The Excise Tax is substantially identical to the tax proposed in the Build Back Better Act in November 2021.2 Specifically, the Excise Tax will apply to repurchases of stock by publicly traded domestic corporations (including certain publicly traded inverted foreign corporations treated as “surrogate foreign corporations”)3 and domestic subsidiaries of publicly traded foreign corporations. Companies are allowed to net certain stock issuances against the stock repurchases before applying the 1% tax. The stated purpose of the Excise Tax is to discourage publicly traded corporations from engaging in stock buybacks that aim to increase share prices and, instead, encourage these corporations to invest in their workers and businesses.4 The Excise Tax will apply to repurchases occurring after December 31, 2022. The details of the Excise Tax, as well as a discussion of its practical implications for corporate transactions and a description of areas where further guidance is needed, follows.
The Excise Tax
Which Companies Are Subject to the Excise Tax?
The Excise Tax is imposed on a “covered corporation,” which is a domestic corporation whose stock is traded on an established securities market (e.g., NYSE, NASDAQ, or London Stock Exchange).5 There is no minimum “market cap” requirement applicable to “covered corporations.” As a result, even small “micro-cap” corporations or corporations in financial distress or bankruptcy will be subject to the Excise Tax. The Excise Tax is also imposed on a covered corporation if a “specified affiliate” repurchases the covered corporation’s stock. A corporation's specified affiliate is a corporation or partnership directly or indirectly controlled by such corporation.6
Additionally, the Excise Tax is imposed when a domestic corporation or partnership (including a foreign partnership with a direct or indirect domestic entity as a partner) purchases any stock of its foreign parent corporation if (i) the foreign parent corporation has stock traded on an established securities market and (ii) such domestic corporation or partnership is a specified affiliate of the foreign parent corporation. The Excise Tax for such repurchases is imposed on the domestic corporation or partnership.
Last, if (i) a foreign corporation is a “surrogate foreign corporation” pursuant to the inversion rules of Code Section 7874(a)(2)(B) and (ii) the stock of such foreign corporation is traded on an established securities market, then the Act treats that foreign corporation as a covered corporation.7 Therefore, repurchases by such foreign corporation and its specified affiliates are subject to the Excise Tax.
The Excise Tax is imposed on the covered corporation itself, not its shareholders.
To What Does the Excise Tax Apply?
The Excise Tax is imposed on the “repurchase” of any stock of a covered corporation by the covered corporation or its specified affiliates. A “repurchase” occurs when a corporation (or its specified affiliate) redeems or otherwise acquires the corporation’s stock from a shareholder in exchange for property. Additionally, the Secretary of Treasury (the “Secretary”) is authorized to specify in regulations that certain transactions are economically similar to redemptions and will therefore be treated as redemptions subject to the Excise Tax.8
How Is the Amount of the Excise Tax Determined?
The amount of the Excise Tax is initially determined based on the fair market value of all of the stock repurchased (or treated as repurchased) by a covered corporation during a taxable year. Thus, even if there are losses in the stock or the covered corporation has no earnings and profits, the Excise Tax applies. Such amount is then reduced by the fair market value of any stock issued by the covered corporation during such taxable year, including any stock issued or provided to employees and any stock issued upon the exercise of an option. This would appear to include stock issued as a stock dividend, but regulations may narrow the scope to stock issued for property or services. For inverted foreign corporations and domestic specified affiliates of foreign corporations that are subject to the Excise Tax, the reduction is limited to the fair market value of the stock issued or provided to employees of the inverted foreign corporation or the specified affiliate, respectively.
What Are the Exceptions to the Excise Tax?
The Excise Tax will not apply in any one of the following six situations:
- if the repurchase is part of a “reorganization” within the meaning of Code Section 368(a) and no gain or loss is recognized on such repurchase;
- if the repurchased stock (or value of the repurchased stock) is contributed to an employer-sponsored retirement plan, employee stock ownership plan, or similar plan;
- if the value of the repurchased stock in the taxable year does not exceed $1 million;
- under regulations prescribed by the Secretary, if the repurchase is by a dealer in securities in the ordinary course of business;
- stock repurchases by registered investment companies or real estate investment trusts; or
- to the extent that the repurchase is treated as a dividend for tax purposes.
