On December 27, 2022, the US Treasury Department and the Internal Revenue Service (“IRS”) issued Notice 2023-2 (the “Notice”), which provides taxpayers interim guidance (until regulations are issued) on how the new 1% excise tax on stock-buybacks will be imposed and administered. The new 1% excise tax was enacted last summer as part of the Inflation Reduction Act of 2022 (“IRA”) and generally applies to any US corporation whose stock is traded on an established securities market and that repurchases more than $1 million of stock over the course of a tax year (a “covered corporation”). Taxpayers may rely on the Notice pending the issuance of proposed regulations.
The Notice clarifies that, for purposes of the stock repurchase excise tax, a repurchase means solely a redemption under § 317(b) of the Internal Revenue Code (the “Code”)1 (with several exceptions discussed below) or an “economically similar transaction.”2
The following redemptions will not be treated as repurchases for the purposes of the excise tax:
- If § 304(a)(1) (acquisitions by related corporations, other than an acquisition by a subsidiary) applies to an acquisition of stock by an acquiring corporation, the acquiring corporation’s deemed distribution in redemption of its stock will not be considered a repurchase for purposes of the excise tax.
- Payments by a covered corporation of cash instead of a fractional share will not be considered a repurchase if (i) the payment is part of a qualified reorganization under § 368(a) or of a distribution of stock and securities of a controlled corporation to which § 355 applies or pursuant to the settlement of an option or a similar financial instrument (for example, a convertible bond or convertible preferred share), (ii) the cash distributed to the shareholder entitled to the fractional share is not separately bargained-for-consideration, (iii) the payment was not made for tax reasons but rather due to administrative necessity, and (iv) the amount of cash paid to the shareholder does not exceed the value of one full share of the stock of the covered corporation.
The following transactions are considered to be economically similar transactions to a repurchase:3
- Acquisitive reorganizations: In the case of an acquisition of a target corporation that is a covered corporation or a covered surrogate foreign corporation (as defined in § 7874(a)(2)(B)) in an acquisitive reorganization, the exchange by the target shareholders of their target corporation stock as part of the acquisitive reorganization will be considered a repurchase by the target corporation.
- “E reorganizations”: In a recapitalization of a covered corporation or a covered surrogate foreign corporation that qualifies as an E reorganization, the exchange of shares by the shareholders as part of the E reorganization will be considered a repurchase by the corporation.
- “F reorganizations”: Where the transferor corporation is a covered corporation or a covered surrogate foreign corporation, the exchange by the transferor corporation shareholders of their transferor corporation stock as part of the F reorganization will be considered a repurchase by the transferor corporation.
- Split-offs: In the case of a split-off by a distributing corporation that is a covered corporation or a covered surrogate foreign corporation, the exchange by the distributing corporation shareholders of their distributing corporation stock for controlled corporation stock and, if applicable, other property (including securities of the controlled corporation) or money will be a repurchase by the distributing corporation.
- Certain § § 331/332 “overlap” complete liquidations: In the case of a complete liquidation of a covered corporation or a covered surrogate foreign corporation to which both § § 331 and 332(a) apply,4 then the distribution subject to § 331 is treated as a repurchase and the distribution subject to § 332(a) is not treated as a repurchase.
Importantly, for the first four categories above, the fair market value of any stock repurchased may be reduced (or eliminated altogether) if certain requirements are met (see discussion below under “Timing, Fair Market Value and the Qualifying Property Exception”), thus possibly excluding these transactions from the scope of the excise tax.
The following transactions are not considered to be economically similar transactions to a repurchase:5
- Complete liquidations: A distribution in complete liquidation of a covered corporation or a covered surrogate foreign corporation to which either § § 331 or 332(a) apply is not a repurchase by the covered corporation or the covered surrogate foreign corporation.
- Divisive transactions under § 355 other than split-offs: A distribution by a distributing corporation of stock of a controlled corporation qualifying under § 355 that is not a split-off will not be considered a repurchase (whether or not the distribution is part of a divisive “D reorganization”).
Acquisitions of Certain Foreign Corporation Stock
If a domestic affiliate corporation of a foreign corporation whose stock is traded on an established securities market acquires stock in the foreign corporation, then the domestic corporation will generally be treated as a "covered corporation" for the purposes of the acquisition and the acquisition will be treated as a repurchase of stock by the covered corporation.
Moreover, the Notice indicates that a domestic affiliate corporation is treated as acquiring foreign corporation stock if the domestic affiliate “funds” the acquisition or repurchase of the foreign corporation stock and this funding is undertaken for a principal purpose of avoiding the stock repurchase excise tax. Additionally, a principal purpose is deemed to exist if the domestic affiliate corporation funds the foreign corporation (by any means other than through distributions) and the foreign corporation acquires or repurchases stock within two years of the funding.
Timing, Fair Market Value and the Qualifying Property Exception
The Notice also provides for timing and valuation guidance on the repurchased stock. Generally, stock is treated as repurchased at the time at which ownership of the stock transfers to the covered corporation or to the applicable acquiror. The fair market value of the stock is determined by the market price of the stock on the date it is repurchased. If the repurchased stock is traded on an established securities market, the market price must be determined by consistently applying one of four specified methods (daily volume-weighted average price, closing price, average of high and low prices, or trading price at the time of repurchase) to all repurchases throughout the covered corporation's taxable year. If the repurchased stock is not traded on an established securities market, the market price is determined under certain § 409A principles.6
The Notice describes exceptions to the general rules for determining the timing and fair market value of repurchased stock. The fair market value of repurchased stock may be reduced for purposes of computing the covered corporation's stock repurchase excise tax base if the repurchase is for property permitted to be received without recognition of gain or loss under § § 354 or 355 and is part of an acquisitive reorganization, an E reorganization, an F reorganization, or a split-off (whether or not the split-off is part of a divisive “D reorganization”) (the “qualifying property exception”). Therefore, in a tax-free reorganization with boot, while the boot component would still be subject to the excise tax, the qualifying property exception will still be available with respect to the stock consideration.
