General Overview
On August 12, 2022, the U.S. House of Representatives approved H.R. 5376, the “Inflation Reduction Act” (the Act), which was signed into law by President Biden on August 16, 2022. The approval and subsequent enactment follow the prior passage of the Act by the Senate on August 7, 2022. The Act adds a new Section 45011 that, subject to certain exceptions and limitations (which are described in more detail below), imposes a one-percent non-deductible excise tax on the fair market value of stock repurchases undertaken by U.S. public companies (or by certain of their affiliates) beginning on January 1, 2023. The tax may also apply to stock repurchases undertaken by certain U.S. affiliates of non-U.S. public companies or by non-U.S. public companies that were involved in an expatriation (or so-called “inversion”) transaction covered by Section 7874. In addition, pending the issuance of any regulatory, administrative, or other guidance, the statutory language of Section 4501 is sufficiently broad such that a wide variety of other common corporate transactions that are not typically perceived as “stock repurchases” may also be subject to the tax.
The Specifics of the Statute
Covered Corporation. The excise tax applies to a “covered corporation.” Section 4501(b) defines the basic concept of a “covered corporation” as “…any domestic corporation the stock of which is traded on an established securities market (within the meaning of Section 7704(b)(1)).” In general, a “domestic corporation” is an entity that is classified as (or that elects to be classified as) a corporation for U.S. federal income tax purposes and that is created or organized in the U.S. or under the law of the U.S. or of any state. An “established securities market” within the meaning of Section 7704(b)(1) generally includes: i) a national securities exchange that is registered under Section 6 of the Securities Exchange Act of 1934 (the Securities Exchange Act); ii) a national securities exchange that is exempt from the Securities Exchange Act because of the limited volume of transactions; iii) a foreign securities exchange that is subject to regulatory requirements that are analogous to the Securities Exchange Act; iv) a regional or local exchange; or v) an interdealer quotation system that regularly disseminates firm buy or sell quotations by identified brokers or dealers by electronic means or otherwise.
Repurchase. Section 4501(c)(1) generally defines a “repurchase” as either: i) a redemption within the meaning of Section 317(b) with regard to the stock of a covered corporation; or ii) any transaction that is determined by Secretary of the Treasury to be economically similar to a such a redemption. Section 317(b) provides that a redemption is any acquisition of stock by a corporation “in exchange for property, whether or not the stock so acquired is cancelled, retired, or held as treasury stock.” The term “property” is defined as “…money, securities, and any other property; except that such term does not include stock in the corporation making the distribution (or rights to acquire such stock).”
Purchases by Specified Affiliates. Section 4501(c)(2) contains rules that seek to impose the excise tax on certain stock repurchases that are undertaken by “specified affiliates” of a covered corporation. In general, a “specified affiliate” is defined as: i) any corporation more than 50 percent of the stock of which is owned (as determined by vote or value) directly or indirectly by a covered corporation; or ii) any partnership more than 50 percent of the capital interests or profits interests of which is held directly or indirectly by a covered corporation.2 For purposes of these rules, it is important to note that the statute does not provide any specific guidance as to how “indirect” stock ownership will be determined. The rules of Section 4501(c)(2) also do not apply to stock repurchases that involve only a specified affiliate and its related covered corporation (or another specified affiliate of such covered corporation).3
Adjustment / Netting for Stock Issuances. Section 4501(c)(3) provides for an adjustment (or “netting”) mechanism that states that the amount of any stock repurchased by a covered corporation shall be reduced 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 a covered corporation (or employees of a specified affiliate of such covered corporation), whether or not such stock is issued pursuant to the exercise of an option.
