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Surprises And Questions Around The New Stock Buyback Tax – Tax Authorities


One of the headline tax changes in the Inflation Reduction Act
of 2022, Public Law 117-169, is a 1% excise tax on stock
repurchases by public companies. Public issuers should be aware
that the new tax, which applies beginning January 1, 2023, extends
broadly to situations beyond run-of-the-mill share repurchases, and
the provision for netting new issuances against repurchases can
operate in unexpected ways. Companies should analyze the potential
application of this tax to any transaction involving the purchase,
exchange, or transfer of their stock. Our tax specialists are
available to evaluate and to advise on mitigation strategies.

Technical Scope of the Excise Tax

Code Section 4501, applies a non-deductible 1% excise tax to the
fair market value of net stock repurchases by certain publicly
traded corporations that take place after December 31, 2022.

Corporations Subject to the Tax

The excise tax applies to U.S. corporations whose stock is
traded on an established securities market (“covered
corporations”).1 Repurchases of stock of a covered
corporation by a “specified affiliate” of such covered
corporation are treated as repurchases by the covered corporation
itself, with the resulting tax imposed on the covered corporation.
A “specified affiliate” is a corporation or partnership
that is majority owned, directly or indirectly, by the covered
corporation.2

The excise tax may also apply to the repurchase of stock of a
non-U.S. corporation whose stock is traded on an established
securities market, if the stock is repurchased by a specified
affiliate that is organized in the U.S. (or a specified affiliate
that is a foreign partnership that has one or more direct or
indirect U.S. partners). In such cases, the excise tax is imposed
on the specified affiliate as if it were a U.S. corporation that
repurchased its own stock.

Finally, the excise tax applies to repurchases of stock
by—or by specified affiliates of—a non-U.S. corporation
that was the acquirer in a so-called “inversion
transaction”3 occurring after September 20, 2021,
if the corporation’s stock is traded on an established
securities market and if the repurchase occurs during the 10-year
period for which Section 7874 of the Code applies with respect to
the inversion. In such cases, the excise tax is imposed on the U.S.
target of the inversion transaction4 as if it had
repurchased its own stock.

Taxable Repurchases and Netting

Section 4501(c)(1) broadly defines “repurchase” to
include any acquisition of a covered corporation’s stock by
such corporation or a specified affiliate for money, securities or
any other property (other than stock of the covered corporation)
and any transaction determined by the Secretary of the Treasury to
be economically similar to such a transaction. The Treasury
Department and the Internal Revenue Service will need to issue
guidance as to the types of transactions that will be treated as
“economically similar” to repurchases.

In determining the amount of repurchases subject to the excise
tax, a covered corporation is allowed to reduce the fair market
value of its repurchases by the fair market value of any stock that
the covered corporation issued during the same tax year. The amount
of this reduction includes the fair market value of stock issued to
employees of the covered corporation or of a specified affiliate
during the tax year, including stock issued on the exercise of
compensatory stock options.

However, the netting provision is strictly limited in the case
of repurchases involving a non-U.S. public company: because the tax
in that case is imposed on the specified affiliate involved in the
repurchase (or in the case of an inversion transaction, on the
inverted U.S. subsidiary), the only issuances taken into account
are those to employees of the specified affiliate (or of the
inverted U.S. subsidiary).

Repurchases Not Subject to the Excise
Tax

Section 4501(e) provides a number of exceptions to the
application of the excise tax. The tax will not apply

  • to the extent the stock repurchase is part of a
    “reorganization,” as defined in Section 368(a) of the
    Code, in which no gain or loss is recognized by shareholders;

  • if the repurchased stock (or stock of equal value) is
    contributed to an employer-sponsored retirement plan, employee
    stock ownership plan, or similar plan;

  • to the extent the repurchase is treated as a dividend under the
    Code;

  • when the total value of the stock repurchased in a tax year is
    $1,000,000 or less;

  • to repurchases by regulated investment companies (mutual funds
    and most ETFs) or real estate investment trusts;

  • to the extent provided in regulations, to repurchases in the
    ordinary course of business by dealers in securities.

Unanticipated Breadth of the Excise Tax and Outstanding
Questions

As noted above the excise tax under Section 4501 is not limited
to traditional stock buybacks by public companies. Because the tax
applies to any acquisition of stock from a stockholder in exchange
for money or other property (other than stock of the covered
corporation itself), it would apply by its terms to, among other
transactions:

  • Certain M&A transactions, particularly those in which the
    consideration paid to target stockholders is treated for tax
    purposes as flowing from the target corporation;

  • Cash paid for fractional shares or in satisfaction of
    dissenters’ rights in M&A transactions;

  • Split-off transactions in which stock of a subsidiary is
    distributed to some stockholders in exchange for a reduction in
    their proportionate holdings of parent company stock;

  • De-SPAC transactions in which shareholders exercise redemption
    rights; and

  • Redemptions or repayment at maturity of non-publicly traded
    securities such as preferred stock.

