The following article is adapted and reprinted from the M&A Tax Report, Vol. 8, No. 7, February 2000, Panel Publishers, New York, NY.


By Robert W. Wood

Basic Continuity Rule

As we all know, continuity of interest requirements are satisfied only if a substantial part of the value of the proprietary interests in the target corporation are preserved in the reorganization. See Reg. §1.368-1(e). A proprietary interest is considered preserved if it is exchanged for a proprietary interest in the issuing corporation. It is not preserved if it is acquired by the issuing corporation for consideration other than stock, or if, in connection with the reorganization, stock of the issuing corporation furnished to the target shareholders in the reorganization is redeemed by the issuing corporation.

Interestingly, the continuity of interest requirements became substantially less onerous back in January 1998 when new regulations were released. These regulations did away with the notion of "post-merger continuity." Thus, the mere fact that there is a disposition of stock of the issuing corporation-the stock that was furnished to the target shareholders in the reorganization-will be disregarded for continuity of interest purposes as long as those persons are not related to the issuing corporation.

As if that wasn't enough, these January 1998 regulations also did away with the "historic shareholder" continuity requirement. Under this hoary rule, only stock received by historic shareholders of the target would count for continuity of interest purposes. Now, the mere disposition of target stock prior to the potential reorganization (to persons not related to the purchaser or the target), will also be disregarded for continuity of interest purposes.

More Good News

It seems that continuity of interest is in the news again, with the release of Revenue Ruling 99-58, 1999-52 I.R.B. 1. There the Service ruled that an acquiring corporation's repurchase (on the open market) of a number of its shares equal to those issued to acquire a target did not affect continuity of interest. (See Reg. §1.368-1(e).) Under the facts of the ruling, the target merged into a widely held publicly traded acquiring company. The target shareholders received cash and shares in the acquiring company. The acquiring company wanted to repurchase (at the prevailing market price on the open market) the same number of shares it issued in the merger.

The reason? To prevent dilution of its existing shareholders. That sounds like a good reason. The Service agreed, concluding that the acquiring corporation's plan did not run afoul of the proscription on redemptions of stock issued in a reorganization (contained in Reg. §1.368-1(e)(1)(i)).

It was important to the Service in so concluding that there was no understanding between the acquiring company and the target shareholders about the repurchase. (This sounds suspiciously like step transaction analysis). Because the purchases on the open market (again a critical element) did not favor former shareholders of the target, the IRS concluded that the merger (and the stock repurchase thereafter) did not resemble a sale of the target. This was a tax-free reorg, followed by a repurchase on the open market of shares, and therefore did not resemble a sale. Thus, it did not adversely affect the company's satisfaction of the continuity of interest requirement.


With the release of Revenue Ruling 99-58, the Service has shown that the continuity of interest doctrine has become substantially more liberal over the last two years. This is good news!

New Continuity of Interest Ruling, Vol. 8, No. 7, M&A Tax Report (February 2000), p. 7.