Attorney Comments on Stock, Asset Transfers After Reorganizations

This letter provides comments on REG-130863-04, which proposes to amend sections 1.368-1 and 1.368-2 of the regulations. The proposed regulations would make three substantive changes. First, the regulations would liberalize the rules regarding downstream transfers of assets or stock after a reorganization to entities owned, in whole or in part, by the transferor. (These transfers have been colloquially referred to as "drop downs.") Second, the regulations would provide guidance on upstream distributions of stock or assets after a reorganization (colloquially referred to as "push ups"). Third, the regulations would delete an example regarding a post-acquisition contribution of stock of the acquired corporation to a partnership. The preamble to the proposed regulations requested comments on whether and how the regulations that implement the continuity of business enterprise requirement for tax free reorganizations should be amended to allow such post-acquisition drop downs of stock to a partnership. The proposed rules on post-acquisition drop downs restate rules proposed in March 2004. In a letter dated March 17, 2004, I provided comments on those rules. This letter will not restate those comments. Instead, this letter will focus primarily on the proposed rules regarding post-acquisition push ups and also respond to the request for comments regarding post- acquisition drops downs of stock to a partnership. As was the case with my prior letter, the views expressed in this letter are my own. They are not official views of McKee Nelson. I have not prepared these comments on behalf of any client of the firm.

For the reasons explained below, I offer three principal recommendations regarding the proposed regulations:

• First, post-acquisition push ups raise two different issues that should be addressed separately. Each issue relates to the application of the step transaction doctrine: whether the distribution should be taken into account (i) in determining whether the acquiring corporation acquired substantially all of Target's assets, and (ii) to recharacterize the transaction as an acquisition by the distributee followed by a drop down. The resolution of each issue depends on the facts of the particular case. In general, any post-acquisition distribution that meets the COBE test can be viewed as independent of the acquisition for the purpose of applying the substantially all requirement. The relevant policies do not support recharacterization of the transaction except perhaps to enforce those rules that impose a tighter limit on non-stock "boot" than the general continuity of interest requirement.

• Second, the detailed drop down rules of section 1.368-2(k) are unnecessary. Any post-acquisition drop down that complies with the COBE rules should not support a recharacterization of the transaction as a potentially taxable direct acquisition by the transferee in the drop down.

• Third, the circumstances in which a post-acquisition transfer of stock to a partnership should be allowed under the COBE rules depend on the paradigm chosen for the general COBE rules. Because the existing COBE rules lack a consistent and coherent rationale, the issue of when stock can be dropped to a partnership should be addressed as part of a comprehensive rationalization of the COBE rules. My prior comment letter offered three possible means of rationalizing the COBE rules. In this letter, I will draw out the implications of each of these three approaches for the specific issue of drops of stock to a partnership. If policymakers choose instead to retain the existing COBE rules, a partnership should be treated as holding the businesses and assets of any corporation in which the partnership owns a controlling stock interest. The rules of the existing regulations could then govern the attribution of the businesses and assets from the partnership to the corporation that issued stock to the target shareholders.

The proposal of rules addressing push ups is another commendable step in a recent trend towards rationalizing the rules governing tax-free reorganizations. This goal of rationalization might be achieved more simply and effectively, however, by addressing separately the two different issues raised by push ups. Because these issues involve the application of the step transaction doctrine, their resolution may differ depending on the facts. Therefore, the "one size fits all" approach of the proposed regulations may not be ideal. Instead, the issues may be best addressed by means of examples in the regulations or revenue rulings that articulate and illustrate the principles relevant to the resolution of each issue.

Starting with the easier of the two issues, the potential recharacterization should be viewed as moot. The transaction would qualify as a "C" reorganization regardless of whether Parent or Sub were viewed as the initial acquiror of the Target assets. The only consequence of recharacterizing the transaction would be to change the location of Target's tax attributes. Under the actual form of the transaction -- an acquisition by Sub followed by a push up -- Sub, as the initial acquiror, would succeed to Target's tax attributes. See Treas. Reg. § 1.381(a)-1(b)(2). If the transaction were recast as a direct acquisition by Parent followed by a drop down, Parent would succeed to Target's tax attributes. See id. But this difference should not support a recharacterization of the acquisition, because the operative rule, by its terms, follows the form of the transaction. If no one corporation ultimately acquires all of Target's assets, the initial acquiror succeeds to Target's tax attributes, even if it does not retain any of the Target assets. See id.