Both the scope of the tax and the application of the netting
provisions raise questions that the Treasury Department and the
Internal Revenue Service may wish to address in administrative
guidance interpreting Section 4501.

The ostensible purpose of the excise tax is to reduce
traditional buybacks, in which a public company, either through a
tender offer or open market purchases, uses available cash to
repurchase some of its outstanding stock, reducing its
“float,” or shares available for public trading. There
are two principal economic criticisms that policy makers have
advanced as reasons for discouraging buybacks. First, policy makers
and others have argued that buybacks prioritize investor returns
over investments in labor and tangible assets. Second, because
buybacks typically increase per-share prices even without a
concomitant increase in earnings, they have been criticized as a
“market manipulation” that can unjustly benefit
executives who have received substantial equity
compensation.5 Whatever the merits of those economic
criticisms, they are directed specifically at cash buybacks of
publicly traded shares, and they do not provide a justification for
taxing the other types of corporate transactions that come within
the scope of Section 4501’s very broad definition of a stock
repurchase.

Potential Application to M&A
Transactions

For instance, a corporate acquisition in which a purchaser takes
a public company private may be structured in one of two ways: (a)
in a manner that is treated for tax purposes as a redemption by the
public company of its outstanding stock and an issuance of new debt
and equity to the purchaser or (b) in a manner that is treated as a
purchase of the public company’s stock by a new private company
owned by the purchaser.

If the purchaser adopts the first type of structure, the cash
flowing to the former stockholders of the acquired company
(including both holders of publicly-traded shares and any persons
holding non-traded, privately placed stock of the company) would be
treated as a repurchase potentially subject to the excise
tax.6 This type of transaction would not appear to raise
concerns similar to those that have been raised about stock
buybacks. The acquired company will continue to operate its
business and to retain all of the same working capital that it held
prior to the transaction; the transaction may even augment the
resources available for investment in the business. And there is no
potential for stock price manipulation, since the stock of the
target company will no longer be publicly traded after the
transaction. But, in the absence of administrative guidance to the
contrary, such a transaction would be subject to excise tax on the
same terms as a buyback. And this is true even though the tax
clearly does not apply to the alternative form of the same
transaction in which a new private company is treated as buying the
stock of the acquired company.

Along similar lines, it is possible for certain forms of
public-public M&A transactions to be treated for tax purposes
as involving a redemption of stock by the target company, either
for cash, for stock of the acquiring company, or for a combination
of the two. If such a transaction is structured as a tax-free
reorganization and all of the consideration is common stock of the
acquiring company, then any repurchase of the target’s shares
that is deemed to occur is exempt from the excise tax under the
exception for Code Section 368 reorganizations. The situation is
less clear, however, if any consideration is paid to the target
shareholders in the form of cash, non-qualified preferred stock, or
other so-called “boot.” Does the exception under Section
4501(e)(1) “to the extent that” a repurchase is part of a
reorganization and no gain or loss is recognized apply to the
portion of the consideration paid in qualifying stock, while the
boot is subject to excise tax? Or does the exception not apply at
all, because the recognition of any gain or loss in the transaction
takes it outside the scope of the exception?

The excise tax treatment of an M&A transaction should not
depend (1) on whether the parties adopt a form that the tax law
treats as a redemption rather than as a purchase of target stock by
the buyer or (2) on whether all or any portion of the transaction
qualifies for nonrecognition under Section 368. As with the
“going private” purchase, this sort of M&A
transaction does not by its nature raise concerns about
manipulating the market in the target company’s shares or about
depleting the assets available to invest in the target
company’s business, and it does not make sense to treat it as
equivalent to a standalone stock buyback.

Even in a Section 368 reorganization that is not otherwise
treated as a redemption for tax purposes, there is some question as
to whether the payment of boot may be treated as a redemption in
the case of a stockholder who receives only boot. If treated as a
repurchase by a public target company, the payment of boot to such
stockholders would then be subject to the excise tax, even though
it does not originate from the target company and is economically
equivalent to the payments received from the acquiring company by
other stockholders whose payments are not subject to the tax.

Finally, regardless of the structure adopted for an M&A
transaction, two types of cash payments that typically receive
little attention may be subject to the excise tax even though they,
like the transaction as a whole, do not raise the considerations
attendant to stock buybacks. The first is the payment of cash to
stockholders of a public acquired company who exercise dissent or
appraisal rights under applicable corporate law. The second is the
payment—in transactions where some or all of the
consideration for an acquisition is paid in the form of stock of a
public acquiring company—of cash in lieu of fractional shares
that would otherwise need to be issued in order to distribute the
consideration to the stockholders of the acquired company on a pro
rata basis. Since payments to dissenters are treated for tax
purposes as redemptions by the acquired company and cash in lieu of
fractional shares is treated for tax purposes as a redemption by
the acquiring company, such payments would be subject to the excise
tax if, in combination with any other repurchases during the same
year, they exceed the $1 million threshold under Section 4501.

