Question

Explain and provide an example of the judicial principle of continuity of business enterprise.

Answer 1

Definition

The continuity of business enterprise doctrine is a taxation principle applicable to corporate mergers and acquisitions. The doctrine holds that, in order to qualify as a tax-deferred reorganization, the acquiring entity must either continue the target company's historic business or should use a substantial portion of the target's business assets when conducting business.

In summary, the doctrine applies to how taxes are treated when a firm changes hands. The purchasing entity must maintain the business operationally or retain most of the assets when two entities merge to get tax-deferred status.

Explanation and Example

The continuity of business enterprise doctrine applies only to the business and business assets of the target company, and not to the acquiring company. Therefore, in a situation where most of the assets of a company are sought to be disposed of (divested), one way of ensuring compliance with the continuity doctrine is by making this company the acquirer rather than the target. This is a technique that has been approved by the IRS.

Under U.S. federal tax code, corporate reorganizations have often enjoyed preferential treatment. However, taxes can get tricky depending on whether a transaction is a reorganization or the sale of an ownership interest. For a transaction to qualify as a reorganization, thus treated favorably tax-wise, the continuity of business enterprise doctrine examines whether a target's shareholders, before the reorganization, have continued to hold a proprietary interest in the reorganized firm. Essentially, it requires that the shareholders of a target entity receive a significant share of their consideration in the purchasing entity's stock. Additionally, the doctrine requires that the acquiring corporation either continue the target's operations or use a significant portion of the target's assets in a business form. If these conditions cannot be met, the tax code views the target's shareholders as having disposed of, rather than continued, their interest in the target's business and assets. Thus, the transaction would fail to qualify as a reorganization and would be taxed at both the corporate and shareholder levels.