Corporate Reorganizations; Guidance on the Measurement of Continuity of Interest, 54631-54637 [05-18263]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 70, Number 179 (Friday, September 16, 2005)]
[Rules and Regulations]
[Pages 54631-54637]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 05-18263]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9225]
RIN 1545-BD53


Corporate Reorganizations; Guidance on the Measurement of 
Continuity of Interest

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulation.

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SUMMARY: This document contains final regulations that provide guidance 
regarding the satisfaction of the continuity of interest requirement 
for corporate reorganizations. The final regulations affect 
corporations and their shareholders.

DATES: Effective Date: These regulations are effective September 16, 
2005.

FOR FURTHER INFORMATION CONTACT: Jeffrey B. Fienberg, at (202) 622-7770 
(not a toll free number).

SUPPLEMENTARY INFORMATION:

Background

    The Internal Revenue Code of 1986 (Code) provides for general 
nonrecognition treatment for reorganizations described in section 368 
of the Code. In addition to complying with the statutory and certain 
other requirements, to qualify as a reorganization, a transaction 
generally must satisfy the continuity of interest (COI) requirement. 
COI requires that, in substance, a substantial part of the value of the 
proprietary interests in the target corporation be preserved in the 
reorganization.
    On August 10, 2004, the IRS and Treasury Department published a 
notice of proposed rulemaking (REG-129706-04) in the Federal Register 
(69 FR 48429) (hereinafter the proposed regulations) identifying 
certain circumstances in which the determination of whether a 
proprietary interest in the target corporation is preserved would be 
made by reference to the value of the issuing corporation's stock on 
the day before there is an agreement to effect the potential 
reorganization. In particular, in cases in which the consideration to 
be tendered to the target corporation's shareholders is fixed in a 
binding contract and includes only stock of the issuing corporation and 
money, the issuing corporation stock to be exchanged for the 
proprietary interests in the target corporation would be valued as of 
the end of the last business day before the first date there is a 
binding contract to effect the potential reorganization (the signing 
date rule). Under the proposed regulations, consideration is fixed in a 
contract if the contract states the number of shares of the issuing 
corporation and the amount of money, if any, to be exchanged for the 
proprietary interests in the target corporation. The signing date rule 
is based on the principle that, in cases in which a binding contract 
provides for fixed consideration, the target corporation shareholders 
generally can be viewed as being subject to the economic fortunes of 
the issuing corporation as of the signing date.
    No public hearing regarding the proposed regulations was requested 
or held. However, several written and electronic comments regarding the 
notice of proposed rulemaking were received. After consideration of the 
comments, the proposed regulations are adopted as revised by this 
Treasury decision.

Explanation of Provisions

    These final regulations retain the general framework of the 
proposed regulations but make several modifications in response to the 
comments received. The following sections describe the most significant 
comments and the extent to which they have been incorporated into these 
final regulations.

A. Fixed Consideration

    As stated above, the proposed regulations require that the 
consideration in a contract be fixed in order for the signing date rule 
to apply. One commentator identified a number of contractual 
arrangements that do not provide for fixed consideration within the 
meaning of the proposed regulations, but, nevertheless, are 
arrangements in which the consideration should be treated as fixed and, 
therefore, eligible for the signing date rule. In particular, the 
commentator identified a number of circumstances in which, rather than 
stating the number of shares and money to be exchanged for target 
corporation shares, a contract may provide that a certain percentage of 
target corporation shares will be exchanged for stock of the issuing 
corporation. One such circumstance is where a merger agreement permits 
the target corporation some flexibility in issuing its shares between 
the signing date and effective date of the potential reorganization. 
Such an issuance may occur, for example, upon the exercise of employee 
stock options. As a result, the total number of outstanding target 
corporation shares at the effective time

[[Page 54632]]

of the merger and, therefore, the total number of shares of the 
acquiring corporation to be issued in the merger, may not be known when 
the merger agreement is signed.
    In addition, a contract may permit the target corporation 
shareholders to elect to receive stock (the number of shares of which 
may be determined pursuant to a collar) and/or money or other property 
in respect of target corporation stock, but provide that a particular 
percentage of target corporation shares will be exchanged for stock of 
the issuing corporation and a particular percentage of target 
corporation stock will be exchanged for money. In these cases, if 
either the stock or the cash consideration is oversubscribed, 
adjustments are made to the consideration to be tendered in respect of 
the target corporation shares such that the specified percentage of 
target corporation shares is, in fact, exchanged for stock of the 
issuing corporation.
    The IRS and Treasury Department agree that a contract that provides 
for either the percentage of the number of shares of each class of 
target corporation stock, or the percentage by value of the target 
corporation shares, to be exchanged for issuing corporation stock 
should be treated as providing for fixed consideration, as long as the 
target corporation shares to be exchanged for issuing corporation stock 
and the target corporation shares to be exchanged for consideration 
other than issuing corporation stock each represents an economically 
reasonable exchange. Just as in cases in which the contract states the 
number of shares of the issuing corporation and the amount of money, if 
any, to be exchanged for the proprietary interests in the target 
corporation, in these cases, the target corporation shareholders 
generally can be viewed as being subject to the economic fortunes of 
the issuing corporation as of the signing date. Accordingly, these 
final regulations include an expanded set of circumstances in which a 
contract will be treated as providing for fixed consideration.

