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April 19, 2024

Nelson Mullins Tax Report – IRS Releases Proposed Regulations on 1% Tax on Stock Buybacks under IRA

By C. Wells Hall, III, Tim Wagner, Amanda Wilson, Deepan Patel, Seth Proctor, Maurice D. Holloway

On August 7, 2022, the Senate passed the Inflation Reduction Act (the “IRA”),[1]  which included a number of key tax provisions, including revenue raisers to offset the green energy tax credits and other provisions. Although previous versions of the IRA included a provision to close the carried interest tax loophole, it was ultimately swapped out in favor of a 1% excise tax on stock buybacks at the behest of Senator Kyrsten Sinema from Arizona.[2] In addition to raising revenue, new Section 4501 was intended to help correct a tax policy inefficiency stemming from the different tax treatment of dividends and stock buybacks.

The 1% Excise Tax on Stock Buybacks - Background

When corporations distribute profits, they do so by either issuing dividends or by buying back a portion of their own shares. The effect of a stock buyback is that the value of the remaining stocks held by shareholders increases. While dividends are generally taxable when received by shareholders, an increase in stock value as the result of a stock buyback is not taxable until a shareholder sells. The 1% excise tax on stock buybacks purportedly results in more even tax treatment of the two payout methods, which have similar economic effects. The 1% excise tax took effect for stock redemptions occurring on or after January 1, 2023. The basic tax regime includes the following features:

  • Section 4501 imposes on each covered corporation an excise tax (stock repurchase excise tax) equal to 1% of the fair market value of any stock of the corporation that is repurchased during a taxable year. The amount of the stock repurchase excise tax equals the product obtained by multiplying 1%, by the “stock repurchase excise tax base” of the covered corporation.
  • A covered corporation is not subject to the stock repurchase excise tax with regard to a taxable year if, during that taxable year, the aggregate fair market value of the covered corporation’s repurchases of its stock does not exceed $1,000,000 (the “de minimis exception”).
  • Covered corporation. For purposes of the stock repurchase excise tax, the term covered corporation means any domestic corporation the stock of which is traded on an established securities market (within the meaning of § 7704(b)(1))
  • No deduction is allowed for the payment of the stock repurchase excise tax.

Section 4501(e) provides that subsection (a) shall not apply:

  • to the extent that the repurchase is part of a reorganization (within the meaning of Section 368(a)) and no gain or loss is recognized on such repurchase by the shareholder under chapter 1 by reason of such reorganization,
  • in any case in which the stock repurchased is, or an amount of stock equal to the value of the stock repurchased is, contributed to an employer-sponsored retirement plan, employee stock ownership plan, or similar plan,
  • in any case in which the total value of the stock repurchased during the taxable year does not exceed $1,000,000,
  • under regulations prescribed by the Secretary, in cases in which the repurchase is by a dealer in securities in the ordinary course of business,
  • to repurchases by a RIC or a REIT, or
  • to the extent that the repurchase is treated as a dividend.

A key feature of the 1% excise tax is the offset for new stock issues in the same taxable year as the stock buyback (the “netting rule”). The 1% excise tax applies to the fair market value of any repurchases of stock by a covered corporation during its taxable year, reduced by (i) the fair market value of any repurchases excluded by an exception listed in Section 4501(e) above, and (ii) the fair market value of any issuances of the covered corporation’s stock during its taxable year that, under Section 4501(c)(3), offset the amount of any repurchases of the covered corporation’s stock (therefore, the use of the term “netting rule”).

The netting rule reduces the amount taken into account under Section 4501(a) with respect to any stock repurchased by a covered corporation by the fair market value of any stock issued by the covered corporation during the taxable year, including the fair market value of any stock issued or provided to employees of the covered corporation or employees of a specified affiliate of the covered corporation during the taxable year (whether or not the stock is issued or provided in response to the exercise of an option to purchase the stock).

Special rules apply to acquisitions of stock by applicable specified affiliates of a covered corporations, often economically equivalent to a stock buyback by the covered corporation itself. If an applicable specified affiliate of an applicable foreign corporation acquires stock of the applicable foreign corporation from a person that is not the applicable foreign corporation or a specified affiliate of such applicable foreign corporation-

  • the applicable specified affiliate is treated as a covered corporation with regard to the acquisition,
  • the acquisition is treated as a repurchase of stock of a covered corporation by the covered corporation, and
  • the netting rule adjustment under Section 4501(c)(3) is determined only with respect to stock issued by the specified affiliate to employees of the specified affiliate.

