Corporate Reorganizations; Guidance on the Measurement of Continuity of Interest, 12974-12980 [E7-5128]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 72, Number 53 (Tuesday, March 20, 2007)]
[Rules and Regulations]
[Pages 12974-12980]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E7-5128]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9316]
RIN 1545-BG14


Corporate Reorganizations; Guidance on the Measurement of 
Continuity of Interest

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains final and temporary regulations that 
provide guidance regarding the satisfaction of the continuity of 
interest requirement for corporate reorganizations. These regulations 
affect corporations and their shareholders. The text of the temporary 
regulations also serves as the text of the proposed regulations set 
forth in the notice of proposed rulemaking on this subject in the 
Proposed Rules section in this issue of the Federal Register.

DATES: Effective Date: These regulations are effective March 20, 2007.
    Applicability Date: For dates of applicability, see Sec.  1.368-
1T(e)(8)(ii).

FOR FURTHER INFORMATION CONTACT: Lisa S. Dobson at (202) 622-7790 (not 
a toll-free number).

SUPPLEMENTARY INFORMATION: 

Background and Explanation of Provisions

    The Internal Revenue Code of 1986 (Code) provides 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) (2004 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. On 
September 16, 2005, the IRS and Treasury Department published final 
regulations in the Federal Register (TD 9225, 70 FR 54631) (2005 final 
regulations) which retained the general framework of the 2004 proposed 
regulations but made several modifications in response to the comments 
received regarding the proposed regulations. Specifically, the 2005 
final regulations provide that 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 is valued 
on the last business day before the first date such contract is a 
binding contract (the signing date), if the contract provides for fixed 
consideration (the signing date rule).
    After consideration of comments relating to the 2005 final 
regulations, the IRS and Treasury Department are revising those 
regulations as set forth in this Treasury decision. These temporary 
regulations provide guidance for measuring whether the COI requirement 
is satisfied. The following sections specifically describe the 
revisions.

A. Applicability of the Signing Date Rule

    For purposes of determining whether COI is satisfied, the 2005 
final regulations require the consideration to be exchanged for the 
proprietary interests in the target corporation to be valued on the 
last business day before the first date such contract is a binding 
contract, if such contract provides for fixed consideration. As noted 
in the preamble to the 2005 final regulations, the signing date rule is 
based on the principle that, where a binding contract provides for 
fixed consideration, the target corporation shareholders can generally 
be viewed as being subject to the economic fortunes of the issuing 
corporation as of the signing date. However, if the contract does not 
provide for fixed consideration, the signing date value of the issuing 
corporation stock is not relevant for purposes of determining the 
extent to which a proprietary interest in the target corporation is 
preserved.
    These temporary regulations continue to apply the signing date rule 
where the contract provides for fixed consideration. If the contract 
does not provide for fixed consideration, the temporary regulations 
provide that the signing date rule is not applicable. Further, these 
temporary regulations clarify that where fixed consideration includes 
other property that is identified by value, that specified value is the 
value of such other property to be used in determining whether COI is 
satisfied.

B. Definition of Fixed Consideration

    As noted above, the temporary regulations provide that the signing 
date rule only applies to contracts that provide for fixed 
consideration. These temporary regulations modify the definition of 
fixed consideration.
    The 2005 final regulations provide four circumstances in which a 
contract will be treated as providing for fixed consideration. 
Generally, under the 2005 final regulations, a contract provides for 
fixed consideration if (1) the contract states the number of shares of 
the issuing corporation plus the amount of money and any other property 
to be exchanged for all proprietary interests in the target 
corporation; (2) the contract states the number of shares of the 
issuing corporation plus the amount of money and any other property to 
be exchanged for each proprietary interest in the target corporation; 
(3) the contract states the percentage of proprietary interests in the 
target corporation to be exchanged for stock of the issuing 
corporation; or (4) the contract states the percentage of each 
proprietary interest in the target corporation to be exchanged for 
stock of the issuing corporation.
    These temporary regulations combine the first two circumstances 
into one sentence that defines fixed consideration. No substantive 
change to these two definitions of fixed consideration is intended with 
this amendment.
    The target corporation shareholders are generally subject to the 
economic fortunes of the issuing corporation as of