B. Contingent Consideration

    The fact that a contract provides for contingent consideration will 
generally prevent a contract from being treated as providing for fixed 
consideration. One commentator suggested that a contract should not be 
treated as failing to provide for fixed consideration solely because it 
provides for contingent consideration that can only increase the 
proportion of issuing corporation stock to cash to be exchanged for 
target corporation shares. Where stock of the issuing corporation is 
the only type of consideration that is subject to a contingency, the 
delivery of any of the contingent consideration to the target 
corporation shareholders will enhance the preservation of the target 
corporation's shareholders' proprietary interests. Therefore, these 
final regulations provide for a limited exception to the general rule 
that an arrangement that provides for contingent consideration will not 
be one to which the signing date rule applies. The exception applies to 
cases in which the contingent consideration consists solely of stock of 
the issuing corporation and the execution of the potential 
reorganization would have resulted in the preservation of a substantial 
part of the value of the target corporation shareholders' proprietary 
interests in the target corporation if none of the contingent 
consideration were delivered to the target corporation shareholders.
    The IRS and Treasury Department continue to study whether other 
arrangements involving contingent consideration should be within the 
scope of the signing date rule. Among these arrangements are cases in 
which the contingent consideration consists not only of issuing 
corporation stock but also of money or other property and cases in 
which the issuing corporation stock to be issued in respect of target 
corporation stock is determined pursuant to a collar.

C. Nature of Consideration

    As described above, under the proposed regulations, the signing 
date rule applies only when the consideration to be provided in respect 
of target corporation shares includes only stock of the issuing 
corporation and money. One commentator suggested that the signing date 
rule should be expanded to apply to transactions in which the non-stock 
consideration includes property other than money. Under these final 
regulations, the signing date rule may apply in such cases. Therefore, 
under these final regulations, the signing date rule may apply, for 
example, in cases in which proprietary interests in the target 
corporation are exchanged for stock and securities of the issuing 
corporation.

D. Valuation

1. The ``As of the End of the Last Business Day'' Rule
    The proposed regulations require that, if the signing date rule 
applies, the consideration to be tendered in respect of the target 
corporation shares surrendered be valued as of the end of the last 
business day before the first date there is a binding contract to 
effect the potential reorganization. One comment requested 
clarification of the meaning of as of the end of the last business day. 
That comment suggested that an average of the high and low trade price 
on that day should be an acceptable value for this purpose. 
Alternatively, the comment suggested that if a single trade were to 
determine the value of the issuing corporation stock, the closing price 
of the issuing corporation stock on the relevant market should be used. 
The comment further described an approach for identifying the relevant 
stock market.
    In response to these comments, these final regulations remove the 
requirement that the consideration be valued as of the end of the last 
business day before the first date that there is a binding contract. 
Instead, they provide general guidance that the consideration to be 
exchanged for target corporation shares pursuant to a contract must be 
valued the day before such contract is a binding contract.
2. New Issuances
    The IRS and Treasury Department recognize that the application of 
the requirement that the consideration to be exchanged for proprietary 
interests in the target corporation be valued on the last business day 
before the first date there is a binding contract to effect the 
potential reorganization may be unclear in cases in which the 
consideration does not exist prior to the effective date of the 
reorganization. For example, suppose that, in the potential 
reorganization, the issuing corporation will issue a new class of its 
stock in exchange for the shares of the target corporation. The 
question has arisen as to how to value those to be issued shares under 
the signing date rule, given that they do not exist on the last 
business day before the first date that there is a binding contract to 
effect the potential reorganization. Thus, these final regulations 
clarify that this new class of stock will be deemed to have been issued 
on the last business day before the first date there is a binding 
contract to effect the potential reorganization for purposes of 
applying the signing date rule.

E. Escrowed Stock

1. Pre-Closing Covenants
    The proposed regulations provide that placing part of the stock 
issued or money paid into escrow to secure customary target 
representations and warranties will not prevent the consideration in a 
contract from being fixed. One comment suggested that this rule should 
be expanded to include