If a covered corporation repurchases stock and contributes the stock or an equivalent amount of stock to an employer-sponsored retirement plan, the fair market value of the repurchased stock may be reduced for purposes of computing the stock repurchase excise tax base. The amount of the reduction is based on whether the contributed stock is of the same class as the repurchased stock or a different class. The reduction in the stock repurchase excise tax base applies for stock contributions made during or on account of the covered corporation's taxable year. In addition, the fair market value of repurchases may be reduced for repurchases by dealers in securities in the ordinary course of business and repurchases by RICs and REITs.
If a covered corporation repurchases stock and the repurchase is treated as a distribution of a dividend under § § 301(c)(1) or 356(a)(2), the fair market value of the repurchased stock may be reduced for purposes of computing the covered corporation's stock repurchase excise tax base. There is a rebuttable presumption that a repurchase that is subject to § § 302 or 356(a) is not eligible for this exception, but the covered corporation may rebut this presumption by providing sufficient evidence that the shareholder treated the repurchase as a dividend on their federal income tax return. This evidence includes information reporting, certification from the shareholder, and demonstration that the covered corporation has sufficient earnings and profits to treat the distribution or receipt of money or other property as a dividend.
The Netting Rule
The netting rule reduces the stock repurchase excise tax base for the taxable year by the aggregate fair market value of the covered corporation's stock that was either (a) issued or provided to employees of the covered corporation or employees of a specified affiliate during the covered corporation's taxable year or (b) issued by the covered corporation to persons other than employees of the covered corporation or a specified affiliate during the covered corporation's taxable year. The netting rule applies to any arrangement where stock is issued or provided to an employee of a covered corporation or of a specified affiliate as compensation for services performed as an employee (including transfers of stock under § 83 or pursuant to a stock option described in § 421).
Under the netting rule, the fair market value of stock issued or provided to employees is determined as of the date the employee is treated as the beneficial owner of the stock for federal income tax purposes. This is generally the date that the stock is transferred to the employee and is substantially vested within the meaning of § 83. Stock transferred that is not substantially vested is not treated as issued or provided to the employee until it vests, except in certain circumstances, such as when the employee makes a valid election under § 83(b).
There are certain circumstances in which an issuance of stock is disregarded for purposes of the netting rule, including stock splits, issuances to a specified affiliate, stock issuances that qualify for the qualifying property exception described above (given that these issuances already reduce the excise tax base under such exception), deemed issuances under § 304(a)(1), fractional shares deemed to be issued, stock issued by a covered corporation that is a dealer in securities, and stock issued by the target corporation in a transaction qualifying under § 368(a)(2)(E).
The Notice provides that the stock repurchase excise tax must be reported on Form 720 (Quarterly Federal Excise Tax Return). To facilitate the computation of the excise tax, the IRS also intends to issue an additional form that taxpayers will be required to attach to Form 720. Although Form 720 is filed quarterly, the Treasury Department and IRS expect the forthcoming proposed regulations to provide that the excise tax will be reported once per taxable year on the Form 720 that is due for the first full quarter after the close of the taxpayer’s taxable year. For example, a taxpayer with a taxable year ending on December 31, 2023, would report its stock repurchase excise tax on Form 720 for the first quarter of 2024, due on April 30, 2024. The Treasury Department and the IRS expect the forthcoming proposed regulations to provide that the deadline for payment of the excise tax is the same as the filing deadline and that no extensions are permitted for reporting or paying the excise tax owed.
Examples and Request for Comments
Several examples in the Notice describe other transactions that may or may not be subject to the stock repurchase excise tax. In an example on the treatment of leveraged buyouts or acquisitions partially funded by a target corporation, the target was treated as borrowing a portion of the acquisition proceeds from a lender and using those proceeds to redeem its stock from the target’s shareholders. Therefore, the redemption is a repurchase subject to the excise tax.
In another example, the Notice describes a redemption of mandatorily redeemable preferred stock and characterizes it as a repurchase because the covered corporation redeemed an instrument that is considered stock for tax purposes (the preferred stock) and the redemption was a § 317(b) redemption. The Notice does not describe any current exception for preferred stock redemptions, regardless of whether the preferred stock was issued prior to the IRA or was itself traded on an established securities market. The Treasury Department and the IRS are requesting comments on whether there are certain circumstances under which special rules should be provided specifically for redeemable preferred stock. Similarly, the Notice solicits comments on whether special rules should be provided for repurchases of options or other financial instruments, among other open issues.
1 Unless otherwise noted, all Section references are to the Code.
2 Section 317(b) states “stock shall be treated as redeemed by a corporation if the corporation acquires its stock from a shareholder in exchange for property, whether or not the stock so acquired is cancelled, retired, or held as treasury stock.”
3 The Notice describes this as an exclusive list.
4 A § 332(a) liquidation generally applies to a corporate shareholder that owns at least 80% of the liquidating corporation. § 331 applies to any complete liquidation of a corporation.
5 The Notice describes this as a nonexclusive list.