The IRS on Dec. 27 released initial guidance (Notice 2023-2) on the new excise tax on repurchases of corporate stock under Section 4501 that took effect for repurchases after Dec. 31, 2022.
The notice contains key definitions and operating rules related to the stock repurchase excise tax and examples applying the rules. The IRS provided important clarity on which types of transactions will be “economically similar” to redemptions and which transactions qualify for exceptions. The notice also describes anticipated rules for reporting and paying the tax annually, while requesting additional comments and pledging future guidance.
The IRS intends to issue proposed regulations consistent with the notice, and taxpayers may rely on the rules in the notice until proposed regulations are issued.
Background
Section 4501 imposes an excise tax on each covered corporation equal to 1% of the fair market value (FMV) of the corporation’s stock repurchased by that corporation during a taxable year.
A “covered corporation” is any domestic corporation the stock of which is traded on an established securities market within the meaning of Section 7704(b)(1). The definition of an established securities market is provided in regulations under Section 7704(b) and includes a national securities exchange registered under Section 6 of the Securities Exchange Act of 1934 and certain foreign securities exchanges.
The amount subject to tax is reduced by the FMV of any repurchases excluded by an exception listed under Section 4501(e) (statutory exceptions) and the FMV of any stock issued by the covered corporation stock (the netting rule).
The statutory exceptions consist of the following:
- Repurchases to the extent that they are part of a reorganization (within the meaning of Section 368(a)) and no gain or loss is recognized by the shareholder
- Repurchases where the stock repurchased (or stock of equal value) is contributed to an employer-sponsored retirement plan, employee stock ownership plan (ESOP), or similar plan
- Repurchases in which the total value of stock repurchased during the taxable year does not exceed $1 million
- Repurchases by a dealer in securities in the ordinary course of business as prescribed in regulations
- Repurchases by a regulated investment company (RIC) or a real estate investment trust (REIT)
- Repurchases to the extent they are treated as a dividend
The acquisition of stock of a covered corporation by a “specified affiliate” of that covered corporation is treated as a repurchase by the covered corporation. The tax may also apply to acquisitions or repurchases of stock of a foreign corporation under certain circumstances.
The tax is not deductible by the covered corporation for U.S. federal income tax purposes, and applies to repurchases that occur after Dec. 31, 2022.
Computation
The notice describes in more detail how taxpayers compute their stock repurchase excise tax in a given taxable year. Generally, the stock repurchase excise tax imposed on a covered corporation is equal to 1% of the stock repurchase excise tax base.
The stock repurchase excise tax base is obtained by determining the aggregate FMV of all repurchases of the covered corporation’s stock by the covered corporation during its taxable year and then reducing such amount by both the FMV of stock repurchased under a statutory exception and the aggregate FMV of stock issued or provided by the covered corporation under the netting rule.
Stock is treated as repurchased at the time at which ownership of the stock transfers to the covered corporation or to the applicable acquiror (defined in the notice). The notice clarifies that the stock repurchase excise tax base is determined for each taxable year separately and any reductions are not carried forward or backward to preceding or succeeding taxable years.
The notice defines the term “stock” as any instrument issued by a corporation that is stock, or treated as stock, for federal tax purposes at the time of issuance regardless whether the instrument is publicly traded.
Grant Thornton Insight
The definition of stock includes stock that is not traded on an established market. Therefore, the stock repurchase excise tax may apply to a covered corporation related to a repurchase of stock that is not publicly traded (e.g., non-publicly traded preferred stock).
Redemptions and economically similar transactions
The notice provides important guidance on what transactions will be considered “repurchases” for purposes of Section 4501. Under Section 4501(c), the term “repurchase” means: (i) a redemption within the meaning of Section 317(b) with regard to stock of a covered corporation (a redemption); and (ii) any transaction determined by Treasury to be economically similar to such a redemption under Section 317(b) (an economically similar transaction).
The notice provides exceptions for two types of transactions that are redemptions under Section 317(b) but will not be considered repurchases:
- Section 304(a)(1) transactions
- Certain payments of cash in lieu of a fractional share if the payment is carried out as part of a reorganization under Section 368 or a distribution under Section 355, or pursuant to a settlement of an option or similar financial instrument (e.g., a convertible bond or a convertible preferred share), when certain requirements are met
Grant Thornton Insight
The list of redemptions that are not repurchases under Section 3.04(3) of the notice does not include a redemption that occurs in certain transactions when the consideration of a stock acquisition is partially funded by the target corporation or there is a leveraged buyout. The notice has two examples that treat such a redemption as a repurchase for purposes of the stock repurchase excise tax (see Example 3 and Example 4). Taxpayers may want to consider if there are viable structuring alternatives for transactions that are impacted by the stock repurchase excise tax.