[[Page 54633]]

consideration placed in escrow to secure target's performance of 
customary pre-closing covenants (rather than representations and 
warranties). That commentator stated that there is no reason to 
distinguish between customary pre-closing covenants, on the one hand, 
and customary representations and warranties, on the other hand. The 
IRS and Treasury Department agree. Accordingly, these final regulations 
extend the rule related to escrows to include consideration placed in 
escrow to secure target's performance of customary pre-closing 
covenants.
2. Effect of Escrowed Consideration on Satisfaction of COI
    Some commentators have indicated that certain examples in the 
proposed regulations suggest that escrowed stock, even if it is 
forfeited to the issuing corporation, is treated as preserving the 
target shareholders' proprietary interests in the target corporation. 
The IRS and Treasury Department believe that escrowed consideration 
that is forfeited should not be taken into account in determining 
whether the COI requirement is satisfied. This conclusion reflects the 
view that the forfeiture of escrowed consideration is in substance a 
purchase price adjustment. Accordingly, the examples in these final 
regulations reflect that forfeited stock is not treated as preserving 
the target corporation shareholders' proprietary interests in the 
target corporation and forfeited non-stock consideration is not treated 
as counting against the preservation of the target corporation's 
shareholders' proprietary interest in the target corporation. The IRS 
and Treasury Department continue to consider the effect on COI of 
escrowed consideration and contingent consideration.
3. Revenue Procedure 84-42
    One commentator requested clarification regarding the impact of the 
proposed regulations on Revenue Procedure 84-42 (1984-1 C.B. 521). Rev. 
Proc. 84-42 includes certain operating rules of the IRS regarding the 
issuance of letter rulings, including the circumstances in which the 
placing of stock in escrow will not prevent the IRS from issuing a 
private letter ruling. The IRS and Treasury Department continue to 
review the existing revenue procedures relating to reorganizations in 
light of the numerous regulatory changes since the publication of these 
procedures and the policy against issuing rulings in the reorganization 
area unless there is a significant issue, which is reflected in Rev. 
Proc. 2005-3. Rev. Proc. 84-42 is not amended at this time.

F. Anti-Dilution Provisions

    One comment suggested that consideration in a contract should not 
be treated as fixed unless the contract includes a customary anti-
dilution provision. The commentator posited an example in which the 
absence of an anti-dilution clause and the occurrence of a stock split 
with respect to the stock of the issuing corporation prior to the 
effective date of a potential reorganization results in the value of 
the consideration received in respect of the target corporation shares 
being substantially different from its value on the day before the 
first date there is a binding contract.
    The IRS and Treasury Department do not believe that the absence of 
a customary anti-dilution provision should necessarily preclude the 
application of the signing date rule as dilution may not, in fact, 
occur. However, the IRS and Treasury Department are concerned that 
application of the signing date rule is not appropriate if the contract 
does not contain an anti-dilution clause relating to the stock of the 
issuing corporation and the issuing corporation alters its capital 
structure between the first date there is an otherwise binding contract 
to effect the potential reorganization and the effective date of the 
potential reorganization in a manner that materially alters the 
economic arrangement of the parties to the binding contract. 
Accordingly, these final regulations provide that, in such cases, the 
consideration will not be treated as fixed.

G. Contract Modifications

    The proposed regulations require that if a term of a binding 
contract that relates to the amount or type of consideration the target 
shareholders will receive in a potential reorganization is modified 
before the closing date of the potential reorganization, and the 
contract as modified is a binding contract, then the date of the 
modification shall be treated as the first date there is a binding 
contract. Thus, such a modification requires that the stock of the 
issuing corporation be valued as of the end of the last business day 
before the date of the modification in order to determine whether the 
transaction satisfies the COI requirement.
    One commentator suggested that a contract should not be treated as 
being modified for this purpose if the modification has the sole effect 
of increasing the number of shares of the issuing corporation to be 
received by the target shareholders. The IRS and Treasury Department 
agree that, because such a modification only enhances the preservation 
of the target corporation's shareholders' proprietary interests, it is 
not appropriate to value the consideration to be provided to the target 
corporation shareholders as of the day before the date of the 
modification rather than as of the day before the date of the original 
contract, at least in cases in which the transaction would have 
satisfied the COI requirement under the signing date rule if there had 
been no modification. Therefore, these final regulations provide that a 
modification that has the sole effect of providing for the issuance of 
additional shares of issuing corporation stock to the target 
corporation shareholders will not be treated as a modification if the 
execution of the potential reorganization would have resulted in the 
preservation of a substantial part of the value of the target 
corporation shareholders' proprietary interest in the target 
corporation if there had been no modification. In such cases, the 
determination of whether a proprietary interest in the target 
corporation has been preserved is made by reference to the value of the 
consideration as of the last business day before the first date the 
contract was binding, not the last business day before the 
modification. The IRS and Treasury Department continue to consider 
whether this exception should be extended to certain cases in which the 
modification results in not only additional shares of the issuing 
corporation to be issued to target corporation shareholders, but also 
additional money or other property to be transferred to target 
corporation shareholders.

H. Application of Principle Illustrated by Examples

    One commentator asked whether the principle that the COI 
requirement is satisfied where 40 percent of the target corporation 
stock is exchanged for stock in the issuing corporation that is 
illustrated in the examples of the proposed regulations (which relate 
to the application of the signing date rule) also applies in cases in 
which the signing date rule does not apply. The IRS and Treasury 
Department believe that this principle is equally applicable to cases 
in which the signing date rule does not apply as it is to cases in 
which the signing date rule does apply.