The resolution of the first issue raised by Example 1, whether Sub's distribution to Parent should be taken into account in applying the "substantially all" requirement, requires a review of the purposes of that requirement. The original rationale for the substantially all requirement was to ensure that stock-for-asset acquisitions qualified as reorganizations only when they looked like mergers. See S. REP. No. 73-558, reprinted in 1939-1 C.B. (part 2) 586, 598 (stock-for-assets acquisitions "are, when carried out as prescribed . . . sufficiently similar to mergers and consolidations as to be entitled to similar treatment."). The original rationale justifies taking into account in applying the test only that portion of the assets held by Target immediately before the acquisition. Pre- or post-acquisition distributions do not make the acquisition look less like a merger because they would not affect the qualification of a merger itself for reorganization treatment. Over time, however, the substantially all requirement has come to be viewed as a backstop to section 355, preventing a divisive transaction that would not meet the requirements of section 355 from qualifying as a C reorganization. See S. REP. No. 83-1622, at 274 (1954). See also Rev. Ruls. 2001-25, 2001-1 C.B. 1291, and 88-48, 1988-1 C.B. 117.

The purposes of the substantially all requirement do not require that Sub's post-acquisition distribution to Parent be taken into account in determining whether Sub acquired substantially all of Target's assets. As noted above, post-acquisition distributions never violate the original "looks like a merger" rationale for the substantially all requirement. The distribution in issue raises no concern under the modern anti-bail-out rationale because it does not cause the transaction to be divisive at the shareholder level. The Target shareholders still own their retained interest in Target's business through a single piece of paper: the Parent stock issued in exchange for the Target assets. The distribution from Sub to Parent does not provide the Target shareholders with the opportunity to dispose of part of their investment and retain the balance of it in a dividend-equivalent transaction.

In conclusion, the distribution in Example 1 can appropriately be treated as a separate transaction from the acquisition for the purpose of determining the form of the acquisition and applying the substantially all requirement. Those conclusions do not depend on the quantum of assets distributed by Sub to Parent; they are equally valid if the distribution itself comprised substantially all of Target's assets.

A recharacterization of an acquisition and push up to Parent as a direct acquisition by Parent could raise an issue regarding the application of the substantially all test to pre-acquisition distributions, as illustrated by Example 2.

The policies underlying the substantially all requirement do not require taking the pro-acquisition distribution in Example 2 into account as part of the acquisition transaction. The pre-acquisition distribution can thus be treated as an independent transaction, Pre-acquisition distributions never implicate the original "looks like a merger" rationale for the substantially all test. And the distribution cannot be viewed as allowing an end run around the anti-ball-out conditions of section 355. If the pre-acquisition distribution had the effect of a dividend, it would not have qualified as an exchange under section 302, and the distributee shareholders would not have been entitled to capital gain treatment. Conversely, if the Target shareholders had surrendered some of their Target stock in exchange for the preacquisition distribution, and the distribution had qualified for capital gain treatment, it would only have been because, under the rules of section 302, the distribution was not equivalent to a dividend. In that case, capital gain treatment would be justified. Finally, if the distribution took the form of the stock of a subsidiary of Target, and the conditions of section 355 were met, the Target shareholders would not have been subject to tax at all on their receipt of the stock. But in that case, implementing the policies of section 355 would not require denying reorganization treatment to the acquisition. The Target shareholders would have received the stock of the Target subsidiary tax-free precisely because the overall transaction was consistent with the policies of section 355. Therefore, if Parent had actually acquired the assets of Target and dropped some of those assets down to a controlled subsidiary, Target's pre-acquisition distribution of assets to its shareholders would not have violated the policies of the substantially all requirement. In such a case, the pre-acquisition distribution could have appropriately been treated as independent of the acquisition. Consequently, implementing the policies of the substantially all requirement does not require recharacterizing the acquisition in Example 2 as a direct acquisition of Target assets by Parent followed by a drop down of part of those assets to a controlled subsidiary. Once again, these conclusions hold regardless of the quantum of the assets distributed by Target to Parent in the post-acquisition distribution.