If a covered surrogate foreign corporation[3] repurchases its stock, or if a specified affiliate of the covered surrogate foreign corporation acquires stock of the covered surrogate foreign corporation-

  • the expatriated entity with respect to the covered surrogate foreign corporation is treated as a covered corporation with respect to the repurchase or acquisition,
  • the repurchase or acquisition is treated as a repurchase of stock of a covered corporation by the covered corporation, and
  • the netting rule adjustment is determined only with respect to stock issued or provided by the expatriated entity to employees of the expatriated entity.

Interim guidance with respect to the 1% buyback tax was issued by the IRS on December 27, 2022 in the form of Notice 2023-2, 2023-3 IRB 374 (“Notice 2023-2”).[4] 

The 2024 Proposed Regulations

After receiving a number of comments from the tax community,[5] the IRS released further guidance on the application of the 1% tax on April 9, 2024, in the form of proposed regulations.[6] A second set of proposed regulations,[7] released the same day, includes procedural rules for reporting and paying the tax, recordkeeping, and penalties.

No Per Se Funding Rule

The 2024 proposed regulations would eliminate the widely criticized “per se” rule regarding funding purchases of affiliated foreign corporation stock and replace it with a rebuttable presumption that would apply to only a targeted category of fundings.

In a statement accompanying the release, Treasury characterized the updated proposed rule as a “targeted anti-abuse rule,” intended to ensure that “foreign-parented multinational corporations pay their fair share of the tax, without ordinary course intercompany funding transactions among their corporate affiliates being inadvertently captured.”

Under the funding rule, a U.S. affiliate is considered to acquire the stock of an applicable foreign corporation for purposes of the excise tax if (1) it funds that acquisition “by any means,” and (2) avoidance of the excise tax is a principal purpose of the funding.

The interim guidance, Notice 2023-2, would have imposed a rule that the principal purpose test is met in all cases in which the foreign corporation acquires or repurchases stock within two years of receiving funding from the U.S. affiliate. The 2024  proposed regulations would replace that strict rule with a rebuttable presumption that applies only for transactions defined as “downstream” fundings that occur within two years. The government believes those transactions were most likely to raise the anti-tax avoidance concerns underlying the funding rule.

The presumption would apply where qualifying affiliates of a foreign corporation directly or indirectly fund a “downstream relevant entity” within two years of a stock purchase by or on behalf of that entity. A downstream relevant entity is one in which one or more affiliates of an applicable foreign corporation — individually or together, directly, or indirectly — own 25% or more of the stock (measured either by vote or by value) or of the capital or profits interests. The presumption can be rebutted with facts and circumstances that clearly establish that avoiding the excise tax was not a principal purpose of the funding.

Changes to the Netting Rule

The 2024 proposed regulations would also narrow an exception to the netting rule — which allows companies to reduce their excise tax base to the extent of stock issuances — for stock issued to affiliated companies.

The 2024 proposed regulations clarify that stock issued by a covered corporation to a specified affiliate is treated as issued for purposes of the netting rule if that stock is transferred by the specified affiliate during the same taxable year to a person who is not the covered corporation or a specified affiliate of that corporation, so long as (1) the covered corporation does not otherwise reduce its stock repurchase excise tax base for the issuing year with respect to the stock, and (2) the subsequent transfer by the specified affiliate is not in connection with the performance of services provided to the specified affiliate.[8]

The first requirement is intended to ensure that the stock is not double counted if, for example, the stock is “issued” to the specified affiliate and subsequently “provided” to the specified affiliate’s employees. The second requirement is intended to ensure that stock transferred to a non-employee service provider of a specified affiliate would not qualify under this rule.

In other words, under the proposed regulations, stock issued by a covered corporation to its specified affiliate (or stock that is treated as so issued under Reg. §1.83-6(d)) would be counted for purposes of the netting rule under two different provisions depending on whether the subsequent transfer by the specified affiliate is in connection with the performance of services. First, if the subsequent transfer is not in connection with the performance of services, then the stock transferred would be counted as stock “issued” by the covered corporation if and when the stock is transferred, during the same taxable year as the original issuance, to a person who is not the covered corporation or a specified affiliate of the corporation. Second, if the subsequent transfer (or deemed transfer under Reg. §1.83-6(d)) is in connection with the performance of services, then the stock transferred would be counted as stock “provided” by the specified affiliate, but only if the stock is transferred to an employee of the specified affiliate. Stock transferred to a non-employee service provider of a specified affiliate would not be counted for purposes of the netting rule.