I. Restricted Stock

    The IRS and Treasury Department are continuing to consider the 
appropriate treatment of restricted stock in the

[[Page 54634]]

determination of whether the COI requirement is satisfied.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations and, because 
these regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Therefore, a Regulatory Flexibility Analysis is not required. 
Pursuant to section 7805(f) of the Code, the proposed regulations 
preceding these regulations were submitted to the Chief Counsel for 
Advocacy of the Small Business Administration for comment on their 
impact on small business.

Drafting Information

    The principal author of these regulations is Christopher M. Bass of 
the Office of the Associate Chief Counsel (Corporate). 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.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read, in 
part, as follows:

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

0
Par. 2. Section 1.368-1 is amended as follows:
0
1. Paragraph (e)(1)(i) is amended as follows:
0
A. Removing the language ``(e)(3)'' and adding in its place ``(e)(4)'' 
wherever it appears.
0
B. Removing the language ``(e)(3)(i)(A)'' and adding ``(e)(4)(i)(A)'' 
in its place.
0
2. Redesignating paragraphs (e)(2) through (e)(7) as (e)(3) through 
(e)(8), respectively.
0
3. Adding a new paragraph (e)(2).
0
4. In newly designated paragraphs (e)(3) through (e)(8), remove the 
language ``(e)(6)'' wherever it appears, and add the language 
``(e)(7)'' in its place.
0
5. In newly designated paragraphs (e)(3) through (e)(8), remove the 
language ``(e)(4)'' wherever it appears, and add the language 
``(e)(5)'' in its place.
0
6. In newly designated paragraphs (e)(3) through (e)(8), remove the 
language ``(e)(3)'' wherever it appears, and add the language 
``(e)(4)'' in its place.
0
7. In newly designated paragraphs (e)(3) through (e)(8), remove the 
language ``(e)(2)'' wherever it appears, and add the language 
``(e)(3)'' in its place.
0
8. In newly designated paragraph (e)(4)(ii)(B), remove the language 
``(e)(3)(i)(A)'' wherever it appears, and add the language 
``(e)(4)(i)(A)'' in its place.
0
9. In newly designated paragraph (e)(7), Example 1, remove the language 
``(e)(1) and (2)'' whenever it appears, and add the language ``(e)(1) 
and (3)'' in its place.
0
10. In newly designated paragraph (e)(7), Example 2, make the following 
revisions:
0
A. Remove the language ``(e)(3)(i)(B)'' wherever it appears, and add 
the language (e)(4)(i)(B)'' in its place.
0
B. Remove the language ``(e)(3)(i)(A) and (ii)(B)'' wherever it 
appears, and add the language ``(e)(4)(i)(A) and (ii)(B)'' in its 
place.
0
11. In newly designated paragraph (e)(7), Example 3, where the language 
``(e)(1) and (2)'' wherever it appears, and add the language ``(e)(1) 
and (3)'' in its place.
0
12. In newly designated paragraph (e)(7), Example 4, paragraph (iii), 
remove the language ``(e)(3)(i)(A) and (B)'' wherever it appears, and 
add the language ``(e)(4)(i)(A) and (B)'' in its place.
0
13. In newly designated paragraph (e)(7), Example 6, remove the 
language ``(e)(3)(i)(A) and (B)'' wherever it appears, and add the 
language ``(e)(4)(i)(A) and (B)'' in its place.
0
14. In newly designated paragraph (e)(7), Example 8, remove the 
language ``(e)(3)(i)(A)'' wherever it appears, and add the language 
``(e)(4)(i)(A)'' in its place.
0
15. Revising newly designated paragraph (e)(8).
    The addition and revision read as follows:


Sec.  1.368-1  Purpose and scope of exception of reorganization 
exchanges.

* * * * *
    (e) * * *
    (2) Measuring continuity of interest--(i) In general. In 
determining whether a proprietary interest in the target corporation is 
preserved, the consideration to be exchanged for the proprietary 
interests in the target corporation pursuant to a contract to effect 
the potential reorganization shall be valued on the last business day 
before the first date such contract is a binding contract, if such 
contract provides for fixed consideration.
    (ii) Binding contract--(A) In general. A binding contract is an 
instrument enforceable under applicable law against the parties to the 
instrument. The presence of a condition outside the control of the 
parties (including, for example, regulatory agency approval) shall not 
prevent an instrument from being a binding contract. Further, the fact 
that insubstantial terms remain to be negotiated by the parties to the 
contract, or that customary conditions remain to be satisfied, shall 
not prevent an instrument from being a binding contract.
    (B) Modifications--(1) In general. If a term of a binding contract 
that relates to the amount or type of the consideration the target 
shareholders will receive in a potential reorganization is modified 
before the closing date of the potential reorganization, and the 
contract as modified is a binding contract, the date of the 
modification shall be treated as the first date there is a binding 
contract.
    (2) Exception. Notwithstanding paragraph (e)(2)(ii)(B)(1) of this 
section, a modification of a term that relates to the amount or type of 
consideration the target shareholders will receive in a potential 
reorganization will not be treated as a modification for purposes of 
that provision if--
    (i) That modification has the sole effect of providing for the 
issuance of additional shares of issuing corporation stock to the 
target corporation shareholders; and
    (ii) The execution of the potential reorganization would have 
resulted in the preservation of a substantial part of the value of the 
target corporation shareholders' proprietary interest in the target 
corporation if there had been no modification.
    (C) Tender offers. For purposes of this paragraph (e)(2), a tender 
offer that is subject to section 14(d) of the Securities and Exchange 
Act of 1934 [15 U.S.C. 78n(d)(1)] and Regulation 14D (17 CFR 240.14d-1 
through 240.14d-101) and is not pursuant to a binding contract, is 
treated as a binding contract made on the date of its announcement, 
notwithstanding that it may be modified by the offeror or that it is 
not enforceable against the offerees. If a modification (not pursuant 
to a binding contract) of such a tender offer is subject to the 
provisions of Regulation 14d-6(c) (17 CFR 240.14d-6(c)) and relates to 
the amount or type of the consideration received in the tender offer, 
then the

