Proposed Tax Regulations Ease Tax-Free Merger Planning
By: THOMAS W. GARTON
September 2004
On August 8, the Treasury announced new Proposed Regulations under Code Section 368. The tax-free reorganization provisions clarify a sticky "continuity of interest" problem that has plagued transaction planners. The continuity of interest rule provides that to qualify as a tax-free reorganization, the "selling" shareholders generally must receive at least 40% of the value of the merger consideration in stock of the acquiring company.
The problem has been that the measure of that relative value was taken at the date of closing, not when the agreement was struck between the parties. If 40% of the proposed consideration was stock of the acquirer when the deal was signed and the market value of that stock dropped prior to closing, the 40% test could be failed. Elaborate collars and adjustments were sometimes used to prevent this consequence.
The proposed regulations establish that where the number of acquirer shares being given in the transaction is fixed, the value is measured at the date of the binding agreement, not closing. Once the 40% continuity of interest rule is met, there is no need to worry about shifts in stock value. This new rule has some important exceptions, however, so a careful reading is advised.
While these regulations are not yet effective, they signal a welcome and much-needed softening in the previously rigid approach to this issue.