COBE in Statutory Mergers.
Honbarrier, 115 TC No. 23, involved the sole shareholder of Colonial, Inc., predominantly a freight trucking company. Colonial reported consecutive yearly losses up to 1988. The entity's trucking operations then ceased and Honbarrier liquidated the company. The earnings from the sale were invested in tax-exempt bonds and a municipal bond fund worth over $7 million.
Central Transport, Inc., an S corporation of which Honbarrier was the majority shareholder, was a separate trucking company that transported bulk chemicals. In December 1993, Central acquired Colonial in a merger. The parties treated the merger as a tax-free A reorganization. Central stated several business purposes for the merger, including obtaining Colonial's ICC operating rights for the expansion of Central's operations, reducing operating and administrative expenses and using Colonial's cash for Central's immediate expansion.
Prior to the merger, Central (the surviving entity) declared a $7 million distribution payable to its shareholders--$2.4 million in cash and approximately $4.5 million in tax-exempt bonds, to be acquired from Colonial. Central claimed the $7 million distribution as a payment of previously taxed income (PTI) reflected in its accumulated adjustments account.
According to the Tax Court, to qualify as a tax-free reorganization, a merger must meet three additional requirements: (1) business purpose, (2) continuity of business enterprise (COBE) and (3) continuity of interest (COI). Mergers between corporations in similar lines of business generally comply with the business-purpose requirement.
COBE required the issuing corporation (Central) to continue the target's historical business or use a significant portion of the target's business assets during daily operations. The business enterprise is the target's actual function; whether a manufacturer, distributor or holding company, an entity's historical business is that in which it has engaged during the most recent, consecutive fiscal periods.
If a shareholder's interest in a target is fairly evaluated and exchanged for an interest of equal value in the issuing corporation, or continues to function as a proprietary interest in the target, the COI in the target is preserved (Regs. Sec. 1.368-1(e)(1)(i)). In essence, COI is how the interest shareholders of each company held prior to a reorganization relates to their interest in the target after the merger.
The Tax Court concluded that Central did not continue Colonial's historical business enterprise of the last five years--as a holding company. It also determined that Central was not using Colonial's historic business assets in its ongoing business.
According to the Tax Court, if Central had used the return from the bonds acquired from Colonial to operate as a holding company and manage the financial instruments to finance the intended expansion, it would have been (1) using the target's assets in the financial operations of the newly created entity and (2) continuing the historical business of managing and investing bonds and bond funds. Additionally, if Central had spent cash on hand for distribution purposes (rather than using the cash obtained from the merger), it would have been using PTI for distribution to shareholders. The COBE test would have been met and the new entity would indeed have been a tax-free A reorganization.
Mergers (as with other types of reorganizations) require strict adherence to form and substance. Regulations require that merging parties meet continuity tests to obtain the tax benefits of reorganization. With proper planning, Honbarrier might have been able to restructure the transaction to realize his tax (as well as his business) objectives.
FROM SHIBU M. JOSEPH, NEW YORK, NY
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|Title Annotation:||continuity of business enterprise|
|Author:||Joseph, Shibu M.|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 2001|
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