Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
Continuity of Business Enterprise: A Concept Whose Time Has Passed
David F. Shores*
Since the early days of the federal income tax, corporate reorganizations have received preferential treatment. For example, suppose Target Corporation (T) is merged into the acquiring corporation (P) with the T shareholders receiving P stock. The transaction qualifies as a reorganization under section 368(a)(1)(A), which provides that “the term ‘reorganization’ means a statutory merger or consolidation.” Under section 354, T shareholders achieve the nirvana of tax-free treatment for gain realized on their exchange of T stock for P stock. Similarly, gain realized on T’s transfer of assets to P by operation of law under the applicable merger statute will qualify for nonrecognition under section 361.
The most commonly expressed reason for nonrecognition treatment is that the reorganization exchange involves a mere change in the form of ownership, or, as described by the regulations under section 368, it involves a mere readjustment of the shareholders’ continuing interest in property under modified corporate form. The reason is less than compelling. By exchanging their T stock for P stock, the T shareholders give up a portion of their interest in T’s assets and earnings in exchange for an interest in P’s assets and earnings. Indeed, if the value of T is small compared to the value of P, the T shareholders’ newly acquired interest in P’s assets and earnings will overwhelm their retained interest in T’s assets and earnings.
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The notion that a reorganization involves a mere change in the form of ownership, as opposed to a sale or disposition of one’s interest in the acquired corporation, has given rise to two common law doctrines that must be satisfied for a transaction to qualify as a reorganization: (1) the continuity of shareholder interest doctrine (COSI) and (2) the continuity of business enterprise doctrine (COBE). COSI asks whether T shareholders, prior to the reorganization, have continued to hold a proprietary interest in the reorganized firm. Essentially, it requires that the shareholders of T receive a substantial share of their consideration in the form of P stock. COBE requires that the acquiring corporation either continue T’s business or use a significant portion of T’s assets in a business. Failure to meet either the COSI or COBE requirement means that the T shareholders have disposed of, rather than continued, their interest in T’s business and assets. Hence, the transaction fails to qualify as a reorganization and is taxed at both the corporate and shareholder level. As discussed below, regulations that became effective in 1998 have revised the COSI requirement, making it much easier to satisfy that requirement than previously had been the case. Regulations relating to COBE have also been revised; however, COBE has not been altered to the same degree as has COSI.
The main theme of this Article is that the COBE doctrine should be abolished, or at least revised in a way that corresponds to the revision of COSI. Essentially, the argument is that COBE, like COSI, is an outgrowth of the “mere change in the form of ownership” rationale for nonrecognition treatment of corporate reorganizations. That rationale is not persuasive in the vast majority of reorganizations and thus provides a weak foundation for COSI and COBE. That notion has already been reflected in the relaxation of the COSI requirement and supports relaxation, if not abolition, of the COBE requirement.
Further support for abolishing COBE is provided by the general recognition that redeployment of corporate assets can enhance economic efficiency. At least in theory, most reorganizations are undertaken for just that reason. The acquiring corporation believes that it can utilize T’s assets in a more profitable way than has T. And by approving the merger, the T shareholders indicate that they share that belief. If T were taxed on the transfer of its assets, and the T shareholders were taxed on the exchange of their T stock for P stock, the tax system would create a very substantial obstacle to the redeployment of assets. So, nonrecognition in effect neutralizes the tax system, enabling the parties to choose to merge without having to overcome the heavy burden of double taxation. It is submitted that this tax neutralization principle not only provides a more persuasive rationale for nonrecognition treatment of corporate reorganizations than does the traditional mere change in the form of ownership rationale, but that it is supported by the legislative history of the original corporate reorganization provisions. And the COBE doctrine does not further the tax neutralization principle.
*Professor Emeritus of Law, Wake Forest University School of Law.