Acquisitions of Stock of Certain Foreign Corporations. Section 4501(d) sets forth rules that can have the effect of imposing the excise tax on certain stock repurchases that are undertaken by either i) a “specified affiliate” of an “applicable foreign corporation” or ii) a “covered surrogate foreign corporation” (or one of its “specified affiliates”). For purposes of these rules, the defined term “specified affiliate” has the same general meaning as set forth in Section 4501(c)(2)(B), but, in the case of an “applicable foreign corporation,” includes only a domestic corporation, a domestic partnership, or a foreign partnership that has a domestic entity as a direct or indirect partner. An “applicable foreign corporation” is defined as any foreign corporation the stock of which is traded on an established securities market.4 A “covered surrogate foreign corporation” is generally defined by reference to the so-called “anti-inversion rules” as set forth in Section 7874(a)(2)(B) of the Code (by substituting “September 20, 2021” for “March 4, 2003” each place it appears), and the relevant stock must also be traded on an “established securities market.”5In the event that a stock repurchase is covered by the rules of Section 4501(d), the excise tax is imposed on the applicable “specified affiliate” (in the case of a the rule for an “applicable foreign corporation”) or what is defined as the “expatriated entity” (in the case of the rule for a “covered surrogate foreign corporation”).6 Finally, it should also be noted that stock repurchases covered by Section 4501(d) are only able to apply the stock adjustment (or “netting”) rule contained in Section 4501(c)(3) to the extent that stock is issued or provided to employees of the “specified affiliate” (in the case of an “applicable foreign corporation”) or to employees of the “expatriated entity” (in the case of a “covered surrogate foreign corporation”).7
Exceptions. Section 4501(e) sets forth six potential exceptions to the imposition of the excise tax: i) repurchases that are part of a “reorganization” within the meaning of Section 368(a) and for which no gain or loss is recognized by a shareholder by reason of such reorganization; ii) repurchases that are accompanied by a contribution of the repurchased stock (or an amount of stock equal to the value of the stock repurchased) to an employer-sponsored retirement plan, employee stock ownership plan, or similar plan; iii) a case where the total value of the stock repurchased during the taxable year does not exceed $1 million; iv) under regulations to be prescribed by the Secretary of the Treasury, repurchases that are made by a dealer in securities in the ordinary course of business; v) repurchases by a regulated investment company (as defined in Section 851) or a real estate investment trust; and vi) repurchases that are treated as a “dividend” for U.S. income tax purposes.
Regulations and Guidance. The Secretary of the Treasury has the authority to prescribe regulations or other guidance that is deemed necessary or appropriate to carry out, and to prevent the avoidance of, the purposes of Section 4501, including regulations and other guidance relating to: i) preventing the potential abuse of the exceptions set forth in Section 4501(e); ii) special classes of stock and preferred stock; and iii) the application of the rules related to “applicable foreign corporations” and “covered surrogate foreign corporations” contained in Section 4501(d).
Potential Implications for Common Corporate Transactions
Stock Repurchases / Redeemable Equity Securities. In general, the excise tax will impose an incremental cost of one percent on all forms of stock repurchase transactions, including open market repurchases, privately negotiated purchases (such as those effected pursuant to accelerated share repurchase programs), and purchases in registered self-tender offers. The excise tax will also generally apply to any equity securities that are puttable by the holder, callable by the issuer or mandatorily redeemable by their terms (such as mandatorily redeemable preferred stock), even if such equity securities were originally issued prior to the enactment of the new statute. Moreover, the excise tax will be imposed directly on the relevant “covered corporation,” which in most cases will be a domestic corporate issuer (and which in the case of an “applicable foreign corporation” or a “covered surrogate foreign corporation” will be the applicable “specified affiliate” or “expatriated entity,” respectively). Although the one-percent excise tax may not be viewed as material in relation to the fair market value of any particular stock repurchase, for stock repurchases that aggregate to a sufficient size, the one percent tax may eventually reach a level that is viewed as material in an absolute sense (e.g., a covered corporation that engaged in stock repurchases with a fair market value of $100 million in a particular taxable year would be subject to a $1 million excise tax). Taxpayers should also keep in mind that there is the potential for the rate of such tax to be subjected to an additional increase in the future as a further revenue raising measure.
Convertible Debt / Call Spread and Capped Call Structures. Corporate issuers that raise capital with convertible debt often enter into hedging transactions (typically referred to as “call spread” or “capped call” structures) that are designed to minimize the potential impacts of dilution upon the ultimate occurrence of a conversion event. To the extent that such transactions are settled in shares of the corporate issuer (rather than being settled in cash), the excise tax would generally apply to a domestic covered corporation, subject to any adjustment (or “netting”) that might occur by reason of a concurrent issuance of shares to the holders of the debt. However, if a hedging transaction does not settle at the same time as a conversion of the underlying debt (which is sometimes the case), and instead settles in a later taxable year, then a share settlement of such hedging transaction would not be able to be adjusted (or “netted”) by the shares issued at the time the debt was converted.
