RSM Resources

Background
The continuity of interest (COI) began as a judiciallycreated requirement of tax-free reorganizations requiring receipt of asignificant continuing interest in the post reorganization corporation.  The Treasury subsequently incorporated COI asa regulatory requirement.

On September 15, 2005 the final regulations were issued(T.D. 9225) providing guidance for the determination of COI with respect tobinding contracts with fixed and contingent consideration.  The temporary regulations make changes to the2005 regulations.  

Recent Guidance
Issued March 19, 2007, the Temporary regulations (Temp. Reg.§ 1.368-1T(e)(2)) apply to transactions occurring pursuant to binding agreementsas of September 16, 2005; however, transitional relief allows application ofregulations in effect prior to March 20, 2007. 

Under the new rules, COI is determined under the “SigningDate Rule” if agreement is a Binding Contract providing for Fixed Consideration.  In such cases, COI is determined based uponthe value of issuing corporation (P) stock on the “last business day before thefirst date such contract is a binding contract.” Temp. Reg. §1.368-1T(e)(2)(i).

If the agreement does not provide for fixed consideration,taxpayers must wait until the transaction closes to determine satisfaction ofthe COI requirement.

The regulations define a Binding Contract as a contractenforceable under applicable law against the parties.  The fact that conditions outside the controlof the parties, such as regulatory approval, do not prevent execution of abinding contract, nor does subsequent negotiation of insubstantial terms, northe satisfaction of remaining customary conditions.  Temp. Reg. § 1.368-1T(e)(2)(ii)(A)

The regulations treat a contract as providing FixedConsideration if it provides for the number of shares of each class of stock ofP stock, the amount of money, and the other property (identified either byvalue or by specific description), if any, to be exchanged for all targetcorporation (T) stock, or each proprietary interest in T.  Temp. Reg. § 1.368-1T(e)(2)(iii)(A).

The fact that an agreement includes a shareholder electionfor mix of consideration does not prevent the agreement from providing fixedconsideration.  Rather, fixedConsideration includes agreements allowing the election of a number of sharesof P stock and/or money and/or other property in exchange for All of theshareholder’s T stock, or Each of the shareholder’s T shares, if thedetermination of the number of shares of issuing corporation stock isdetermined using the value of the stock on the last business day before thefirst date there is a binding contract. Temp. Reg. § 1.368-1T(e)(2)(iii)(A).

In addition, the regulations provide rules for applying theFixed Consideration requirement to the receipt of contingent consideration andthe Binding Contract requirement to certain contract modifications.  The key factor underlying each special rule isthe requirement that the recipient retains the risk and reward of ownership ofthe P shares from the signing date forward.

Summary
The temporary regulations provide guidance on a number ofissues concerning the COI requirement. However, the regulations fall short of addressing numerous transactionsutilizing contingent consideration such as collars and contingent arrangementsproviding for a mix of cash and equity.  Assuch, when structuring a transaction intended to represent a tax-freereorganization, agreements should be reviewed carefully to determine whetherthey fall under the Signing Date Rule or if the closing date will control.