Form Follows Function: The Continuity of Business Enterprise Doctrine

I. Introduction

The idea that “form follows function” is one of the most important principles in design theory.¹ The idea originally claimed that “a skyscraper’s exterior design should reflect the internal functions of the building. [The form] clearly reflects and intuitively communicates to us what the function of the end product is.”²

According to U.S. federal tax law, gain or loss must be recognized upon the exchange of property. The reorganization provisions of the code have the purpose of excepting some corporate transactions from this general rule. The Treasury regulations say that the code’s reorganization provisions are meant to:

except from the general rule certain specifically described exchanges incident to such readjustments of corporate structures made in one of the particular ways specified in the Code, as are required by business exigencies and which effect only a readjustment of continuity interest in property under modified corporate forms.³ [Emphasis added.]

The continuity of business enterprise (COBE) doctrine emerged from case law and is regarded as a “spinoff of the continuity of interest doctrine at the corporate level.”⁴ The doctrine was later incorporated into Treasury regulations.⁵

The COBE is intended to distinguish transactions that are in substance sale transactions from those that effect only a readjustment of continuing interests in property under modified corporate form.⁶ The COBE doctrine considers the acquiring corporation’s connection with the acquired assets or stock after the exchange, so it can be seen as an expression of the policy objective of the code’s reorganization provisions.

The COBE regulations are inadequate in conforming to their intended function, both in terms of regulatory drafting and practical implementation. To demonstrate their failure, we will use two case studies: the Treasury regulations addressing the transfer of assets to corporations and partnerships after a tax-free reorganization (the “remote continuity” doctrine), and the application of COBE to the use of special purpose acquisition companies (SPACs) in tax-free reorganizations.

First, from a practical standpoint, the COBE regulations provide no clarity on whether a SPAC, which holds cash and cash equivalents with the purpose of completing a future acquisition, can satisfy the tests that compose the COBE requirement. While the COBE doctrine is intended to function as an antiabuse doctrine, it may also hinder nonabusive transactions, such as de-SPAC transactions, or lead to behaviors that do not align with the business purpose of those transactions.

Second, from a regulatory drafting perspective, the COBE regulations effectively allow sales to unrelated parties by allowing post-reorganization transfers of the target corporation’s assets to partnerships without specifying the type of partnership interests that could satisfy the continuity requirement.

We propose a reevaluation of the COBE regulations, by placing the policy goal in the larger context of the code’s reorganization provisions.

II. The Continuity of Business Enterprise Doctrine

A. Overview

Except for the reorganizations of section 368(a)(1)(E) (recapitalization) and section 368(a)(1)(F) (mere change of form),⁷ the COBE under the modified corporate form is required for a transaction to constitute a tax-free reorganization.⁸

To satisfy the COBE requirement, the issuing corporation must either:

• continue the target’s historic business (“business continuity” test); or

• use a significant portion of the target’s historic business assets in a business (“asset continuity” test).⁹

The term “issuing corporation” refers to the acquiring corporation (AC) or, in a triangular reorganization, the corporation that controls the acquiring subsidiary.¹⁰ Thus, the “continuity interest in property” to which the Treasury regulations refer purports to be materialized through guaranteeing a connection between (1) the AC (that is, the modified corporate form) and (2) either the assets or the business that belonged to the acquired corporation (TC). All the facts and circumstances must be considered in determining whether a transaction satisfies either the business continuity test or the asset continuity test.¹¹

B. Background and Policy Development

COBE arose from several cases in which the courts held that the reorganization rules should not apply when the corporate business was liquidated and followed by the start-up of a new business of either the same or a different type.¹² Early decisions interpreting the COBE doctrine focused on the business activity both before and after the reorganization.¹³ The IRS took the position that COBE was satisfied if the surviving corporation engaged in a business identical or similar to the transferor corporation’s business.¹⁴ The IRS later concluded, however, that “the surviving corporation need not continue the activities conducted by its predecessors,”¹⁵ and the surviving corporation could continue any business (even if not identical or similar to the business of the transferor corporation) to satisfy COBE.

Ultimately, the IRS and Treasury issued regulations defining the COBE requirement (1981 or COBE regulations) as a response to a transaction that became common in the 1970s and eventually became a concern to the IRS.¹⁶ In the transaction, described in Rev. Rul. 79-434, 1979-2 C.B. 155, a target corporation (TC) sells its assets for cash in a taxable transaction (in which often the target’s tax basis for its assets approximates the selling price so that the target corporation’s taxable gain on the sale is not substantial)¹⁷ and, anticipating being acquired by a mutual fund, temporarily holds cash and marketable securities (the “replacement assets”) pending consummation of a purported reorganization with the mutual fund.