[[Page 54635]]

date of the modification shall be treated as the first date there is a 
binding contract.
    (iii) Fixed consideration--(A) In general. A contract provides for 
fixed consideration if it provides--
    (1) The number of shares of each class of stock of the issuing 
corporation, the amount of money, and the other property (identified 
either by value or by specific description), if any, to be exchanged 
for all of the proprietary interests in the target corporation;
    (2) The number of shares of each class of stock of the issuing 
corporation, the amount of money, and the other property (identified 
either by value or by specific description), if any, to be exchanged 
for each proprietary interest in the target corporation;
    (3) The percentage of the number of shares of each class of 
proprietary interests in the target corporation, or the percentage (by 
value) of the proprietary interests in the target corporation, to be 
exchanged for stock of the issuing corporation, provided that the 
proprietary interests in the target corporation to be exchanged for 
stock of the issuing corporation and the proprietary interests in the 
target corporation to be exchanged for consideration other than stock 
of the issuing corporation each represents an economically reasonable 
exchange as of the last business day before the first date there is a 
binding contract to effect the potential reorganization; or
    (4) The percentage of each proprietary interest in the target 
corporation to be exchanged for stock of the issuing corporation, 
provided that the portion of each proprietary interest in the target 
corporation to be exchanged for stock of the issuing corporation and 
the portion of each proprietary interest in the target corporation to 
be exchanged for consideration other than stock of the issuing 
corporation each represents an economically reasonable exchange as of 
the last business day before the first date there is a binding contract 
to effect the potential reorganization.
    (B) Shareholder elections--(1) In general. A contract that is not 
described in paragraph (e)(2)(iii)(A) of this section and pursuant to 
which a target corporation shareholder has an election to receive stock 
and/or money and other property in respect of target corporation stock 
is treated as providing for fixed consideration if the contract 
provides--
    (i) The minimum number of shares of each class of stock of the 
issuing corporation and the maximum amount of money and other property 
(identified either by value or by specific description) to be exchanged 
for all of the proprietary interests in the target corporation; or
    (ii) The minimum percentage of the number of shares of each class 
of proprietary interests in the target corporation, or the minimum 
percentage (by value) of the proprietary interests in the target 
corporation, to be exchanged for stock of the issuing corporation, 
provided that the proprietary interests in the target corporation to be 
exchanged for stock of the issuing corporation and the proprietary 
interests in the target corporation to be exchanged for consideration 
other than stock of the issuing corporation each represents an 
economically reasonable exchange as of the last business day before the 
first date there is a binding contract to effect the potential 
reorganization.
    (2) Special rules. (i) In the case of a shareholder election 
described in paragraph (e)(2)(iii)(B)(1)(i) of this section, the 
determination of whether a proprietary interest in the target 
corporation is preserved shall be made by assuming the issuance by the 
issuing corporation of the minimum number of shares of each class of 
stock of the issuing corporation and the maximum amount of money and 
other property allowable under the contract and without regard to the 
number of shares of each class of stock of the issuing corporation and 
the amount of money and other property actually exchanged thereafter 
for proprietary interests in the target corporation.
    (ii) In the case of a shareholder election described in paragraph 
(e)(2)(iii)(B)(1)(ii) of this section, the determination of whether a 
proprietary interest in the target corporation is preserved shall be 
made by assuming the issuance of issuing corporation stock in exchange 
for the minimum percentage of the number of shares of each class of 
proprietary interests in the target corporation, or the minimum 
percentage (by value) of proprietary interests in the target 
corporation, as the case may be, to be exchanged for stock of the 
issuing corporation allowable under the contract and without regard to 
the percentage of the number of shares of each class of proprietary 
interests in the target corporation, or the percentage (by value) of 
proprietary interests in the target corporation, actually exchanged for 
stock of the issuing corporation.
    (C) Contingent consideration--(1) In general. In general, the fact 
that a contract provides for contingent consideration will prevent a 
contract from being treated as providing for fixed consideration. 
However, a contract will not fail to be treated as providing for fixed 
consideration solely as a result of a provision that provides for 
contingent consideration, if--
    (i) The contingent consideration consists solely of stock of the 
issuing corporation; and
    (ii) The execution of the potential reorganization would have 
resulted in the preservation of a substantial part of the value of the 
target corporation shareholders' proprietary interests in the target 
corporation if none of the contingent consideration were delivered to 
the target corporation shareholders.
    (2) Exception for escrows. For purposes of paragraph 
(e)(2)(iii)(C)(1) of this section, contingent consideration does not 
include consideration paid in escrow to secure target's performance of 
customary pre-closing covenants or customary target representations and 
warranties.
    (D) Escrows. Placing part of the consideration to be exchanged for 
proprietary interests in the target corporation in escrow to secure 
target's performance of customary pre-closing covenants or customary 
target representations and warranties will not prevent a contract from 
being treated as providing for fixed consideration.
    (E) Anti-dilution clauses. The presence of a customary anti-
dilution clause will not prevent a contract from being treated as 
providing for fixed consideration. However, the absence of such a 
clause will prevent a contract from being treated as providing for 
fixed consideration if the issuing corporation alters its capital 
structure between the first date there is an otherwise binding contract 
to effect the potential reorganization and the effective date of the 
potential reorganization in a manner that materially alters the 
economic arrangement of the parties to the binding contract.
    (F) Dissenters' rights. The possibility that some shareholders may 
exercise dissenters' rights and receive consideration other than that 
provided for in the binding contract will not prevent the contract from 
being treated as providing for fixed consideration.
    (G) Fractional shares. The fact that money may be paid in lieu of 
issuing fractional shares will not prevent a contract from being 
treated as providing for fixed consideration.
    (iv) Valuation of new issuances. For purposes of applying paragraph 
(e)(2)(i) of this section, any class of stock, securities, or 
indebtedness that the issuing corporation issues to the target 
corporation shareholders pursuant to the potential reorganization and 
that does not exist before the first date there is a binding contract 
to effect the potential reorganization is deemed to have been issued on 
the last business