Although Examples I and 2 illustrate cases in which the relevant policies do not require recharacterization of the acquisition as a direct acquisition by Parent, Example 3 illustrates a case in which recharacterization might be appropriate.

Whether the acquisition in Example 3 should be recharacterized as a direct acquisition by Parent depends on how rigorously one wants to enforce the solely for voting stock requirement of section 368(a)(1)(C). The basic policies underlying the reorganization rules as a whole do not require recharacterizing the transaction as a taxable acquisition giving rise to the recognition of both corporate and shareholder-level gain. The Target shareholders have maintained their interest in Target's business in modified form through their ownership of Parent stock. To the extent that the Target shareholders receive cash, they would be required to recognize any realized gain. See I.R.C. § 356(a)(1). It seems particularly harsh to require the former Target shareholders to recognize all of their realized gain as a result of a post-acquisition action taken by Parent and Sub. The absence of a clear rationale for the requirement that all or most of the consideration provided in a C reorganization be Parent voting stock suggests that the requirement need not be rigorously enforced by application of the step transaction doctrine. Of course, allowing parties to circumvent the voting stock requirement for a C reorganization by dividing their transaction into two steps could render the requirement a dead letter. But section 368(a)(1)(C) is mostly a dead letter already. If Parent wants to acquire Target's assets, it is usually easiest to do so by means of a state law merger. The parties in Example 3 could avoid the solely for voting stock issue by having Target merge directly into Parent, which could then transfer some of the acquired assets to Sub. If for non-tax reasons, such as avoiding the need for a vote by the Parent shareholders, the parties prefer the two-step transaction of a forward triangular merger and distribution, why should the parties be required to jump through the narrower hoop of section 368(a)(1)(C)?

If policymakers determine that a transaction such as that in Example 3 may appropriately be recharacterized as a direct acquisition by Parent in certain circumstances to enforce the solely for voting stock requirement of C reorganizations, it is not clear that recharacterization should depend on whether the post-acquisition distribution itself comprises substantially all of the Target assets. The issue could be viewed as turning on which corporation, Parent or Sub, is appropriately viewed as the principal acquirer of the Target assets. If so, a distribution of a majority of the Target assets, even if less than substantially all, could be viewed as sufficient to justify recharacterization of the transaction.

In conclusion, because post-acquisition distributions raise two different issues, the resolution of which may vary depending on the circumstances, post-acquisition distributions might be more appropriately addressed by means of examples provided in the regulations or by revenue rulings that articulate and illustrate the principles that should govern the resolution of each issue. As demonstrated above, post-acquisition distributions that meet the COBE requirement never violate the policies of the substantially all requirement, regardless of the proportion of Target's assets that the distribution comprises. Therefore, any post-acquisition distribution that meets COBE can be viewed as independent of the acquisition for the purpose of applying the substantially all requirement. In many cases, the potential recharacterization of the acquisition as a direct acquisition by Parent would be moot. If the recharacterization changes the form of the transaction from one that is not subject to the substantially all requirement to one that is subject to the requirement, the recharacterization could make a difference in weighing the effects of a pre-acquisition distribution by Target. But in these cases, while the recharacterization is not demonstrably moot, recharacterization would be inappropriate, because the pre-acquisition distribution would not violate the policies underlying the substantially all requirement. The recharacterization might also make a difference if it changes the tolerance for cash or other boot. The decision to recharacterize in these cases depends on the rigor with which one wants to enforce the divergent boot tolerance rules. Because these different rules are historical anomalies that cannot be explained by the general principles governing tax-free reorganizations, I do not recommend using step transaction principles to recharacterize the acquisition and rigorously enforce the rules that provide a more stringent limit on boot than the general continuity of interest requirement. But if one were inclined to enforce the boot tolerance rules rigorously, it is not clear that recharacterization should turn on whether the post-acquisition distribution itself comprises substantially all of Target's assets. Thus, the resolution of the two issues raised by post-acquisition push ups depends on the circumstances. Consequently, guidance on the treatment of post-acquisition distributions might be simpler and more effective if it took the form of examples or revenue rulings. Addressing the issues by examples or rulings would avoid the need for a single set of rules that accommodate all foreseeable issues and circumstances, thereby simplifying the regulations without diminishing the meaningfulness of the guidance provided to taxpayers. Indeed, by breaking down the issues and explaining how differences in facts affect the resolution of the issues, the guidance would be more thorough than the proposed regulations. The proposed regulations, at best, provide no guidance on cases in which the post-acquisition distribution comprises substantially all of Target's assets and, at worst, could be read to imply that such a distribution causes an otherwise qualifying reorganization to be fully taxable.