In the reorganization, the target corporation would then transfer its replacement assets to the mutual fund, receiving in exchange (and redistributing to its shareholders) voting stock of the mutual fund corporation in a purported tax-free section 368(a)(1)(C) reorganization. Professors Martin D. Ginsburg, Jack S. Levin, and Donald E. Rocap describe the result of this “2-step transaction” by indicating that the target’s shareholders (who typically had a very low basis in their stock in the target) sought to avoid tax on the exchange of their target stock for the mutual fund stock.¹⁸ In the view of the IRS, the transaction “represents a purchase by [TC] of the shares of [AC] prior to [TC’s] liquidation.”¹⁹

Some commentators on the 1981 regulations argued that COBE was unnecessary because the continuity requirement of the reorganization provisions of the code was met by satisfying the continuity of proprietary interest requirement, a judicially developed doctrine that requires that a portion of the consideration paid in the acquisition of a target corporation is a minimum amount of the stock of AC.²⁰ Treasury responded that “an exchange of stock without a link to the underlying business or business assets resembles any stock for stock exchange and, as such, is a taxable event.”²¹

Instead, COBE was intended to ensure that “tax-free reorganizations effect only a readjustment of [TC] shareholders’ continuing interest in [TC’s] property under a modified corporate form,” by requiring that the interest retained by the former target shareholders represent a link to TC’s business or its business assets.²² The approach of the 1981 regulations, however, has been described as more liberal than the case law that preceded them.²³ Compared with the case law, “it is not necessary that the same corporate business continue wholly uninterrupted to qualify for reorganization treatment.”²⁴ This approach is reflected in the two tests that are necessary to satisfy COBE under the regulations and are described below.

C. Overview of the COBE Tests

1. The business continuity test.

One approach to meeting the COBE requirement is through the continuation by AC of the historic business conducted by TC. Establishing this requirement typically entails that AC is engaged in the same line of business as TC, although that factor alone might not be conclusive.²⁵ A corporation’s historic business is the business it has conducted most recently, but it cannot be a business that the corporation entered into as a part of a plan of reorganization.²⁶ The preamble to the COBE regulations says that “the intent of this language was to make it clear that under established step transaction principles the continuity of business enterprise test does not necessarily focus on the business conducted immediately before the acquisition” by AC.²⁷

If TC has more than one line of business, the continuance by AC of one of these lines of business will satisfy the test.²⁸ Thus, AC has broad liberty to sell the assets that constitute the majority of the lines of business that TC had as long as it continues one of TC’s lines of business.

2. The asset continuity test.

Under the asset continuity test, AC must use a significant portion of TC’s historic business assets in any business (regardless of whether that business was historically conducted by TC).²⁹ Indeed, the preamble to the 1981 regulations explains that COBE may exist even if AC’s use of TC’s assets differs from TC’s use of those assets.³⁰

A corporation’s historic business assets may include stocks, securities, and intangible operating assets, such as goodwill, patents, and trademarks, regardless of whether they have a tax basis.³¹ The regulations do not provide numerical guidance on what constitutes a significant portion of a corporation’s assets. Rather, the use of a significant portion of TC’s assets in a business will be determined by comparing the relative importance of those assets with the operation of the business.

All other facts and circumstances, such as the net fair market value of the assets used, will be considered.³² That approach has been described as unnecessarily vague,³³ considering that the code and the IRS have adopted a more concrete approach when they incorporate similar requirements to grant reorganization status to some transactions.³⁴ The language in the regulations generates a subjective evaluation that may lead to uncertainty in determining whether AC uses a substantial portion of TC’s historic business assets.³⁵

The examples featured in the Treasury regulations demonstrate that compliance with this test is attained when one-third of TC’s historical business assets are preserved and used in AC’s business.³⁶ The IRS, however, has taken the position that this example should be limited to the business continuity test and does not illustrate any mathematical approach to satisfying asset continuity.³⁷ AC is treated as using TC’s historic business assets even when the assets serve only as a backup source of supply.³⁸ Courts have held that the COBE requirement is satisfied even if AC plans to sell the business to which TC’s assets are transferred soon as long as the acquirer plans to use the assets in that business.³⁹

III. Form Does Not Always Follow Function

A. Introduction

We can scrutinize the effectiveness of COBE in fulfilling its intended purpose by examining two problematic scenarios. First, we will evaluate COBE under the remote continuity doctrine, focusing on the guidelines concerning the transfer of the target corporation’s assets to partnerships after a reorganization. Second, we will analyze COBE’s application to de-SPAC transactions.

B. Case 1: The Remote Continuity Doctrine

1. Introduction to the remote continuity doctrine.

The remote continuity doctrine is relevant for multiparty reorganizations. This doctrine is a logical development of COBE, focusing on the location of TC’s business after the acquisition by AC and on the potential impact of any post-reorganization transfer of TC’s assets or stock by AC to a subsidiary or other related entity.⁴⁰ Professors Cheryl D. Block, Ari Glogower, and Joshua D. Blank illustrate the “remoteness” aspect of this doctrine as “measuring the distance the target business has traveled from its ‘roots,’ referring to its ‘place’ immediately before the acquisition.”⁴¹ The IRS has stated that this doctrine focuses on the link between the former TC’s shareholders and the business assets of TC following the reorganization.⁴²

Based on the so-called Groman-Bashford doctrine and its progeny,⁴³ the IRS had formerly interpreted COBE to require “immediate” (rather than “remote”) COBE.⁴⁴ This position was widely criticized.⁴⁵ The IRS adopted final remote COBE regulations relating to post-reorganization transfers to corporations and to partnerships. Those amendments to the COBE regulations have expanded the scope of permissible transfers in multiparty reorganizations and provided reassurance to many taxpayers.⁴⁶ But they have also weakened the effectiveness of COBE in following the policy goal of the reorganization provisions of the code.

