[Federal Register Volume 60, Number 33 (Friday, February 17, 1995)]
[Proposed Rules]
[Pages 9309-9312]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-3771]



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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[CO-62-94]
RIN 1545-AT15


Continuity of Interest in Transfer of Target Assets After 
Qualified Stock Purchase of Target

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the 
income tax treatment of the transfer of target assets to the purchasing 
corporation or another member of the same affiliated group as the 
purchasing corporation (the transferee) after a qualified stock 
purchase (QSP) of target stock, if a section 338 election is not made. 
These regulations provide guidance to parties to such transfers and 
their shareholders. This document also provides notice of a public 
hearing on these proposed regulations.

DATES: Written comments and outlines of topics to be discussed at the 
public hearing scheduled for June 7, 1995, must be received by May 19, 
1995.

ADDRESSES: Send submissions to: CC:CORP:T:R (CO-62-94), room 5228, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. In the alternative, submissions may be hand delivered between 
the hours of 8 a.m. and 5 p.m. to: CC:CORP:T:R (CO-62-94), Courier's 
Desk, Internal Revenue Service, 1111 Constitution Avenue NW., 
Washington, DC. The public hearing will be held in room 3313, Internal 
Revenue Building, 1111 Constitution Avenue NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
William Alexander, (202) 622-7780; concerning the submissions and 
requests for a hearing, Christina Vasquez, (202) 622-7180 (not toll-
free numbers).
SUPPLEMENTARY INFORMATION:

Background

    This document proposes guidance as to the treatment of transfers of 
target assets to another corporation after a qualified stock purchase 
of target stock, if a section 338 election is not made for the target. 
It addresses the effect of section 338 on the result in Yoc Heating v. 
Commissioner and similar cases.
    Under Sec. 1.368-1(b), for a transfer of assets to be pursuant to a 
reorganization within the meaning of section 368, there must be a 
continuity of interest in the target's business enterprise on the part 
of those persons who, directly or indirectly, were the owners of the 
enterprise prior to the reorganization.
    In Yoc Heating v. Commissioner, 61 T.C. 168 (1973), a corporation 
bought 85 percent of a target corporation's stock for cash and notes. 
As part of the same plan, the target subsequently transferred its 
assets to a newly formed subsidiary of the purchaser and dissolved. The 
purchaser received additional stock of its subsidiary in exchange for 
the purchaser's target stock and the minority shareholders received 
cash in exchange for their target stock.
    The Tax Court, viewing the stock purchase and asset acquisition as 
an integrated transaction in which the purchaser acquired all of the 
target's assets for cash and notes, held there was insufficient 
continuity of interest to qualify the asset transfer as a 
reorganization under section 368 because the shareholders of the target 
before the stock purchase received no stock in the acquiring entity. As 
a result, the subsidiary received a cost basis in the target's assets.
    In addition to Yoc Heating, there are other cases in which courts 
have denied reorganization treatment and have given the transferee a 
stepped-up basis in the target's assets following the purchase of the 
target's stock and the merger of the target into the purchaser or a 
related corporation. See, e.g., Russell v. Commissioner, 832 F.2d 349 
(6th Cir. 1987), aff'g Cannonsburg Skiing Corp. v. Commissioner, T.C. 
Memo 1986-150 (corporation purchased target stock and then target 
merged into purchaser); Security Industrial Insurance Co. v. United 
States, 702 F.2d 1234 (5th Cir. 1983) (corporation purchased stock of 
targets and then targets merged into purchaser, which then transferred 
the target assets to a subsidiary of the purchaser); South Bay 
Corporation v. Commissioner, 345 F.2d 698 (2d Cir. 1965) (individual 
purchased stock in two targets and then targets merged into a third 
corporation owned by the individual); Superior Coach of Florida 
[[Page 9310]] v. Commissioner, 80 T.C. 895 (1983) (individual purchased 
target stock and then target merged into another corporation controlled 
by the individual); Estate of McWhorter v. Commissioner, 69 T.C. 650 
(1978), aff'd, 590 F.2d 340 (8th Cir. 1978) (corporation purchased 
target stock and then target merged into purchaser); and Kass v. 
Commissioner, 60 T.C. 218 (1973), aff'd, 491 F.2d 749 (3d Cir. 1974) 
(corporation purchased target stock and then target merged into 
purchaser).
    The Yoc Heating court's analysis of the transaction as, in 
substance, a taxable asset acquisition by the subsidiary is consistent 
with generally applied federal income tax principles. For example, in 
Kimbell-Diamond Milling Co. v. Commissioner, 14 T.C. 74 (1950), aff'd 
per curiam, 187 F.2d 718 (5th Cir.), cert. denied, 342 U.S. 827 (1951), 
an acquiring corporation's purchase of a target corporation's stock 
followed by the liquidation of the target was treated for federal 
income tax purposes as, in substance, a direct purchase of the target's 
assets by the acquiring corporation. The Tax Court's characterization 
in Kimbell-Diamond was based on a finding that the acquiring 
corporation intended to obtain the target's assets rather than its 
stock. As a result, the acquiring corporation's basis in the target's 
assets was determined by reference to the purchase price of the 
target's stock.
    In 1954, Congress codified principles derived from Kimbell-Diamond 
by enacting former section 334(b)(2) of the Internal Revenue Code of 
1954, which created an objective test that permitted a stock purchase 
followed by liquidation of the target to be treated as an asset 
acquisition. S. Rep. No. 1622, 83d Cong., 2d Sess. 257 (1954).
    In 1982, Congress repealed section 334(b)(2) and replaced it with 
section 338, which provides that, if a corporation makes a qualified 
stock purchase (QSP) of the stock of a target, the purchasing 
corporation may elect to have the target treated as having sold all of 
its assets at the close of the acquisition date in a single transaction 
and as a new corporation that purchased all such assets at the 
beginning of the following day. Section 338 was ``intended to replace 
any nonstatutory treatment of a stock purchase as an asset purchase 
under the Kimbell-Diamond doctrine.'' H.R. Conf. Rep. No. 760, 97th 
Cong., 2d Sess. 467, 536 (1982), 1982-2 C.B. 600, 632.
    Under section 338(i), the IRS and Treasury are authorized to 
prescribe such regulations as may be necessary or appropriate to carry 
out the purposes of section 338. The IRS and Treasury believe that the 
result in Yoc Heating is inconsistent with the legislative intent 
behind section 338. As a result of the enactment of section 338, an 
intragroup merger or similar transaction following a QSP generally 
should not be treated as part of an overall asset acquisition. The 
qualified stock purchase must be accorded its intended effect. Cf. Rev. 
Rul. 90-95, 1990-2 C.B. 67 (applying sections 332 and 334 to a merger 
of the target into the purchasing corporation following a QSP). If a 
section 338 election is not made, in a subsequent intragroup merger or 
similar transaction, the target assets generally should preserve their 
historic basis maintained in the qualified stock purchase. The IRS and 
Treasury believe that applying the reorganization rules to the target 
and purchasing group in mergers and similar transactions following a 
QSP is the simplest and most effective means of achieving the 
congressional intent in repealing the Kimbell-Diamond doctrine.

Explanation of Provisions

    Proposed Sec. 1.338-2(c)(3) applies to the transfer of target 
assets to the purchasing corporation or another member of the same 
affiliated group as the purchasing corporation (the transferee) 
following a QSP of target stock, if the purchasing corporation does not 
make a section 338 election for the target.
    As noted above, for the transfer of target assets to be pursuant to 
a reorganization within the meaning of section 368, there must be a 
continuity of interest in the target's business enterprise on the part 
of those persons who, directly or indirectly, were the owners of the 
enterprise prior to the reorganization. See Sec. 1.368-1(b). The 
proposed regulations generally provide that, by virtue of the 
application of section 338, the purchasing corporation's target stock 
acquired in the QSP represents an interest on the part of a person who 
was an owner of the target's business enterprise prior to the transfer 
that can be continued in a reorganization for the purpose of 
determining whether the continuity of interest requirement is 
satisfied. A corollary provision enables the transfer to satisfy the 
requirements for an acquisitive reorganization under section 
368(a)(1)(D).
    Notwithstanding the general rule above, the proposed regulations 
provide that sections 354, 355, 356 and 358 do not apply to any person 
other than the purchasing corporation or another member of the same 
affiliated group as the purchasing corporation unless the transfer of 
target assets is pursuant to a reorganization under generally 
applicable rules without regard to the provisions of the proposed 
regulations. The legislative history of section 338 does not indicate 
any intent to eliminate the continuity of interest requirement 
generally and allow reorganization treatment to shareholders receiving 
stock in acquisitions where the overall consideration does not preserve 
continuity of interest. The rules provided in the proposed regulations 
reconcile Congress' concerns in enacting section 338 with general 
reorganization principles.
    The IRS and Treasury request comments on the proposed rules, 
including, particularly, comments regarding the collateral consequences 
of treating the transaction as a reorganization to the target and to 
the purchasing corporation and its affiliates, but not to persons 
unaffiliated with the purchasing corporation. The IRS and Treasury also 
solicit comments as to whether guidance is needed as to the proper 
treatment of post-QSP mergers and similar transactions if a section 338 
election is made for the target.

