If you thought the recent price increase at your neighborhood store was inflation’s last flop, think again. The Inflation Reduction Act (“IRA”), which was signed into law by President Biden on August 16, 2022, is estimated to raise $739 billion over the decade. The IRA is financed primarily by several targeted tax increases. Revenues will go toward initiatives designed to combat climate change, reduce the nation’s debt, and, hopefully, reduce inflation. The IRA is a starkly diminished version of the proposed “Build Back Better Act,” which passed the House in 2021 but never received a vote in the Senate. Most of the tax proposals in the Build Back Better Act didn’t make it into the new bill, but a few did.
As discussed in more detail below, among the significant tax law changes in the IRA1 are:
- A 15% minimum tax rate (“corporate minimum tax”) on the adjusted financial statement income (“AFSI” or “adjusted book income”) of corporations with average annual adjusted book income of $1 billion; and
- A 1% excise tax on certain corporate stock repurchases.
15% Corporate Minimum Tax on Adjusted Book Income
A corporate alternative minimum tax was imposed in various forms beginning in 1969—and repealed in 2017. For most of that period, the tax base was not financial statement income but the regular income tax base with various preferences added back.
The new corporate minimum tax will apply to “applicable corporations,” defined as those with $1 billion or more in annual adjusted book income (as opposed to adjusted taxable income), calculated over a three-year period average. Corporations connected through greater than 50% ownership are generally aggregated to calculate the $1 billion adjusted book income threshold. A US corporation that is a member of a foreign-parented group will only be an applicable corporation if the group’s average AFSI is $1 billion or more and the average adjusted book income of the US corporations of the group, together with any effectively connected income of the foreign corporations (as reflected for AFSI purposes), is $100 million or more. Once a corporation becomes an applicable corporation subject to the corporate minimum tax, it remains an applicable corporation (subject to certain exceptions) even if the income test is no longer met in subsequent years. For corporations in existence for less than three years, the minimum tax will be based on the earnings in the years of existence. The corporate minimum tax excludes Subchapter S corporations, RICs, and REITs. It has been estimated that the new provisions will apply to about 150 companies and are expected to raise $313 billion in taxes over 10 years.2
When applicable, the corporate minimum tax for a particular year would be the greater of the amounts computed under the regular US corporate federal income tax or the corporate minimum tax. The corporate minimum tax is generally equal to 15% of the corporation’s AFSI. Book profits are the profits that corporations are required to report publicly to shareholders and potential investors and are often much larger than the profits they report to the IRS for tax purposes. Taxpayers are generally allowed to credit the corporate minimum tax paid in a prior year against their regular tax liability in a future year to the extent the regular tax liability exceeds the amount of its minimum tax for the future year.
Because the corporate minimum tax effectively focuses on book income (subject to several adjustments) rather than taxable income, deductions that may have been available in computing a corporation’s regular US tax liability may be effectively denied in computing book profits, potentially resulting in higher overall US corporate federal income tax liabilities.
As a result of the corporate minimum tax being based on financial, rather than tax, accounting principles, the law creates several new concepts that taxpayers will need to adapt to. These include the concepts of “adjusted financial statement income” or “AFSI” and new definitions and standards for determining an “applicable corporation” that is subject to the corporate minimum tax. As noted, AFSI starts with the income reported on the taxpayer’s financial statements (e.g., SEC Form 10-K or other Annual Report) and can be reduced by newly defined “financial statement net operating losses,” depreciation allowances (significantly, tax —and not financial statement—depreciation with respect to tangible property is used to calculate AFSI), and certain general business credits under Section3 38 (subject to limitations), including the R&D credit.
Other than the specific adjustments provided in the statute, AFSI would not take into account provisions applicable in the calculation of the regular income tax (e.g., Section 163(j) limitations on interest deductions, Section 382 limitations on loss carryforwards).