2. Transfers to corporations.

The COBE regulations implicitly permit transfers of target assets or target stock among members of a “qualified group” for purposes of satisfying COBE.⁴⁷ For this purpose, AC is treated as holding all the businesses and assets of all members of the qualified group.⁴⁸ A qualified group is defined as one or more chains of corporations connected through stock ownership with AC, but only if:

• AC owns directly stock meeting the requirements of section 368(c) (that is, ownership of at least 80 percent of the voting stock and 80 percent of each other class of stock) in at least one other corporation; and

• stock meeting the requirements of section 368(c) in each of the corporations (except AC) is owned directly (or indirectly through a partnership) by one or more of the other corporations.⁴⁹

A transfer of assets to a second-tier subsidiary should not prevent a transaction that otherwise qualifies as a reorganization from satisfying COBE.⁵⁰ Indeed, even drop-downs to third-tier subsidiaries are permissible.⁵¹ It is also permissible to transfer the assets to multiple subsidiaries.⁵² Reg. section 1.368-2(k) provides a post-reorganization transfer safe harbor for transactions qualifying as reorganizations when there are successive transfers to corporations controlled by the transferor.⁵³

3. Transfers to partnerships.

The Treasury regulations implicitly permit transfers of target assets to partnerships.⁵⁴ For purposes of COBE, a partnership is treated as an aggregate, whereby the partners are viewed as co-owners, each with an undivided interest in the partnership’s assets.⁵⁵ The partners are treated as owning the target corporation’s business assets used in a partnership business in accordance with such partner’s interest in the partnership.⁵⁶

Under the regulations, AC will be treated as conducting a business of a partnership if one of the following applies:

• AC (or members of the qualified group) has a “significant interest” in the partnership business (that is, at least 33.3 percent interest in such partnership).⁵⁷ The interests of all members of the qualified group are aggregated for purposes of the significant interest test.⁵⁸

• AC (or a member of the qualified group) performs active and substantial management functions as a partner.⁵⁹

From the examples featured in the regulations, it appears that the active management test is satisfied if the partner owns at least 20 percent interest in the partnership and performs active and substantial management functions for the business, “including making significant business decisions and regularly participating in the overall supervision, direction, and control of the employees.”⁶⁰ Some practitioners have commented that:

the performance of active and substantial management functions as a partner is probably never sufficient to establish COBE by itself. If, in addition, the acquirer owns, directly or indirectly, a substantial even though less than significant interest in the partnership, COBE probably exists unless there are facts that indicate an intention not to continue the business.⁶¹

4. Analysis.

The regulations governing the remote continuity doctrine exhibit a marked, even inexplicable, divergence in treatment between transfers to corporations and those to partnerships. Regarding transfers to corporations, the regulations maintain a degree of continuity between the assets of the former TC and its shareholders by including the control requirement of section 368(c). Other sections of the code based on the “mere change in form of ownership” rationale⁶² also incorporate the requirement to provide for nonrecognition treatment to some transactions in which “the taxpayer has not really ‘cashed in’ on the theoretical gain, or closed out a losing venture.”⁶³ Some examples of those sections are section 351(a), which defers gain or loss to transfers of property to a corporation in exchange for stock of the corporation, and section 368(a)(1)(B), which provides nonrecognition treatment in stock-for-stock acquisitions. The incorporation of a control requirement seems appropriate because it is an important element in considering continuity of interest.

Block, Glogower, and Blank comment, in the context of section 351(a), that “to qualify for tax-free treatment, [the shareholders] must receive enough stock to reflect a substantial continuity of their investment in the business assets.”⁶⁴ Nevertheless, Congress has deemed that the 80 percent threshold provides enough continuity in some cases. Whether the 80 percent control test reflects a substantial continuity of the shareholders’ investment in the business assets is beyond the scope of this article.

The regulations provide for a lower threshold in the case of partnerships. As noted, holding a 33.3 percent interest in a partnership that holds TC’s assets seems to be enough to satisfy the remote continuity doctrine.⁶⁵ Moreover, if AC (or a member of its qualified group) performs active and substantial management functions as a partner, a 20 percent interest seems to be enough, which is troublesome when considering that the regulations do not distinguish between capital and profits interests. The issuance of a 20 percent profits interest is a standard in the private equity industry, in which private equity fund managers take a 20 percent share of future partnership profits as the equity portion of their compensation.⁶⁶

A profits interest gives the partner specific rights in the partnership, but has no current liquidation value. A capital interest gives the partner specific rights in the partnership and has a positive current liquidation value.⁶⁷ Because profits interests have no current liquidation value, if the partnership were liquidated immediately upon the post-reorganization transfer of TC’s assets, “all of the drawn-down capital would be returned” to the capital interests holders.⁶⁸

It is not clear why the regulations provide for such different treatment between post-reorganization transfers of assets to corporations and partnerships. When implementing the rules, Treasury stated that:

in response to comments requesting a partnership aggregation rule, the final regulations, through a system of attribution, aggregate the interests in a partnership business held by all the members of a qualified group. The final regulations provide rules under which a corporate partner may be treated as holding assets of a business of a partnership. . . . Furthermore, in certain circumstances, [AC] will be treated as conducting a business of a partnership.⁶⁹

