Judicial authority and Treasury Regulations have established various criteria that must be complied with for a transaction to constitute a tax free reorganization under Section 368 of the Internal Revenue Code (the “Code”). Among these items is a requirement that the consideration received by the selling shareholders in the reorganization consist of, in “substantial part,” equity in the acquiring corporation (or its parent corporation). This requirement is referred to as “continuity of interest” (COI) in the acquiring corporation. The requirement is consistent with the policy that a tax free reorganization contemplates the sellers having a continuing interest in the purchaser. The continuing interest requirement provides that the target corporation’s shareholders must receive a “definite and substantial interest” in the acquiring corporation. An open question is the percentage of the value of the consideration received by the target shareholders which is required to be equity in the acquiring corporation in order for the interest to be definite and substantial. At least one court has ruled that 25 percent is sufficient,1 while the United States Supreme Court ruled that 38 percent will suffice.2 The IRS has announced that for purposes of obtaining a private letter ruling, fifty percent of the consideration must be in the form of acquiring corporation equity.3 Examples in the Treasury Regulations provide that when 40 percent of the consideration for the target corporation’s equity is stock of the acquiring corporation or its parent the transaction satisfies the COI requirement.4
The COI requirement can create difficulties when the acquiring corporation’s stock fluctuates in value during the period between the signing of the agreement and the actual consummation of the reorganization. For example, on the date the deal is signed the equity consideration may constitute 50 percent of the total consideration to be received by the target’s shareholders; however, at the time of the closing, the value of the acquiring corporation’s stock may have dropped so that the equity consideration is less than 40 percent of the total consideration. This may disqualify the transaction from treatment as a tax-free reorganization. Treasury Regulations Section 1.368-1T(e)(2) was issued to address this potential problem.
Treasury Regulations Section 1.368-1T(e)(2) provides that for purposes of determining whether the COI requirement is satisfied, the consideration to be received is valued as of the last business day prior to the first date on which there is a binding contract (the “Signing Date”), so long as the contract provides for fixed consideration. The existence of a binding contract is determined by the applicable laws under which the contract would be enforced against the parties. The fact that the agreement is conditioned upon regulatory approval or other conditions outside the control of the parties will not prevent the agreement from being a binding contract.
A contract provides for fixed consideration if it sets forth the number of shares of each class of stock of the acquiring corporation, the amount of money, and the other property (either by value or description) to be exchanged for all of the “proprietary interests” in the target corporation or for each interest in the target corporation. If the agreement gives the target corporation shareholders the option of receiving acquiring corporation stock and/or money or other property in exchange for the target shareholder’s interests in the target corporation, then the agreement will still be deemed to provide for fixed consideration so long as the number of acquiring corporation shares to be received is determined using the value of the acquiring corporation stock on the Signing Date.5
Generally, a contract that provides for contingent adjustments to the consideration will be treated as providing for fixed consideration if it would satisfy the requirements above without regard to the contingent adjustment provision. However, contingent adjustments based on any increase or decrease in the value of the acquiring corporation stock, the acquiring corporation assets, or any surrogate for either of those values during the period after the Signing Date do not provide for fixed consideration.6 Thus, a formula that ensures that the acquiring corporation stock represents a certain percentage of the total consideration by adjusting the number of shares based on the per share value would not provide for fixed consideration and the Signing Date valuation would not be controlling for COI purposes. Instead, the COI determination will be based on the closing date value of the stock.
The use of an escrow to ensure the target corporation’s compliance with customary pre-closing covenants or representations and warranties does not prevent the contract from providing for fixed consideration. As such, the Signing Date valuation is permissible. However, if any portion of the escrowed shares are forfeited, then only the shares that are actually received by the target shareholders are counted for purposes of determining whether the 40 percent requirement is satisfied. Thus, where an agreement provides for $40 of the value to be paid to target shareholders in acquiring corporation shares and $60 in cash and a portion of the shares are placed in escrow and later forfeited, the value of the shares will be determined as of the Signing Date, but only that portion of the shares that the target shareholders actually receive will be used to determine whether the COI requirement is satisfied.
Similarly, the possibility that some shareholders, through the exercise of dissenters’ rights, may receive consideration other than that provided in the binding contract does not prevent the contract from providing for fixed consideration. Furthermore, an anti-dilution clause does not prevent a contract from providing for fixed consideration. However, if the acquiring corporation alters its capital structure between the Signing Date and the consummation of the transaction, the absence of an anti-dilution clause will prevent the contract from providing fixed consideration.7
These rules provide important guidelines for determining whether the Signing Date is used to determine whether the COI requirement is satisfied. However, there are many situations in which it is less than clear whether adjustment in the event that the acquiring corporation pays a dividend after the Signing Date and before the closing date. If the adjustment provides that the target shareholders will receive additional consideration to make up for any distributions, the fixed consideration requirement may not be met.8
Since compliance with the COI requirement is necessary to obtain reorganization treatment, structuring the consideration to meet the requirements of Section 1.368-1T(e)(2) will avoid concerns of valuation changes that will prevent tax free treatment.