The notice also includes an exclusive list of transactions that are considered economically similar to a redemption under Section 317(b) and will constitute a repurchase for purposes of the tax:
- The exchange by the target corporation shareholders of their target corporation stock as part of an acquisitive reorganization (i.e., a reorganization under Sections 368(a)(1)(A), (C), or (D)) when the target corporation is a covered corporation or a covered surrogate foreign corporation
- An exchange by the recapitalizing corporation shareholders of their recapitalizing corporation stock as part of a recapitalization that constitutes an “E Reorganization” under Section 368(a)(1)(E) of a covered corporation or a covered surrogate foreign corporation
- The exchange by the transferor corporation shareholders of their transferor corporation stock as part of an “F Reorganization” under Section 368(a)(1)(F) when the transferor corporation is a covered corporation or a covered surrogate foreign corporation
- The exchange by the distributing corporation shareholders of their distributing corporation stock for controlled corporation stock, and other property, if applicable, in the case of a split-off distribution qualifying under Section 355 when the distributing corporation is a covered corporation or a covered foreign surrogate corporation
- Each distribution that Section 331 applies in the case of a complete liquidation of a covered corporation or a covered surrogate foreign corporation to which both Sections 331 and 332 apply
The notice provides a nonexclusive list of transactions that are not economically similar transactions. The nonexclusive list of the transactions that are not economically similar transactions consists of the following:
- A distribution in complete liquidation of a covered corporation or a covered surrogate foreign corporation to which either Sections 331 or 332 apply
- A distribution by a distributing corporation of stock of a controlled corporation under Section 355 that is not a split-off.
Grant Thornton Insight
The list of transactions that are not economically similar transactions resolve uncertainty regarding the extent the IRS would interpret distributions in complete liquidation of a covered corporation that are subject to the stock repurchase excise tax. The notice provides two examples that illustrate when a distribution in a complete liquidation is, and is not, an economically similar transaction. First, example 16 describes a complete liquidation in which only Section 331 applies. It is not an economically similar transaction. Then Example 17 describes a fact pattern in which both Sections 331 and 332 apply. It is an economically similar transaction to the extent that Section 331 applies to a liquidating distribution.
Determining fair market value
The FMV of repurchased stock is the market price of the stock on the date the stock is repurchased. Similarly, the FMV of stock issued, other than stock issued to an employee, is generally the market price of the stock on the date the stock is issued.
If the price at which the repurchased stock is purchased differs from the market price of the stock on the date the stock is repurchased, the FMV of the stock is the market price on the date the stock is repurchased. If repurchased stock is traded on an established securities market, the taxpayer must determine the market price of the repurchased stock by applying one of the following acceptable methods listed in the notice:
- The daily volume-weighted average price as determined on the date the stock is repurchased
- The closing price on the date the stock is repurchased
- The average of the high and low prices on the date the stock is repurchased
- The trading price at the time the stock is repurchased.
The market price of repurchased stock that is traded on an established securities market must be determined by consistently applying one of the methods to all repurchases through the covered corporation’s taxable year. The same method also must be consistently applied to determine the market price of stock issued under the netting rule through the taxable year, other than for stock issued to an employee.
If repurchased stock is not traded on an established securities market, the market price of the stock is determined as of the date of the repurchase under the principles of Treas. Reg. § 1.409A-1(b)(5)(iv)(B)(1).
Grant Thornton Insight
Given that the FMV of repurchased and issued stock is determined on each date that stock is repurchased or issued, the computation of tax may be a significant undertaking for corporations that have a large volume of transactions because it will require determining a FMV for each transaction.
De minimis exception
As stated above, a covered corporation is not subject to the stock repurchase excise tax for a taxable year if the aggregate fair market value of the covered corporation’s repurchases of its stock does not exceed $1 million during that taxable year (the de minimis exception).
The notice clarifies that the determination of whether the de minimis exception applies in a given taxable year is made before applying a reduction for a statutory exception and a reduction under the netting rule.
Grant Thornton Insight
The IRS interpretation of this rule means a corporation can owe tax on less than $1 million in stock repurchases if the aggregate amount of repurchases exceeds $1 million before exceptions and netting reductions bring it below $1 million.