It is conceivable that the adoption of an aggregation rule to the transfer of assets to partnerships could be a product of planning drift.⁷⁰ Under an aggregate approach, a partnership is viewed as “merely an aggregation of the activities of its partners each of whom has an undivided interest in each of the partnership’s assets.”⁷¹ In contrast, under an entity approach, “a partner is treated as having an undivided interest in the entity, i.e., the partnership itself, and not in each of the partnership assets.”⁷²

While the adoption of an aggregate approach for post-reorganization transfers of assets to partnerships may not be inherently problematic, the reasoning behind Treasury’s choice of a relatively low threshold (that is, 20 or 33.3 percent) for attribution of the partnership assets to the partners in the context of the remote continuity doctrine is not clearly articulated in the regulations.

This treatment is problematic from a reorganization policy perspective. Even if it could be argued that holding as little as 20 or 33.3 percent is enough to reflect substantial continuity of the former target shareholders’ investment in the business assets of TC now held by a partnership, the fact that the regulations do not distinguish between capital and profits interests adds a layer of complication to the continuity issue.

According to the regulations, if AC receives a 20 percent profits interest and performs active managerial activities in a partnership that receives the post-reorganization assets (for example, as a private equity fund manager), the remote continuity doctrine and, by extension, COBE could be deemed satisfied. However, if the partnership is liquidated later, AC would not receive any capital, that is, any of the post-reorganization assets. If Treasury deemed that a link existed between the former TC’s shareholders and TC’s assets in this scenario, it can be inferred that such a link is excessively and unnecessarily weak.

While it is possible to argue that the IRS possesses tools to address these types of abusive transactions, such as the step transaction doctrine, it is reasonable to assert that, from a regulatory standpoint, the current formulation of the COBE regulations fails to uphold the continuity requirement. The COBE regulations have effectively enabled the transfer of post-reorganization assets to unrelated parties by permitting a more flexible treatment to post-reorganization transfers of TC’s assets to partnerships, without distinguishing between capital and profits interests.⁷³

C. Case 2: De-SPAC Transactions

1. A brief introduction to SPACs.

SPACs are publicly traded corporations formed with the sole purpose of effecting a merger with a privately held business to enable it to go public. In creating a SPAC, the founders sometimes have at least one acquisition target in mind, but they do not identify that target to avoid extensive disclosures during the initial public offering process.⁷⁴ A SPAC is generally capitalized with minimum capital, and then it is subject to an IPO process when it obtains cash proceeds raised from public investors. In exchange for their initial contribution, sponsors receive promoter shares and warrants, which are convertible into another class of shares of the SPAC in connection with the successful closing of a business combination transaction.⁷⁵

The SEC has described SPACs as shell companies when they become public, which essentially means that they do not have an underlying operating business and do not have assets other than cash and limited investments, including the proceeds from the IPO.⁷⁶ SPACs usually have 24 months to identify and complete an acquisition. Until an acquisition is completed, almost all the cash raised by the SPAC must be held in a trust account to be used for a future acquisition transaction and to facilitate any required redemptions. While in a trust account, the funds are typically invested in short-term, risk-free Treasury instruments.⁷⁷

The SPAC can be a “target” corporation in a putative reorganization (that is, a de-SPAC merger). Within this context, tax advisers have encountered the uncommon dilemma of determining whether a transaction of this nature can comply with COBE regulations. The common situations in which a de-SPAC transaction could be desirable involve the acquisition of a foreign corporation by a domestic SPAC through a horizontal double-dummy structure and the acquisition of a partnership.⁷⁸ The concerns about whether the acquisition of a SPAC can satisfy COBE are based on both tests that compose this doctrine.

2. Application of the COBE tests.

A SPAC, as a recently formed company searching for a business to acquire, may not have a historic business to continue. Case law has been unanimous in determining that activities preparatory to entering into a business are not regarded as actually engaging in a business.⁷⁹ Thus, the search activities carried on by a SPAC could not likely be considered a historic business. Even if the activity of searching for a business to acquire is considered a business, such a business is discontinued once the business combination has been settled.⁸⁰ Under the COBE regulations, a business started or entered into as part of the overall plan of reorganization will not qualify to satisfy the business continuity test.⁸¹

Whether a SPAC has historic business assets is another problematic issue. From the time the SPAC raises funds in an IPO, it will place the cash proceeds into a trust account for a prescribed period without any assets or businesses other than a mission to find a suitable acquisition target. Thus, the historic business assets of the SPAC would appear to be limited to the temporary investments held to fund an acquisition.

Thus, tax planners advise — based on reg. section 1.368-1(d)(5), Example 1 — that the post-merger company retain at least one-third of the SPAC’s cash so as to argue that a significant portion of the SPAC’s historic assets will be used in the continuing business.⁸² That is problematic for two reasons: (1) Cash is a fungible asset, calling into question whether it could be regarded as a historic asset, and (2) it shows that the COBE regulations go against the economic reality of the business. Even if the cash is used, has the SPAC’s historic business continued?

