Coopers & Lybrand Criticize Proposed COI Regs

Gary B. Wilcox and Samuel P. Starr of Coopers & Lybrand LLP, Washington, have criticized the proposed regulations on the continuity of proprietary interest requirement for corporate reorganizations. Specifically, Wilcox and Starr say, reg. section 1.368-1T creates a "confusing inconsistency" between the solely for stock requirement and the COI doctrine. Also, they say, the reg unduly restricts an S corporation's ability to distribute its accumulated adjustment accounts before a reorganization.

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May 5, 1998

C:DOM:CORP:R (REG-120882-97)

Donald C. Lubick, Esq.

Charles O. Rossotti

Stuart L. Brown, Esq.

COMMENTS ON PROPOSED AND TEMPORARY REGULATIONS SECTION 1.368-1T

Dear Gentlemen:

[1] These comments are made in response to the Notice of Proposed Rulemaking (REG-120882-97) published in the Federal Register on January 28, 1998, containing proposed and temporary Treasury Regulation Section 1.368-1T (the "Temporary Regulation"). The Temporary Regulation relates to the continuity of proprietary interest ("COI") requirement in corporate reorganizations where there has been a redemption by the target corporation ("T") of its stock or an extraordinary distribution with respect to such stock. The Temporary Regulation was published in the Federal Register on the same day that the previously proposed COI and continuity of business enterprise ("COBE") regulations were published as final Treasury Regulations (the "Final Regulations").

[2] We commend the Internal Revenue Service for liberalizing and updating the COI/COBE requirements as reflected in the Final Regulations. In particular, the focus of the Final Regulations on the form of consideration provided by the issuing corporation ("P") to T's shareholders, and the resulting elimination of pre- and post- reorganization continuity requirements with respect to T shareholders, will be a great help in effecting tax-free reorganizations. We agree that the appropriate COI inquiry should be limited solely to the consideration paid by P or parties related to P. Because the Temporary Regulation does not adhere to this line of inquiry, it is our view that certain revisions and clarifications are required.

[3] The Temporary Regulation generally provides that COI in T is not preserved if, prior to and in connection with a reorganization, a T shareholder is redeemed, receives an extraordinary distribution, or has its stock purchased by a party related to T. In this regard, the Temporary Regulation imposes a blanket rule and requires no examination as to the source of funds for such payments.

[4] We understand that the Service has considered earlier comments to the effect that the source of the funds for the redemption or distribution should be identified, and has rejected that approach because of the difficulty in administration and the notion that pre-reorganization distributions and redemptions should be treated the same as those made by the acquiring corporation after the reorganization. We also understand that the preamble to the Temporary Regulation provides that the "solely-for-voting-stock" requirement is not affected by the new rules. Nevertheless, we believe that the Temporary Regulation creates a confusing inconsistency between the solely-for-voting-stock requirement and the COI doctrine and improperly intrudes into the realm of other reorganization standards, such as COBE and the "substantially all" requirement. In addition, in its present form, the Temporary Regulation unduly restricts the ability of an S corporation to distribute its accumulated adjustments account prior to a reorganization.

LIMITATION OF COI CONCERN TO P-FUNDED PAYMENTS

[5] We believe that, for COI purposes, T should be able to redeem and/or and make distributions to its shareholders without regard to the amounts involved as long as the source for such payments is T's own cash or assets on hand. A purchase of T stock by a party related to T also should be permitted if the purchaser is either using its own funds or acting on behalf of T. These actions should be permitted at any time prior to a reorganization, even if effected pursuant to a plan of reorganization. There should be no COI concern as long as T (or a related party) is merely depleting its own assets.