Spinoffs, Split-offs, Reorganizations, SPAC Redemptions, Boot in Reorganizations

The 2024 proposed regulations follow the framework established in Notice 2023-2 with regard to corporate reorganizations. As in the initial guidance, the proposed regulations affirm that spinoffs are not subject to the stock buyback tax, but split offs are subject to the tax. The rules include an exclusive list of economically similar transactions that qualify as stock repurchases.

It is notable that the preamble states that the IRS rejected suggestions by stakeholders that transition relief could be provided for redemptions by, and liquidations of, a special purpose acquisition company (“SPAC”) formed prior to the enactment date, to the extent the SPAC is contractually obligated to offer redemption rights to its shareholders as agreed prior to the enactment date.  The IRS rejected this suggestion based on the plain language of Act § 10201(d), which provides that the amendments made by Act § 10201 apply to repurchases of stock after December 31, 2022. That section contains no reference to repurchases that occur pursuant to a binding commitment entered into prior to the enactment date.

The proposed regulations retain the Notice 2023-2 treatment of “boot” in reorganizations, confirming that the statutory reorganization exception in Section 4501(e)(1) exempts stock repurchases in reorganizations to the extent stock is exchanged for qualifying property. The portion of stock repurchased with cash or other nonqualifying property would be treated as a taxable repurchase.

Redeemable preferred stock (whether at the company or the holder’s option) continues to be subject to the tax. The preamble to the proposed regulations explains that that the plain language of Section 4501 does not provide an exception for such redemptions.

The proposed rules generally apply to transactions that occur after April 12, 2024, including those to which a funding that occurred between December 27, 2022, and April 12, 2024, inclusive, is allocated.

Comments and requests for a public hearing on REG-115710-22 are due by June 11, 2024. For the procedural rules (REG-118499-23), comments and public hearing requests are due by May 13, 2024.

Tax Reporting and Payment

The buyback tax will be reported on Form 720, “Quarterly Federal Excise Tax Return,” and a new Form 7208, “Excise Tax on Repurchase of Corporate Stock.” A draft version of Form 7208 is available on the IRS website. The final form will be released before the first quarterly filing deadline, according to the Treasury statement.

In line with a June 2023 IRS announcement,[9] taxpayers with a tax year ending after December 31, 2022, must report liability for the buyback tax on the Form 720 due for the first full quarter after final regulations are published and payment is due with that filing. No extensions will be permitted for reporting or for payments due.

The new proposed rules replace the interim guidance provided by Notice 2023-2. That notice is now obsolete with respect to “repurchases, issuances, and provisions of stock of a covered corporation” that occur after April 12, 2024.

Nelson Mullins will continue to monitor the status of proposed regulations and provide updates as appropriate. If you have any questions or comments about the foregoing summary of the proposed regulations, please contact Wells Hall, Maurice Holloway, Tim Wagner, Amanda Wilson, Deepan Patel, or Seth Proctor, who have contributed to the preparation of this Report, or any other member of the firm’s tax practice group.

 


[1] H.R. 5376. Sections of the Act will be referred to as “Act §.” References to “Section” in this Report refer to Sections of the Internal Revenue Code of 1986 (the “Code”) and references to “Reg. §” refer to Proposed and Final Regulations promulgated under the Code.

[2] Benjamin Guggenheim, Senate Drops Carried Interest Curbs to Secure Sinema’s Vote, Tax Notes, Aug. 5, 2022, https://www.taxnotes.com/tax-notes-today-federal/budgets/senate-drops-carried-interest-curbs-secure-sinemas-vote/2022/08/05/7dvlv?highlight=senate%20drops%20carried%20interest.

[3] The term “covered surrogate foreign corporation” means any surrogate foreign corporation (as determined under Section 7874(a)(2)(B) by substituting “September 20, 2021” for “March 4, 2003” each place it appears) the stock of which is traded on an established securities market, but only with respect to taxable years that include any portion of the applicable period with respect to such corporation under Section 7874(d)(1). Section 4501(d)(3)(B).

[4] See American Bar Association Section of Taxation Comments on Notice 2023-2 Regarding the Excise Tax Under Section 4501 (March 20, 2023).

https://www.americanbar.org/content/dam/aba/administrative/taxation/policy/2023/032023comments-3.pdf

[5] id.

[8] Prop. Reg. § 58.4501-4(f)(2).

[9] Announcement 2023-18, 2023-30 IRB 366.

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