[[Page 54636]]

day before the first date there is a binding contract to effect the 
potential reorganization.
    (v) Examples. For purposes of the examples in this paragraph 
(e)(2)(v), P is the issuing corporation, T is the target corporation, S 
is a wholly owned subsidiary of P, all corporations have only one class 
of stock outstanding, A is an individual, no transactions other than 
those described occur, and the transactions are not otherwise subject 
to recharacterization. The following examples illustrate the 
application of this paragraph (e)(2):

    Example 1. Application of signing date rule. On January 3 of 
Year 1, P and T sign a binding contract pursuant to which T will be 
merged with and into P on June 1 of Year 1. Pursuant to the 
contract, the T shareholders will receive 40 P shares and $60 of 
cash in exchange for all of the outstanding stock of T. Twenty of 
the P shares, however, will be placed in escrow to secure customary 
target representations and warranties. The P stock is listed on an 
established market. On January 2 of Year 1, the value of the P stock 
is $1 per share. On June 1 of Year 1, T merges with and into P 
pursuant to the terms of the contract. On that date, the value of 
the P stock is $.25 per share. None of the stock placed in escrow is 
returned to P. Because the contract provides for the number of 
shares of P and the amount of money to be exchanged for all of the 
proprietary interests in T, under paragraph (e)(2) of this section, 
there is a binding contract providing for fixed consideration as of 
January 3 of Year 1. Therefore, whether the transaction satisfies 
the continuity of interest requirement is determined by reference to 
the value of the P stock on January 2 of Year 1. Because, for 
continuity of interest purposes, the T stock is exchanged for $40 of 
P stock and $60 of cash, the transaction preserves a substantial 
part of the value of the proprietary interest in T. Therefore, the 
transaction satisfies the continuity of interest requirement.
    Example 2. Treatment of forfeited escrowed stock. (i) The facts 
are the same as in Example 1 except that T's breach of a 
representation results in the escrowed consideration being returned 
to P. Because the contract provides for the number of shares of P 
and the amount of money to be exchanged for all of the proprietary 
interests in T, under paragraph (e)(2) of this section, there is a 
binding contract providing for fixed consideration as of January 3 
of Year 1. Therefore, whether the transaction satisfies the 
continuity of interest requirement is determined by reference to the 
value of the P stock on January 2 of Year 1. Because, for continuity 
of interest purposes, the T stock is exchanged for $20 of P stock 
and $60 of cash, the transaction does not preserve a substantial 
part of the value of the proprietary interest in T. Therefore, the 
transaction does not satisfy the continuity of interest requirement.
    (ii) The facts are the same as in Example 2 (i) except that the 
consideration placed in escrow consists solely of eight of the P 
shares and $12 of the cash. Because the contract provides for the 
number of shares of P and the amount of money to be exchanged for 
all of the proprietary interests in T, under paragraph (e)(2) of 
this section, there is a binding contract providing for fixed 
consideration as of January 3 of Year 1. Therefore, whether the 
transaction satisfies the continuity of interest requirement is 
determined by reference to the value of the P stock on January 2 of 
Year 1. Because, for continuity of interest purposes, the T stock is 
exchanged for $32 of P stock and $48 of cash, the transaction 
preserves a substantial part of the value of the proprietary 
interest in T. Therefore, the transaction satisfies the continuity 
of interest requirement.
    Example 3. Redemption of stock received pursuant to binding 
contract. The facts are the same as in Example 1 except that A owns 
50 percent of the outstanding stock of T immediately prior to the 
merger and receives 10 P shares and $30 in the merger and an 
additional 10 P shares upon the release of the stock placed in 
escrow. In connection with the merger, A and S agree that, 
immediately after the merger, S will purchase any P shares that A 
acquires in the merger for $1 per share. Shortly after the merger, S 
purchases A's P shares for $20. Because the contract provides for 
the number of shares of P and the amount of money to be exchanged 
for all of the proprietary interests in T, under paragraph (e)(2) of 
this section, there is a binding contract providing for fixed 
consideration as of January 3 of Year 1. Therefore, whether the 
transaction satisfies the continuity of interest requirement is 
determined by reference to the value of the P stock on January 2 of 
