The government released proposed regulations this month implementing the excise tax imposed on repurchases of corporate stock that was enacted in 2022.  Although these regulations provide some welcome clarity as to the scope of the tax and the procedures for calculating and paying it, they are likely to disappoint those who had hoped that the Treasury would exempt from the excise tax a number of transaction types that Congress may not have intended to target with the law.

Enacted as part of the Inflation Reduction Act of 2022, Section 4501 of the Internal Revenue Code imposes a 1% excise tax on repurchases of stock by public U.S. companies, as well as purchases of the stock of publicly traded foreign companies by their U.S. affiliates, subject to a number of enumerated exceptions.  In particular, the tax is imposed on the value of all such stock repurchased during the taxable year, reduced by the value of all of the stock issued during the same year (the so-called “netting rule”).  In Notice 2023-2, the IRS provided provisional guidance on the buyback tax, soliciting comments from the public in anticipation of more definitive regulations.

The proposed regulations expand on the rules set forth in the Notice in a number of respects, including how repurchased and issued shares should be valued, when companies become and cease to be subject to the excise tax, and how to treat issuances of stock to (and forfeitures of stock by) employees and independent contractors.   Generally speaking, however, the proposed regulations follow the approach taken in the Notice in the vast majority of respects, including in a number of places where many commenters had hoped the Treasury and IRS would adopt a more liberal rule:

• Merger Consideration. In many merger and other corporate acquisition structures, purchase price paid to target corporation shareholders is treated as a payment in redemption of their stock to the extent funded by cash or borrowing at the target. (This is especially common in many private equity and leveraged buyout contexts.)  In most cases, this technical distinction is irrelevant to target shareholders, most of whom are generally eligible for capital gains treatment regardless of the source of funds.  Notice 2023-2, however, respected this formal designation in applying the excise tax to these transactions to the extent of target-funded consideration.  Many commenters had suggested this was inappropriate because transactions of this type, while technically “redemptions” for income tax purposes, were not the typical “stock buybacks” that they believed Congress intended to target with the excise tax.  The proposed regulations retained the Notice’s approach, however, noting that the excise tax applies to all transactions considered “redemptions” for income tax purposes, with only specified exceptions.
• Debt-Like Preferred Stock. The government likewise declined the suggestion that the buyback tax should not apply to the redemption of “straight” or “debt-like” preferred stock, with terms such as a fixed “coupon” dividend and either a fixed redemption date or a put right by the holder.  Again, commenters argued that stock of this sort should be exempt from the excise tax on policy grounds. In particular, they argued that a mandatory redemption or one at the holder’s instance would not be subject to the kind of manipulation that Congress perceived to be at work in stock buybacks, and that imposing an excise tax on such redemptions could push more taxpayers to overleverage by issuing debt in circumstances where preferred stock would otherwise be more appropriate.  Once again, the IRS and Treasury rejected these policy-based arguments in favor of a formalistic approach that would (with one narrow exception) encompass all stock redemptions unless specifically exempted.
• Tier 1 Capital. The Treasury and IRS did yield in their formalistic approach in one narrow instance, holding that both redemptions and issuances of preferred stock that qualifies as additional tier 1 capital would be disregarded for purposes of the excise tax.  Such instruments are routinely issued for regulatory purposes by regulated financial institutions in order to manage risk, and the conditions under which they can be redeemed or repurchased are strictly controlled.  Under the proposed regulations, these instruments, even if denominated as preferred stock, would be excluded from the definition of “stock,” and so their repurchase would not be subject to excise tax (nor would their issuance reduce an issuer’s excise tax under the “netting rule”).
• Split-Offs. Both the Notice and the proposed regulations apply the excise tax to “split-offs”—but in a very limited way.  These transactions, in which a corporation distributes stock of a subsidiary to one or more shareholders in exchange for its own outstanding stock (such as pursuant to an exchange offer) can be effected free of income tax to both shareholders and the distributing corporation.  While the Treasury and IRS rejected the suggestion to exempt split-off transactions altogether from the excise tax (noting that they are, in form, repurchases), they did provide that in calculating the excise tax, the value of the parent stock repurchased would be offset by the value of the subsidiary stock distributed in exchange.  Accordingly, as a general matter there should be no excise tax on a straightforward all-stock split-off transaction so long as the value of the stock distributed equals or exceeds the value of the stock repurchased, which is generally the case. (Indeed, most public split-offs effected pursuant to an exchange offer are conducted at a premium to the value of the distributed company stock in order to encourage participation.)  The government also affirmed that pro-rata “spin-offs” and complete corporate liquidations, which do not take the form of a repurchase or redemption, are exempt from the tax altogether.
• Funding Rule. Another area where the Treasury and IRS adopted a narrower approach in the proposed regulations was on the so-called “funding rule” for indirect repurchases of stock of foreign corporations by their U.S. affiliates. While stock repurchases by foreign corporations are generally not subject to the excise tax, the statute provides that where a U.S. affiliate of a public foreign corporation purchases its parent’s stock, that purchase will be subject to excise tax.  While it is rare for such corporations to acquire this stock directly, the Notice included an anti-abuse “funding rule” under which the excise tax would apply if (i) the U.S. affiliate funds “by any means” (including through distributions or loans) the repurchase of stock of the non-U.S. issuer and (ii) the funding was undertaken with a principal purpose of avoiding the excise tax.  The Notice further included a “per se” rule that such a principal purpose would be conclusively deemed to exist if that funding (other than distributions) occurred within two years of the funded entity’s repurchase of stock.  While the Treasury and IRS retained the general anti-abuse rule in the proposed regulations, they abandoned the strict “per se” rule in favor of a rebuttable presumption of a principal purpose that would apply only in the narrower case of “downstream fundings” made to 25%-or-greater foreign subsidiaries of the U.S. affiliate.

The proposed regulations are still subject to finalization.  In addition, the Biden administration has proposed increasing the excise tax from 1% to 4% in its proposed 2025 budget.