[[Page 12975]]

the signing date only if the contract specifies the number of shares of 
the issuing corporation to be exchanged for all or each proprietary 
interest in the target corporation. Accordingly, the temporary 
regulations provide that the signing date rule is applicable in these 
situations. The IRS and Treasury Department request comments regarding 
whether it is appropriate to include in the definition of fixed 
consideration a contract that specifies a fixed percentage of the 
shares of the issuing corporation to be exchanged for all or each 
proprietary interest in the target corporation.
    The temporary regulations eliminate the third and fourth 
circumstances described in the 2005 final regulations from the 
definition of fixed consideration. Because these types of transactions 
do not specify the number of shares of the issuing corporation to be 
received in the exchange, the target corporation shareholders are not 
subject to the economic fortunes of the issuing corporation as of the 
signing date. These provisions were removed because, in such 
situations, applying the signing date rule may produce inappropriate 
results.
    A commentator noted that a transaction in which a fixed percentage 
of target corporation shares is exchanged for issuing corporation 
shares could inappropriately be precluded from satisfying COI due to 
the application of the signing date rule. For example, if the number of 
the issuing corporation shares to be received by the target corporation 
shareholders depends on the value of the issuing corporation shares on 
the closing date, and the issuing corporation shares appreciate 
significantly between the signing date and the closing date, the 
signing date rule could prevent a transaction from satisfying COI 
notwithstanding the fact that a substantial part of the value of the 
proprietary interests in the target corporation is exchanged for 
proprietary interests in the issuing corporation.
    Further, the temporary regulations continue to treat a contract 
that provides for a shareholder election between shares of the issuing 
corporation stock and the money or other property to be exchanged for 
the proprietary interests in the target corporation as a contract that 
provides for fixed consideration in the circumstances described below.

C. Shareholder Elections

    The 2005 final regulations contain a rule generally stating that a 
contract that permits the target corporation shareholders to elect to 
receive stock and/or money and/or other property with respect to their 
target corporation stock will be treated as providing for fixed 
consideration if the contract also provides the minimum number of 
shares of the issuing corporation stock and the maximum amount of money 
or other property to be exchanged for all of the proprietary interests 
in the target corporation, the minimum percentage of the number of 
shares of each class of proprietary interests in the target corporation 
to be exchanged for stock of the issuing corporation, or the minimum 
percentage (by value) of the proprietary interests in the target 
corporation to be exchanged for stock of the issuing corporation. The 
2005 final regulations further include two special rules prescribing 
certain assumptions to be made in the determination of whether COI is 
satisfied in shareholder election cases. For example, in the case in 
which the contract states the minimum number of shares of the issuing 
corporation stock and the maximum amount of money or other property to 
be exchanged for all of the proprietary interests in the target 
corporation, the determination of whether a proprietary interest in the 
target corporation is preserved is made by assuming the issuance of the 
minimum number of shares of each class of stock of the issuing 
corporation and the maximum amount of money or 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 or 
other property actually exchanged for proprietary interests in the 
target corporation.
    These temporary regulations treat certain transactions that allow 
for shareholder elections as providing for fixed consideration 
regardless of whether the agreement specifies the maximum amount of 
money or other property, or the minimum amount of issuing corporation 
stock, to be exchanged in the transaction. As noted above, if the 
target corporation shareholders can generally be viewed as subject to 
the economic fortunes of the issuing corporation as of the signing 
date, it is appropriate to treat the contract as providing for fixed 
consideration and to apply the signing date rule. The IRS and Treasury 
Department believe that these circumstances exist in cases where the 
target corporation shareholders may elect to receive issuing 
corporation stock in exchange for their target corporation stock at an 
exchange rate based on the value of the issuing corporation stock on 
the signing date. For example, if the issuing corporation stock has a 
value of $1 per share on the last business date before the first date 
on which the contract is binding, and the agreement provides that the 
target corporation shareholders may exchange each share of target 
corporation stock for either $1 or issuing corporation stock (based on 
the signing date value), the target corporation shareholders that 
choose to exchange their target corporation stock for stock of the 
issuing corporation are subject to the economic fortunes of the issuing 
corporation with respect to such stock as of the signing date. 
Accordingly, the IRS and Treasury Department believe that it is 
appropriate in such a case to apply the signing date rule to value the 
stock of the issuing corporation for purposes of testing whether the 
transaction satisfies the COI requirement.
    Additionally, the IRS and Treasury Department are concerned that 
the assumptions in the shareholder election rule in the 2005 final 
regulations may create confusion about whether COI is satisfied based 
on the delivery of stock that does not in fact preserve the target 
corporation shareholders' proprietary interest in the target 
corporation when such result was not intended. For example, the rule 
might appear to suggest that stock that is redeemed in connection with 
the potential reorganization will nonetheless be treated as preserving 
the target corporation shareholders' proprietary interests in the 
target corporation, although this result would be contrary to Treas. 
Reg. 1.368-1(e)(1). Further, these assumptions could prevent a 
transaction from satisfying COI even though a substantial part of the 
value of the proprietary interests in the target corporation is 
actually exchanged for proprietary interests in the issuing 
corporation.
    Because of this potential for confusion, and because these 
assumptions are not relevant to the revised shareholder election 
provision, the temporary regulations remove the assumptions so that the 
determination of whether COI is preserved depends on the actual 
consideration exchanged. Example 9 of the Temporary Regulations has 
been modified to illustrate the revised rules regarding shareholder 
elections.

