A trap for the unwary in the COI regs.

• Author: Weber, Neal A.
• Position: Continuity of interest

All forms of acquisitive reorganizations as defined in Sec. 368 require that there be a continuity of interest (COI) in the transaction. The doctrine was first made applicable by the courts, not by any statute, so it has been referred to as a judicial doctrine. However, for at least 50 years COI has also been firmly ensconced in the regulations. For much of its long history COI required that to qualify under Sec. 368 as a reorganization, a significant portion of the consideration to be received by the shareholders of an acquired corporation had to be stock of either the acquiring corporation or the direct parent of the acquiring corporation. A parent is a corporation that controls--as defined in Sec. 368(c)--the acquiring corporation.

The notion of what was a "significant" portion of the total consideration to be received was debated somewhat, but in the final analysis most practitioners were quite comfortable if at least 40% of the value of the total consideration to be received was stock of the acquiring corporation (see John A. Nelson Co. v. Helvering, 296 U.S. 374 (1935)). In addition, the acquired company shareholders were required to hold the acquiring corporation stock that they received for some period of time. To the chagrin of many business people, there was no indication of just how long the acquired corporation shareholders had to hold onto the stock received. Was a year long enough? How about two years? In fact, the answer was quite vague in that it was driven by the step-transaction doctrine. In very general terms, this meant that the acquiring corporation stock had to be retained until its disposition was not related to the acquisition--that is, the acquisition and the subsequent divestiture of stock had to be unrelated events.

This vagueness about how long the stock of the acquiring corporation had to be retained after the acquisition led to a significant change to the COI regulations in 1998, which is now embodied in Regs. Sec. 1.368-l(e). These regulations changed the COI requirement by eliminating the requirement that the stock of the acquiring corporation be retained post-acquisition. COI is now satisfied even if the stock of the acquiring corporation is sold immediately after the acquisition. In fact, the shareholders of the acquired corporation can even divest the stock they receive pursuant to a binding obligation entered into before the acquisition (see Regs. Sec. 1.368-l(e)(8), Example (1)). The shareholders of the...