The information presented is only of a general nature, intended simply as background material, is current only as of the latest revision date, October 15, 2007, omits many details and special rules and cannot be regarded as legal or tax advice.

The judicially created "continuity of proprietary interest" doctrine (usually referred to simply as "continuity of interest") originated from the notion that the reason certain corporate acquisitions are accorded tax-free status is because the shareholders of the acquired corporation maintain some equity position in the continuing enterprise.

Prior law required the Target shareholders to retain a continuing equity interest in the ongoing enterprise. However, in regulations adopted in January of 1998 the IRS abandoned this so-called "post-reorganization" continuity requirement. The new regulations start from the premise that the continuity of interest requirement is intended to prevent transactions resembling sales from being accorded tax-free treatment.

The focus is now strictly on the consideration received in the transaction by the Target shareholders. Continuity of interest requires that a certain percentage of that consideration be Parent (or Acquiring) stock.

Target shareholders are free to dispose of the Parent (or Acquiring) stock following the transaction, even pursuant to binding commitments entered into in anticipation of the transaction.

However, acquisitions from the former Target shareholders, whether before or after the acquisition, for cash (or other non-stock consideration) by Parent, Acquiring or related persons will be integrated with the acquisition transaction.

Similarly, Target redemptions of its stock or distributions with respect to its stock prior to and in connection with the transaction can also be problematic where those events can be integrated with the acquisition under the step transaction doctrine.

In general, Parent (or Acquiring) stock and any other property comprising the consideration for Target stock is valued as of the closing date for the transaction. Where both Parent (or Acquiring) stock and cash are used in a transaction and where, as is common, the number of Parent shares to be issued to Target shareholders is based on an average Parent stock trading price over some period ending prior to the closing date, a lower Parent stock trading price as of the closing date can result in a reduction in the ratio that the value of the Parent stock as of the closing date bears to the value of the total consideration.

In temporary regulations adopted in March 2007, and that by their terms expire in March 2010, the IRS adopted a limited "signing date" rule; Parent (or Acquiring) stock and any other property is to be valued for continuity of interest purposes as of the last business day before there is a binding contract for the transaction if the contract provides for fixed consideration.

A contract provides for fixed consideration if it specifies the number of shares of Parent (or Acquiring) stock, the amount of money and any other property (either by value or specific description) to be exchanged in the transaction for Target stock.

A contract does not fail to provide for fixed consideration solely because it provides for contingent adjustments to the consideration if it would be treated as providing for fixed consideration determined without regard to the contingent adjustments and those contingent adjustments do not prevent the Target shareholders from being subject to the economic benefits and burdens of ownership of the Parent (or Acquiring) stock after the last business day before there is a binding contract. An adjustment based on post-signing changes in the trading price of Target stock would thus not cause a contract to fail to provide for fixed consideration. However, adjustments based on post-signing changes in the trading price of Parent (or Acquiring) stock would cause a contract to fail to provide for fixed consideration.

A contract does not fail to provide for fixed consideration where (i) some of the consideration is placed in escrow to provide an indemnification fund for breaches of customary pre-closing covenants or customary representations and warranties, (ii) the contract contains a customary anti-dilution clause (but the absence of such a clause can cause the contract to fail to provide for fixed consideration if Parent (or Acquiring) alters its capital structure post-signing), (iii) there is the possibility that some Target shareholders may exercise dissenters' rights or (iv) the contract provides that Target shareholders will receive cash in lieu of fractional Parent (or Acquiring) shares.

Historically, the IRS imposed a 50% continuity requirement for advance ruling purposes. In other words, if Target were merged into Acquiring with the former Target shareholders receiving Acquiring stock and other property, the IRS required the Acquiring stock to have a value at least equal to 50% of the value of all the formerly outstanding Target stock. Case law suggested that continuity of interest could be maintained at something less than 50%; tax opinion practice varied, but tax opinions with 45% or even 40% continuity were not uncommon. Examples in the March 2007 regulations confirm that 40% continuity is sufficient.

© 2007