D. Contract Modifications

    The 2005 final regulations generally provide that a modification of 
the contract results in a new signing date. However, the 2005 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

[[Page 12976]]

corporation shareholders will not be treated as a modification if the 
execution of the transaction pursuant to the original agreement 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 there had been no modification. One commentator 
suggested that this rule be broadened to include modifications that 
decrease the money or other property that will be delivered to the 
target corporation shareholders. These temporary regulations reflect 
this broadening.
    Further, the IRS and Treasury Department believe that the signing 
date rule should also apply to provide certainty regarding the value of 
the issuing corporation stock used for purposes of testing COI if the 
transaction fails to qualify as a tax-free reorganization. For this 
reason, the IRS and Treasury Department believe that the exception to 
the modification rule should also be available for certain types of 
modifications if the transaction fails to satisfy COI at the time of 
the execution of the contract. Accordingly, these temporary regulations 
provide that certain contract modifications will not result in a new 
signing date if the terms of the original contract would have prevented 
the transaction from qualifying as a reorganization.

E. Contingent Consideration

    The 2005 final regulations provide that contingent consideration 
will generally prevent a contract from being treated as providing for 
fixed consideration. However, the 2005 final regulations provide for a 
limited exception to that general rule. 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 was 
delivered to the target shareholders. The IRS and Treasury Department 
received a number of comments regarding the effect of contingent 
consideration on the application of the signing date rule.
    A number of commentators suggested that the scope of the exception 
should be expanded to include cases in which the delivery of the 
contingent consideration to the target corporation shareholders does 
not decrease the ratio of the value of the shares of issuing 
corporation stock to the value of the money or other property 
(determined as of the last business day before the first date there is 
a binding contract) to be delivered to the target corporation 
shareholders relative to the ratio of the value of the shares of the 
issuing corporation stock to the value of the money or other property 
(determined as of the last business day before the first date there is 
a binding contract) to be delivered to the target corporation 
shareholders if none of the contingent consideration were delivered to 
the target corporation shareholders. These temporary regulations modify 
and expand the applicability of the signing date rule to certain 
transactions that provide for contingent adjustments (i.e., increases 
or decreases) to the consideration.
    As described above, the signing date rule is based on the principle 
that, where a binding contract provides for fixed consideration, the 
target corporation shareholders can generally be viewed as being 
subject to the economic fortunes of the issuing corporation as of the 
signing date. The IRS and Treasury Department believe that where this 
principle holds true, the signing date rule should apply regardless of 
whether the transaction potentially qualifies as a reorganization, and 
regardless of whether the contract provides for certain contingent 
adjustments to the otherwise fixed consideration. Accordingly, these 
temporary regulations provide that, generally, a contract that 
otherwise qualifies as providing for fixed consideration will be 
treated as providing for fixed consideration even if it provides for 
contingent adjustments to the consideration, and regardless of whether 
the transaction would have satisfied COI in the absence of any 
contingent adjustments. However, if the terms of the contingent 
adjustments potentially prevent the target corporation shareholders 
from being subject to the economic fortunes of the issuing corporation 
as of the signing date, the contract will not be treated as providing 
for fixed consideration.
    Accordingly, these temporary regulations provide that a contract 
will not be treated as providing for fixed consideration if it provides 
for contingent adjustments to the consideration that prevent (to any 
extent) the target shareholders from being subject to the economic 
benefits and burdens of ownership of the issuing corporation as of the 
signing date. For example, a contract will not be treated as providing 
for fixed consideration if it provides for contingent adjustments in 
the event that the value of the stock of the issuing corporation, the 
value of the assets of the issuing corporation, or the value of any 
surrogate for either the value of the stock of the issuing corporation 
or the assets of the issuing corporation increase or decrease after the 
last business day before the first date there is a binding contract, or 
if the terms of the contingent adjustment provide that any increase or 
decrease in the number of shares of the issuing corporation will be 
computed using any value of the issuing corporation shares after the 
last business day before the first date the contract is a binding 
contract.

