The following article is adapted from reprinted from the M&A Tax Report, Vol. 7, No. 11, June 1999, Panel Publishers, New York, NY.


By Robert W. Wood, San Francisco

In addition to the more familiar continuity of interest (COI) requirement, to qualify as a tax-free reorganization, an acquisition must also satisfy the continuity of business enterprise requirement. Continuity of business enterprise will be considered to exist if the issuing corporation either continues the target's historic business or, alternatively, uses a significant portion of the target's historic business assets in any business. For this purpose, if the target has multiple lines of business, the continuity of business enterprise requirement requires only that the issuing corporation must continue a significant line of business.

The regulations dealing with continuity of business enterprise provide that the issuing corporation will be treated as holding the assets and businesses of all members of the qualified group consisting of chains of corporations connected through stock ownership with the issuing corporation. This extended view of continuity only applies, though, if the issuing corporation owns directly an amount of stock described in Section 368(c) in at least one other corporation. Plus, the same amount of stock in each corporation must be owned directly by one of the other corporations. The basic Section 368(c) standard, of course, is that the ownership must be of stock possessing 80% of the total combined voting power of all classes of stock entitled to vote, and 80% of the total number of shares of each class of non-voting stock.

The Clinton administration's budget proposal would significantly change this set of rules. If the administration's proposal passes, the amount of stock referred to in the qualified group definition would be 80% of the voting power and 80% of the value of the relevant corporation's outstanding stock. There would be no specific percentage of the number of each class of stock would be required.

Under current law, the issuing corporation is treated as conducting the business carried on by a partnership. Consequently, the target's assets can be conveyed, as part of the plan, to a partnership as long as the members of the qualified group meet one of the following requirements: (1) they own, in the aggregate, a significant interest in the partnership (a one-third interest should suffice); or (2) they have active and substantial management functions (within the meaning of Rev. Rul. 92-17) with respect to the partnership's business, and have at least a 20% interest in the partnership.

Relaxed Continuity

As a result of these recent concessions, the continuity of business enterprise requirement can be satisfied even though the target's historic business or its historic business assets are ultimately lodged in a "remote" entity in which the issuing corporation only has what can be described as an attenuated interest.

The regulations point out that the mere fact that the issuing corporation is in the same line of business as the target tends to establish continuity of business enterprise. Yet, that alone is not sufficient. In Revenue Ruling 87-76, Corp. X was an investment company that invested in a diversified portfolio of municipal bonds. X entered into an agreement to acquire Corp. Y, an investment company that historically invested in a diversified portfolio of corporate stocks and bonds. Pursuant to the acquisition agreement, Corp. Y was required to dispose of its stocks and bonds and to reinvest the proceeds in a portfolio of municipal bonds that was consistent with Corp. X's investment objectives and policies. The ruling concludes that the continuity of business enterprise requirement was not satisfied.

The asset component of the continuity of business enterprise test was not complied with under these facts because Corp. Y's historic business assets were sold to unrelated third parties as part of the plan of reorganization. Accordingly, they were not used by Corp. X in any business. Moreover, the parties could not rely on the regulatory presumption (that an issuing corporation and target being in the same line of business establishes continuity) because the ruling concludes that the constituents were not in the same line of business.

Investing is investing, you may well say. Not so fast, says the Service. Although both corporations were in the business of making investments, Corp. Y's historic business involved investing in stocks and bonds. This was not in the same line of business as investing in municipal bonds. Thus, the business that Corp. X conducted after the transaction was not the same line of business that Corp. Y was engaged in prior to the closing. Obviously, the IRS has adopted an exceedingly narrow view of a line of business, one that is virtually of thread-size thickness.

Scope of Business Questioned

Further evidence of this restrictive approach can be found in Letter Ruling 9916028. There, two mutual funds executed a transaction that they sought to qualify as a reorganization under Section 368(a)(1)(C). The acquiring company (Buyer) had invested in a diversified portfolio of equity securities, with an emphasis on companies that had shown above average growth rates in earnings. The Target had invested in a portfolio of securities comprised of common stocks of companies that it felt were "well-positioned to benefit from demographic and cultural changes." The transaction was completed and, as part of the plan, theBuyer indicated it would sell Target's assets and reinvest the proceeds in a manner consistent with its investment objectives and policies. In contrast, the Buyer represented that it would only sell 66% of the Target's assets.

One can infer from the Buyer's show of restraint that the IRS likely concluded that the Buyer and Target were not in the same line of business. If they were, it seems probable that the Buyer would have redeployed all of the Target's assets. The transaction would still have satisfied the continuity of business enterprise requirement because the Regulations presume continuity is satisfied when Buyer and Target are in the same line of business. In light of the IRS' myopia regarding what it sees as the narrow scope of the line of business concept, the Buyer was apparently constrained to retain 33% (a significant portion) of the Target's historic business assets.

It would appear that such a retention of assets was inconsistent with the Buyer's investment philosophy. It probably would have preferred to dispose of these assets and use the proceeds to purchase stocks of companies with the requisite above average growth rates in earnings.

Form, Substance and Tax Lawyering

Oddly, these issues can generally be avoided with relatively little difficulty. What is necessary is to have parties who are willing to alter the form (but not necessarily the substance) of the transaction. It is well-settled that the continuity of business enterprise test does not apply to the business or business assets of the acquiring (as opposed to the target) corporation. As a consequence, in cases where the continuity of business enterprise requirement is in danger of being breached, the requirement can usually be finessed by structuring the transaction as a reverse acquisition.

The continuity of business enterprise requirement will be satisfied, even though substantially all of the historic business assets of a constituent company are slated to be discarded, if the parties to the transaction make the acquiring corporation the entity whose historic business will be terminated or curtailed. The IRS has approved of this simple approach to skirting the continuity of business enterprise requirements in Revenue Ruling 81-25.

Continuity of Business Enterprise Requirement: Loved but Misunderstood?, Vol. 7, No. 11, The M&A Tax Report (June 1999), p. 7.