Some authors, citing case law referring to investment activities carried on by and liquid assets held by target corporations, have recently argued that a SPAC’s assets or business might satisfy the COBE requirement to the extent that a significant portion of the historic assets of the SPAC remains in the business.⁸³ The authors acknowledge that “when the historic business of a company consists solely of investment activities, a change in asset mix or product line focus [two of the dangers that SPACs face in a de-SPAC transaction] can result in a transaction more closely resembling a sale than a corporate readjustment.” Despite that, the authors suggest that “a minor change in the investment asset mix is not necessarily fatal.”⁸⁴

The authors also suggest that when the SPAC sponsors have industry-specific or other expertise in an area, COBE might be satisfied if those sponsors remain actively involved in the management of AC after the de-SPAC transaction because AC will be deemed to hold the intangible assets (goodwill and know-how) that are part of TC’s historic business assets through their sponsors.⁸⁵

3. Analysis.

Several factors present a significant obstacle to determining whether a SPAC undergoing a de-SPAC transaction has a historic business that AC may continue. Further, as previously mentioned, the interchangeable nature of cash raises concerns regarding the classification of cash held by the SPAC before the de-SPAC transaction as a historic business asset when held by AC following the reorganization. It raises questions such as how much cash should be retained and how it should be used by AC, but the COBE regulations fail to provide any guidance on these matters. Also, mandating that AC retains the cash and uses it in a specific way after the de-SPAC transaction appears to be an excessively formalistic means of fulfilling the COBE requirement, which may encourage behaviors that are inconsistent with the economic and business objectives of a de-SPAC transaction.

Also, the subjective nature of the “significant portion of the assets” test creates an unnecessary complication to this analysis. The IRS might rely on the preamble to the 1981 regulations, which refer to Mitchell,⁸⁶ to conclude that the use of cash (the proceeds from the sale of the target corporation’s assets) in AC’s business does not indicate reorganization treatment. Taxpayers may, however, find sufficient differences between a de-SPAC transaction and Mitchell, with the most important being that in a de-SPAC transaction, there is no liquidation or disposition of the historic assets of the SPAC by AC.

When analyzed from a policy perspective, certain de-SPAC transactions do not resemble a sale of a business or business assets of the SPAC, which is the goal of the COBE regulations. Indeed, “there is no sale or monetization of the SPAC’s assets. The only cash being received by SPAC shareholders, as so-called Target shareholders, is typically paid in connection with shareholder redemptions before the merger transaction. Effectively, there is no discontinuation or monetization of the SPAC’s ‘business’ of seeking a return on its investment.”⁸⁷

Indeed, the IRS has ruled that the merger of a pure holding company with and into its operating subsidiary (which resembles a de-SPAC transaction) satisfied COBE because, as a matter of policy, it was appropriate to treat the historic business of the holding company as the business of its operating subsidiary.⁸⁸ Even though this transaction presents some differences from a de-SPAC transaction (for example, it involves a downstream merger rather than a merger with an unrelated operating corporation), the IRS concluded that the attribution of the operating subsidiary’s historic business to the holding company was appropriate as a matter of policy.

That is especially pertinent when a SPAC is established with a specific industry focus, and its sponsors possess expertise in said industry. When a SPAC is acquired by AC, it may continue with that industry focus. Moreover, the economic reality of merger transactions demonstrates that there has been no liquidation of the assets held by the SPAC, and as a result of the de-SPAC transaction, it is transformed into a corporate modified form. The de-SPAC transaction highlights that, from a practical standpoint, the COBE regulations are inadequate in addressing certain transactions that they should cover.

IV. Reassessing Continuity: COBE as a SAAR

A. Introduction

Should the COBE doctrine be considered a specific or general antiabuse rule? From a policy standpoint, it is beneficial to reevaluate COBE as a specific antiabuse rule (SAAR) and incorporate a GAAR to address abusive transactions in corporate reorganizations. Below we discuss that argument and its drawbacks, along with the drawbacks associated with reclassifying COBE as a SAAR and the adoption of a GAAR.

B. Who Is Served by the COBE Requirement?

Developing a new COBE doctrine or devising additional requirements for reorganization treatment is arduous. As discussed above, the COBE regulations — as well as the judicial precedents and opinions of the IRS and tax professionals — have established a set of guidelines that, despite falling short of the policy objectives of the reorganization provisions of the code, have proven resilient. Hence, this article seeks to reassess the true nature of COBE. Although difficulties with the COBE regulations have been identified in this article, the process of reassessing the continuity requirement is more of a matter of design than of problem-solving acumen. In other words, the continuity doctrine issue necessitates a proactive and user-centric approach rather than a reactive one.⁸⁹ For this purpose, it is necessary to identify who is served by the COBE doctrine.

