The Proposed Share Buyback Tax under the Inflation Reduction Act

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The Inflation Reduction Act of 2022 includes an excise tax that, if enacted, will make share repurchases by publicly traded companies more costly starting in 2023.[1] The proposed tax is meant to be a significant revenue-raiser, partially filling a revenue gap created by the removal of the carried interest provisions from the bill and modifications to the proposed book minimum tax.[2] Although the excise tax may seem straightforward when viewed at a high level, the text of the provision reveals some unexpected results.[3]

IN DEPTH


OVERVIEW

The tax on share repurchases is imposed at a 1% rate on the total value of shares repurchased during the company’s tax year. The tax applies to most types of share repurchases made by US publicly traded companies, irrespective of whether a particular share repurchase is or is not part of a share buyback program. Because the new tax is an excise tax, it applies at a flat rate without regard to whether the repurchasing company has taxable income or loss during the year. The tax is imposed on the repurchasing corporation and is a nondeductible expense.[4]

When computing the tax base, the amount of repurchased shares is reduced by the value of any newly issued shares. In this way, the tax may be thought of as a tax on the net number of shares that are retired during the year. Companies are, in effect, given credit for new shares that are issued in a primary or secondary offering, shares issued to satisfy option exercises and shares issued to provide stock-based compensation.[5]

If enacted as is, the tax would apply to repurchases that take place after December 31, 2022. The cutoff for the effective date turns on whether a particular share repurchase was consummated after that date. In contrast, the date when a particular share repurchase plan was announced or approved is irrelevant. There is no grandfather rule or transition relief for shares that are repurchased in 2023 pursuant to a share repurchase program that was authorized in 2022 or earlier.

The tax also applies to repurchases in 2023 irrespective of whether the corporation happens to be on a fiscal or calendar year for tax purposes.[6]

A de minimis threshold prevents the tax from being imposed if the total share repurchases during the year does not exceed $1 million.

APPLIES TO US PUBLICLY TRADED COMPANIES

The excise tax applies almost exclusively to US publicly traded corporations. Share repurchases by foreign parented corporate groups generally escape taxation, even repurchases of American Depositary Receipts or shares that are publicly traded on US exchanges.

A company is considered “publicly traded” for this purpose if its shares are traded on any established securities market. This includes companies with shares that are traded on a regional or local market, not just companies that are listed on the New York Stock Exchange or the Nasdaq Stock Market. The tax also applies to US companies with shares that are traded on non-US exchanges, such as the London Stock Exchange, Euronext N.V. and Toronto Stock Exchange.

In the case of a foreign publicly traded corporation, the excise tax applies in limited circumstances. The excise tax may apply to a foreign parented publicly traded group if, for example, a controlled US subsidiary happens to purchase the foreign publicly traded parent’s shares. This aspect of the tax could pose a trap for the unwary in the mergers and acquisitions sector, but it will be easy enough for the well-advised to navigate around.

The provision includes a protective measure designed to prevent the excise tax from being an incentive to invert. In general, if a US corporation inverts in a transaction after September 20, 2021, share repurchases by its new foreign parent are potentially subject to the tax. This is the case if the US corporation inverted in a transaction in which the foreign parent is treated as a surrogate foreign corporation.[7] In such a case, the excise tax applies to the publicly traded foreign parent’s share repurchases if they are made within a 10-year applicable period following the inversion.

“REPURCHASES” ARE BROADLY DEFINED

Although the provision is colloquially referred to as a tax on “buybacks,” it is computed based on the value of shares “repurchased” by the publicly traded company. A repurchase is further defined for this purpose as a “redemption” of stock within the meaning of section 317(b). This definition expands the scope of the provision to include several types of transactions that are not considered “buybacks” in the traditional sense.

