Continuity of interest and continuity of business enterprise.

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 the regulations). Once the relevant T businesses and T assets are attributed to P, COBE is tested under the general rule of the final COBE regulations.

Additional Final Regulations: COI Requirement for Corporate Reorganizations

The IRS has published amendments to the final regulations on satisfying the COI and COBE requirements for corporate reorganizations. The final COI regulation provides that acquisitions of T stock for cash by a corporation related to P (the issuing corporation) generally do not preserve COI. Example 2 of those final regulations was amended to clarify and illustrate the "related" language and to avoid any implication of a reference to qualified stock purchases under Sec. 338.

The amendment to the final regulations applies to transactions occurring after Jan. 28,1998, but not to any transaction occurring pursuant to a written agreement that is (subject to customary conditions) binding on Jan. 28, 1998 and at all times thereafter.

Temporary and Proposed Regulations Provide Additional Guidance on COI

The Service also published Temp. Regs. Sec. 1.368-1T on certain aspects of COI not covered in the final regulations. Temp. Regs. Sec. 1.368-1T(e) (1) (ii) (A) provides that a proprietary interest in T is not preserved if, in connection with a potential reorganization, the T stock is redeemed, or to the extent that (prior to and in connection with a potential reorganization) an extraordinary distribution is made with respect to the T stock. An extraordinary distribution with respect to T stock, followed by a sale of the remaining T stock to P, has the same effect on the value of the proprietary interest in T as a pro rata redemption by T followed by a sale of the outstanding T stock to P. The regulations request comments on the circumstances under which a distribution will be treated as an extraordinary distribution. A proprietary interest in T is not preserved if (prior to and in connection with a potential reorganization) a shareholder related to T acquires T stock, with consideration other than stock of either T or P. A related shareholder does not include an individual or other noncorporate shareholder.

These regulations apply to transactions occurring after Jan. 28, 1998, except transactions occurring pursuant to a written agreement binding on that date.

FROM DONALD L. HERSKOVITZ, J.D., LL.M., WASHINGTON, DC