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18 April 202412 minute read

Treasury and IRS publish proposed regulations concerning stock buyback excise tax

On April 9, 2024, the US Department of the Treasury and the Internal Revenue Service (IRS) published two packages of proposed regulations under Section 4501[1] (Proposed Regulations, which can be found here and here) concerning the one-percent excise tax on certain stock buybacks (Excise Tax).

The Excise Tax was enacted on August 16, 2022, as part of the Inflation Reduction Act, and generally applies to stock repurchases (often referred to as buybacks) and “economically similar” transactions by covered corporations (generally, publicly traded US corporations and certain foreign corporations) on or after January 1, 2023.[2] On December 27, 2022, Treasury and the IRS issued Notice 2023-2 (Notice), which provided temporary guidance regarding the Excise Tax.

With a few exceptions, the Proposed Regulations largely follow the Notice, but provide more than 40 illustrative examples that give practical guidance to taxpayers. For details on the Notice and the framework of the Excise Tax, refer to our original DLA Piper summary.

In this alert, we highlight some key aspects of the Proposed Regulations as compared to the Notice, and provide a more detailed discussion of the primary substantive change from the Notice – that being the substantially relaxed funding rule (Funding Rule) that imposes the Excise Tax on certain domestic companies that fund a stock buyback for a foreign-parented group.

Headlines from the Proposed Regulations

  • SPACs. Treasury and the IRS confirmed their view that no specific rules relating to SPACs are necessary. Accordingly, repurchases of SPAC stock pursuant to the exercise of redemption rights by shareholders continue to be subject to the Excise Tax, subject to the netting rule. Further, share issuances made by a SPAC or, in some instances, by the SPAC’s target in connection with a de-SPAC transaction likely will not be counted toward meeting the netting rule, although shares issued by the SPAC to new “PIPE” investors may be counted. Finally, the Proposed Regulations 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, which in the case of a SPAC often occurs where the SPAC sponsor has waived its rights to such a distribution. Because the Excise Tax is not applicable to redemptions by foreign corporations, we expect that, going forward, SPACs will typically be formed offshore in order to avoid application of the Excise Tax.

  • Spinoffs, split-ups, and split-offs. Consistent with the Notice, the Proposed Regulations would provide that spinoffs and split-ups that qualify under Section 355 generally are not subject to the Excise Tax. The Proposed Regulations would clarify, however, that a distribution of non-qualifying property in exchange for stock of the distributing company in pursuance of a spinoff or a split-up would be a repurchase. The Proposed Regulations also would treat split-offs as repurchases but clarify that such transactions would generally be eligible for the reorganization exception to the extent qualifying property is distributed.

  • Uniform boot rule in tax-deferred reorganizations. The Proposed Regulations generally follow the Notice and would include cash or other non-stock consideration (so-called “boot”) paid to the target shareholders in tax-deferred reorganizations in the base amount subject to the Excise Tax, regardless of whether acquiring corporation or target corporation funds the payment. Accordingly, the Proposed Regulations would reject a “sourcing approach” advocated by some taxpayers. While cash paid in lieu of fractional shares will generally not be subject to the Excise Tax, the preamble to the Proposed Regulations provides that cash paid to dissenters in connection with a tax-deferred reorganization may be subject to the Excise Tax.

  • Taxable acquisitions funded by target. The Proposed Regulations follow the Notice and would treat the target-corporation-funded portion of the consideration in a taxable acquisition of target corporation as subject to the Excise Tax. Treasury and the IRS therefore rejected taxpayer recommendations that “take private” transactions be excluded from the Excise Tax or that the regulations adopt a “sourcing approach.”

  • Non-stock instruments generally not addressed. The Proposed Regulations would treat as stock any instrument issued by a corporation which is stock or is treated as stock for federal income tax purposes. The Proposed Regulations would clarify that this determination is made at the time of issuance and is not retested while the instrument is outstanding. Treasury declined to provide specific rules for convertible debt, tracking stock, or Section 305(a) warrants, generally noting that such instruments would be tested under existing federal income tax guidance. However, the Proposed Regulations provide additional guidance and examples with respect to options (cash-settled v. physically settled), forfeiture of restricted stock, and Section 305(a) warrants, particularly with respect to how such instruments would be valued and treated under the netting rule.

  • No exception for preferred stock (except for one very limited exception). The Proposed Regulations would generally treat all instruments treated as common or preferred stock as stock for purposes of the Excise Tax. As to preferred stock, the Proposed Regulations would include a narrow exclusion for “additional tier 1 preferred stock,” which the Proposed Regulations would define to mean preferred stock that qualifies as “additional tier 1 capital.”

  • Valuation of stock. The Proposed Regulations generally follow the Notice, treating the “market price” of stock on the date the stock is repurchased or issued as the fair market value. Except for privately traded stock, the Proposed Regulations would ignore the purchase price. Consistent with the Notice, the Proposed Regulations would require taxpayer to choose from one of four methods to value publicly traded stock and the taxpayer must consistently apply the chosen method to all repurchases and issuances throughout the taxable year. For stock issued to employees and privately traded stock, the Proposed Regulations generally follow the Notice with some additional guidance provided.

  • Section 83(b) elections. The Proposed Regulations would provide that stock is treated as issued or provided to an employee or other service provider when there is a transfer of beneficial ownership, including where the recipient makes a valid section 83(b) election with respect to restricted stock. Where stock is treated as beneficially owned, it can be counted for purposes of the netting rule. Conversely, the forfeiture of such stock is treated as a repurchase.