Year 1. In addition, S is a person related to P under paragraph 
(e)(4)(i)(A) of this section. Accordingly, A is treated as 
exchanging his T shares for $50. Because, for continuity of interest 
purposes, the T stock is exchanged for $20 of P stock and $80 of 
cash, the transaction does not preserve a substantial part of the 
value of the proprietary interest in T. Therefore, the transaction 
does not satisfy the continuity of interest requirement.
    Example 4. Modification of binding contract--continuity not 
preserved. The facts are the same as in Example 1 except that on 
April 1 of Year 1, the parties modify their contract. Pursuant to 
the modified contract, which is a binding contract, the T 
shareholders will receive 50 P shares (an additional 10 shares) and 
$75 of cash (an additional $15 of cash) in exchange for all of the 
outstanding T stock. On March 31 of Year 1, the value of the P stock 
is $.50 per share. Under paragraph (e)(2) of this section, although 
there was a binding contract providing for fixed consideration as of 
January 3 of Year 1, terms of that contract relating to the 
consideration to be provided to the target shareholders were 
modified on April 1 of Year 1. Because the modified contract 
provides for the number of P shares and the amount of money to be 
exchanged for all of the proprietary interests in T, under paragraph 
(e)(2) of this section, the modified contract is a binding contract 
providing for fixed consideration as of April 1 of Year 1. 
Therefore, whether the transaction satisfies the continuity of 
interest requirement is determined by reference to the value of the 
P stock on March 31 of Year 1. Because, for continuity of interest 
purposes, the T stock is exchanged for $25 of P stock and $75 of 
cash, the transaction does not preserve a substantial part of the 
value of the proprietary interest in T. Therefore, the transaction 
does not satisfy the continuity of interest requirement.
    Example 5. Modification of binding contract disregarded--
continuity preserved. The facts are the same as in Example 4 except 
that, pursuant to the modified contract, which is a binding 
contract, the T shareholders will receive 60 P shares (an additional 
20 shares as compared to the original contract) and $60 of cash in 
exchange for all of the outstanding T stock. In addition, on March 
31 of Year 1, the value of the P stock is $.40 per share. Under 
paragraph (e)(2) of this section, although there was a binding 
contract providing for fixed consideration as of January 3 of Year 
1, terms of that contract relating to the consideration to be 
provided to the target shareholders were modified on April 1 of Year 
1. Nonetheless, the modification has the sole effect of providing 
for the issuance of additional P shares to the T shareholders. In 
addition, the execution of the terms of the contract without regard 
to the modification would have resulted in the preservation of a 
substantial part of the value of the T shareholders' proprietary 
interest in T because, for continuity of interest purposes, the T 
stock would have been exchanged for $40 of P stock and $60 of cash. 
Therefore, the modification is not treated as a modification under 
paragraph (e)(2) of this section. Accordingly, whether the 
transaction satisfies the continuity of interest requirement is 
determined by reference to the value of the P stock on January 2 of 
Year 1. Despite the modification, the transaction continues to 
satisfy the continuity of interest requirement.
    Example 6. New issuance. The facts are the same as in Example 1, 
except that, in lieu of the $60 of cash, the T shareholders will 
receive a new class of P securities that will be publicly traded. In 
the aggregate, the securities will have a stated principal amount of 
$60 and bear interest at the average LIBOR (London Interbank Offered 
Rates) during the 10 days prior to the potential reorganization. If 
the T shareholders had been issued the P securities on January 2 of 
Year 1, the P securities would have had a value of $60 (determined 
by reference to the value of comparable publicly traded securities). 
Whether the transaction satisfies the continuity of interest 
requirement is determined by reference to the value of the P stock 
and the P securities to be issued to the T shareholders on January 2 
of Year 1. Under paragraph (e)(2)(iv) of this section, for purposes 
of valuing the new P securities, they will be treated as having been 
issued on January 2 of Year 1. Because, for continuity of interest 
purposes, the T stock is exchanged for $40 of P stock and $60 of 
other property, the transaction preserves a substantial part of the 
value of the proprietary interest in T. Therefore, the transaction 
satisfies the continuity of interest requirement.
    Example 7. Economically unreasonable exchange. On January 3 of 
Year 1, P and T