2. The detailed rules of section 1.368-2(k) are unnecessary. In my prior comment letter, I argued that the regulatory drop down rules of section 1.368-2(k) were made superfluous by the elimination of the remote continuity of interest doctrine as a separate test for reorganization status and the interpretation of the statutory drop down rule of section 368(a)(2)(C) as permissive rather than restrictive. That argument overlooked the issue of whether a post-acquisition drop down of acquired stock or assets might support a recharacterization of the transaction. As explained in my prior comment letter, the only policy issue raised by drop downs is the extent to which they attenuate the link between the former Target shareholders and Target's businesses. The COBE rules adequately address this concern. Therefore, any post-acquisition drop down that complies with the COBE rules should not support a recharacterization of the transaction as a potentially taxable direct acquisition by the transferee in the drop down. This principle can be articulated more simply than by means of the detailed rules of section 1.368-2(k). The principle could also be illustrated by an example in the regulations or a revenue ruling. Elimination of the detailed rules of section 1.368-2(k) would avoid the need to conform those rules and the COBE rules.

3. The circumstances in which a post-acquisition transfer of stock to a partnership should be allowed under the COBE rules depend on the paradigm chosen for the general COBE rules.

The proposed regulations would delete from section 1.368-2(k)(3) an example in which a transfer of Target stock to a partnership after an acquisition of that stock causes the acquisition to fail to qualify as a triangular B reorganization because the acquiring corporation loses control of Target. See Treas. Reg. § 1.368-2(k)(3), Example 3. In the example, S-1 acquired all of the stock of T in exchange for P stock. P owned 80 percent of the stock of S-1. After the acquisition, and as part of the same plan, S-1 transferred the T stock to S-2, and S-2 transferred the T stock to S-3. S-1 owned 80 percent of the stock of S-2 and S-2 owned 80 percent of the stock of S-3. S-2 and S-3 then jointly formed a new partnership, PRS. S-3 transferred the T stock to PRS in exchange for an 80-percent interest in PRS. S-2 transferred cash to PRS in exchange for a 20-percent interest. The example concludes that the transfer of the T stock by S-3 to PRS violated the control requirement for triangular B reorganizations because, after the transfer, S-1 did not control T. My prior comment letter questioned the policy justification for the application of the step transaction doctrine reflected in the example. I am therefore pleased to learn that the IRS and Treasury Department are "studying" the application of the control requirement in the case presented by the example, and have proposed to remove the example from the regulations pending the outcome of that study.

The preamble to the proposed regulations requests comments "on whether and how the COBE regulations should be amended to permit stock transfers to partnerships." The preamble suggests that the transfer of T stock by S-3 to PRS in Example 3 of section 1.368-2(k)(3) would violate the COBE requirement. Thus, the drafters believe that allowing stock transfers to partnerships, such as that illustrated by Example 3, requires an amendment to the regulations.

