On April 9, 2024, the U.S. Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) issued long-awaited proposed regulations under Section 45011 relating to the one percent stock buyback excise tax. This alert provides a brief summary of some key aspects of the proposed regulations that may be of particular importance to clients of the firm.
General Background
The excise tax was enacted as part of the “Inflation Reduction Act” and originally signed into law on August 16, 2022. The excise tax generally applies to stock repurchases and “economically similar” transactions undertaken by publicly traded U.S. corporations and certain foreign corporations on or after January 1, 2023. On December 27, 2022, Treasury and the IRS issued temporary interim guidance regarding certain aspects of the excise tax in the form of administrative Notice 2023-2 (the Notice).
The Proposed Regulations
The newly published proposed regulations will effectively replace the Notice and may generally be relied upon by taxpayers until the regulations are finalized. In general, the proposed regulations adopt and retain the prior approaches set forth in the Notice and also address a variety of previously unanswered questions related to the implementation of the excise tax. For detailed prior coverage of the excise tax and the Notice, see Wilson Sonsini Tax Alerts dated August 16, 2022, and January 3, 2023.
M&A / Restructuring Transactions
Tax-Free Reorganizations
The proposed regulations generally retain and continue to apply the approach set forth in the Notice with respect to certain acquisitive reorganizations of publicly traded target corporations under Section 368, to the extent that such transactions involve the payment of cash or other non-stock consideration to the target shareholders. The rules potentially apply to a variety of acquisitive transaction types, including direct or “two-step” forward triangular mergers and reverse triangular mergers (and regardless of whether the acquiring corporation is itself publicly traded). As a result, the one percent excise tax remains a potentially material transaction cost that should be properly evaluated and accounted for by the parties. In addition, any cash paid in lieu of fractional shares will generally remain outside the scope of the excise tax. However, the preamble to the proposed regulations states that any cash paid to dissenters in connection with an acquisitive reorganization may be subject to the excise tax.
Post-Closing Purchase Price Adjustments
The proposed regulations contain rules relating to the potential issuance of shares by a publicly traded acquiring corporation (including in connection with the acquisition of a private target) in connection with earnouts and upon the expiration of indemnification escrows or other holdback arrangements. In general, for purposes of the “netting rule” and determining the acquiring corporation’s excise tax base, the fair market value of such shares should be determined based on the market price of the shares as of the date on which ownership transfers for U.S. federal income tax purposes. In addition, if issued shares are later forfeited pursuant to an earnout or indemnification arrangement, such shares should generally be treated consistently as being repurchased for purposes of the “netting rule” and valued based on the market price on the date of forfeiture.
Spin-Offs / Restructurings and Recapitalizations
Under the proposed regulations, if a corporate “spin-off” transaction is not effected as a typical pro-rata distribution of shares of the “spun-off” entity to the distributing corporation’s shareholders (such as might be the case with a non-pro-rata “split-off” transaction), then the excise tax will continue to apply. However, the excise tax does not apply to so-called “split-up” transactions in which the distributing corporation completely liquidates as a result of making separate distributions to different shareholder groups. The proposed regulations also clarify that a distribution of cash or other non-stock consideration in pursuance of a “spin-off” or “split-up” would be subject to the excise tax. Furthermore, certain types of restructurings that involve commonly controlled corporations continue to 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 or that involve the payment of cash or other non-stock consideration as part of the transaction.
Taxable Acquisitions / Leveraged Buyouts
The proposed regulations retain the approach of the Notice with respect to taxable acquisitions and leveraged buyouts. As a result, unless an exception applies, any portion of the purchase price that is determined to be funded by the target corporation under applicable U.S. federal income tax principles will be subject to the excise tax, even if the target corporation is no longer publicly traded following the transaction (e.g., in a take-private transaction).