Inconsistent Application to Corporate
Split-Offs

Public split-off transactions, that is, distributions of stock
of a corporate subsidiary in which some shareholders participate
(receiving subsidiary stock in exchange for some of their parent
company stock) and others do not, are subject to similar arbitrary
distinctions under new Section 4501. By their nature, these
transactions cannot raise the same concerns as cash stock buybacks,
since no cash is leaving the company and the impact on stock price
depends on factors relevant to the underlying business and how it
is divided between the two resulting companies, not on a reduction
in float. They accordingly should not in principle be subject to
the excise tax. However, the tax likely will apply to some
split-offs in the absence of favorable administrative guidance.

A split-off that is taxable (i.e., treated for income tax
purposes as a taxable exchange of subsidiary stock for parent
stock) will be subject to tax under the literal terms of Section
4501 except in the very unusual case that it is treated in its
entirety as a dividend. A split-off that is tax-free under Section
355 of the Code could qualify for the exception for Section 368
reorganizations if the parent company forms a new subsidiary in
connection with the split-off.7 But a tax-free split-off
of an existing subsidiary generally would not qualify for that
exception, and there is no separate exception for transactions
described in Section 355. And if such a transaction were structured
as a pro-rata spinoff of the subsidiary, rather than a split-off,
it generally would not be subject to the excise tax. There is no
apparent justification for these distinctions in treatment among
transactions that are economically similar to one another and
economically distinct from the buyback transactions that are the
intended object of the excise tax.

Repurchases Pursuant to the Terms of An Instrument
— SPAC Initial Combinations and Preferred
Stock

Redemptions in de-SPAC transactions and repurchases of preferred
stock (either at scheduled retirement or pursuant to integrated
redemption rights) raise yet another issue in the application of
the excise tax. Although these transactions do resemble traditional
repurchases in that cash leaves the issuing company, they differ in
that they take place under the terms of the very instruments under
which that cash came into the company in the first place. As a
result, such redemptions arguably should never be treated as a
reduction in corporate capital of the type that the excise tax is
meant to discourage, since the redemption provisions were one of
the terms on which the capital was originally raised. For this and
the reasons discussed below, the Treasury Department and the
Internal Revenue Service may wish to limit or clarify the
application of the excise tax to such redemptions in administrative
guidance under Section 4501.

A “SPAC,” or special purpose acquisition company, is a
corporation that issues publicly-traded stock to raise capital with
which to undertake a corporate acquisition. One of the terms of
that stock, in some cases, is that stockholders of the SPAC who do
not approve of the acquisition that is ultimately completed (the
initial business combination or “de-SPAC” transaction)
are entitled to have their capital returned by the SPAC at the time
of the acquisition. The right to receive those funds, by electing
to have the SPAC redeem the stockholder’s Class A shares, is
part of the terms on which the SPAC raises capital, and is
economically distinct from buybacks that are initiated by a public
company itself.

Such redemptions are covered by the definition of repurchase
under Section 4501 even though they do not raise the concerns that
accompany typical stock buybacks. The redemptions do not affect the
SPAC’s ability to pay wages or make other business investments
because by definition the SPAC does not conduct its own
business.8 And, since the redemptions occur at the
option of the stockholders, not based on a decision by SPAC
management, they do not raise concerns about stock price
manipulation.

Similarly, when a corporation raises funds by issuing preferred
stock, the terms of that stock may provide for its retirement
according to a set schedule or pursuant to redemption options on
the part of the holder or the issuer.9 Because those
terms are a condition of raising capital, it is not appropriate to
treat the resulting repurchases as a voluntary reduction in capital
by the issuer subject to the Section 4501 excise tax. They are more
comparable to payments upon the early retirement or maturity of
debt securities, which are clearly outside the scope of Section
4501. In addition, in many cases (and similarly in this respect to
redemptions in a de-SPAC transaction), these repurchases do not
have a predictable impact on public share prices and—at least
in the case of scheduled retirements and redemptions at the option
of the holder—are not even under the control of
management.

Issues Regarding Application of the Netting
Rule

As noted above, Section 4501 contains a netting rule under which
issuances of stock by a covered corporation are netted against
repurchases by the corporation that take place in the same tax
year. The rule is drafted, however, in a way that does not always
accomplish its purpose and may lead to unexpected results.

