposal is undertaken in connection with the potential reorganization.
A proprietary interest is also not preserved if (in connection with the potential reorganization) an extraordinary distribution is made with respect to it. A person is related to the target if it is a corporation that is a member of the target's affiliated group or a corporation whose purchase of target's stock would be described in Sec. 304(a)(2) — that is a corporation 50% or more of the value or voting power of the stock of which is owned, directly and indirectly, by the target.
The IRS may be taking an unreasonably harsh position with respect to the question of when such a disposal is effected in connection with the potential reorganization. While this question is ultimately a function of the proper application of the step transaction doctrine, Letter Ruling 9907001 may signal an intent on the part of the IRS to adopt an approach that focuses solely on timing, specifically temporal proximity. In Letter Ruling 9907001 the taxpayer was constrained to represent that during the five-year period, ending on the date of the business combination, neither target (nor any person related to target) will have acquired any stock of the target.
The need for this representation may signal that the IRS will automatically conclude that redemptions of target stock occurring within the five-year period preceding the transaction are made in connection with the potential reorganization. If this presumption is made, taxpayers will frequently find that their ability to meet the continuity of interest requirement will be impaired.
Perhaps here at The M&A Tax Report we may be reading a bit too much into this representation. After all, maybe the IRS will address the "in connection with" question using normal step transaction doctrine tenets. And we're all pretty comfortable with step transaction authority. But the dark clouds do seem to loom overhead.
If it turns out that the five-year rule represents official IRS policy, we may find that the elimination of pre- and post-transaction continuity notions (in cases where the relevant disposition of stock involves an unrelated purchaser) is little more than a pyrrhic victory.
Stingy Continuity of Interest Rulings, Vol. 7, No. 9, M&A Tax Report (April 1999), p. 6.