The COBE regulations arose as a response to transactions that, even fitting within the statutory language of the reorganization provisions, resembled more appropriately a sale of assets, that is, transactions that were “outside the plain intent of the statute”⁹⁰ or “abusive transactions.” The COBE doctrine can be properly understood as an antiabuse doctrine, that is, a doctrine that is intended to exclude transactions that constitute “abuses” of the limits of the reorganization provisions of the code from nonrecognition treatment.⁹¹ This interpretation gains further support when we consider that another corollary of the nonstatutory doctrines applicable to reorganizations, the business purpose doctrine, has been interpreted as a common law antiabuse doctrine.⁹² As in Gregory v. Helvering, COBE has arisen from a rejection of a literalist approach to the reorganization provisions of the code. Indeed, Pinellas Ice & Cold Storage,⁹³ which is one of the first antecedents to the continuity doctrines (in particular, to the continuity of proprietary interest doctrine), is seen as the “significant shift to a substantive anti-taxpayer approach.”⁹⁴ Antiabuse (or antiavoidance)⁹⁵ rules are deemed as weapons in the government’s arsenal⁹⁶ and, as such, are not leaning to a pro-taxpayer approach.

COBE can be properly interpreted as an antiabuse rule to be used by the government to deny nonrecognition treatment to transactions that do not align with the policy goals of the reorganization provisions. The “person” that is served by COBE is the government and, in particular, the IRS.

C. GAAR vs. SAAR

Having identified COBE as an antiabuse rule, the next logical issue is to determine whether COBE is a GAAR or a SAAR. The delimitation of COBE within these categories is important to determine its scope.

GAARs provide broad and flexible authority to a country’s tax authority that can be applied to specific sections or the entire revenue code.⁹⁷ GAARs’ flexibility and unclear boundaries have the effect of “make it far more difficult for avoidance-minded taxpayers to plan around or right up to its limitations,”⁹⁸ while decreasing certainty in the law for nonabusive taxpayers.⁹⁹ GAARs have three common design elements: a trigger, which is usually a tax avoidance arrangement; a tax benefit, which flows from the trigger; and a reconstruction provision, which provides authority to the revenue authority to reverse the tax outcome of the tax avoidance arrangement and to levy a tax against the taxpayer as if the abusive transaction had never occurred.¹⁰⁰ The vagueness of GAARs ties them to judicial interpretation for matters such as their applicability and understanding.¹⁰¹

SAARs are provisions that deny tax benefits or advantages that would otherwise be available to taxpayers, or limit or condition their application.¹⁰² SAARs are targeted at narrow, “specific areas where abuse has been previously identified or revenue leakage is suspected.”¹⁰³ Some disadvantages or weaknesses of SAARs include their specificity and the fact that they could be easily avoided and incorporated into new avoidance activities.¹⁰⁴

Based on this conceptual framework, a reasonable conclusion is that COBE can be classified as a SAAR since its purpose is not to grant the IRS broad and flexible authority to recharacterize a broad range of transactions. In fact, the COBE rule does not include a clear triggering mechanism for its application, unlike other rules that are commonly regarded as GAARs.¹⁰⁵ The COBE rules were established to ensure that the interest retained by the former shareholders of TC after a merger or acquisition is linked to TC’s business or business assets.¹⁰⁶ It is unfortunate, however, that the 1981 regulations — as some authors have identified¹⁰⁷ — contain some ambiguous requirements. In the following section, we will discuss why it is necessary to reevaluate COBE so that it conforms to its appropriate doctrinal category, namely, a SAAR.

D. Legal Certainty in COBE Doctrine

As a SAAR, COBE should be designed for a narrow and specific scope of application. This would enable taxpayers to align their behavior to satisfy the nonstatutory requirements of the reorganization provisions of the code,¹⁰⁸ including in the problematic cases identified in this article. From a policy perspective, legal certainty is desirable and necessary to structure transactions and conduct business.¹⁰⁹

The spaces for ambiguity that the current COBE regulations provide should be avoided. Thus, for example, the asset continuity test could incorporate an objective criterion when the link between the former target shareholders and TC’s assets is deemed preserved. The code has an example of that in section 368(a)(1)(C), which contains the requirement that TC must transfer “substantially all” of its assets to AC. That term has been defined as “assets representing at least [90 percent] of the fair market value of the net assets, and at least [70 percent] of fair market value of gross assets held by the target corporation immediately preceding the transfer.”¹¹⁰ The regulations could incorporate what case law and the IRS have already accepted: Investment assets and liquid assets can satisfy the COBE requirement when TC has never materially altered or modified its business or its assets.¹¹¹

Also, the asset continuity requirement could be merged with the business continuity test. To satisfy the COBE requirement, AC should use in its business substantially all of the target corporation’s assets used by TC in one line of business. In that regard, all the considerations regarding the business continuity requirement could be retained. However, tying the business continuity test to the asset continuity test seems to be a better approach to satisfy the policy goal of the COBE regulations of preserving a link between the former target shareholders and TC’s business assets.

Interpreting COBE as a SAAR does not mean that the ability of the IRS to challenge abusive transactions would be undermined. SAARs are not protective rules.¹¹² Therefore, the administration should be empowered to question transactions carried on by taxpayers, even if they satisfy the nonstatutory requirements for nonrecognition treatment under the reorganization provisions. This is where GAARs enter into play, as weapons for the government to attack transactions that, on their face, comply with the reorganization requirements but that lack business purposes beyond tax avoidance.

