On April 9, 2024, Treasury and the IRS released proposed regulations for the excise tax on stock repurchases, which closely align with the interim guidance in Notice 2023-2 (the Notice). The government has opted to base the application of the excise tax on established U.S. federal income tax principles, which are at times highly fact dependent, declining to take advantage of the broad grant of regulatory authority to create more intuitive and administrable rules. This is particularly noticeable in cases that do not implicate the purported policy objectives of the excise tax. However, the proposed regulations do offer some helpful clarifications and as expected, revise the widely criticized rule in the Notice that automatically assumed certain stock repurchases of a foreign corporation are funded by U.S. sources, and therefore subject to the excise tax (the per se rule).
The 1% excise tax on stock repurchases primarily targets U.S. corporations with "publicly traded" stock and extends to certain acquisitions by "specified affiliates" – entities for which a U.S. corporation or certain public foreign corporations own more than 50% of the stock. Stock is treated as repurchased when the transaction is a redemption for tax purposes or economically similar as determined by Treasury, subject to several statutory exceptions, including a de minimis rule which exempts corporations from the excise tax if their annual repurchases do not exceed $1 million. The excise tax is imposed on the net fair market value of repurchased stock during the taxable year, after accounting for certain newly issued stock (the netting rule).
Not Much Relief on Scope
The proposed regulations would broadly apply to stock redemptions and economically similar transactions, including the following:
- Redemptions of debt-like preferred stock (with a new limited exception for certain stock issued by a bank) and any stock subject to mandatory redemption or a unilateral holder put option;
- Certain tax-free reorganizations, such as acquisitive reorganizations (including bankruptcy "G" reorganizations) to the extent the stock is exchanged for cash or other property (commonly referred to as "boot") (new bankruptcy clarification);
- Leveraged buyouts and certain other taxable "take-private" transactions;
- Split-off transactions;
- Certain forfeitures and clawbacks of stock, such as stock subject to post-closing price adjustments (new rule); and
- Certain acquisitions of corporations or partnerships that own stock in the covered corporation (new "constructive specified affiliate acquisition" rule).
The redemptions and transactions that would not be treated as repurchases include the following:
- Certain distributions occurring in the taxable year in which a corporation completely liquidates;
- Certain redemptions pursuant to the resolution or plan of dissolution of a corporation, even if some classes of stock do not receive consideration for redeemed shares (new clarification);
- Deemed redemptions in certain acquisitions by brother-sister corporations;
- Payments made in cash in lieu of fractional shares in a tax-free reorganization or the settlement of an option or similar financial instrument if certain requirements are met;
- Certain net cash settlements of an option contract or other derivative financial instrument with respect to stock of a covered corporation (new rule); and
- Spin-off transactions.
A&M Insight:
The application of the excise tax is form driven. For example, certain liquidations are not subject to the excise tax, whereas acquisitive reorganizations that include boot – which often involve a liquidation – are subject to the excise tax. Additionally, if, in a traditional private equity acquisition structure, the parent contributes borrowed funds to a subsidiary to purchase the stock of a target (even if the target has cash on hand), the funded stock purchase would not be subject to the excise tax. However, the transaction would be subject to the excise tax if cash of the target corporation is used to pay the purchase price. As a result, corporations must carefully assess the excise tax implications when contemplating tax-free reorganizations that involve boot, take-private transactions, and other common transactions. To mitigate the effects of the excise tax, these corporations should explore alternative transaction structures, weighing the benefits of taxable versus tax-free approaches, and consider the strategic use of different financial instruments, such as debt or options, as opposed to preferred stock.
Special purchase acquisition companies (SPACs), while likely disappointed that the government declined to propose special rules for their industry, should appreciate that shares redeemed in a complete liquidation or dissolution would not be treated as repurchases even if some classes of shares do not receive a liquidating distribution (e.g., shares owned by SPAC sponsors who typically waive redemption rights).
Further, if the new constructive specified affiliate acquisition rule is adopted in the final regulations, buyers should consider the potential application of the excise tax in their diligence.