[[Page 54637]]

sign a binding contract pursuant to which T will be merged with and 
into P on June 2 of Year 1. At that time, A is T's sole shareholder. 
Pursuant to the contract, 60 percent of the T stock will be 
exchanged for $80 of cash and 40 percent of the T stock will be 
exchanged for 20 shares of P stock. As of January 2, 20 shares of P 
stock have a value of $20, representing only 20 percent of the value 
of the total consideration to be received by the T shareholders. 
Because the percentage of proprietary interests in the target 
corporation to be exchanged for stock of the issuing corporation and 
the proprietary interests in the target corporation to be exchanged 
for money do not each represent an economically reasonable exchange 
as of the last business day before the first date there is a binding 
contract to effect the potential reorganization, under paragraph 
(e)(2)(iii)(A)(3) of this section, the contract is not treated as a 
binding contract that provides for fixed consideration.
    Example 8. Absence of anti-dilution clause. On January 3 of Year 
1, P and T sign a binding contract pursuant to which T will be 
merged with and into P on June 1 of Year 1. Pursuant to the 
contract, the T shareholders will receive 40 P shares and $60 of 
cash in exchange for all of the outstanding stock of T. The contract 
does not contain a customary anti-dilution provision. The P stock is 
listed on an established market. On January 2 of Year 1, the value 
of the P stock is $1 per share. On April 10 of Year 1, P issues its 
stock to effect a stock split; each shareholder of P receives an 
additional share of P for each P share that it holds. On April 11 of 
Year 1, the value of the P stock is $.50 per share. Because P 
altered its capital structure between January 3 and June 1 of Year 1 
in a manner that materially alters the economic arrangement of the 
parties, under paragraph (e)(2)(iii)(E) of this section, the 
contract is not treated as a binding contract that provides for 
fixed consideration.
    Example 9. Shareholder election with a proration mechanism. On 
January 3 of Year 1, P and T sign a binding contract pursuant to 
which T will be merged with and into P on June 1 of Year 1. Pursuant 
to the contract, at the shareholders' election, each share of T will 
be exchanged for cash of $1 or, alternatively, P stock that has a 
value of $1, if the value of each share of P stock is at least $.80 
and no more than $1.20 on the effective date of the potential 
reorganization; 1.25 shares of P stock, if the value of each share 
of P stock is less than $.80 on the effective date of the potential 
reorganization; or .83 shares of P stock, if the value of each share 
of P stock is more than $1.20 on the effective date of the potential 
reorganization. In addition, the contract provides for a proration 
mechanism to ensure that 50 percent of the T shares will be 
exchanged for cash and 50 percent of the T shares will be exchanged 
for P stock. On January 2 of Year 1, T has 100 shares outstanding. 
The P stock is listed on an established market. On January 2 of Year 
1, the value of the P stock is $1 per share. Because the contract 
provides for the percentage of the number of shares of each class of 
proprietary interests in T, and the percentage (by value) of the 
proprietary interests in T, to be exchanged for stock of P and the 
other requirements of paragraph (e)(2)(iii)(A)(3) of this section 
are satisfied, there is a binding contract providing for fixed 
consideration as of January 3 of Year 1. Therefore, whether the 
transaction satisfies the continuity of interest requirement is 
determined by reference to the value of the P stock on January 2 of 
Year 1. Because, for continuity of interest purposes, the T stock is 
exchanged for $50 of P stock and $50 of cash, the transaction 
preserves a substantial part of the value of the proprietary 
interest in T. Therefore, the transaction satisfies the continuity 
of interest requirement.
* * * * *
    (8) Effective date. Paragraphs (e)(1) and (e)(3) through (e)(7) of 
this section apply to transactions occurring after January 28, 1998, 
except that they do not apply to any transaction occurring pursuant to 
a written agreement which is binding on January 28, 1998, and at all 
times thereafter. Paragraph (e)(1)(ii) of this section, however, 
applies to transactions occurring after August 30, 2000, unless the 
transaction occurs pursuant to a written agreement that is (subject to 
customary conditions) binding on that date and at all times thereafter. 
Taxpayers who entered into a binding agreement on or after January 28, 
1998, and before August 30, 2000, may request a private letter ruling 
permitting them to apply the final regulation to their transaction. A 
private letter ruling will not be issued unless the taxpayer 
establishes to the satisfaction of the IRS that there is not a 
significant risk of different parties to the transaction taking 
inconsistent positions, for Federal tax purposes, with respect to the 
applicability of the final regulations to the transaction. Paragraph 
(e)(2) of this section applies to transactions occurring pursuant to 
binding contracts entered into after September 16, 2005.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
    Approved: September 6, 2005.
Eric Solomon,
Acting Deputy Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 05-18263 Filed 9-15-05; 8:45 am]
BILLING CODE 4830-01-P