[6] Where T has incurred indebtedness to fund pre- reorganization redemptions or distributions, a facts and circumstances standard should be adopted for determining if COI has been preserved. If debt is incurred before a merger or asset acquisition, admittedly it may be difficult under certain circumstances to determine if T's assets will be used to repay the debt after the merger or asset acquisition has been completed. In these circumstances, it might be reasonable to impute the funding of the distribution or redemption to P. Cf. Rev. Rul. 71-364, 1971-2 C.B. 182 (T's distribution of excess retained cash in connection with a "C" reorganization did not violate the "solely" requirement); Rev. Rul. 73-102, 1973-1 C.B. 186 (acquirer's assumption of T's liabilities to dissenters in connection with a "C" reorganization constituted other property).

[7] On the other hand, if T incurred debt to fund a redemption or distribution before a stock reorganization, COI should be preserved as long as the debt is not guaranteed, assumed, or otherwise repaid by P, either directly or indirectly. See, e.g., Rev. Rul. 75-360, 1975-2, C.B. 110 (T's payment of a dividend prior to a reorganization with borrowed funds was considered "other property" because acquirer repaid the loan). For this purpose, Waterman Steamship principles conceivably could apply. See Waterman Steamship Corp. v. Commissioner, 430 F.2d 1185 (5th Cir. 1970) (pre-sale dividend of short-term note treated as sales proceeds provided by purchaser); P.L.R. 9717036 (January 28, 1997) (T's pre-sale dividend of note respected because it would be paid with cash from T's operations; Waterman tracing analysis applied by IRS). To the extent repayment of any T indebtedness rightfully can be imputed to P, it would be appropriate to take the redemption or distribution funded by the indebtedness into account in determining whether the COI requirement has been satisfied.

[8] In the preamble to the Temporary Regulation, the IRS stated that it rejected a tracing of funds approach because it would be "extremely difficult to administer." Without doubt, a tracing approach would be more difficult than the blanket rule imposed by the Temporary Regulation. Nevertheless, tracing with respect to pre- reorganization redemptions and dividends has been permitted by the IRS in the "solely-for-voting-stock" context for more than forty years. See, e.g., Rev. Rul. 55-440, 1955-2 C.B. 226; Rev. Rul. 56- 184, 1956-1 C.B. 190; Rev, Rul. 68-435, 1968-2 C.B. 155; Rev. Rul. 70- 172, 1970-1 C.B. 77. Abandonment of this well-established approach in favor of the broad prohibition of the Temporary Regulation does nothing to advance a fair application of the reorganization provisions and is contrary to spirit and intent of the Final Regulations.

[9] If a tracing approach is not adopted, there will be a confusing inconsistency between the COI requirement and the solely- for-voting-stock requirement. When non-stock consideration is provided by P to T shareholders in connection with a reorganization, it will be considered "boot" for both COI and solely-for-voting-stock purposes. However, when non-stock consideration is provided by T to its shareholders in connection with a reorganization, it will be considered boot for COI purposes, but apparently not for solely-for- voting-stock purposes. This distinction lacks a persuasive rationale. After all, the solely-for-voting-stock requirement is really just a statutorily imposed COI requirement, and, according to the preamble to the Temporary Regulation, tracing will continue to apply for this purpose.

[10] Another reason offered for the Temporary Regulation is that a pre-reorganization distribution or redemption should be treated the same as one made by the acquirer after the reorganization. We should keep in mind that the reorganization requirements are very formalistic, and that it may not be inappropriate to distinguish between pre- and post-reorganization distributions and redemptions.

[11] An additional problem with the Temporary Regulation is that it would impact or overlap with COBE requirements. For example, assume that T had three lines of business of approximately equal value and T distributed the assets of two of those businesses to its sole shareholder. Immediately thereafter, all of T's stock was acquired by P in exchange solely for P voting stock in an attempted "B" reorganization. This distribution would comply with the COBE requirements. See Treas. Reg. Section 1.368-1(d)(5), Example 1. However, assuming that a distribution of two-thirds of the value of T would constitute a "substantial part" of the value of T, the distribution would cause an otherwise good "B" reorganization to fail because of COI. This would be so even though all of T's shareholders became P shareholders and the only consideration received from P was its voting stock. In this case, the Temporary Regulation would effectively require the retention of at least fifty percent of the historic assets or business, in the guise of preserving COI.