F. Anti-Dilution Provisions

    These temporary regulations also clarify that if the issuing 
corporation's capital structure is altered and the number of shares of 
the issuing corporation to be issued to the target corporation 
shareholders is altered pursuant to a customary anti-dilution clause, 
the signing date value of the issuing corporation's shares must be 
adjusted to take this alteration into account.

G. Other Issues

    The IRS and Treasury Department continue to study other issues 
related to the determination of whether the COI requirement is 
satisfied.

Effective Date

    These temporary regulations are effective March 20, 2007 and apply 
to transactions occurring pursuant to a binding contract entered into 
after September 16, 2005. These temporary regulations provide 
transitional relief for certain transactions occurring pursuant to a 
binding contract entered into after September 16, 2005, and on or 
before March 20, 2007. Parties to transactions within the scope of the 
transitional relief may elect to apply the 2005 final regulations 
instead of these temporary regulations. Certain parties must adopt 
consistent treatment to obtain this relief.

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 has also been 
determined that 5 U.S.C. 553(b) and (d) do not apply to these 
regulations. For applicability of the Regulatory Flexibility Act, 
please refer to the cross-reference notice of proposed rulemaking 
published elsewhere in this issue of the Federal Register. Pursuant to 
section 7805(f) of the Internal Revenue Code, these regulations were 
submitted to the Chief Counsel for Advocacy of the Small Business

[[Page 12977]]

Administration for comment on their impact on small business.

Drafting Information

    The principal author of these regulations is Lisa S. Dobson 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.

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 by:
0
1. Revising paragraph (e)(2).
0
2. Redesignating the text of paragraph (e)(8) as paragraph (e)(8)(i) 
and revising it.
0
3. Adding paragraph (e)(8)(ii).
    The revisions and addition read as follows:


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

* * * * *
    (e) * * *
    (2) [Reserved]. For further guidance, see Sec.  1.368-1T(e)(2).
* * * * *
    (8) Effective dates--(i) In general. 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 regulations 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.
    (ii) Signing date rule. [Reserved]. For further guidance, see Sec.  
1.368-1T(e)(8)(ii).

0
Par. 3. Section 1.368-1T is added to read as follows:


Sec.  1.368-1T  Purpose and scope of exception of reorganization 
exchanges (temporary).

    (a) through (e)(1) [Reserved]. For further guidance, see Sec.  
1.368-1(a) through (e)(1).
    (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. If a portion of the 
consideration provided for in such a contract consists of other 
property identified by value, then this specified value of such other 
property is used for purposes of determining the extent to which a 
proprietary interest in the target corporation is preserved. If the 
contract does not provide for fixed consideration, this paragraph 
(e)(2)(i) is not applicable.
    (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) Modification of a transaction that preserves continuity of 
interest. 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 transaction 
that 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 there had been no modification will not be 
treated as a modification if--
    (i) The modification has the sole effect of providing for the 
issuance of additional shares of issuing corporation stock to the 
target corporation shareholders;
    (ii) The modification has the sole effect of decreasing the amount 
of money or other property to be delivered to the target corporation 
shareholders; or
    (iii) The modification has the effect of decreasing the amount of 
money or other property to be delivered to the target corporation 
shareholders and providing for the issuance of additional shares of 
issuing corporation stock to the target corporation shareholders.
    (3) Modification of a transaction that does not preserve continuity 
of interest. 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 transaction 
that would not have resulted in the preservation of a substantial part 
of the value of the target corporation shareholders' proprietary 
interests in the target corporation if there had been no modification 
will not be treated as a modification if--
    (i) The modification has the sole effect of providing for the 
issuance of fewer shares of issuing corporation stock to the target 
corporation shareholders;
    (ii) The modification has the sole effect of increasing the amount 
of money or other property to be delivered to the target corporation 
shareholders; or
    (iii) The modification has the effect of increasing the amount of 
money or other property to be delivered to the target corporation 
shareholders and providing for the issuance of fewer shares of issuing 
corporation stock to the target corporation shareholders.
    (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

