Continuity of interest and continuity of business enterprise.

• Author: Herskovitz, Donald L.
• Position: Taxation doctrines in corporate reorganization context

he IRS has issued important final regulations that provide guidance on the satisfaction of the continuity of interest (COI) and continuity of business enterprise (COBE) requirements for corporate reorganizations. The regulations affect corporations and shareholders involved in mergers and acquisitions. The tax law provides general nonrecognition treatment for specifically described reorganizations under Sec. 368. In addition to complying with the statutory requirements, a transaction generally must satisfy the court-imposed COI and COBE requirements.

COI

The purpose of the COI requirement is to prevent transactions that resemble sales from qualifying for nonrecognition of gain or loss available in corporate reorganizations. Regs. Sec. 1.368-1(e)(1)(i) provides that the COI requirement is satisfied if, in substance, a substantial part of the value of the proprietary interest in the target corporation (T) is preserved in the reorganization. A proprietary interest in T is preserved if, in a potential reorganization, it is exchanged for a proprietary interest in the acquiring or issuing corporation (P). However, a proprietary interest in T is not preserved if, in connection with the potential reorganization, it is acquired by P for consideration other than P stock, or P stock exchanged for a proprietary interest in T is redeemed.

Regs. Sec. 1.368-1(e) also concludes that COI is not violated by sales of T or P stock to unrelated P shareholders both before and after a potential reorganization. Although a related shareholder does not include an individual or other noncorporate shareholder, a sale to a related corporation could violate the COI requirement. The final regulations do not apply to certain reorganizations involving transfers to controlled corporations and spin-offs.

COBE

The COBE requirement is fundamental to the notion that tax-free reorganizations merely readjust continuing interests in property. COBE requires that P (the acquiring or issuing corporation) either continue T's historic business or use a significant portion of T's historic business assets in a business. The final regulations treat P as conducting a T business or owning T business assets if these activities are conducted by a member of P's qualified group or, in certain cases, by a partnership that has a member of the qualified group as a partner. A qualified group is one or more chains of corporations connected through stock ownership representing control (as defined in...