If the applicable corporation is a US shareholder of one or more controlled foreign corporations (“CFCs”), the AFSI will not include the Subpart F or GILTI inclusions of the applicable corporation or any dividends received from the CFCs. Rather, the AFSI will include the applicable corporation’s pro rata share of the CFCs’ income and expense items, adjusted under rules similar to those applicable in determining AFSI. If the aggregate CFCs’ result is negative for a taxable year, the AFSI is not reduced by that negative CFC adjustment, but, rather, the CFC loss is carried forward and may reduce a positive CFC adjustment in a future year. The applicable corporation will also be entitled to a “corporate AMT foreign tax credit” with respect to foreign taxes paid or accrued by the applicable corporation or its CFCs. For US groups with low-taxed foreign operations, the alternative minimum tax may result in a higher US tax bill: the rate of tax will now be 15% instead of the 10.5% rate on GILTI under the regular income tax.
A last-minute change in the legislation removed the aggregation of income of separate corporations owned by the same investment fund or partnership, providing relief for private equity funds and their portfolio companies.
The new corporate minimum tax will be particularly onerous to companies with significant stock-based compensation and research and development expenses as these items often create the most significant book/tax differences. In addition, only book losses from 2020 and later years may be taken into account and then only to offset up to 80% of book income. Book losses may be carried forward but may not be carried back. Book losses are not taken into account for purposes of the $1 billion and $100 million income tests used in determining whether a corporation is an applicable corporation.
This new corporate minimum is effective for tax years beginning after December 31, 2022. Therefore, taxpayers will need to adjust quickly to the imposition of this new tax.
The Stock Repurchase Excise Tax
Distributions and stock buybacks are both ways that corporations transfer profits to shareholders. Shareholders typically pay income tax on corporate distributions. Stock buybacks, on the other hand, are intended to increase the stock price while not immediately resulting in income (to the non-selling shareholders). The 1% excise tax will reduce, but not eliminate, this advantage.
The IRA’s 1% excise tax on certain corporate stock repurchases is effected through the creation of a new Chapter 37 and corresponding Section 4501 in the Internal Revenue Code. The excise tax is imposed on “Covered Corporations” repurchasing their shares directly or through a “Specified Affiliate.” A “repurchase” is defined as a “redemption” under Section 317(b) (i.e., an acquisition by a corporation of its own stock from its shareholders in exchange for property) or any transaction determined by the IRS to be “economically similar” to a redemption.
The tax is generally equal to 1% of the fair market value of the stock repurchased by the Covered Corporation or the Specified Affiliate. However, there is an offset rule under which the fair market value of the repurchased stock is reduced by the fair market value of any stock issued by the covered corporation during the same taxable year.
A Covered Corporation is any US corporation publicly traded on an established securities market. A Specified Affiliate is (a) any corporation whose stock, as determined by vote or value, is directly or indirectly owned more than 50% by the Covered Corporation or (b) a partnership whose capital interest or profits interest is directly or indirectly owned more than 50% by the Covered Corporation. The excise tax is not deductible for federal income tax purposes. The Covered Corporation (not the stockholder or the Specified Affiliate) pays the tax.
The excise tax does not apply under several circumstances: (a) if the stock buyback is part of a nontaxable corporate reorganization qualifying under Section 368(a) where no gain or loss is recognized; (b) if the repurchased stock, or any amount equal to the repurchased stock, is contributed to an employer-sponsored retirement plan, employee stock ownership plan, or similar plan; (c) if the total value of the repurchased stock in a taxable year does not exceed $1 million; (d) if the repurchase is by a securities dealer in its ordinary course of business; (e) if the repurchase is by a RIC or a REIT; or (f) if the repurchase qualifies as a dividend for federal income tax purposes.
It is worth noting that the scope of the excise tax may extend beyond public company share buyback programs and could potentially apply to other corporate transactions, especially in light of the regulatory authority granted to the IRS to extend its application to transactions that are “economically similar” to a redemption. It is not clear that this result was intended in all cases. For example:
- Preferred stock redemptions: There is no exception for repurchased stock that is not publicly traded. Therefore, the repayment at maturity of non-publicly traded stock of a Covered Corporation would be subject to the excise tax, even in the case of mandatorily redeemable preferred stock that had been issued prior to the effective date of this provision. The statute contemplates a grant of regulatory authority to the IRS to “address special classes of stock and preferred stock,” so it is conceivable some relief may be afforded in regulations.
