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Corporate Tax Bulletin (April 1997)

Internal Revenue Service Proposes
Significant Changes in Shareholder
Continuity of Interest

By Laura E. Watts, now a tax partner in the San Francisco office of Pillsbury Winthrop Shaw Pittman LLP. If you have or can obtain the Acrobat Reader, you may wish to download our April 1997 Corporate Tax Bulletin (a 376K pdf file), containing the printed version of this article and also available via ftp at ftp.pmstax.com/corp/bull9704.pdf. You can also download the Notice of Proposed Rulemaking (a 36K pdf file), containing the text of the proposed regulations and also available via ftp at ftp.pmstax.com/corp/preg-shcont.pdf

This information is only of a general nature, intended simply as background material, omits many details and special rules and cannot be regarded as legal or tax advice.

On December 23, 1996, the Treasury Department published a notice of proposed rulemaking in an attempt to clarify a previously murky rule of corporate tax law, the continuity of shareholder interest requirement, which has been the subject of debate among tax practitioners for many years.


A tax-free reorganization involves at least the corporation whose stock or assets are being acquired ("Target") and the corporation providing the consideration, including its own stock, to acquire those stock or assets ("Acquiring"). Section 368 of the Internal Revenue Code (the "Code") contains seven basic structures for corporate reorganizations which are eligible for tax-free treatment. Each structure has its own requirements. Some of the requirements are identified in the statute and some are described in the Income Tax Regulations (the "Regulations"). One requirement that is common to all but one [fn. 1] of the reorganization structures is the continuity of shareholder interest requirement contained in section 1.368-1(b) of the Regulations.

The proposed regulations establish that the continuity of shareholder interest requirement concerns the consideration furnished by the Acquiring corporation to the Target shareholders in a reorganization. Under the proposed regulations, post-reorganization sales of Acquiring stock, subject to certain exceptions, do not violate the continuity of shareholder interest requirement. However, the proposed regulations do not address the consequences of pre-reorganization sales of Target stock on the continuity of shareholder interest requirement, otherwise known as the historic shareholder requirement.

The Existing Rule

The rule contained in the existing regulations states that

"[r]equisite to a reorganization under the Code are (except as provided in section 368(a)(1)(D) of the Code) a continuity of interest on the part of those person who, directly or indirectly, were the owners of the enterprise prior to the reorganization ..."[fn. 2]

The current rule does not explain what is meant by "a continuity of interest." The concept is drawn from case law and was adopted by the Treasury Department in section 1.368-1(b) of the Regulations. For some time, it has been unclear whether "a continuity of interest" referred merely to consideration furnished by Acquiring or encompassed further requirements that the Target shareholders should, at least at the time of the reorganization, intend to maintain a continuing interest in Acquiring through ownership of Acquiring stock. Or, as stated in Revenue Procedure 86-42, 1986-2 C.B. 722, the Target shareholders must have no plan or intention to sell the Acquiring stock received in the reorganization. Commentators have referred to this concept as "post-reorganization continuity."

The Proposed Rule

Under the proposed continuity of interest regulations (1) the Acquiring corporation must furnish consideration representing a proprietary interest in the affairs of the Acquiring corporation and (2) such consideration must represent a substantial part of the value of the stock or properties transferred in the transaction. A transaction that satisfies these two prongs is deemed to be sufficiently distinguishable from a sale to warrant nonrecognition of gain or loss in transactions that otherwise qualify for the corporate reorganization provisions of section 368 of the Code and the Regulations.

The proposed rule limits the continuity of shareholder interest requirement to the consideration furnished by Acquiring to the Target shareholders. Thus, it rejects the concept of post-reorganization continuity. The first example in the proposed regulations also demonstrates that the continuity requirement is solely a "consideration received" requirement.

A owns all of the stock of T. T merges into P. In the merger, A receives stock of P having a fair market value of $50x and cash of $50x. Immediately after the merger and pursuant to a pre-existing binding contract negotiated by A, A sells all of the stock of P received by A in the merger to B, a party not related to P. The transaction satisfies the continuity of shareholder interest requirement because A received stock of P representing a substantial part of the value of the total consideration transferred in the acquisition.

Thus, a Target shareholder may sell Acquiring stock acquired in a reorganization to a person unrelated to Acquiring, even pursuant to a pre-existing, binding contractual agreement, and still receive tax-free treatment.[fn. 3] Moreover, implicit in the above described example is the position that even if the step transaction doctrine is applied, the requirement that Acquiring furnish Acquiring stock in the reorganization will still be met since the sales proceeds are from a person that is unrelated to Acquiring.

The proposed regulations make it clear that the Target shareholders may not sell the Acquiring stock received in the transaction back to Acquiring or a party related to Acquiring as part of the overall transaction.[fn. 4] The preamble to the regulations notes that, in this context, the transaction may be recast, presumably under the step transaction doctrine, to treat the acquiring corporation as furnishing cash in the reorganization and depending upon the amount of stock sold, the transaction may not satisfy the continuity of interest requirement.


  1. A recapitalization, otherwise known as section 368(a)(1)(E) reorganization, does not require that there be continuity of shareholder interest. [return to text]

  2. The parenthetical concerning 368(a)(1)(D) reorganizations continues to remain a mystery. Some commentators attribute this cryptic reference to divisive D reorganizations. This view is supported by the subsequent promulgation of regulations under section 355 of the Code which contain a separate continuity of shareholder interest requirement for section 355 distributions. Some portion of these distributions will be divisive D reorganizations. Similarly, the reference to "directly or indirectly" is unclear since the attribution rules of section 318 do not apply to reorganizations contained in 368 other than acquisitive D reorganizations by virtue of 368(a)(2)(H) of the Code. [return to text]

  3. The Service has noted in the preamble to the proposed continuity of shareholder interest regulations that it must change its ruling policy contained in Revenue Procedure 86-42, 1986-2 C.B. 722 which, for purposes of obtaining a letter ruling, requires certain Target shareholders to represent that they have no plan or intention to sell the Acquiring stock received in the transaction which represents more than 50 percent of the value of the formerly outstanding Target stock. [return to text]

  4. Example 4 in the proposed continuity of shareholder interest regulations demonstrates that an unrelated party, such as an investment banker, who acts as an agent for Acquiring by purchasing the Acquiring stock issued in the reorganization and shortly thereafter selling such Acquiring stock back to Acquiring will be ignored or viewed as a conduit and Acquiring will be regarded as using cash rather than Acquiring stock in the transaction. Presumably, if the investment banker was not acting on behalf of Acquiring and, rather than selling the Acquiring stock back to Acquiring or a related party, sold such stock to the public or an unrelated person, the continuity of shareholder interest requirement would be satisfied. [return to text]

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