Other statutory exceptions
The notice has guidance for applying the other statutory exceptions. Generally, the FMV of stock repurchased by a covered corporation in a repurchase that qualifies for a statutory exception is a reduction for purposes of computing the covered corporation’s stock repurchase excise tax base. The statutory exceptions are described in more detail below.
Qualified property repurchase
The FMV of stock repurchased by a covered corporation in a “qualified property repurchase” is a reduction to the extent that the repurchase is for property permitted by Sections 354 or 355 to be received without recognition of gain or loss. The notice defines a qualified property repurchase as one made by:
- A target corporation as part of an acquisitive reorganization
- A covered corporation or a covered surrogate foreign corporation as part of an E reorganization
- A transferor corporation as part of an F reorganization
- A distributing corporation as part of a split-off (whether or not part of a D reorganization).
Grant Thornton Insight
Notwithstanding that each of these exchanges are included as economically similar transactions and treated as repurchases, the stock repurchase excise tax base may be reduced, at least in part, under the qualified property repurchase exception. However, the qualified property repurchase exception may not reduce the entire amount of such a repurchase (e.g., see Example 19 of the notice that describes a reorganization under Section 368(a)(1)(A) in which the target shareholders receive boot).
Contribution to employer-sponsored retirement plan
The FMV of stock repurchased by a covered corporation is a reduction if the stock that is repurchased, or an amount of stock equal to the FMV of the stock repurchased, is contributed to an employer-sponsored retirement plan. The notice defines an employer-sponsored retirement plan as a retirement plan maintained by a covered corporation that is qualified under Section 401(a), including an employee stock ownership plan (ESOP) as described in Section 4975(e)(7).
The notice provides different rules for determining the amount of the reduction depending on whether the same or different class of stock is repurchased and contributed. Additional rules in the notice relate to the timing of the contributions and the interaction with the netting rule. For purposes of the reduction, a covered corporation may treat stock contributions to an employer-sponsored retirement plan as having been contributed in the prior taxable year if contributed by the filing deadline for the first full quarter after the close of the taxpayer’s taxable year and on account of that taxable year. Stock contributed to an employer-sponsored plan is not treated as issued for purpose of the netting rule.
Repurchases by a dealer in securities
The FMV of stock repurchased by a covered corporation (or an applicable acquiror) that is a dealer in securities is a reduction to the extent the stock is acquired in the ordinary course of the dealer’s business of dealing in securities.
The reduction applies solely to the extent that the dealer does all of the following:
- Accounts for the stock as securities held primarily for sale to customers in the dealer’s ordinary course of business
- Disposes of the stock within a period of time that is consistent with the holding of the stock for sale to customers in the dealer’s ordinary course of business
- Does not sell or otherwise transfer the stock to an applicable acquiror, or the dealer (if it is an applicable acquiror) does not sell or otherwise transfer the stock to the covered corporation or another applicable acquiror other than in a sale or transfer to a dealer that also satisfies the requirements.
Repurchases by a RIC or a REIT
A repurchase by a covered corporation that is a RIC or a REIT is a reduction for purposes of computing the covered corporation’s stock repurchase excise tax base.
Repurchases treated as a dividend
The FMV of stock repurchased by a covered corporation is a reduction to the extent the repurchase is treated as a distribution of a dividend under Sections 301(c)(1) or 356(a)(2). A repurchase to which Sections 302 or 356(a) applies is presumed to be subject to Sections 302(a) or 356(a)(1), but a covered corporation may rebut the presumption by establishing sufficient evidence that the shareholder treats the repurchase as a dividend on the shareholder’s federal income tax return. The notice details how a covered corporation provides sufficient evidence.
Grant Thornton Insight
The dividend exception applies to the extent that a redemption under Section 302(d) is treated as a dividend under Section 301(c)(1), assuming sufficient evidence is provided, and not to the extent such redemption is treated under Sections 301(c)(2) and (3). Thus, the exception does not seem to apply to the extent there is not sufficient earnings and profits to characterize the entire repurchase as a dividend.
Netting rule
The stock repurchase excise tax base for a taxable year of a covered corporation is further reduced under the netting rule by the aggregate FMV of stock of the covered corporation that is issued. There are separate rules for stock issued or provided to employees of the covered corporation or a specified affiliate.