The COBE regulations should be amended to clarify the circumstances in which stock transfers to partnerships do not violate the COBE test. Again, the only policy issue raised by post-acquisition transfers of stock or assets is whether they unduly attenuate the link between the former Target shareholders and the Target's business. A post-acquisition transfer of stock to a partnership need not unduly attenuate that link. Indeed, the transfer at issue in Example 3 of section 1.368-2(k)(3) actually increased the extent to which the P stock held by the former T shareholders represented an indirect interest in T's business. After the transfer of T stock by S-2 to S-3, the former T shareholders owned stock of an entity (P) that owned a 51.2-percent indirect economic interest in the T business.¹ P also indirectly controlled the T business, through P's control of S-1, S-1's control of S-2, and S-2's control of S-3. After the transfer of T stock by S-3 to PRS, P owned a 53.76-percent indirect economic interest in the T business.² In addition, P continued to control T's business because the only two partners of PRS were indirect controlled subsidiaries of P. Because the transfer of the T stock by S-3 to PRS did not reduce, but increased, the link between the former T shareholders and T's business, the transfer should not violate the COBE rules. The COBE regulations should be amended to permit stock transfers to partnerships in any case in which the transfer does not unduly attenuate the link between the former Target shareholders and Target's business.

Contrary to the assertion in the preamble to the proposed regulations, it is not clear that a post-acquisition transfer of Target stock to a partnership such as the one illustrated in Example 3 of section 1.368-2(k)(3) violates the existing COBE rules. If the T stock were viewed as a business asset of PRS, the T stock would be attributed ratably to its partners. See Treas. Reg. § 1.368-1(d)(4)(iii)(A). Section 1.368-1(d)(1) suggests that, depending on the facts and circumstances, a merger of holding companies can meet the COBE test. If a holding company is viewed as engaged in a business, then the stock of its operating subsidiary may appropriately be viewed as an operating asset. If the T stock owned by PRS were attributed to its partners under section 1.368-1(d)(4)(iii)(A), S-2 would be treated as owning 80 percent of the T stock. If S-2's attributed ownership of T stock were treated as "direct" ownership for the purpose of defining P's qualified group, T would be a member of the qualified group. See Treas. Reg. § 1.368-1(d)(4)(ii). Even if T were not a member of the qualified group, the COBE requirement would still be met if T's business could be attributed to PRS. Because S-2 and S-3 were both members of P's qualified group, P would be treated as conducting any business of PRS. PRS owned all of the stock of T. Consequently, PRS indirectly conducted T's business. In Revenue Ruling 85-197, 1985-2 C.B. 197, the Service held that a downstream merger of a holding company parent into its operating subsidiary met the COBE test. The ruling stated that, "[f]or purposes of the [COBE] requirement, the historic business of P is the business of S, its operating subsidiary." Similarly, PRS could be viewed as engaged in the business of T, a wholly owned operating subsidiary of PRS. If so, P, the corporation that issued stock to the former T shareholders, would be treated as engaged in T's business, satisfying the COBE test.

For the reasons explained above, the transfer of T stock by S-3 to PRS in Example 3 of section 1.368-2(k)(3) does not violate the policies underlying the COBE rules. On the facts of the example, the policy argument is compelling. PRS owned all of the stock of T. Members of P's qualified group owned all of the interests in PRS. Thus, the transfer of T stock by S-3 to PRS did not affect P's indirect control over T's business. It did not dilute the indirect economic interest in T's business represented by the P stock. In fact the transfer increased P's indirect economic interest in T's business. The example shows that, at least in some cases, transfers of stock to partnerships should not violate the COBE rules. The question remains, in what circumstances should such transfers be allowed?

Because the existing COBE rules lack a consistent and coherent rationale, the issue of when stock can be dropped to a partnership should be addressed as part of a comprehensive rationalization of the existing COBE rules. The basic policy choice implemented in the rationalization would then inform the decision of when to allow post-acquisition drops of Target stock to a partnership. My prior comment letter offered three possible means of rationalizing the COBE rules. I will draw out below the implications of each of these three approaches for the specific issue of drops of stock to a partnership. I will begin, however, by considering the implications of the existing COBE rules in recognition of the possibility that policymakers might choose to allow transfers of stock to partnerships without otherwise changing the existing COBE rules.