Special-Purpose Acquisition Companies (SPACs) and “De-SPAC” Transactions
In the preamble to the proposed regulations, Treasury and the IRS stated that they are of the view that no special rules are necessary or appropriate in order to carry out the implementation of the excise tax with respect to SPACs. As a result, the proposed regulations do not exempt repurchases of stock that may occur in a de-SPAC transaction pursuant to the exercise of shareholder redemption rights. In addition, in many cases, share issuances made either by the SPAC or possibly by the target / combining corporation in connection with a de-SPAC acquisition are not likely to be available to offset any of the SPACs redemptions (except possibly with respect to shares that might be issued by the SPAC to new “PIPE” investors). The proposed regulations also clarify that a complete liquidation of a corporation (including a SPAC) will not generally be treated as a repurchase and therefore will not be subject to the excise tax, even in a case where not all shareholders receive a liquidating distribution (such as a SPAC sponsor that has waived such rights).
Capital Markets Transactions
Non-Participating “Debt-Like” Preferred Stock / Mandatorily Redeemable Stock
The proposed regulations do not provide any exceptions to the potential application of the excise tax for non-participating “debt-like” preferred stock (i.e., non-convertible preferred stock that is limited and preferred as to dividends and does not participate in corporate growth to any significant extent) and mandatorily redeemable stock. The proposed regulations do provide a limited exception for “additional tier-one preferred stock” that qualifies as tier-one capital for certain regulated financial institutions.
Accelerated Share Repurchase (ASR) Programs
The proposed regulations do not provide any new special rules that may be used by taxpayers to determine when the tax ownership of shares that are subject to an ASR program may be considered transferred for U.S federal income tax purposes and therefore subject to the excise tax. Instead, in the preamble to the proposed regulations, Treasury and the IRS stated that such a question is inherently factual in nature, and taxpayers should continue to evaluate ASR arrangements based on pre-existing law.
Convertible Debt / Integrated Call-Spread and Capped-Call Transactions
In the preamble to the proposed regulations, Treasury and the IRS confirmed that whether a convertible debt instrument is treated as debt or equity should be tested at the time of issuance (and not potentially retested while the security remains outstanding). As a result, even if a convertible debt instrument is deep-in-the-money and is subsequently redeemed or settled for cash, the retirement of the convertible debt will not be subject to the excise tax. Treasury and the IRS also stated their view in the preamble that the tax integration of a convertible debt instrument with the cost of entering into a qualifying “call-spread” or “capped-call” hedging transaction does not change the amount of stock actually repurchased or issued, and therefore under the proposed regulations, an issuer’s excise tax base should be determined without regard to such integration.
Compensatory Transactions
Net Share Settlements
The proposed regulations generally expand the approach taken in the Notice to provide that stock withheld by a corporation to satisfy the exercise price of a stock option or to cover any withholding obligation (including state or foreign tax withholdings in addition to federal tax withholdings) is not treated as issued for purposes of the “netting rule.”
“Sell to Cover” Transactions
The proposed regulations provide that stock issued pursuant to a “sell to cover” arrangement (where stock is typically issued to a third-party broker and then sold to satisfy a corporation’s withholding obligations) is treated as an issuance for purposes of the “netting rule.”
Restricted Stock
The Notice did not expressly address the treatment of a subsequent forfeiture of restricted stock for purposes of the excise tax. In general, the proposed regulations treat a forfeiture of restricted stock as a repurchase on the date of forfeiture (in an amount equal to the fair market value of such stock on the date of forfeiture) if such forfeited stock was originally treated as issued because a Section 83(b) election was made. As a result, a corporation may have a potential mismatch (positive or negative) for purposes of the “netting rule” with respect to the fair market value of restricted stock that may be issued in one taxable year and subsequently forfeited in another taxable year.
Effective Date / Review and Comment Period
With certain exceptions, the proposed regulations are generally applicable to repurchases of stock occurring after December 31, 2022, and during taxable years ending after December 31, 2022, and to issuances of stock occurring during taxable years ending after December 31, 2022. The proposed regulations are also subject to a public review and comment period before they will be finalized and made effective.
[1] All “Section” references are to the Internal Revenue Code of 1986, as amended.