The statute provides that the Secretary shall provide regulations to carry out, and to prevent the abuse or avoidance of, the purpose of the Excise Tax.
Practical Implications and Need for Regulatory Guidance
- Preferred Stock and other Non-Publicly-Traded or Special Classes of Stock
- The statute contemplates regulatory guidance to address special classes of stock and preferred stock. Although the Excise Tax generally applies only to transactions involving corporations that have issued stock traded on an established securities market, the Excise Tax is imposed on the repurchase of “any stock” of such covered corporation (i.e., not limited to repurchases of publicly traded shares). Therefore, absent regulatory guidance to the contrary, the redemption or repayment at maturity of non-publicly-traded preferred stock of a covered corporation is subject to the Excise Tax. Furthermore, the statute does not provide for any form of “grandfathering” for mandatorily redeemable preferred stock issued prior to the effective date of the Excise Tax. For example, if a covered corporation issued three-year mandatorily redeemable preferred stock on January 5, 2020, absent any postenactment regulatory or administrative relief, the Excise Tax will be imposed on the redemption of such preferred stock on January 5, 2023.
- U.S. SPACs
- The Excise Tax would apply to any redemption of stock over the course of the life of a special purpose acquisition company (“SPAC”) that is a covered corporation (i.e., a Delaware SPAC as opposed to a Cayman SPAC), including in connection with its initial business combination or “de-SPAC” transaction, even though redeeming shareholders are generally recouping their original economic investment without any real economic gain. The Excise Tax will therefore become an additional issue to consider for Cayman SPACs that will redomesticate in connection with planned de-SPAC transactions. The Excise Tax on de-SPAC-related redemptions may be reduced by the issuance of SPAC shares in the SPAC initial public offering or in connection with any private investment in public equity (“PIPE”) investment, but only if such issuances occur in the same taxable year as the redemptions. Issuances to PIPE investors often take place contemporaneously with the de-SPAC transaction and would be expected to significantly reduce the amount of the Excise Tax. However, SPACs may experience high rates of redemptions and difficulty finding PIPE investors in difficult market conditions, which could cause the amount of redemptions subject to the Excise Tax without offset from other issuances to be material. Last, the Excise Tax may apply in connection with the winding up of a SPAC if a target is not identified within the term of the SPAC or pursuant to a SPAC proxy solicitation (for a discussion of the Excise Tax as it applies to liquidations, see below).
- Partially Tax-Free Reorganizations
- The statutory language of the Act provides an exemption from the Excise Tax if the repurchase is both part of a “reorganization” within Code Section 368(a) and no gain or loss is recognized. This exception would not be expected to apply to the extent that a party to the reorganization receives cash or other property (i.e., “boot”) in addition to acquiror stock (and the receipt of boot is not treated as a dividend). When a corporation acquires the stock of another corporation in a partially tax-free acquisitive merger pursuant to which the shareholders of the target corporation exchange their shares in part for newly issued shares of the acquiring corporation and in part for a cash payment, the transaction is generally treated as if first, all of the target shareholders exchanged their target stock solely for stock of the acquiring corporation and then, the acquiring corporation redeemed a portion of the acquiror stock received by the target shareholders for cash.9 The second part of this deemed transaction is treated as a redemption for tax purposes if the deemed redemption is “substantially disproportionate” or “not essentially equivalent to a dividend” with respect to the applicable target shareholders. Absent regulatory guidance, it is unclear whether, and under what circumstances, such a deemed redemption will be considered a “repurchase” subject to the Excise Tax if shares of the target and/or acquiring corporation are publicly traded. Similarly, cash payments made to shareholders in lieu of fractional shares in a stock-for-stock merger may also be subject to the Excise Tax.10
- Section 355 Split-off Transactions
- The definition of “repurchase” appears to technically include a tax-free split-off transaction in which a parent corporation (the “distributing corporation”) exchanges stock of a controlled subsidiary for a portion of the distributing corporation’s outstanding stock, absent regulatory guidance to the contrary. While split-offs are generally effected as part of a “divisive” tax-free reorganization governed by Section 368(a)(1)(D), the exchanging shareholders’ tax-free treatment generally applies regardless of “whether or not the distribution is in pursuance of a plan of reorganization,” which means such treatment is not “by reason of” the reorganization and appears to fall outside of the reorganization exemption.11 If the distributing corporation is a covered corporation, split-offs may be subject to the Excise Tax, imposing a cash tax cost on an otherwise cashless transaction. As a result, covered corporations contemplating divisive corporate restructurings may want to consider structuring the transaction as a “straight” spin-off (i.e., a pro rata distribution to all of its shareholders) rather than a split-off.