First, under the terms of the statute, netting is not permitted
across tax years. As a result, if a company were to issue stock and
repurchase stock as part of a single transaction, but the issuance
and the repurchase occurred in different tax years (even if
separated only by a short period in absolute terms), it appears
that netting would not be permitted. Similar considerations apply
to a repurchase paired with the issuance of convertible debt, where
the conversion of the debt, while anticipated, will typically occur
outside of the tax year in which the issuance and repurchase occur.
This limitation undermines the apparent purpose of the netting
provision and the Treasury Department and the Internal Revenue
Service may wish to consider guidance addressing the application of
the netting rule to integrated or otherwise related
transactions.10

Second, even when issuances and redemptions occur in the same
tax year, netting under Section 4501(c)(3) is based on the value of
stock issued and repurchased, not based on the number of shares.
Changes in the stock prices may therefore cause a tax to be
incurred in transactions where a share issuance is paired with a
repurchase of the same number of shares, such as antidilution
buybacks in connection with equity compensation and stock-settled
call spread or capped call arrangements in connection with
convertible debt, unless all settlements take place at exactly the
same price (or at least on the same date).

Third, it is not 100% clear that the issue of new shares under
the terms of a convertible debt instrument even qualifies as an
issuance eligible for netting under Section 4501(c)(3). Income tax
authorities are inconsistent on the question of whether the
conversion of debt to stock pursuant to its terms is treated as an
exchange of the debt for stock or a continuation of the same
security in a new form. As a policy matter, debt conversions ought
to qualify for netting, since they have the effect of increasing
the issuer’s net worth and outstanding share capital, and
guidance to that effect would be helpful.

Finally, the statute is not clear as to the application of the
$1 million threshold in situations involving netting. As described
above, the statute provides that the excise tax will not apply when
“the total value of the stock repurchased during the taxable
year does not exceed” $1 million. The netting provision
reduces the amount “taken into account” with respect to
stock that is repurchased by the value of the covered
corporation’s stock issuances. Without further guidance, it is
not clear how the statute applies if a covered corporation’s
gross repurchases exceed $1 million, but its net repurchases do
not.

Conclusion

Ironically, while some analysts are suggesting that an excise
tax at a rate of 1% may not effectively discourage the cash
buybacks that were the intended target of the legislation’s
sponsors, the new tax may well impede or require the restructuring
of other types of corporate transactions, even though those
transactions seem to be outside its intended scope.

Public companies should carefully consider the potential
application of Section 4501 to any transaction involving the
purchase, exchange, or transfer of their stock, and should
establish procedures to account for issuances and redemptions in a
manner that will facilitate year-end compliance. Companies may also
wish to consider the timing of planned transactions in light of the
statute’s January 1, 2023 effective date.

Footnotes

1. “Established securities market” is defined
by reference to Section 7704(b)(1) of the Code, and includes
national securities exchanges such as the Nasdaq Stock Market,
certain foreign securities exchanges, and regional or local
exchanges. Although the statute is not explicit on the point, it
would appear that a publicly traded partnership that is taxed as a
corporation under the Code will be treated as a corporation for
purposes of the excise tax.

2. The relevant thresholds for majority ownership are
ownership of more than 50% of the stock of a corporate specified
affiliate or more than 50% of the capital interests or profits
interests of a partnership specified affiliate.

3. I.e., an entity that is a “surrogate foreign
corporation” under Section 7874(a)(2)(B) of the
Code.

4. I.e., the entity that is the “expatriated
entity” under Section 7874(a)(2) of the Code.

5. Some observers also criticize the income tax rules
that may allow stockholders selling shares in a buyback to recover
their tax basis in those shares before realizing gains, by contrast
to a taxable dividend, which is taxed without any recovery of
basis. However, the tax law already has a set of rules under
Section 302 of the Code that are designed to decide whether a
particular stock repurchase is similar enough to a dividend that it
should be taxed as such.

6. The tax liability may be reduced, under Section
4501’s netting rule, by the value of stock treated as issued by
the target company to the purchaser, subject to the limitations on
that rule that are noted below.

7. Tax-free spinoffs involving a new subsidiary typically
constitute reorganizations described in Code Section
368(a)(1)(D).

8. The redemptions may or may not affect the assets
available for pursuit of the target company’s business,
depending on whether the de-SPAC transaction has been structured to
capitalize the target company as well as to acquire it, or only to
consummate the acquisition.

9. Preferred share classes frequently are not publicly
traded, but the excise tax under Section 4501 is not limited to
publicly traded share classes so long as the issuer has any class
of stock that is traded on an established securities market.
Similar considerations to those discussed here apply to
non-publicly-traded common share classes that may be subject to
redemption rights.

10. Such guidance might also apply the netting rule to
redemptions that occur pursuant to the terms of a stock instrument,
such as the scheduled preferred stock retirements and de-SPAC
redemptions discussed above.

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.



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