Revenue Procedure 2018-12 provides methods that taxpayers may use to value certain publicly traded issuing-corporation stock received by a target corporation's shareholders in a potential reorganization for purposes of determining whether the continuity of interest (COI) requirement under Reg. Section 1.368-1(e) is satisfied. Specifically, if the requirements of the revenue procedure are satisfied, the taxpayer may determine the value of the stock issued in the transaction by using one of these safe harbors: (i) the average of the daily volume weighted average prices; (ii) the average of the daily average high-low trading prices; or (iii) the average of the daily closing prices.

Overview of COI and prior methods for determining it

To qualify as a reorganization under Section 368(a), a transaction must satisfy the COI requirement by preserving a substantial part of the value of the target shareholders' proprietary interests (i.e., stock) in the target. A proprietary interest in the target is preserved if it is exchanged for stock of the issuing corporation (i.e., the acquiring corporation or, in the case of a triangular reorganization, a corporation in control of the acquiring corporation). To determine whether the COI requirement is satisfied, the value of the issuing-corporation stock that the target shareholders received is compared to the aggregate value of the consideration that the target shareholders received.

Before 2011, the determination of whether the COI requirement was satisfied had been based on the value of the issuing-corporation stock "as of the effective date of the reorganization" (the Closing Date). Under this rule (Closing Date Rule), a decline in the value of the issuing-corporation stock between the date a contract to effect a potential reorganization becomes binding (the Signing Date) and the Closing Date could cause a transaction to fail the COI requirement. Final COI regulations issued in December 2011 contain a special rule (the Signing Date Rule) requiring the consideration to be valued as of the end of the last business day before the first date there is a binding contract (the Pre-Signing Date), so long as the contract provides for fixed consideration to be exchanged for the target shareholders' stock. (See Tax Alert 2012-0067.)

Overview of Revenue Procedure 2018-12

Applicable transactions

Section 3 of the revenue procedure permits taxpayers to rely on the Safe Harbor Valuation Methods (defined below) if: (i) either the Signing Date Rule or the Closing Date Rule applies to the transaction; and (ii) the requirements below are satisfied:

1. The target shareholders receive a combination of issuing-corporation stock and cash or other property in exchange for their target stock in a transaction that, apart from the COI requirement, would qualify as a reorganization described in Section 368(a)(1)(A), (B), (C) or (G).

2. The shares of issuing-corporation stock that are exchanged for target stock are traded on a national securities exchange that has been registered with the Securities Exchange Commission under Section 6 of the Securities Exchange Act of 1934 (Exchange Traded Stock).

3. All parties to the potential reorganization treat the transaction in a consistent manner (i.e., as either qualifying or not qualifying as a reorganization).

4. The transaction is effected pursuant to a binding contract that specifies: (i) the Safe Harbor Valuation Method and Measuring Period (defined below) that will be used to value the Exchange Traded Stock, and (ii) the applicable national securities exchange. In addition, under the contract, the parties must utilize the value of each class of Exchange Traded Stock, as determined under the selected Safe Harbor Valuation Method and Measuring Period, in determining the number of shares of each class of issuing-corporation stock and the amount of money and/or other property to be exchanged for target stock.

5. The contract terms described previously must be fulfilled at the Closing Date, in all material respects.

If the Closing Date Rule applies, in addition to the requirements noted above, the transaction must be effected pursuant to a contract that is binding on the parties no later than the beginning of the first trading day of the Measuring Period.

Safe harbor valuation methods and measuring periods

Section 4 of the revenue procedure sets forth three valuation methods (Safe Harbor Valuation Methods) that the taxpayer may use when determining whether the COI requirement is satisfied. Each method utilizes an averaging approach to calculate the value of a share of stock determined over a specific number of consecutive trading days, based on the trading days of the specified exchange, with at least five but not more than 35 consecutive trading days (the Measuring Period). The Safe Harbor Valuation Methods allow taxpayers to use either: (i) the daily volume weighted average price, (ii) the daily average high-low trading price, or (iii) the average of the daily closing prices.

If the Closing Date is a trading day on the specified exchange, the Measuring Period must end no later than the Pre-Signing Date or Closing Date. If the Closing Date is not a trading day, the Measuring Period must end no later than the last trading day before the Closing Date. If the Signing Date Rule applies to the transaction, the Measuring Period must end no earlier than three trading days before the Pre-signing Date. If the Closing Date Rule applies to the transaction, the Measuring Period must end no earlier than three trading days before the closing Date.

Observations

Although Revenue Procedure 2018-12 applies to a limited universe of reorganizations (i.e., those involving publicly traded issuing corporations), it nevertheless should serve as a welcome development for affected taxpayers by providing methods for achieving greater certainty that the COI requirement is satisfied in qualifying transactions where there is a delay in the Signing Date and the Closing Date. Going forward, it will likely affect how acquisition agreements are drafted. Additionally, the Service has stated that it is willing to entertain requests for rulings and determination letters regarding transactions and legal issues to which the safe harbor does not apply and regarding the applicability of the safe harbor itself.

Notably, Revenue Procedure 2018-12 provides that its valuation safe harbor "is available solely for purposes of determining whether the COI requirement is satisfied." But the issue it addresses — how to value stock for federal tax purposes — arises in multiple contexts (e.g., how to determine the value of a redeeming corporation's stock exchanged in a public tender, for purposes of a Section 302 redemption). Query whether the valuation principles described in the revenue procedure may be reasonably applied in other income tax contexts? (e.g., compare Reg. Section 20.2031-2, providing valuation method for stocks and bonds for estate tax purposes).

———————————————