[[Page 12978]]

amount or type of the consideration received in the tender offer, then 
the 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 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 the proprietary interests in the target 
corporation, or to be exchanged for each proprietary interest in the 
target corporation. A contract that provides a target corporation 
shareholder with an election to receive a number of shares of stock of 
the issuing corporation and/or money and/or other property in exchange 
for all of the shareholder's proprietary interests in the target 
corporation, or each of the shareholder's proprietary interests in the 
target corporation, provides for fixed consideration if the 
determination of the number of shares of issuing corporation stock to 
be provided to the target corporation shareholder is determined using 
the value of the issuing corporation stock on the last business day 
before the first date there is a binding contract.
    (B) Contingent adjustments to the consideration--(1) In general. 
Except as provided in paragraph (e)(2)(iii)(B)(2) of this section, a 
contract that provides for contingent adjustments to the consideration 
will be treated as providing for fixed consideration if it would 
satisfy the requirements of paragraph (e)(2)(iii)(A) of this section 
without the contingent adjustment provision.
    (2) Exceptions. A contract will not be treated as providing for 
fixed consideration if the contract provides for contingent adjustments 
to the consideration that prevent (to any extent) the target 
corporation shareholders from being subject to the economic benefits 
and burdens of ownership of the issuing corporation stock after the 
last business day before the first date the contract is a binding 
contract. For example, a contract will not be treated as providing for 
fixed consideration if the contract provides for contingent adjustments 
to the consideration in the event that the value of the stock of the 
issuing corporation, the value of the assets of the issuing 
corporation, or the value of any surrogate for either the value of the 
stock of the issuing corporation or the assets of the issuing 
corporation increase or decrease after the last business day before the 
first date there is a binding contract; or in the event the contract 
provides for contingent adjustments to the number of shares of the 
issuing corporation stock to be provided to the target corporation 
shareholders computed using any value of the issuing corporation shares 
after the last business day before the first date there is a binding 
contract.
    (C) 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.
    (D) 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 transaction and the effective date of the transaction in 
a manner that materially alters the economic arrangement of the parties 
to the binding contract. If the number of shares of the issuing 
corporation to be issued to the target corporation shareholders is 
altered pursuant to a customary anti-dilution clause, the value of the 
shares determined under paragraph (e)(2)(i) of this section must be 
adjusted accordingly.
    (E) 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.
    (F) 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 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 this paragraph (e)(2), 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) Escrowed 
stock. 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 this paragraph (e)(2), 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. Pursuant to paragraph 
(e)(1)(i) of Sec.  1.368-1, 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) Escrowed stock and cash. The facts are the same as in 
paragraph (i) of this Example 2 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 this paragraph (e)(2), there is a binding 
contract providing for fixed consideration as of January 3 of Year 
1. Therefore, whether the

[[Page 12979]]

