The Continuity Of Interest And Continuity Of Business Enterprise Regulations

I. INTRODUCTION

In January 1998, Treasury issued final continuity of†interest and continuity of business enterprise regulations under†section 368. 1 Although these regulations were proposed in similar†form in December 1996, the final regulations are different from†the proposed regulations in some important ways. At the same†time that Treasury issued the final regulations, Treasury issued†temporary and proposed regulations addressing pre-reorganization†redemptions and extraordinary distributions.2 These pre-reorganization†regulations were finalized in modified form in†August 2000. 3 This article reviews the continuity of interest†and continuity of business enterprise requirements, and explains†and analyzes the final, temporary, and proposed regulations.

II. CONTINUITY OF INTEREST

A. Overview

In order for a transaction to qualify as a tax-free†reorganization under section 368, the transaction must satisfy†the continuity of interest ("COI") requirement.4 Thus, the†historic shareholders of the target corporation must have a†continuing interest in the target assets and target business†through the acquisition of the stock of the acquiring†corporation. This requirement has its origins in cases dating†back to Pinellas Ice & Cold Storage v. Commissioner,5 and†Helvering v. Minnesota Tea Co..6

The Internal Revenue Service ("Service" or "IRS")†considers the continuity of interest requirement as satisfied†if, following the transaction, historic shareholders of the†target corporation hold stock of the acquiring corporation (as a†result of prior ownership of target stock) representing at least†50% of the value of the stock of the target corporation.7 Cases†have, however, approved reorganizations with significantly lower†percentages of stock consideration.8

2. Application of Step-Transaction Doctrine

1. Law Prior to Final Regulations

   Under the law prior to the issuance of the final COI†regulations in January 1998, the Service, and to a lesser extent†the courts, applied the step-transaction doctrine to determine†if the COI requirement was satisfied. Accordingly, transactions†occurring before and after sales of stock generally were†examined to determine their effect on COI.9 However,†dispositions not contemplated at the time of the reorganization†transaction generally did not adversely affect the COI†requirement.10 The Service and the courts looked to the facts†and circumstances of each transaction in determining whether to†apply the step-transaction doctrine.

   In McDonald's Restaurant of Illinois, Inc. v.†Commissioner, the Seventh Circuit held that a merger failed the†continuity of interest requirement where the shareholders of the†target corporation sold their acquiring corporation stock soon†after the transaction. The Court applied the step-transaction†doctrine in determining that the merger and post-transaction†sale were interdependent steps and that the target shareholders†did not plan to continue as investors at the time of the†merger.11

   In J.E. Seagram Corp. v. Commissioner,12 the Tax Court†concluded that sales by public shareholders, prior to a†reorganization, may be ignored when considering the COI†requirement. In that case, Seagram purchased approximately 32%†of Conoco's stock for cash pursuant to a tender offer.†Subsequently, DuPont purchased approximately 46% of Conoco's†stock pursuant to its own tender offer, and Conoco merged into†DuPont. In the merger, Seagram exchanged its Conoco stock for†DuPont stock. The Tax Court held that the continuity of†interest requirement was satisfied, because DuPont acquired†Conoco for 54% stock and 46% cash. The Tax Court concluded that†Seagram "stepped into the shoes" of 32% of the Conoco†shareholders. Accordingly, Seagram's recent purchase of stock†did not destroy the COI requirement.13

2. Final Regulations

   In December 1996, the Service issued proposed†regulations relating to the affect of post-reorganization†transactions by target shareholders on the COI requirement.14 In†January 1998, the Service finalized the proposed regulations,†with some changes. In addition, the Service issued temporary†and proposed regulations that cover pre-reorganization†transactions.15 The final regulations state that 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."16 Thus, the regulations†require that "a substantial part of the value of the proprietary†interests in the target corporation be preserved in the†reorganization."17

   In the preamble to the new regulations, the Service†states that, although cases such as McDonald's focus on whether†the target corporation's shareholders "intended on the date of†the potential reorganization to sell their [acquiring†corporation] stock and the degree, if any, to which [the†acquiring corporation] facilitates the sale," the Service and†the Treasury Department concluded that

   the law as reflected in these cases does not further the principles of reorganization treatment and is difficult for both taxpayers and the IRS to apply consistently.18

   Thus, the Service decided to effectively reverse McDonald's,†stating that the final regulations will "greatly enhance†administrability in this area," and will "prevent 'whipsaw' of†the government," such as where the target corporation's†shareholders and the acquiring corporation take inconsistent†positions as to the taxability of a transaction.19

   Under the final regulations, a "proprietary interest"†in the target corporation is preserved if the interest in the†target corporation is: (1) exchanged for a proprietary interest†in the "issuing" corporation,20 (2) exchanged by the acquiring†corporation for a direct interest in the target corporation†enterprise, or (3) otherwise continued as a proprietary interest†in the target corporation.21 In determining whether a†proprietary interest in the target corporation is preserved, all†the facts and circumstances are considered.22 However, no†proprietary interest in the target corporation is preserved if

   in connection with the potential reorganization, [the proprietary interest] is acquired by the issuing corporation for consideration other than stock of the issuing corporation, or stock of the issuing corporation furnished in exchange for a proprietary interest in the target corporation in the potential reorganization is redeemed.23

   Thus, some post-reorganization transactions -- namely†redemptions -- will cause a reorganization to fail the COI†requirement. However, post-reorganization sales of stock will†not destroy continuity, as long as such sales are not to the†issuing corporation or a party related to the issuing†corporation.24 Thus, as noted above, the final regulations†reverse McDonald's.

   †Under the final regulations, dispositions of stock of†the target corporation...