What is the Continuity of Interest Doctrine?
The Continuity of Interest Doctrine (CID) requires shareholders of an acquired company to hold an equity stake in the acquiring company to allow tax deferral. The doctrine, (or CID, also known as Continuity of Proprietary Interest) stipulates that a corporate acquisition of a target firm can be done on a tax-free basis if the shareholders of the acquired company receive and hold an equity stake in the acquiring company.
The Continuity of Interest Doctrine was intended to ensure that a stockholder in an acquired company, who continued to hold an interest in the successor corporation or continuing entity created after the reorganization, would not be taxed. In practical terms, however, the doctrine can do little to enforce a continuing interest because shareholders of the acquired company are free to dispose of their holdings as soon as the acquisition transaction is completed.
Understanding the Continuity of Interest Doctrine (CID)
The Internal Revenue Service (IRS) abandoned the post-reorganization continuity requirement and adopted new regulations in January 1998 and eventually finalized the regulations in December, 2011. The focus of the new regulations was primarily on the consideration received by the shareholders of the acquired company, with the objective of preventing a transaction that is actually a sale of the company from receiving tax-free status. The Continuity of Interest doctrine requires that a specified percentage of such consideration be in the form of the acquiring company's stock. While the IRS required this percentage to be 50% for advance ruling purposes, case law suggests that Continuity of Interest can be maintained even at 40%.
The continuity of interest requirement is determined based upon when a binding contract for acquisition by the parent company is signed, and the price at which the stock of the target firm is purchased. In an acquisition, shareholders of the target firm may typically receive stock in the acquiring firm as well as cash for their shares originally held in the target firm. In the case of a cash-only sale of stock in a target company, shareholders of the acquired firm would typically pay tax on the sale of shares when the acquisition is completed. Under CID, taxes would be deferred until the point at which they sold the shares acquired in the merger.