transaction satisfies the continuity of interest requirement is 
determined by reference to the value of the P stock on January 2 of 
Year 1. Pursuant to paragraph (e)(1)(i) of Sec.  1.368-1, for 
continuity of interest purposes, the T stock is exchanged for $32 of 
P stock and $48 of cash, and 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 this paragraph 
(e)(2), 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 Sec.  1.368-1. Accordingly, A is treated as 
exchanging his T shares for $50 of cash. 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 this paragraph (e)(2), 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. The execution of the transaction without modification 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 there had been no modification. However, 
because the modified contract provides for additional P stock and 
cash to be exchanged for all the proprietary interests in T, the 
exception in paragraph (e)(2)(ii)(B)(2) of this section does not 
apply to preserve the original signing date. 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 this 
paragraph (e)(2), 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. 
Pursuant to paragraph (e)(2)(ii)(B)(2) of this section, the 
modification is not treated as a modification for purposes of 
paragraph (e)(2)(ii)(B)(1) 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. Because, for continuity of interest purposes, the T stock is 
exchanged for $60 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 6. New issuance. The facts are the same as in Example 1, 
except that, instead 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. Fixed consideration--continuity not preserved. 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, 60 shares of the T stock will be exchanged for $80 
of cash and 40 shares of the T stock will be exchanged for 20 shares 
of P stock. 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. This contract provides for fixed 
consideration and 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. However, applying the 
signing date rule, the P stock represents only 20 percent of the 
value of the total consideration to be received by the T 
shareholders. Accordingly, based on the economic realities of the 
exchange, 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 8. Anti-dilution clause. (i) 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)(D) of this section, the contract is not treated as a 
binding contract that provides for fixed consideration. Accordingly, 
whether the transaction satisfies the continuity of interest 
requirement cannot be determined by reference to the value of the P 
stock on January 2 of Year 1.
    (ii) Adjustment for anti-dilution clause. The facts are the same 
as in paragraph (i) of this Example 8 except that the contract 
contains a customary anti-dilution provision, and the T shareholders 
receive 80 P shares and $60 of cash in exchange for all of the 
outstanding stock of T. Under paragraph (e)(2)(iii)(D) of this 
section, the contract is treated as a binding contract that provides 
for fixed consideration as of January 3 of Year 1. Therefore, 
whether the transaction satisfies the continuity of interest 
requirement is generally determined by reference to the value of the 
P stock on January 2 of Year 1. However, under paragraph 
(e)(2)(iii)(D) of this section, the value of the P stock on January 
2 of Year 1 must be adjusted to take the stock split into account. 
For continuity of interest purposes, the T stock is exchanged for 
$40 of P stock (($1/2) x 80) and $60 of

[[Page 12980]]