The principal issue raised by applying the existing COBE rules to transfers of stock to partnerships is when and how to attribute to the transferee partnership the business and assets of the corporation whose stock is transferred. The existing regulations provide rules for attributing to partners the business and assets of a partnership. See Treas. Reg. § 1.368-1(d)(4)(iii). Under the existing regulations, the concept of control provides the touchstone for attributing the business and assets of a corporation to its shareholders. See Treas. Reg. §§ 1.368-1(d)(4)(i) and (ii). Therefore, the conceptual framework of the existing regulations suggests that a partnership should be treated as holding the businesses and assets of any corporation in which the partnership owns a controlling stock interest. The rules of the existing regulations could then govern the attribution of the business and assets from the partnership to the corporation that issued stock to the target shareholders. On the facts of Example 3, PRS would be treated as holding T's businesses and assets because PRS controlled T. Section 1.368-1(d)(4)(iii)(B) would then attribute T's businesses from PRS to P because S-2 and S-3 -- both members of P's qualified group -- own in the aggregate all of the interests in PRS.

As noted above, however, the adoption of rules governing post-acquisition transfers of stock to a partnership should ideally occur in the context of a larger rationalization of the COBE rules. My prior comment letter identified the discontinuities in the existing regulations and offered three proposals that would address some or all of these discontinuities. To review briefly, the existing regulations inappropriately distinguish between (i) control established through vertical chains of corporations and other forms, (ii) transfers of stock or assets to subsidiary corporations and partnerships, and (iii) dilution caused by a post-acquisition drop down and dilution caused by the acquisition itself. The first discontinuity could be addressed by applying the control test on an aggregate basis. That is, a corporation would be included in the qualified group if it is controlled, in the aggregate, by one or more other members of the qualified group. The first and second discontinuities could be addressed by an aggregate test that takes into account both economic interests and retained control. Under this approach, a corporation would be included in the qualified group if one or members of the qualified group own, in the aggregate, stock of the corporation that (1) meets the requirements of section 368(c), or (2) has a value equal to a significant portion of the total value of all of the stock of the corporation. Finally, all three discontinuities could be addressed by allowing any drop down that itself qualifies for nonrecognition treatment. The appropriate treatment of post-acquisition transfers of stock to a partnership under each of these three approaches would be relatively straightforward, as shown below.

If policymakers adopt the first proposal suggested in my prior comment letter, a corporation should be included in the qualified group if one or more "qualified shareholders" own, in the aggregate, a controlling interest in the corporation. For this purpose, qualified shareholders would include other corporate members of the qualified group and any partnership the business of which would be attributed to the issuing corporation under section 1.368- 1(d)(4)(iii)(B). This approach would permit the transfer of Target stock to PRS in Example 4 below.

If policymakers adopt the second recommendation of my prior comment letter, in which economic interests would be taken into account along with control in defining the qualified group, a corporation should be included in the qualified group if one or more qualified shareholders own, in the aggregate, stock of the corporation that (1) meets the requirements of section 368(c), or (2) has a value equal to a significant portion of the total value of all of the stock of the corporation. Again, the definition of "qualified shareholder" would include any corporation that is a member of the qualified group and any partnership the business of which would be attributed to the issuing corporation under section 1.368-1(d)(4)(iii)(B). This approach would permit the transfer of Target stock described in Example 5 below.

The third and most expansive recommendation of my prior comment letter could readily accommodate transfers of stock to partnerships. Under that recommendation, any transfer that itself qualified for nonrecognition treatment would not violate COBE. If this recommendation were adopted, any transfer of stock to a partnership in exchange for a partnership interest would not violate COBE because the transfer would qualify for nonrecognition treatment under section 721. This approach would permit the transfer of Target stock described in Example 6 below.

To review, as noted at the outset, I offer three principal comments on the proposed regulations. First, while the proposed rules addressing push ups represent a commendable step towards rationalization of the reorganization rules, guidance on push ups could be simpler and more effective if it addressed separately the two substantive issues they raise: the application of the substantially all test and the potential recharacterization of the transaction as a direct acquisition by the distributee. The effect a post-acquisition push up on the qualification of the acquisition for reorganization treatment is essentially a step transaction issue that should take into account all of the facts and circumstances. Therefore, the issues may be best addressed by means of examples in the regulations or by revenue rulings. The examples or rulings should illustrate the following principles:

• Any post-acquisition distribution that meets the COBE rules can be viewed as independent of the acquisition for the purpose of applying the substantially all requirement.

• Recharacterization of the transaction as a direct acquisition by the distributee is not appropriate to cause the acquisition to fail to qualify as a reorganization as a result of a pre-acquisition distribution.

