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With or Without You: Debt and Equity and Continuity of Interest

39 Pages Posted: 30 Dec 2010 Last revised: 23 Jan 2011

Meredith R. Conway

Suffolk University Law School

Date Written: May 30, 2010


Continuity of interest is a judicially created doctrine designed to ensure that when holders of corporate interests in tax-free reorganizations exchange those interests merely on paper, the exchange is tax-free. The doctrine was intended to ensure that a holder who continued his interest in a corporation would not be taxed. Unfortunately, the continuity of interest doctrine throughout the years became distorted as a result of misinterpretations of both legislative history and judicial decisions. The doctrine was intended to provide that as long as an exchange is purely on paper and takes place in a tax-free reorganization, the exchange will be tax-free. Instead, it has become a mechanical hurdle where a certain percentage of shareholder participation in an exchange (ranging from 40% to 80%) meets the continuity of interest doctrine. The doctrine itself does little to ensure a continuing interest because shareholders are free to sell their interest immediately after the exchange. Furthermore, the doctrine has been interpreted from judicial decisions to apply only to stock and equity and not to debt. Therefore, even when a reorganization meets the tax-free reorganization provisions, if a debt holder exchanges his interest for a similar debt instrument in the new corporation, he is not included within the continuity of interest doctrine.

The doctrine must be revisited and revised. The types of instruments that can be exchanged on a tax-free basis should be narrowed and limited to only instruments that are economically equivalent, excluding exchanges that are not economically equivalent but result in the ownership of instruments labeled as stock. First, the quantitative measure, an ineffective mechanical hurdle that can be used by stockholders to deliberately avoid the tax-free reorganization provisions, should be removed. The current level of required participation is simply too low to be meaningful. In addition, the participation of other shareholders bears little on whether a particular holder intends to continue and maintain his interest in the corporation (the behavior Congress wanted to encourage). This will allow more reorganizations to qualify for tax-free treatment, particularly Type A reorganizations, but because the other reorganization requirements must still be met, it will only serve to defer taxes, not eliminate them. This will also result in putting significantly more pressure on the continuity of business enterprise requirement.

Second, the qualitative measure of continuity of interest that determines what counts as an interest in the corporation must be critiqued - specifically, how the continuity of interest doctrine applies to debt. The distinction between debt and equity has become an arbitrary assessment. A label is attached to an instrument created by a tax attorney or investment banker often because of desired tax attributes. However, the label often bears little resemblance to whether the instrument is debt or equity. In reality, making such a determination is often impossible because the corporate instruments created today often carry attributes of both debt and equity. Therefore, the emphasis on equity and stock in the continuity of interest doctrine should be removed.

Ultimately the continuity of interest requirement should be evaluated on a holder-by-holder basis, and an exchange should meet the continuity of interest requirement as long as the interests received are economically equivalent to, and mirror, the interests given up. Furthermore, any reorganization would still have to meet all the other requirements under state and federal law for tax-free reorganizations. Any interest holder, irrespective of the label attached to the instrument, should be afforded tax-free treatment provided that the instrument received is economically equivalent to the instrument given up in the exchange.

Suggested Citation

Conway, Meredith R., With or Without You: Debt and Equity and Continuity of Interest (May 30, 2010). Stanford Journal of Law, Business, and Finance, Vol. 15, p. 261, 2010; Suffolk University Law School Research Paper No. 10-67. Available at SSRN:

Meredith Conway (Contact Author)

Suffolk University Law School ( email )

120 Tremont Street
Boston, MA 02108-4977
United States

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