Accelerated Share Repurchase (ASR) Programs. An ASR program is a privately negotiated contract between a company and an equity derivatives dealer. A typical ASR is structured as follows: on the “prepayment date” (one-to-three business days after the contract is executed), the company will make an upfront payment to the dealer for the dollar amount of stock the company commits to repurchase. The dealer in turn will deliver a number of shares (obtained by borrowing from institutional stock lenders), determined by dividing an agreed upon percentage (e.g., 70-85 percent) of the company’s upfront payment by the price per share at execution. Such shares are generally retired by the company or classified as treasury shares. On the “termination date” (which may be accelerated by the dealer), the total number of shares repurchased under the ASR is determined based on i) the arithmetic average of a published daily volume weighted average price of the company’s common stock over the term of the ASR minus ii) a specified, negotiated discount. If the total number of shares repurchased by the company under the ASR at the final price per share is more than the number of shares initially delivered by the dealer to the company, the dealer will be required to deliver additional shares to the company to cover the difference. However, if the price of the company’s common stock increases significantly during the term, the company may be obligated to deliver either cash or shares (at the company’s election) to the dealer upon termination, although in practice this is unlikely to occur.
The form of the ASR is that a repurchase occurs on the prepayment date to the extent of the 70-85 percent delivered at the time, which would be subject to an excise tax if it occurs on or after January 1, 2023. This treatment is consistent with the fact that the delivered shares are canceled upon delivery and are generally not considered issued and outstanding (e.g., they are removed for purposes of calculating earnings per share). A second repurchase would occur on the termination date if the dealer delivers additional shares. If, on the other hand, the company delivers additional shares to the dealer, this would be an additional issuance. If the termination date is in the same taxable year as the prepayment date, the adjustment / netting rules described above should apply to reduce the excise tax on the initial repurchase. However, if the termination date is in a different taxable year, the additional issuance would not offset the initial repurchase, although it could perhaps net against other repurchases in the year of the termination date. It is not clear how a delivery of cash by the company would be treated for purposes of the excise tax. Alternatively, the excise tax might not apply until the number of shares that is repurchased is fixed, which would not occur until settlement on the termination date. In that case, an ASR that terminated on or after January 1, 2023 would be subject to the excise tax in its entirety based on the amount of stock finally repurchased, even if the ASR was executed prior to January 1, 2023 (unless grandfathering rules are provided by regulations issued by the Secretary of the Treasury).
SPACs. The excise tax may also apply to certain transactions undertaken by special purpose acquisition companies (SPACs). Specifically, in connection with a SPAC’s initial business combination transaction (or “de-SPAC” event) the exercise of redemption rights by the shareholders of the SPAC may trigger the excise tax (subject to potential adjustment / netting for any shares of the SPAC that might be concurrently issued to the target shareholders or to new “PIPE” investors).
Merger and Acquisition Transactions. Based on the plain language of the statute (and pending the issuance of any forthcoming regulatory or other guidance), there appears to be a variety of ways in which a traditional merger or acquisition transaction may result in the imposition of the excise tax. For example, a merger or acquisition may sometimes involve a related distribution of cash or other property to the shareholders of either the target or acquiring corporation that is taxed as a return of tax basis or as a sale or exchange (and which would appear to be subject to the excise tax). Other features of a typical merger or acquisition transaction that may be potentially subject to the excise tax include the payment of cash to dissenting shareholders, cash paid in lieu of fractional shares, or possibly even the payment of cash “boot” in connection with certain types of “reorganization” transactions under Section 368(a) (including, for example, a “two-step” forward merger under Section 368(a)(1)(A)).
Spin-Offs / Restructurings and Recapitalizations. As with the potential issues related to merger and acquisition transactions, certain types of corporate separations (commonly referred to as “spin-offs”), restructurings (including complete or partial liquidations), or recapitalizations may also result in the imposition of the excise tax. For example, while a corporate “spin-off” transaction may be non-taxable to both the distributing corporation and its shareholders under Section 355, the list of available exemptions to the excise tax set forth in Section 4501(e) does not include a transaction effected under Section 355. As a result, if a so-called “spin-off” transaction is not effected as an actual pro-rata distribution of shares of the “spun-off” entity (such as would be the case in a non-pro-rata “split-off” or “split-up” transaction), then the transaction may be subject to the excise tax. Furthermore, certain types of restructurings that involve commonly controlled corporations may be subject to the excise tax (e.g., as a result of the rules that apply to purchases by “specified affiliates”), as well as certain recapitalization transactions that do not qualify as a “reorganization” under Section 368(a) or that involve the payment of cash or other “boot” as part of the transaction.