Second, the detailed rules of section 1.368-2(k) are unnecessary. Any post-acquisition drop down that complies with the COBE rules should not support a recharacterization of the transaction as a potentially taxable direct acquisition by the transferee in the drop down. This principle could be articulated as an operative rule in the regulations or could be illustrated by examples or revenue rulings.

Third, the circumstances in which a post-acquisition transfer of stock to a partnership should be allowed under the COBE rules depend on the paradigm chosen for the general COBE rules. The principal issue raised by transfers of stock to a partnership is when the business and assets of the corporation whose stock is transferred should be attributed to the partnership. The general framework of the existing regulations, with their focus on section 368(c) control, suggests that a partnership should be treated as holding the businesses and assets of any corporation in which a partnership owns a controlling stock interest. But the existing COBE rules lack a consistent and coherent rationale. Therefore, the issue of when stock can be dropped to a partnership should be addressed as part of a comprehensive rationalization of the COBE rules. My prior comment letter made three recommendations for how this rationalization might be accomplished.

• Under the narrowest proposal, the control test would be applied on an aggregate basis, rather than limiting the qualified group to corporations in vertical chains of control. Under this proposal, a corporation would be included in the COBE qualified group if is controlled, in the aggregate, by, one or more members of the qualified group. This proposal could accommodate transfers of stock to partnerships by including a corporation in the qualified group if one or more "qualified shareholders" own, in the aggregate, a controlling interest in the corporation. For this purpose, qualified shareholders would include other corporate members of the qualified group and any partnership the business of which would be attributed to the issuing corporation under section 1.368-1(d)(4)(iii)(B).

• The intermediate proposal would apply an aggregate test that takes into account both economic interests and retained control. Under this approach, a corporation would be included in the qualified group if one or members of the qualified group own, in the aggregate, stock of the corporation that (1) meets the requirements of section 368(c), or (2) has a value equal to a significant portion of the total value of all of the stock of the corporation. This proposal, too, could accommodate transfers of stock to partnerships through the "qualified shareholder" concept -- that is, a corporation would be included in the qualified group if one or more qualified shareholders own, in the aggregate stock of the corporation that meets the control or value tests. The term "qualified shareholder" would be defined in the manner described above.

• The broadest proposal would allow any post-acquisition transfer of stock or assets that itself qualifies for nonrecognition treatment. This proposal would readily accommodate transfers of stock to partnerships because section 721 grants nonrecognition treatment to those transfers. Despite the breadth of the proposal, it would be fully supported by the policies underlying the COBE rules. The qualification of the transfer for nonrecognition treatment would reflect the premise that the transferor has retained its interest in the transferred stock or assets in modified form. If the transferor has retained its interest in modified form, then so, too, have the former Target shareholders. Moreover, the third proposal is the only one that would eliminate the arbitrary distinction between dilution of the former Target shareholders' interests as a result of the post-acquisition transfer and dilution caused by the acquisition itself.

² Through its 80-percent interest in PRS, S-3 owned an 80-percent indirect economic interest in T's business. Through S-2's 20-percent interest in PRS, S-2 owned a 20-percent indirect economic interest in T's business. S-2 owned in total an 84-percent indirect economic interest in T's business: 20 percent through its ownership of PRS, and 64 percent through its 80-percent interest in S-3 (.8 x .8 = .64). S-1, through its 80-percent interest in S-2, owned a 67.2 percent indirect economic interest in T's business (.8 x .84 = .672). And P, through its 80-percent interest in S-1, owned a 53.76 percent indirect economic interest in T's business (.8 x .672 = .5376).

³ Before the transfer, P indirectly owned a 51.2-percent interest in T's business (.8 x .8 x .8). After the transfer, S-3 indirectly owned a 69.2-percent interest in T's business (.56 x .7 =.392 + .3 =.692). S-2 indirectly owned an 86.16-percent interest in T's business [(.44 x.7) + (.8 x .692)]. S-1 indirectly owned a 68.928-percent interest in T's business (.8 x.8616). And P indirectly owned a 55.1424-percent interest in T's business (.8 x .68928).