Proposed Effective Date

    Section 1.338-2(c)(3) is proposed to be effective for transfers of 
target assets occurring on or after the date final regulations are 
filed with the Office of the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in EO 12866. Therefore, 
a regulatory assessment is not required. It has also been determined 
that section 553(b) of the Administrative Procedure Act (5 U.S.C. 
chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do 
not apply to these regulations, and, therefore, a Regulatory 
Flexibility Analysis is not required. Pursuant to section 7805(f) of 
the Internal Revenue Code, this notice of proposed rulemaking will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Comments and Requests for a Public Hearing

    Before this proposed regulation is adopted as a final regulation, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) that are submitted timely to the IRS. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for June 7, 1995, at 10 a.m. in 
room [[Page 9311]] 3313, Internal Revenue Building, 1111 Constitution 
Avenue NW, Washington, DC. Because of access restrictions, visitors 
will not be admitted beyond the Internal Revenue Building lobby more 
than 15 minutes before the hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons that wish to present oral comments at the hearing must 
submit written comments by May 19, 1995, and submit an outline of the 
topics to be discussed and the time to be devoted to each topic (signed 
original and eight (8) copies) by May 19, 1995.
    A period of 10 minutes will be allocated to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these regulations is William Galanis, 
Office of Assistant Chief Counsel (Corporate), Internal Revenue 
Service. However, other personnel from the IRS and Treasury Department 
participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read, 
in part, as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.338-0 is amended by adding entries for 
Sec. 1.338-2(c)(3) to read as follows:


Sec. 1.338-0  Outline of topics.

* * * * *


Sec. 1.338-2  Miscellaneous issues under section 338.

* * * * *
    (c)* * *
    (3) Consequences of post-acquisition elimination of target.
    (i) Scope.
    (ii) Continuity of interest.
    (iii) Control requirement.
    (iv) Example.
    (v) Effective date.
* * * * *
    Par. 3. Section 1.338-2 is amended by adding paragraph (c)(3) to 
read as follows:


Sec. 1.338-2  Miscellaneous issues under section 338.

* * * * *
    (c) * * *
    (3) Consequences of post-acquisition elimination of target--(i) 
Scope. The rules of this paragraph (c)(3) apply to the transfer of 
target assets to the purchasing corporation (or another member of the 
same affiliated group as the purchasing corporation) (the transferee) 
following a qualified stock purchase of target stock, if the purchasing 
corporation does not make a section 338 election for target.
    (ii) Continuity of interest. By virtue of section 338, in 
determining whether the continuity of interest requirement of 
Sec. 1.368-1(b) is satisfied on the transfer of assets from target to 
the transferee, the purchasing corporation's target stock acquired in 
the qualified stock purchase represents an interest on the part of a 
person who was an owner of the target's business enterprise prior to 
the transfer that can be continued in a reorganization. Notwithstanding 
the preceding sentence, sections 354, 355, 356 and 358 do not apply to 
any person other than the purchasing corporation or another member of 
the same affiliated group as the purchasing corporation unless the 
transfer is pursuant to a reorganization under generally applicable 
rules without regard to this paragraph (c)(3)(ii).
    (iii) Control requirement. By virtue of section 338, the purchasing 
corporation is treated as a shareholder of the target transferor for 
the purpose of determining whether, immediately after the transfer of 
target assets, a shareholder of the transferor is in control of the 
corporation to which the assets are transferred within the meaning of 
section 368(a)(1)(D).
    (iv) Example. This paragraph (c)(3) is illustrated by the following 
example:

    Example. (A) Facts. P, T, and X are domestic corporations. T and 
X each operate a trade or business. A and K, individuals unrelated 
to P, own 85 and 15 percent, respectively, of the stock of T. P owns 
all of the stock of X. The total adjusted basis of T's property 
exceeds the sum of T's liabilities plus the amount of liabilities to 
which T's property is subject. P purchases all of A's T stock for 
cash in a qualified stock purchase. P does not make an election 
under section 338(g) with respect to its acquisition of T stock. 
Shortly after the acquisition date, and as part of the same plan, T 
merges under applicable state law into X in a transaction that, but 
for the question of continuity of interest, satisfies all the 
requirements of section 368(a)(1)(A). In the merger, all of T's 
assets are transferred to X. P and K receive X stock in exchange for 
their T stock. P intends to retain the stock of X indefinitely.
    (B) Status of transfer as a reorganization. By virtue of section 
338, for the purpose of determining whether the continuity of 
interest requirement of Sec. 1.368-1(b) is satisfied, P's T stock 
acquired in the qualified stock purchase represents an interest on 
the part of a person who was an owner of T's business enterprise 
prior to the transfer that can be continued in a reorganization 
through P's continuing ownership of X. Thus, the continuity of 
interest requirement is satisfied and the merger of T into X is a 
reorganization within the meaning of section 368(a)(1)(A). Moreover, 
by virtue of section 338, the requirement of section 368(a)(1)(D) 
that a target shareholder control the transferee immediately after 
the transfer is satisfied because P controls X immediately after the 
transfer. In addition, all of T's assets are transferred to X in the 
merger and P and K receive the X stock exchanged therefor in 
pursuance of the plan of reorganization. Thus, the merger of T into 
X is also a reorganization within the meaning of section 
368(a)(1)(D).
    (C) Treatment of T and X. Under section 361(a), T recognizes no 
gain or loss in the merger. Under section 362(b), X's basis in the 
assets received in the merger is the same as the basis of the assets 
in T's hands. X succeeds to and takes into account the items of T as 
provided in section 381.
    (D) Treatment of P. By virtue of section 338, the transfer of T 
assets to X is a reorganization. Pursuant to that reorganization, P 
exchanges its T stock solely for stock of X, a party to the 
reorganization. Because P is the purchasing corporation, section 354 
applies to P's exchange of T stock for X stock in the merger of T 
into X. Thus, P recognizes no gain or loss on the exchange. Under 
section 358, P's basis in the X stock received in the exchange is 
the same as the basis of P's T stock exchanged therefor.
    (E) Treatment of K. Because K is not the purchasing corporation 
(or an affiliate thereof), section 354 does not apply to K's 
exchange of T stock for X stock in the merger of T into X unless the 
transfer is pursuant to a reorganization under generally applicable 
rules without regard to paragraph (c)(3)(ii) of this section. Under 
general income tax principles applicable to reorganizations, the 
continuity of interest requirement is not satisfied because P's 
stock purchase and the merger of T into X are pursuant to an 
integrated transaction in which A, the owner of 85 percent of the 
stock of T, received solely cash in exchange for A's T stock. See, 
e.g., Yoc Heating v. Commissioner, 61 T.C. 168 (1973); Kass v. 
Commissioner, 60 T.C. 218 (1973), aff'd, 491 F.2d 749 (3d Cir. 
1974). Thus, the requisite continuity of interest under Sec. 1.368-
1(b) is lacking and section 354 does not apply to K's exchange of T 
stock for X stock. K recognizes gain or loss, if any, pursuant to 
section 1001(c) with respect to its T stock.

    (v) Effective date. The provisions of this paragraph (c)(3) are 
effective for transfers of target assets on or after the 
[[Page 9312]] date final regulations are filed with the Office of the 
Federal Register.
* * * * *
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 95-3771 Filed 2-16-95; 8:45 am]
BILLING CODE 4830-01-P