- LBO transactions: The excise tax may also affect certain common leveraged buyout (“LBO”) structures that involve a deemed stock redemption for tax purposes. In a typical LBO structure, a buyer company forms a transitory merger subsidiary for purposes of acquiring the target corporation through a reverse cash merger. The buyer company contributes cash to the merger subsidiary, and the merger subsidiary also borrows additional cash from a third-party lender. The merger subsidiary then merges into the target corporation with the target corporation surviving, and the target shareholders receive cash consideration for their target stock in an amount equal to the cash contributed by the buyer company plus the loan proceeds from the third-party borrowing. Because the merger subsidiary is disregarded as transitory for tax purposes, the target company is treated as having borrowed the third-party debt and distributed the loan proceeds to its shareholders in redemption of a portion of their target stock. If the target company is a Covered Corporation, it appears the excise tax may apply.
- Tax-free reorganizations with boot: Under case law and IRS guidance, when a corporation acquires the stock or assets of another corporation in a tax-free reorganization in part for shares and in part for cash, the transaction is generally characterized as (1) first, all of the target shareholders exchange their target stock solely for stock of the acquiring corporation and (2) then, the acquiring corporation redeems a portion of the acquiring corporation stock received by the target shareholders for cash. See Comm’r v. Clark, 489 U.S. 726 (1989);Rev. Rul. 93-61, 1993-2 C.B. 118. The redemption in (2) is treated as redemption for tax purposes so long as it is not characterized as a dividend under Section 302. In such case, it is unclear whether the excise tax would apply and under what circumstances (e.g., is the relevant determination whether the acquiring or the target company is a Covered Corporation?).
- SPAC redemptions: A special purpose acquisition company (“SPAC”) often redeems some of its shareholders in connection with the de-SPAC transaction. For a domestic SPAC, that redemption would be subject to the excise tax. The cost of the excise tax may be mitigated under the offset rule given that, contemporaneously with the redemption, the SPAC will also often issue new shares for the private investment in public equity (“PIPE”).
- Split-off transactions: In a tax-free split-off transaction, the parent corporation exchanges stock of a controlled subsidiary in exchange for a portion of the parent corporation’s outstanding stock. This exchange is technically a redemption. Although the split-off is generally undertaken in connection with a tax-free divisive “D reorganization,” it is unclear whether this exchange of parent stock for subsidiary stock should be considered part of the reorganization so as to benefit from the statutory exception to the excise tax.
This new excise tax applies to repurchases that occur after December 31, 2022. As part of the IRA, Treasury has been granted authority to promulgate regulations to carry out the purpose of the new excise tax and to prevent its avoidance.
Given the numerous new concepts introduced in the Internal Revenue Code by the IRA, including basing the corporate minimum tax on book income rather than taxable income, regulations and other guidance to be issued by the IRS and Treasury will play a central role in determining how the new corporate minimum tax and the new excise tax will actually be implemented. The compliance burden for large corporations continues to increase. Some taxpayers may have to calculate regular federal income tax, a separate BEAT liability, the corporate minimum tax, and any liabilities under the OECD’s “Pillar Two” rules while navigating the coordination between each of these regimes (e.g., is the corporate minimum tax a CFC Tax Regime for Pillar Two purposes?). Tax professionals may also have to become experts in financial accounting to build the bridge between tax and accounting that the corporate minimum tax will require. Taxpayers should be prepared to participate in the rulemaking process in order to influence how the many details that need to be filled in via the regulatory process are finalized.
1 Also discussed in the Mayer Brown Legal Updates “US Inflation Reduction Act of 2022: Carbon Capture Use and Sequestration Provisions” (August 22, 2022), “Offshore Wind and the US Inflation Reduction Act” (August 19, 2022), “The US Inflation Reduction Act, Solar and REITs” (August 17, 2022), “The Green Energy Tax Incentives of the Inflation Reduction Act of 2022” (August 2, 2022), and “US Inflation Reduction Act Includes Changes to Carried Interest Taxation” (August 2, 2022) and the Tax Equity Times Blog post “Manchin’s BBB Redux-tion Act – The Inflation Reduction Act of 2022” (July 28, 2022).