For example, a repurchase for this purpose may include an acquisition by the issuer of its own stock for cash, irrespective of whether the purchase is made on the open market or in a private transaction. Shares that are repurchased by the issuer to effectuate a “bootstrap” acquisition or leveraged buyout could be caught in the net of the excise tax.[8] The same could be true for cash that is issued for fractional shares in an acquisition.[9] A “repurchase” could, in theory, even include the mere repayment of preferred stock at its maturity.[10]

A repurchase for this purpose includes both direct purchases of stock by the publicly traded parent and indirect purchases effectuated by a controlled corporate subsidiary or a controlled partnership.[11] A corporation generally is “controlled” for this purpose if more than 50% of its stock is owned, directly or indirectly, by vote or value by the publicly traded parent.

The excise tax only applies to repurchases of stock and so a mere repayment of debt, including long-term debt that is considered a “security” for subchapter C purposes, will not be subject to the tax. Similarly, the repurchase of an unexercised option or warrant should not constitute a repurchase of stock.[12] Also, a transaction in which the issuer’s own stock is the only consideration exchanged for the repurchased stock ought not to be subject to the tax because an issuer’s own shares are not considered “property” under section 317.[13]

The provision includes a grant of regulatory authority to expand the application of the tax further, permitting the US Department of the Treasury (Treasury) to include within the definition of “repurchase” transactions that it determines are “economically similar to” redemptions.[14]

CERTAIN ACQUISITIONS THAT ARE NOT “REPURCHASES”

The provision provides a limited number of exceptions to the scope of the tax. The provision provides an exception for repurchases “to the extent” the transaction is “part of a section 368 reorganization and no gain or loss is recognized on such purchase by the shareholder.”[15] This should provide partial or total protection for section 368(a)(1)(E) recapitalizations and acquisitive reorganizations to the extent that the shareholders obtain tax-free treatment.[16]

A significant exception also applies to “any case” in which the repurchased shares, or an equal amount of stock, is “contributed to an employer-sponsored retirement plan, employee stock ownership plan, or similar plan.” Thus, a public company can repurchase shares from the public and use them to satisfy stock options or make equity contributions to a retirement plan without being subject to the tax.

The provision also excepts repurchases “to the extent that the repurchase is treated as a dividend for purposes of this title.” Dividend-equivalent redemptions under section 302(d) should be excluded as a result, provided that the distribution is treated as a dividend and not a return of capital. This may allow for some share repurchases from large shareholders to be excluded for purposes of the tax. In most cases, however, purchases from small public shareholders will be considered sale or exchange transactions under section 302(a) and ineligible for the exception.[17]

CALCULATING THE FAIR MARKET VALUE OF REPURCHASED SHARES

Much remains to be seen about how the Treasury will implement the provision in regulations and how the Internal Revenue Service will enforce the provision on audit. For example, the tax is applied to the amount of repurchased shares by reference to their “fair market value.” This raises the question of how fair market value will be determined and how publicly traded corporations can comply with the proposed statute given the typically large volume of share repurchases in buyback programs and fluctuations in public share prices over the course of a tax year. One step that the Treasury might consider taking in this regard would be to use its regulatory authority to permit taxpayers to rely on their US Securities and Exchange Commission (SEC) reporting when computing the tax. Under SEC rules, publicly traded companies typically must disclose, on a monthly basis, the total number of shares purchased and the average price paid per share. These amounts typically appear in schedular form in a company’s 10-Q.[18]

CONCLUSION

Share buyback programs will continue to be popular with publicly traded companies, even if the proposed legislation is enacted. The structural incentives for share buyback programs will continue to outweigh the cost of the proposed excise tax. The tax will, however, have an impact on the margins, affecting the decisions of most US publicly traded companies when determining how best to redeploy cash. Companies will also have an incentive to accelerate future share repurchases into calendar year 2022 before the proposed legislation takes effect.

ENDNOTES


[1] Inflation Reduction Act of 2022, HR 5376.

[2] The proposed excise tax is nearly identical to a proposal included in early versions of the Build Back Better Act.

[3] Andrew Verlarde, Stock Buyback Tax Could Cause Taxpayer Headaches, Tax Notes International, November 22, 2021; Peter Evis, Companies Love to Buy Back Their Stock. A Tax Could Deter Them, New York Times

[4] The proposal would amend section 275(a)(6) to treat the excise tax as a nondeductible expense of the repurchasing corporation.