“Economically Similar” Transactions. As previously noted, Section 4501(c)(1)(B) grants the Secretary of the Treasury the authority to determine what transactions should be considered “economically similar” to a “redemption” transaction within the meaning of Section 317(b). In general, pending the issuance of any forthcoming regulatory, administrative, or other guidance, taxpayers should carefully consider whether the excise tax may potentially apply to any transaction, or perhaps a series of related transactions, that may have the same substantive economic effect as a redemption. For example, certain types of distributions that are made to non-corporate shareholders in connection with a “partial liquidation” (within the meaning of Section 302(b)(4)) are not taxed as dividend distributions and are instead taxed as a sale or exchange that may be subject to the excise tax.
Recommendations / Best Practices
Re-Evaluate Current Plans Prior to the 2023 Effective Date. In light of the January 1, 2023, effective date for the new excise tax, it would be advisable for potentially affected taxpayers to determine whether it may be possible to accelerate any planned stock repurchases (or other transactions that may be potentially subject to the excise tax as discussed above) into the 2022 calendar year.
Establish Appropriate Record-Keeping Procedures. Given that the amount of the excise tax is imposed with respect to the fair market value of the aggregate amount of stock repurchases undertaken by a taxpayer within a particular taxable year, affected taxpayers should also ensure that appropriate record-keeping procedures are put in place in order to ensure compliance with the tax and to minimize its potential impact. In particular, taxpayers should ensure that their internal controls are able to appropriately monitor any applicable adjustments (or “netting”) in respect of offsetting stock issuances that may be available, such as stock issuances made to employees in compensatory transactions or stock issued in connection with capital raising or merger and acquisition transactions.
Be Aware of Potential Exceptions to the Excise Tax. In addition to establishing robust internal record-keeping procedures, affected taxpayers should also take steps to ensure that they stay apprised of any available exceptions. For example, with respect to the “dividend” exception, affected taxpayers should carefully monitor the amount of any current or accumulated corporate earnings and profits that may give rise to the potential treatment of a stock repurchase (or other affected transaction) as a dividend, while also evaluating whether it may be necessary to try and request certain relevant information from one or more significant shareholders that participate in a stock repurchase transaction (such as a shareholder’s actual level of direct, indirect, or attributed share ownership both before and after a stock repurchase).8
Develop Forward-Looking Planning Strategies. Following the January 1, 2023, effective date for the excise tax, affected taxpayers would be well-advised to develop comprehensive and forward-looking planning strategies that seek to minimize the effect of the tax. For example, if a taxpayer has plans to engage in a stock repurchase transaction, and at the same time also has plans to contribute shares to an employer-sponsored retirement plan, employee stock ownership plan, or similar plan, it may be optimal to have these two events occur in tandem. Furthermore, as previously noted, it will generally be in the interest of affected taxpayers to make an attempt to utilize the adjustment / “netting” rule to the maximum extent possible by coordinating the consummation of stock repurchases and stock issuances so that they occur within the same taxable year.
[1] All “Section” references are to the U.S. Internal Revenue Code of 1986, as amended.
[2] See § 4501(c)(2)(B).
[3] See § 4501(c)(2)(A).
[4] See § 4501(d)(3)(A).
[5] See § 4501(d)(3)(B). In the case of a “covered surrogate foreign corporation,” the § 4501 excise tax only applies with respect to taxable years that include any portion of the applicable ten-year period following an inversion transaction as set forth in § 7874(d)(1).
[6] See §§ 4501(d)(1)(A), (B) and 4501(d)(2)(A), (B), respectively (which effectively cause a “specified affiliate” of an “applicable foreign corporation” and an “expatriated entity” of a “covered surrogate foreign corporation” to be treated as a “covered corporation” for purposes of the general rule set forth in § 4501(a)). See also, § 4501(d)(3)(C) (which defines “expatriated entity” by reference to § 7874(a)(2)(A)). Furthermore, as with the general rules that are applicable to “specified affiliates” of domestic “covered corporations” under § 4501(c)(2), the rules of § 4501(d)(1) do not apply to stock repurchases that involve only a “specified affiliate” and its related “applicable foreign corporation” (or another specified affiliate of such applicable foreign corporation).
[7] See §§ 4501(d)(1)(C) and (d)(2)(C), respectively.
[8] In this regard, it should be noted that Section 302(b) of the Code sets forth various rules that apply in order to determine whether a redemption may be characterized as a “dividend” and which depend upon ascertaining a shareholder’s level of stock ownership both before and after the redemption. In general, a redemption of stock from a relatively small shareholder of a public corporation will not normally result in dividend treatment. However, in certain situations, dividend treatment may be a possibility (such as, for example, in the case of a redemption by a relatively large shareholder or a shareholder that holds a disproportionate share of the voting power in a corporation through a dual-class / “high vote” capital structure or otherwise).