cash. Therefore, the transaction satisfies the continuity of 
interest requirement.
    Example 9. Shareholder election. 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. On January 2 of Year 1, the value of the 
P stock and the T stock is $1 per share. Pursuant to the contract, 
at the shareholders' election, each share of T will be exchanged for 
cash of $1, or alternatively, P stock. The contract provides that 
the determination of the number of shares of P stock to be exchanged 
for a share of T stock is made using the value of the P stock on the 
last business day before the first date there is a binding contract 
(i.e., $1 per share). Accordingly, the contract provides for fixed 
consideration, and the determination of whether the transaction 
satisfies the continuity of interest requirement is based on the 
number of shares of P stock the T shareholders receive in the 
exchange and by reference to the value of the P stock on January 2 
of Year 1.
    Example 10. Contingent adjustment based on the value of the 
issuing corporation stock--continuity not preserved. 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. On January 2 of Year 1, 
the value of the P stock is $1 per share. Pursuant to the contract, 
if the value of the P stock does not decrease after January 2 of 
Year 1, the T shareholders will receive 40 P shares and $60 of cash 
in exchange for all of the outstanding stock of T. Furthermore, the 
contract provides that the T shareholders will receive $.16 of 
additional P shares and $.24 for every $.01 decrease in the value of 
one share of P stock after January 2 of Year 1. 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 $.40 per share. Pursuant to 
the terms of the contract, the consideration is adjusted so that the 
T shareholders receive 24 more P shares ((60 x $.16)/$.40) and 
$14.40 more cash (60 x $.24) than they would absent an adjustment. 
Accordingly, at closing the T shareholders receive 64 P shares and 
$74.40 of cash. Because the contract provides that additional P 
shares and cash will be delivered to the T shareholders if the value 
of the stock of P decreases after January 2 of Year 1, under 
paragraph (e)(2)(iii)(B)(2) of this section, the contract is not 
treated as providing for fixed consideration, and therefore whether 
the transaction satisfies the continuity of interest requirement 
cannot be determined by reference to the value of the P stock on 
January 2 of Year 1. For continuity of interest purposes, the T 
stock is exchanged for $25.60 of P stock (64 x $.40) and $74.40 of 
cash and 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 11. Contingent adjustment to boot based on the value of 
the target corporation stock--continuity not preserved. 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. On January 2 of Year 
1, T has 100 shares outstanding, and each T share is worth $1. On 
January 2 of Year 1, each P share is worth $1. Pursuant to the 
contract, if the value of the T stock does not increase after 
January 3 of Year 1, the T shareholders will receive 40 P shares and 
$60 of cash in exchange for all of the outstanding stock of T. 
Furthermore, the contract provides that the T shareholders will 
receive $1 of additional cash for every $.01 increase in the value 
of one share of T stock after January 3 of Year 1. On June 1 of Year 
1, the value of the T stock is $1.40 per share and the value of the 
P stock is $.75 per share. Pursuant to the terms of the contract, 
the consideration is adjusted so that the T shareholders receive $40 
more cash (40 x $1) than they would absent an adjustment. 
Accordingly, at closing the T shareholders receive 40 P shares and 
$100 of cash. Because the contract provides the number of shares of 
P stock and the amount of money to be exchanged for all the 
proprietary interests in T, and the contingent adjustment to the 
cash consideration is not based on changes in the value of the P 
stock, P assets, or any surrogate thereof, after January 2 of Year 
1, 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. For continuity of 
interest purposes, the T stock is exchanged for $40 of P stock (40 x 
$1) and $100 of cash. Therefore, the transaction does not satisfy 
the continuity of interest requirement.
    Example 12. Contingent adjustment to stock based on the value of 
the target corporation stock--continuity preserved. 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. On that date T has 100 
shares outstanding, and each T share is worth $1. On January 2 of 
Year 1, each P share is worth $1. Pursuant to the contract, if the 
value of the T stock does not decrease after January 3 of Year 1, 
the T shareholders will receive 40 P shares and $60 of cash in 
exchange for all of the outstanding stock of T. Furthermore, the 
contract provides that the T shareholders will receive $.40 less P 
stock and $.60 less cash for every $.01 decrease in the value of one 
share of T stock after January 3 of Year 1. The contract also 
provides that the number of P shares by which the consideration will 
be reduced as a result of this adjustment will be determined based 
on the value of the P stock on January 2 of Year 1. 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 T stock is $.70 per share 
and the value of the P stock is $.75 per share. Pursuant to the 
terms of the contract, the consideration is adjusted so that the T 
shareholders receive 12 fewer P shares ((30 x $.40)/$1) and $18 less 
cash (30 x $.60) than they would absent an adjustment. Accordingly, 
at closing the T shareholders receive 28 P shares and $42 of cash. 
Because the contract provides for the number of shares of P stock 
and the amount of money to be exchanged for all of the proprietary 
interests in T, the contract does not provide for contingent 
adjustments to the consideration based on a change in value of the P 
stock, P assets, or any surrogate thereof, after January 2 of Year 
1, and the adjustment to the number of P shares the T shareholders 
receive is determined based on the value of the P shares on January 
2 of Year 1, 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. For continuity of interest purposes, the T stock is 
exchanged for $28 of P stock (28 x $1) and $42 of cash. Therefore, 
the transaction satisfies the continuity of interest requirement.

    (e)(3) through (7) [Reserved]. For further guidance, see Sec.  
1.368-1(e)(3) through (7).
    (8) Effective dates. (i) [Reserved]. For further guidance, see 
Sec.  1.368-1(e)(8)(i).
    (ii) Signing date rule. Paragraph (e)(2) of this section applies to 
transactions occurring pursuant to binding contracts entered into after 
September 16, 2005. For transactions occurring pursuant to binding 
contracts entered into after September 16, 2005, and on or before March 
20, 2007, the parties to the transaction may elect to apply the 
provisions of Sec.  1.368-1(e)(2) as contained in 26 CFR part 1, 
revised April 1, 2006, instead of the provisions of this paragraph 
(e)(2). However, the target corporation, the issuing corporation, the 
controlling corporation of the acquiring corporation if stock thereof 
is provided as consideration in the transaction, and any direct or 
indirect transferee of transferred basis property from any of the 
foregoing, may not elect to apply the provisions of Sec.  1.368-1(e)(2) 
as contained in 26 CFR part 1, revised April 1, 2006, unless all such 
taxpayers elect to apply the provisions of such regulations. This 
election requirement will be satisfied if none of the specified parties 
adopts inconsistent treatment. The applicability of this section 
expires on or before March 19, 2010.

Kevin M. Brown,
Deputy Commissioner for Services and Enforcement.
    Approved: March 14, 2007.
 Eric Solomon,
Assistant Secretary of the Treasury (Tax Policy).
 [FR Doc. E7-5128 Filed 3-19-07; 8:45 am]
BILLING CODE 4830-01-P