[5] Section 4501(c)(3). Stock splits seemingly would not impact the base of the excise tax, since a typical stock split merely increases the total number of shares outstanding. In this regard, the exception in section 4501(c)(3) refers to stock that is “issued,” in contrast to shares that are “distributed” on existing stock in a nontaxable transaction under section 305(a).

[6] For example, if a taxpayer has a fiscal year ending on January 31, 2023, share repurchases in January are included when computing the excise tax for that calendar year. Section 4501(a). The effective date language provides that the tax applies “to repurchases (within the meaning of section 4501(c) of the Internal Revenue Code of 1986, as added by this section) of stock after December 31, 2022.”

[7] Section 7874(a)(2)(B). The excise tax also applies to publicly traded foreign corporations that are deemed to be domestic corporations for all purposes of the Code under section 7874(b).

[8] Such share repurchases may be treated as exchanges within the meaning of section 302(b) in which case, absent an exception, the purchases are “redemptions” that may be subject to the excise tax.

[9] See, e.g., Rev. Rul. 66-365, 1966-2 C.B. 116; PLR 200645011 (Nov. 10, 2006).

[10] As one thoughtful speaker put it: “You didn’t know you went to Uncle Sam’s bar when you issued that preferred stock, but apparently you owe him a cover charge.” Andrew Velarde, Stock Buyback Tax Could Cause Taxpayer Headaches, Tax Notes Federal, November 22, 2021 (attributing the comment to Will Dixon of Citigroup Capital Markets, Inc.). The Treasury could, however, create an exception for ordinary course repayments of preferred stock, using its authority under section 4501(f)(2) to issue regulations to address special classes of stock and preferred stock.

[11] Section 4501(c)(2).

[12] This assumes that the options or warrants are not so “deep in the money” as to be treated as deemed exercised under general tax principles. See, e.g., Rev. Rul. 82-150, 1982-2 C.B. 110.

[13] Section 317(a). The provision also excludes from the definition of “property” rights to acquire a corporation’s own stock. As a result, if a corporation issues warrants to a shareholder as consideration to repurchase its own shares, the transaction may not be a “redemption” within the meaning of sections 317(b) and 4501, even if the transaction is taxable to the shareholder under section 1001 (i.e., potentially eligible for capital gain treatment). This should be the case absent an exercise of regulatory authority under section 4501 to apply the tax to “economically similar” transactions.

[14] The Treasury will need to issue regulations to exercise this authority, however, as the statute would not be self-executing.

[15] Section 4501(e)(2). Although the statutory language is not completely clear, the better reading of the provision should be to except shares that are acquired in a section 368 reorganization except to the extent gain or loss is recognized by the shareholder, e.g., except to the extent of taxable boot. The use of the phrase “to the extent that” supports this reading, in contrast to an all-or-nothing rule interpretation in which any amount of taxable gain recognized by a shareholder would prevent the exception from applying to shares acquired from that shareholder.

[16] Commentators have asked whether a section 355 split-off transaction might be viewed, superficially, as “economically similar” to a redemption. Although a split-off, like a share buyback, reduces the number of shares of the distributing company that are outstanding after the transaction is complete, the similarity to a share buyback ends there. Instead, a split-off that qualifies as a tax-free reorganization under section 368(a)(1)(D) and section 355 ought to be eligible for the exception for tax-free reorganizations to the extent no gain or loss is recognized by the shareholder. As a policy matter, the same treatment should be afforded to a split-off occurs pursuant to tax-free section 355 transaction even if the transaction does not also qualify as a divisive D reorganization.

[17] When shares are repurchased from small public shareholders, the reduction in the shareholder’s interest in the company typically qualifies for sale or exchange treatment. See, e.g., Rev. Rul. 76-385, 1976-2 C.B. 92 (reduction in interest from 0.0001118 percent to 0.0001081 percent qualified for exchange treatment).

[18] The source of this provision is 17 C.F.R. § 229.703, which requires reporting of certain purchases of equity securities by the issuer and affiliated purchasers in tabular format.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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