  • Proving the statutory dividend exception to a repurchase. Among others, Section 4501 excludes from the definition of “repurchase” a distribution or redemption that is treated as a dividend for federal income tax purposes. Under the Notice, a redemption was presumed to be a repurchase except to the extent that a taxpayer could prove that the redeemed shareholder treated the repurchase as a dividend under a “sufficient evidence requirement.” The Proposed Regulations largely retain the sufficient evidence requirement specified in the Notice, while providing details on the content required to be included in the required shareholder certification.

  • Reporting and Paying the Tax. Consistent with the Notice, the Proposed Regulations would require a stock repurchase excise tax return for any covered corporation that makes (or is treating as making) a repurchase after December 31, 2022. Such stock repurchase excise tax return would include Form 720, Quarterly Federal Excise Tax Return, on which the stock repurchase excise tax liability would be reported, and an attached Form 7208, Excise Tax on Repurchase of Corporate Stock, on which the stock repurchase excise tax would be calculated. However, for a covered corporation with a taxable year ending after December 31, 2022, and on or before the date final regulations under Section 4501 are published in the Federal Register, the Proposed Regulations would require the Form 7208 for such taxable year to be filed by the due date of the Form 720 (Quarterly Federal Excise Tax Return) for the first full calendar quarter after the date of publication of final regulations in the Federal Register. For example, if a covered corporation had a taxable year ending December 31, 2023, and the date of publication of final regulations in the Federal Register were September 16, 2024, the covered corporation would be required to file the Form 7208 for its 2023 taxable year by January 31, 2025 (the due date of the Form 720 for the calendar quarter ending December 31, 2024).

Relaxation of Funding Rule applicable to foreign-parented groups

The Notice

The Notice’s Funding Rule generally provided that an “applicable specified affiliate” (eg, a domestic corporation within a foreign-parented group) would be deemed to engage in a stock repurchase if (i) the applicable specified affiliate funded by any means (including through distributions, intercompany debt, or capital contributions) the repurchase or acquisition of stock of the “applicable foreign corporation” (eg, the foreign parent), and (ii) such funding was undertaken with a principal purpose of avoiding the Excise Tax.

This “principal purpose” prong was criticized for two primary reasons. First, it was unclear how a domestic corporation could have a principal purpose of avoiding the Excise Tax if that domestic corporation would not otherwise buy stock of the foreign parent. In response, Treasury clarified that a principal purpose of avoiding the Excise Tax exists if there is a principal purpose to fund, directly or indirectly, a stock buyback. Second, the Notice deemed there to be (that is, it was per se) a principal purpose to avoid the Excise Tax if the funding (other than through distributions) occurs within two years, either before or after, the repurchase of stock of the applicable foreign corporation.

Further, the Notice’s per se Funding Rule left foreign-parented corporate groups without much guidance as to what commonly used intercompany arrangements would be treated as funding mechanisms captured by this rule, including (i) intercompany licensing or loan agreements (even those predating the Excise Tax), (ii) ordinary course cash pooling arrangements, and (iii) other arm’s-length operating payments, such as for inventory or services.

The Proposed Regulations

In response, Treasury eliminated the per se Funding Rule and replaced it with a Funding Rule that is accompanied by a limited rebuttable presumption. Under the Proposed Regulations, a principal purpose to fund a stock buyback is presumed to exist if the applicable specified affiliate (eg, a domestic corporation in a foreign-parented group) (i) funds by any means, directly or indirectly, a downstream relevant entity, and (ii) the funding occurs within two years of a covered purchase by or on behalf of the downstream relevant entity. The Proposed Regulations include an example by which US1, a domestic corporation, loans $1,000x to a sister foreign corporation, FB, which lends $900x to foreign corporation FD. FD is indirectly owned by US1 and is therefore a “downstream relevant entity.” FD then buys $800x shares of foreign parent stock. In the example, the Funding Rule applies because US1 ultimately funds an indirectly held subsidiary’s (FD’s) purchase of foreign parent stock, even though the initial funding to FB is not to a downstream relevant entity.

Overall, the revised Funding Rule provides some relief to foreign-parented groups, but the Proposed Regulations’ retention of a subjective “a principal purpose” standard leaves open questions. For example:

  • Could debt repayments be subject to the funding rule, even if the debt instrument pre-dated the Excise Tax? Presumably, facts and circumstances could exist to argue that a debt repayment does not have a principal purpose of funding a stock buyback.

  • Could other ordinary course transactions – such as inventory purchases, royalty payments, and other treasury functions such as cash pooling – give rise to a principal purpose to funding a stock buyback? Potentially, but taxpayers should be ready with facts to support that such a principal purpose does not exist.

The Treasury Department and the IRS declined to adopt specific exclusions from the Funding Rule, stating that the elimination of the per se Funding Rule and the provision of a “targeted” rebuttable presumption should address commentators’ concerns about the Funding Rule’s potential applications to ordinary course transactions. While Treasury specifically rejected a “pure tracing” approach to asserting that a principal purpose to fund a stock buyback exists, taxpayers may find themselves tracing sources and uses of cash to defend against an assertion that a principal purpose existed, particularly for ordinary course transactions and for arrangements that pre-date the Excise Tax.

Effective date

The Proposed Regulations, if finalized, would generally be 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. Please note that the Proposed Regulations are also subject to a public review and comment period before they will be finalized and made effective.

For more information

If you have any questions about the Excise Tax, the Notice, or the Proposed Regulations, feel free to reach out to the authors of this alert, or your DLA Piper Tax contact.

[1] All Section references herein are to the Internal Revenue Code of 1986.
[2] Section 4501 provides that a repurchase by a regulated investment company (RIC) or real estate investment trust (REIT) is not treated as a repurchase for purposes of the Excise Tax.