[12] The better approach would be to leave asset continuity considerations to the existing COBE and "substantially all" requirements. The Temporary Regulation should be revised to reflect this and to limit COI concerns to those situations where non-equity consideration is received by T shareholders either directly or indirectly from P.

SPECIAL TREATMENT OF AAA DISTRIBUTIONS

[13] Shareholders of S corporations must currently include their pro rata share of the corporation's income under Section 1366(a). Any earnings not actually distributed remain in the S corporation, reflected both in (1) the corporation's accumulated adjustments account ("AAA") under Section 1368(e)(1) as well as (2) the shareholders' stock basis under Section 1367(a). The S corporation's shareholders do not include distributions of AAA in taxable income because amounts in AAA already have been taxed. When an S corporation is acquired by a C corporation in a tax-free reorganization, it is common practice for the S corporation to first distribute its entire AAA to its shareholders. Following the post- termination transition period, the AAA loses its status as such and any distributions to the former S corporation shareholders are taxable as dividends to the extent of the acquiring C corporation's earnings and profits, and then as a return of capital.

[14] Unless the Temporary Regulation is modified when finalized, S corporations desiring to engage in tax-free reorganizations will be forced to choose between several unpalatable choices. First, S corporations could distribute more of their earnings on an annual basis in the hope that the final disgorgement of any remaining AAA balance just before a reorganization will not be labeled "extraordinary."

[15] Second, the AAA could be left in the S corporation, and the former S corporation shareholders could promptly sell their stock in P. Because they did not receive AAA distributions, the S corporation shareholders will have a relatively high basis in the P stock received in the reorganization. As a result, they will recognize less gain (or more loss) on the sale of their P stock, and the S corporation stock basis adjustment rules under section 1367 will have accomplished their goal of preventing a second round of tax relating to the same earnings. Moreover, a prompt sale of the P stock to an unrelated party will not imperil the reorganization. See Treas. Reg. Section 1.368-1(e)(6), Example 1.

[16] We submit it is unfair to penalize S corporation shareholders for getting their hands on money on which they have already been taxed. Although Congress did not intend for S corporations to be treated any better than C corporations, it surely never intended for them to be treated any worse. /1/ The Temporary Regulation should be amended when finalized to provide that the term "extraordinary distribution" does not include distributions of AAA, either before or after a corporation's S status terminates.

[17] It should be noted that S corporation shareholders are not the only ones with an incentive to distribute previously taxed earnings prior to a tax-free reorganization. For example, under Section 957, shareholders of controlled foreign corporations (CFCs) may desire these entities to distribute previously taxed income before being acquired. A similar situation arises under Section 856 where a real estate investment trust (REIT) acquires a C corporation. Because a REIT must purge any C corporation E&P that it inherits under Section 857(a), most REITs insist that target C corporations purge all of their "bad" E&P prior to the acquisition. A complete discussion of these other regimes is beyond the scope of this comment. However, these other regimes as well as the S corporation situation deserve more thorough attention before the Temporary Regulation is finalized.

[18] We appreciate the opportunity to provide our comments on the Temporary Regulation and look forward to appearing at your public hearing on May 26. An outline of the topics which we propose to discuss at the hearing is attached. If you desire to discuss any of our comments with us, please contact us at the phone numbers listed below.

Sincerely,

Gary B. Wilcox

Samuel P. Starr

OUTLINE OF TOPICS TO BE DISCUSSED AT

Speaker: Gary B. Wilcox

Topic: Limitation of continuity of interest inquiry to payments

Speaker: Samuel P. Starr

Topic: Amendment of Treasury Regulations Section 1.368-1T to

FOOTNOTE

/1/ See P.L. No. 104-188 (amending section 1371(a) to expand types of subchapter C transactions in which S corporations can engage). See also G.C.M. 39768, supra (analyzing legislative histories from Subchapter S Revision Act of 1982 as well as the Tax Reform Act of 1984 to conclude that Congress intended for S corporations to participate in reorganizations).

END OF FOOTNOTE