As drafted, the COBE regulations provide that the satisfaction of the COBE requirements must be analyzed under all the facts and circumstances.¹¹³ According to a scholar, this analysis must be performed “in light of [COBE’s] policy goal, which is to ensure that reorganizations are limited to readjustments of continuing property interests in modified form and do not ‘involve the transfer of the acquired stock or assets to a “stranger,” which would be inconsistent with reorganization treatment.’”¹¹⁴ Effectively, the facts and circumstances requirement allows the IRS to have some subjectivity when analyzing the satisfaction of COBE. Nevertheless, a GAAR could be incorporated to help the IRS to interpret all the nonstatutory reorganization requirements according to the policy goal of the reorganization provisions.¹¹⁵

The interplay between COBE as a SAAR, with the incorporation of a GAAR that encompasses the policy goal of the reorganization provisions, could be an effective manner to achieve both legal certainty for nonabusive taxpayers in the arrangement of their business transactions and broad authority for the IRS to attack abusive transactions.

The code incorporates a provision that has been interpreted as a GAAR by some scholars,¹¹⁶ namely, section 7701(o). This section codifies the economic substance doctrine, and provides that “in the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.” Those two conditions represent the “trigger” — that is, a transaction will “constitute a tax abusive arrangement if one of two conditions are met: either (1) the transaction does not change in a meaningful way, independent of federal income tax effects, the taxpayer’s economic position or (2) the taxpayer does not have a substantial purpose, independent of federal income tax effects, for entering into the transaction.”¹¹⁷ The tax benefit from that trigger is explained in section 7701(o)(5)(A) as generally “the tax benefits under subtitle A with respect to a transaction.”

Also, section 7701(o)(5)(A) provides that the tax benefit is not allowable if the transaction lacks economic substance, which represents the “reconstruction provision.” Professor Orly Sulami Mazur adds that the requirement in section 7701(o) that the common law economic substance doctrine must be relevant to the transaction or series of transactions means that “the courts will continue to make this determination.”¹¹⁸

The components described above could be included in a GAAR that integrates the policy objective of the reorganization provisions of the code. Reg. section 1.368-1(b) states that the purpose of the code’s reorganization provisions is “to except from the general rule certain specifically described exchanges incident to such readjustments of corporate structures made in one of the particular ways specified in the code, as are required by business exigencies and which effect only a readjustment of continuity interest in property under modified corporate forms.” This policy objective suggests that the GAAR proposed in this article may consist of the following elements:

• Trigger: A purported corporate reorganization will constitute a tax-abusive arrangement if it (1) is not required by business exigencies, or (2) does not effectuate only a readjustment of continuity interest in property under modified corporate forms.

• Tax benefit: The nonrecognition treatment derived from the classification of the transaction or series of transactions as a reorganization under the definition of section 368.

• Reconstruction provision: The IRS has the authority to reverse the reorganization status under section 368 and to levy taxes in accordance with the general principles of U.S. tax law if, under the relevant facts and circumstances, it is determined that a transaction or series of transactions constitutes a tax-abusive arrangement.

E. Potential Drawbacks and Responses

1. COBE as a SAAR does not resolve the remote continuity problem of transfers of assets to partnerships.

Interpreting COBE as a SAAR does not solve one of the problems identified in this article, namely, the lenient approach that Treasury adopted for transfers of assets to partnerships and its difference with transfers to corporations. While this is true, it is important to remember that, along with the low threshold suggested by the regulations, the problem found regarding the transfer of post-reorganization assets to partnerships is tied to the ambiguity of the drafting of the current COBE regulations.

Indeed, Treasury does not clearly identify what kind of partnership interest satisfies the remote continuity doctrine. Based on the arguments presented in this article, it is our view that solely a capital interest has the potential to maintain a link between AC (and, therefore, the former TC shareholders) and the business of the partnership when AC is functioning as a partner. The sufficiency of that link (33.3 or 20 percent) is a matter that is beyond the scope of this article.

Construing COBE as a SAAR serves two objectives. First, it establishes a doctrinal demand for Treasury to ensure the utmost specificity when issuing regulations under COBE, including those pertaining to the remote continuity doctrine. Thus, it is not only desirable from a policy perspective but also a doctrinal necessity for Treasury to define what type of interests can satisfy COBE in the context of transfers of assets to partnerships. Second, from a doctrinal perspective, interpreting COBE as a SAAR serves another purpose: It provides an objective standard for determining whether the partnership is carrying on the business of TC. COBE would be satisfied only if the partnership is using substantially all the assets that were used in one line of business by TC in its own business.

Further, the inclusion of a GAAR could be an important weapon for the IRS to attack transactions in which the corporate partner would not have “too much skin in the game,” such as when the interest held by AC is a profits interest.

2. Ease of avoidance.

When COBE is interpreted as a SAAR, it becomes more susceptible to abuse, which is a common issue with SAARs.¹¹⁹ However, as explained in this article, the risk of abuse can be greatly reduced when a GAAR is also incorporated. This allows the IRS to exercise discretion in identifying abusive transactions that may satisfy a narrowly drafted COBE requirement but are actually more akin to a sale rather than a transaction that achieves a mere “readjustment of continuing interest in property under modified corporate forms.”¹²⁰

Further, as currently drafted, COBE is considered by some authors and practitioners as “loose and reasonably easy to satisfy.”¹²¹ At the same time, however, today’s COBE regulations seem to challenge transactions when the potential of abuse is nonexistent, such as de-SPAC transactions. Thus, the interplay between a narrowly drafted COBE doctrine and the incorporation of a GAAR could be an appropriate mechanism to attack abusive transactions while allowing nonrecognition treatment to transactions that align with the policy of the reorganization provisions of the code.

