1% Stock Buyback Tax: US Treasury, IRS Release Proposed Regulations

On April 9, 2024, the US Department of the Treasury and the Internal Revenue Service issued long-awaited proposed regulations under Section 4501 of the Internal Revenue Code (the “Code”) regarding the 1% stock buyback excise tax (the “Proposed Regulations”).

Introduced by the “Inflation Reduction Act,” enacted on August 16, 2022, the excise tax applies to stock repurchases and “economically similar transactions” undertaken by publicly traded US (and certain foreign) corporations beginning on January 1, 2023. The statute generally imposes a 1% tax on the value of stock repurchased by a covered corporation, subject to a “netting rule” under which the value of the repurchased stock during a taxable year can be reduced by the value of stock issued by the covered corporation in that same year.

Initial guidance was provided through administrative Notice 2023-2 (the “Notice”) on December 27, 2022.

The Proposed Regulations generally follow the Notice, with some changes and clarifications.

Applicability Dates

If finalized, the Proposed Regulations would generally apply to transactions occurring in tax years ending after December 31, 2022. However, certain rules in the Proposed Regulations that had not been included in the Notice will only apply to transactions taking place after April 12, 2024. The provisions relating to stock buybacks by foreign groups have special effective date rules, as discussed below.

A companion set of proposed regulations issued the same day includes a separate set of rules relating to the reporting and payment of the tax. Importantly, the reporting and payment of the excise tax will not be required until the due date of the Form 720 (Quarterly Federal Excise Tax Return) for the first full calendar quarter after the date the final regulations are published.

KEY ASPECTS AND CHANGES

Relaxation of the “Funding Rule” for Foreign Groups

Under Section 4501(d) of the Code, the excise tax can apply when stock of a publicly traded foreign corporation is purchased by a domestic affiliate. The Notice had expanded the scope of this statutory provision through a “funding rule” whereby a repurchase of the publicly traded foreign corporation’s stock would be subject to the excise tax if the acquisition was funded by the domestic affiliate “by any means” (including distributions or loans) and “a principal purpose” of the funding was to avoid the excise tax (a “covered funding”). In addition, the Notice included a “per se” rule under which a principal purpose was deemed to exist where the funding occurred within two years of the acquisition. These rules were heavily criticized as being overly broad, raising concerns that ordinary course transactions involving a US affiliate (e.g., intercompany license or service payments, a cash-pooling arrangement) could trigger application of the “per se” rule upon a repurchase of stock by the foreign public company.

The Proposed Regulations retain the funding rule, clarifying that a principal purpose of avoiding the excise tax will exist if a principal purpose of the covered funding was to fund (directly or indirectly) a covered purchase. However, the Proposed Regulations replace the controversial “per se” rule with a much more limited rebuttable presumption applicable to “downstream” fundings. Generally, a principal purpose will be presumed to exist where a US corporation funds a 25%-owned lower-tier foreign entity within two years of the purchase of foreign parent stock by the funded entity. The presumption can be rebutted if the facts and circumstances “clearly establish” that there was not a principal purpose to avoid the tax. Given that it is limited to funding of downstream affiliates, the rebuttable presumption would appear to cover a fairly narrow set of fact patterns.

The Proposed Regulations provide an ordering rule under which a covered purchase is first treated as having been funded by any covered fundings (before fundings received from other sources).

While the replacement of the “per se” rule with a limited scope rebuttable presumption is a welcome change for foreign groups, the vagueness of a “principal purpose” test and the unfavorable ordering rule will still create uncertainty as to whether the excise tax may apply to repurchases of stock of foreign groups that engage in ordinary course intragroup transactions with their US affiliates.

Applicability Dates

The revised rules in the Proposed Regulations relating to repurchases by foreign groups are generally applicable to transactions occurring after April 12, 2024, while the rules in the Notice would apply to transactions occurring before this date. However, a covered corporation may choose to apply the rules in the Proposed Regulations to transactions occurring after December 31, 2022, and fundings occurring on or after December 27, 2022, provided the taxpayer applies the Proposed Regulations consistently.

Rules Relevant to M&A and Other Corporate Transactions

The New “Constructive Specified Affiliate Acquisition” Rule

The Proposed Regulations contain a new rule that would apply to purchases of stock of a covered corporation by an acquirer that later becomes related to the covered corporation. Under the “constructive specified affiliate acquisition” rule, if:

• a target corporation or partnership is acquired by a covered corporation, and
• at the time of the acquisition, the target entity owns stock of the covered corporation that represents more than 1% of the fair market value of the target entity, and
• that stock was acquired after December 31, 2022

… then the excise tax shall apply with respect to the stock of the covered corporation that had been acquired by the target entity. So it will be important for publicly traded corporations undertaking an acquisition to diligence whether the target company owns any of their stock.

LBOs, IPOs, and Take-Private Transactions

Consistent with the Notice, the Proposed Regulations provide that, unless a statutory exception applies, any consideration in a leveraged buyout or other taxable acquisition that is funded by the target corporation would be treated as a repurchase subject to the excise tax. The excise tax could be avoided to the extent the consideration is funded by the acquiring entity and not the target corporation.