Slightly Expanded Netting Rule
As mentioned above, under the netting rule, a corporation reduces the fair market value of its repurchased stock by the fair market value of certain stock issued during the same taxable year and certain contributions to employer-sponsored retirement plans after the close of such year. The proposed regulations contain an exclusive list of stock issuances that would be disregarded under the netting rule, which includes:
- Stock distributions, regardless of whether they are taxable or tax-free to the corporation's shareholders;
- Stock issuances to a specified affiliate unless the specified affiliate subsequently transfers the stock in the same year, subject to other requirements (new exception to the general rule);
- Stock issuances that are part of a transaction in which the corporation repurchases its shares but a statutory exception to the excise tax applies; and
- Certain issuances of non-stock instruments that are treated as stock for U.S. federal income tax purposes (such as deep-in-the-money options) unless the instruments are repurchased, and the corporation complies with certain reporting requirements (new anti-avoidance rule).
A&M Insight:
Corporations will appreciate the ability to net certain stock issuances to specified affiliates, which is helpful for common transactions in which a subsidiary uses its parent's stock to compensate its employees. However, without further relief under the netting rule, a corporation may not net redemptions with stock issuances by related parties or predecessors, which occur in multi-tier structures commonly used to facilitate certain M&A transactions, such as "double dummy" and "up-C" structures. Therefore, corporations will need to incorporate the effects of the excise tax in their modeling and analysis.
Rebuttable Presumption: Better But Challenging
Under the proposed regulations, if a specified affiliate funds certain repurchases or acquisitions of stock of certain public foreign corporations with the principal purpose of avoiding the excise tax, the stock would be treated as repurchased. A principal purpose, under a new rebuttable presumption rule, would exist if the affiliate funds a downstream entity (25% ownership threshold) within two years of such downstream entity acquiring the stock of the foreign corporation. To rebut the presumption, facts and circumstances must clearly establish that there was not a principal purpose to avoid the tax, and specified affiliates must timely substantiate this position with their excise tax return, as well as satisfy other requirements.
A&M Insight:
Foreign corporations and their U.S. affiliates will appreciate the more narrowly applied rebuttable presumption compared to the per se rule in the Notice. However, determining what constitutes a principal purpose may be challenging. For example, how would a capital contribution intended to satisfy local law capital requirements be treated if the foreign corporation has sufficient capital but no cushion? Or how would a cash infusion or debt issuance to facilitate an acquisition or a payment of a liability be treated? Additionally, with the two-year rule, the stock repurchase and the funding could occur in different taxable years, making it critical that specified affiliates maintain detailed contemporaneous records with supporting documentation that explains the purpose of any downstream monetary transfers.
Corporations should also be mindful that the per se rule from the Notice would apply to fundings between December 27, 2022, and April 13, 2024, unless taxpayers consistently apply the proposed regulations for the repurchases of stock of foreign corporations. Taxpayers choosing to adopt the proposed regulations early should assess their ability to rebut the presumption.
Potential Recordkeeping Requirements for All!
Any covered corporation making a repurchase would be required to file annual stock repurchase excise tax returns and keep complete and detailed records sufficient to accurately establish the amount of repurchases, adjustments, and exceptions required to be shown on its return. Further, the IRS could issue a notice requiring any covered corporation to make returns and statements available, as well as keep specific records to help determine whether the corporation is liable for the excise tax. This is regardless of whether the covered corporation made or was treated as having made a repurchase.
The recordkeeping rules would apply to those amounts included on the returns required to be filed after the final procedural regulations are published in the Federal Register.
A&M Insight:
Corporations whose repurchases are not subject to the excise tax because of a statutory exception or the netting rule should take note of their reporting and recordkeeping requirements. Additionally, without further guidance, the full scope of transactions for which taxpayers must maintain adequate records is unclear and could be onerous, particularly for corporations that typically do not repurchase their stock. Nevertheless, corporations should ensure they have implemented procedures and tools to substantiate their positions, beginning with 2023 purchases, issuances, and transactions.
A&M Tax Says
The excise tax on share repurchases, which became effective beginning in 2023, has introduced significant complexity and uncertainty to structuring of transactions. As the government generally plans to adopt the guidance in the Notice, it seems unlikely that the final regulations will substantially differ from the proposed regulations. Thus, taxpayers should consider the impact of the proposed excise tax rules on acquisition structures and determine appropriate procedures that may be required, considering the anti-avoidance rules and recordkeeping requirements. Additionally, corporations whose annual share repurchases typically do not exceed $1 million should be wary of the de minimis exception, which might not provide the expected protection because of the operation of the rules, particularly the application of the threshold before the statutory exceptions and the netting rule.
Originally Published 19 April 2024
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