3. Burden on the government.

Another possible drawback to the proposal is that the inclusion of a GAAR could impose an onerous burden on the government to demonstrate that a transaction is abusive. However, as is the case with the economic substance doctrine,¹²² the GAAR may specify that it is the taxpayer, rather than the government, who bears the burden of demonstrating that a transaction or series of transactions qualifies as a corporate reorganization. Satisfying a narrowly drafted COBE requirement could establish a prima facie case that a transaction constitutes a corporate reorganization. However, once such a transaction is challenged by the government under the GAAR, the taxpayer would have the burden to prove that the transaction (1) is required by business exigencies, and (2) effectuates only a readjustment of continuity interest in property under modified corporate forms.

In Colombia, for example, nonrecognition treatment applies automatically once the requirements for corporate reorganization status, including some SAARs that are equivalent to the continuity of proprietary interest requirement, are met. Indeed, the requirements for corporate reorganization status are interpreted as:

parameters that allow the parties involved to know in advance the consequences of the operation they intend to carry out. As in all [specific] anti-avoidance rules, it is necessary to establish objective criteria whose compliance or non-compliance is easily verifiable . . . what is fundamental is that this objective parameter respects the principle of legality and contributes to legal certainty.¹²³

However, the Colombian government is empowered to challenge the transactions that are carried out by the strict compliance of the requirements for corporate reorganization status, including the SAARs, through a GAAR “provided that it has solid and reasonable evidence that allows it to question the economic reasonableness of the transaction.”¹²⁴

Even though the GAAR proposed in this article subjects the taxpayers with the burden of proving that their transaction satisfies the conditions of the GAAR, it could be desirable from a policy perspective to impose on the government a minimum threshold to meet, namely, that it has solid and reasonable evidence that provides the government with probable cause to ascertain that a transaction could be abusive. For example, a threshold is met when AC receives a 20 percent profits interest in exchange for the transfer of the target corporation’s assets. Indeed, since a profits interest has zero liquidation value, the government would have solid and reasonable evidence to conclude that such a transaction more resembles a sale than a corporate reorganization.

4. A GAAR would depend on judicial interpretation.

GAARs generally depend on judicial interpretation for their applicability and understanding.¹²⁵ In the context of corporate reorganizations, that is more beneficial than prejudicial.

As discussed above, COBE and other nonstatutory requirements for corporate reorganizations have their origins in case law. A GAAR empowers the judiciary to prevent abusive transactions. Because both the government and the taxpayer’s arguments can be heard in a court of law, this provides an opportunity for further COBE developments, which is crucial when practical developments like de-SPAC transactions test the boundaries of the COBE doctrine. Therefore, the implementation of a GAAR that requires the courts to intervene in preventing abusive transactions would be beneficial for both taxpayers and the government.

V. Conclusion

Eliminating the COBE requirement does not appear to be an effective way to achieve the policy objectives of the reorganization provisions of the code. Treasury has emphasized the importance of COBE in ensuring that tax-free reorganizations simply adjust ongoing interests in property.¹²⁶

However, the current COBE regulations are problematic because of their ambiguity, leading to various issues. On the one hand, the regulations governing the remote continuity doctrine display an apparent inconsistency in their treatment of transfers to corporations versus partnerships. For transfers to corporations, the regulations include a control requirement to maintain continuity between the assets of the former target corporation and its shareholders.

However, for partnerships, the regulations provide for a lower threshold, which is problematic as it does not distinguish between capital and profits interests. This is significant because a profits interest has no current liquidation value, and therefore, if the partnership were liquidated later on, the target corporation’s assets would be transferred to the capital interests’ holders. Therefore, the regulations have effectively enabled the transfer of post-reorganization assets to unrelated parties.

On the other hand, the lack of clear guidance from the COBE regulations on whether a SPAC undergoing a de-SPAC transaction has a historic business that AC may continue presents significant challenges. The interchangeable nature of cash further complicates the analysis, and the subjective nature of the “significant portion of the assets” test creates unnecessary confusion. From a policy perspective, some de-SPAC transactions do not resemble a sale of business assets of the SPAC, and the economic reality of de-SPAC transactions suggests that there has been no liquidation of assets held by the SPAC. Instead, some de-SPAC transactions could properly be viewed as a readjustment of continuity interest in property under modified corporate forms.

Therefore, interpreting COBE as a SAAR is not only doctrinally sound but also beneficial in terms of practicality and policy considerations. But that approach alone does not fully resolve all the challenges associated with the COBE requirement. As a solution, we propose that a GAAR be implemented to scrutinize the application of COBE and other nonstatutory requirements under the reorganization provisions of the code. A GAAR would empower the IRS to address abusive transactions that undermine the policy objectives of the reorganization provisions.