- Leveraged Buyouts
- In a transaction structure that is commonly used in traditional leveraged buyouts, the acquiring entity forms a transitory subsidiary for purposes of acquiring the target corporation by means of a taxable reverse-subsidiary merger. The acquiring entity contributes cash ($X) to the merger subsidiary and the merger subsidiary borrows additional cash ($Y) from a third party lender (the “Bank Debt”) to fund the acquisition. The merger subsidiary then merges into the target corporation, the target shareholders receive cash consideration in exchange for their stock in the amount of $X + $Y and the target corporation, as the surviving entity becomes a wholly owned subsidiary of the acquiring entity and assumes the Bank Debt. Because the merger subsidiary is disregarded as a transitory entity for U.S. federal income tax purposes, the target corporation is treated as borrowing the Bank Debt and distributing the $Y to its shareholders in redemption of a portion of their target stock. Under these facts, if the target corporation is a covered corporation, absent regulatory guidance to the contrary, it appears that the Excise Tax will apply and impose a 1% tax on the deemed redemption of the target shares in exchange for the amount of the Bank Debt.
- Dissenters' Rights
- Shareholders in certain acquisitive transactions involving a public company often have “dissenters' rights,” (also known as “appraisal rights”) pursuant to which shareholders that do not consent to the proposed transaction may cause the surviving corporation to acquire their stock for cash at an appraised value determined in a judicial appraisal procedure. Absent any regulatory exception, such acquisitions will be subject to the Excise Tax even though they would appear to fall outside of the legislative intent of Congress to discourage inflationary stock buybacks. Furthermore, it appears that the Excise Tax will apply to the acquisition of the shareholders’ exercising their dissenters' rights even in the case of an overall transaction that would otherwise be exempt from the Excise Tax under the reorganization exception.12
- Distributions in Complete or Partial Liquidation
- Absent guidance to the contrary, it appears that a distribution of property by a covered corporation in either complete or partial liquidation of such covered corporation may be viewed as a “repurchase” transaction that is subject to the Excise Tax. Similarly, transactions that are not in form liquidations but are treated as “deemed” liquidations under certain provisions of the regulations or other tax guidance, including, for example, deemed liquidations in a stock purchase for which a Section 338 or Section 336 election has been made, may also be subject to the Excise Tax, either under its plain meaning or pursuant to the “economically similar” regulatory mandate.
1 New Section 4501 of the Internal Revenue Code of 1986, as amended (the “Code”).
2 See HR 5376, at Section 138102, as reported in House Rules Committee Print 117-18. 167 Congr. Rec. H6375, H6541 (Nov. 18, 2021).
3 See Code Section 7874(a)(2)(B) for the definition of “surrogate foreign corporations.”
4 See Senate Passes Inflation Reduction Act With Tax Changes, Tax Notes, August 8, 2022, citing Finance Committee Chair Ron Wyden, D-Ore., on his August 6 remarks on the Senate floor.
5 Code Section 4501(b). Established securities market is defined in Code Section 7704(b)(1).
6 Code Section 4501(c)(2). For this purpose, control means the ownership of more than 50% of the stock (by vote or by value) of a corporation or the capital interests or profits interests of a partnership.
7 Code Section 7874(a)(2)(B) references postacquisition stock ownership by former shareholders of a domestic corporation or former partners of a domestic partnership with at least 60% (but less than 80%) of the foreign corporation and that fails the substantial business activities test in such corporation’s foreign country.
8 Code Sections 4501(c) and 317(b).“Property” for this purpose means 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). Code Section 317(a).
9 Code Section 356(a); Commissioner v. Clark, 489 U.S. 726 (1989); Rev. Rul. 93-61, 1993-2 C.B. 118.
10 See Rev. Rul. 66-365.
11 Code Section 355(a)(2)(C).
12 See Rev. Rul. 68-285.
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