The Proposed Regulations provide that a corporation should generally be considered a covered corporation from the date its stock begins trading on an established securities market (the “initiation date”). For privately held corporations that go public, any stock issuances or repurchases after that date would affect the corporation’s excise tax base for the taxable year. Conversely, shares issued or repurchased before the initiation date would not impact the excise tax calculation.

In the case of a take-private transaction, the corporation will cease to be a covered corporation at the end of the day on which its stock ceases to be traded on an established securities market (the “cessation date”). Repurchases on the cessation date would be subject to the stock repurchase excise tax unless a statutory exception applies. Repurchases and issuances after the cessation date would generally not affect the corporation’s excise tax base. However, the Proposed Regulations contain an exception to this general rule: A repurchase that occurs after the cessation date will be subject to the excise tax when the corporation ceased to be a covered corporation pursuant to a plan that included such a repurchase.

Tax-Free Reorganizations

Following the Notice, the Proposed Regulations provide that the following transactions are each treated as a “repurchase”:

(i) the exchange by target shareholders of target stock as part of an “acquisitive reorganization,” and
(ii) an exchange by recapitalizing shareholders of stock in a recapitalization under Section 368(a)(1)(E), and
(iii) an exchange of transferor corporation stock as part of a reorganization under Section 368(a)(1)(F).¹

The statutory exceptions effectively limit the application of the excise tax in these cases to the cash consideration or other boot received by the shareholder in the reorganization.

Post-Closing Purchase Price Adjustments

The Proposed Regulations clarify that shares issued as part of an earn-out or shares subject to forfeiture to satisfy indemnification obligations shall be treated as issued for purposes of the netting rule when the ownership of the stock transfers to the recipient under federal income tax principles. If the issuance of the shares had been counted under the netting rule, the forfeiture of the shares will be treated as a repurchase.

Section 355 Transactions

As in the Notice, the Proposed Regulations affirm that Section 355 distributions (i.e., spin-offs or split-ups) are not subject to the stock repurchase excise tax, but split-offs are.

However, the Proposed Regulations clarify that a distribution by the distributing corporation of non-qualifying property (i.e., cash or other non-stock consideration) in exchange for the distributing corporation’s stock in pursuance of a spin-off or a split-up is treated as a “repurchase” and subject to the excise tax.

Liquidations

As anticipated in the Notice, the Proposed Regulations provide that any distributions in a complete liquidation to which Section 331 or Section 332 (but not both) applies are not subject to the excise tax. Addressing a point of uncertainty, the Proposed Regulations clarify that this will also be the case even if some classes of shares do not receive any distribution in the liquidation (as may be the case of sponsor shares in a SPAC, for example).

Distributions made under Section 331 to minority shareholders in the case of a complete liquidation to which both Section 331 and Section 332 apply are subject to the stock repurchase excise tax.

The Proposed Regulations also confirm that redemptive partial liquidations are subject to the excise tax because those transactions qualify as Section 317(b) redemptions.

Preferred Stock, Sole Exception for “Tier 1 Preferred”

The excise tax generally applies to repurchases of “stock” of a covered corporation. The determination of whether a financial instrument is treated as “stock” is based on federal tax principles. The Proposed Regulations confirm that the excise tax is generally applicable to repurchases of convertible or preferred stock (including mandatorily redeemable preferred stock), notwithstanding several comments that had requested an exception for this type of instrument. The only limited exception introduced by the Proposed Regulations is for “additional tier 1 preferred stock,” that is, a type of preferred stock meeting specific criteria related to bank regulatory capital qualifications. Repurchases of additional tier 1 preferred stock are not subject to the excise tax. Similarly, issuances of additional tier 1 preferred stock would not be counted for purposes of the netting rule.

Restricted Stock, Clawbacks

The Proposed Regulations would provide that restricted stock shall be treated as issued to an employee or service provider for purposes of the netting rule where the recipient has made a valid Section 83(b) election with respect to the stock. In turn, the forfeiture of that stock shall be treated as a repurchase. The Proposed Regulations provide for similar treatment in the case of vested stock that is returned to a covered corporation under a clawback agreement.

Instruments Not in the Legal Form of Stock

The Proposed Regulations contain an anti-abuse rule that disregards the issuance of instruments that are treated as stock for federal income tax purposes but are not in the legal form of stock (e.g., deep-in-the-money options). According to the preamble, without such a rule, a covered corporation could issue deep-in-the-money stock options treated as stock for federal income tax purposes to an accommodation party with the understanding that the options would never be exercised, thus allowing the covered corporation to eliminate any excise tax under the netting rule. Notwithstanding the foregoing, the repurchase of an instrument that is treated as stock for federal income tax purposes is potentially subject to the excise tax even if the instrument is not in the legal form of stock.

¹ Notably, the Proposed Regulations do not treat B reorganizations and Section 351 exchanges as “acquisitive reorganizations” for this purpose.