Confronting Continuity: A Tradition of Fiction in Corporate Reorganizations

Abstract

The “continuity of interest” doctrine has determined the tax treatment of corporate mergers for over seventy years. Under this doctrine, a corporate merger may qualify for tax-deferred treatment if an acquiror corporation pays shareholders of the target corporation consideration that consists of at least a minimum amount of the acquiror corporation’s stock. The continuity of interest doctrine has been criticized as unclear, inefficient, and unfair. Much of this criticism, however, is obsolete and largely unpersuasive. This Article offers a different justification for repealing the doctrine: The end that the continuity of interest doctrine is intended to achieve–an aggregate group of former target corporation shareholders maintaining a “continuity of interest” in the acquiror corporation following a merger–is fiction. Because the doctrine serves a fictional premise, it does not distinguish effectively between special mergers deserving of tax-deferred treatment and ordinary sales that should be taxed currently. The second half of this Article presents a new proposal for replacing the continuity of interest doctrine. Without any regard to the nature of the consideration paid, the proposal delivers tax-deferred treatment where the acquiror corporation continues the historic business of the target corporation for at least two years following the merger and where a target shareholder’s position within the enterprise does not change significantly as a result of its exchange of target corporation stock for stock in this acquiror corporation. While the continuity of interest doctrine serves a fictitious premise, the proposal presented in this Article restores some sense of truth to the policy of reserving special tax treatment for mergers that represent mere changes in form.