General rules for stock issued
Stock is treated as issued or provided by a covered corporation at the time at which, for federal income tax purposes, ownership of the stock transfers to the recipient. The FMV of stock issued is the market price of the stock on the date the stock is issued.
The notice lists the sole circumstances in which an issuance of stock is disregarded, and the stock is not treated as issued for purposes of the netting rule, as follows:
- Stock of a covered corporation distributed by the covered corporation to its shareholders with respect to its stock
- Stock issued by a covered corporation to a specified affiliate of the covered corporation
- Stock issued to the extent that the qualified property repurchase exception applies and the repurchase was not included in the covered corporation’s stock repurchase excise tax base
- Stock treated as issued by the acquiring corporation by reason of Section 304(a)(1)
- Any fractional share deemed to be issued for federal income tax purposes
- Stock issued by a covered corporation that is a dealer in securities to the extent the stock is issued, or otherwise used to satisfy obligations to customers arising, in the ordinary course of the dealer’s business of dealing in securities
- Any target corporation stock that is issued by the target corporation to the merged corporation for consideration that includes the stock of the controlling corporation in a reorganization under Section 368(a)(1)(A) by reason of Section 368(a)(2)(E)
Stock issued or provided to employees
The notice provides special rules for stock issued or provided to employees. The special rules apply to any arrangement under which stock is issued or provided to an employee of a covered corporation, or an employee of a specified affiliate, as compensation for services performed as an employee (e.g. stock in connection with the performance of services under Section 83, or pursuant to a nonqualified stock option or stock option described in Section 421).
The special rules provide that stock withheld by a covered corporation, or a specified affiliate, is not treated as stock issued or provided to an employee for purposes of the netting rule if it is withheld to satisfy either:
- Employer income tax, Medicare, and Social Security tax withholding obligations
- Exercise price of a stock option
Grant Thornton Insight
The rule related to stock withheld to satisfy an employer’s withholding obligation for purposes of the netting rule notably does not seem to include stock withheld to satisfy the employer’s state and local tax withholding obligations.
The notice also provides stock is treated as issued or provided to an employee for purposes of the netting rule:
- If a third party advances to an employee an amount equal to the exercise price of a stock option, or pays the exercise price of the stock option on behalf of the employee, any stock transferred by the covered corporation (or specified affiliate) to the employee or the third party upon exercise of the option is treated as stock issued or provided to the employee.
- If a third party advances to the employee an amount equal to the withholding obligation under Sections 3402 or 3102, or pays an amount equal to that withholding obligation to the covered corporation (or specified affiliate) on behalf of an employee, any stock transferred by the covered corporation (or specified affiliate) to the employee or the third party is treated as stock issued or provided to the employee.
Stock is issued or provided by a covered corporation, or a specified affiliate, to an employee as of the date that the employee is treated as the beneficial owner of the stock for federal income tax purposes.
In general, an employee is treated as the beneficial owner of the stock when the stock is transferred by the covered corporation (or the specified affiliate) to the employee and the stock is substantially vested within the meaning of Treas. Reg. § 1.83-3(b). Thus, stock transferred pursuant to a vested stock award or restricted stock unit is issued or provided when the covered corporation (or specified affiliate) initiates payment of the stock. Stock transferred that is not substantially vested within the meaning of Treas. Reg. § 1.83-3(b) is not issued or provided to the employee until it vests, except if the employee makes a valid election under Section 83(b) as provided in the notice.
Stock transferred to an employee pursuant to an option under Treas. Reg. § 1.83-7 or Section 421, or a stock appreciation right, is issued or provided to the employee for purposes of the netting rule as of the date the employee exercises the option or stock appreciation right.
The FMV of stock issued or provided to an employee is the FMV of the stock, as determined under Section 83, as of the date the stock is issued or provided to the employee.
Grant Thornton Insight
Pairing stock issuances and repurchases in the same year may help taxpayers reduce or eliminate the stock repurchase excise tax. Taxpayers may consider aligning stock repurchases with years in which large amounts of equity-based compensation may be settled in stock.
Acquisitions of foreign stock
If an applicable specified affiliate acquires stock of the applicable foreign corporation from a person that is not the applicable foreign corporation, or another specified affiliate of the same applicable foreign corporation, the applicable specified affiliate is treated as a covered corporation and the acquisition is a repurchase of stock of a covered corporation for purposes of the stock repurchase excise tax.
The notice provides that an applicable specified affiliate is treated as acquiring the stock of an applicable foreign corporation if: (i) the applicable specified affiliate funds the acquisition or repurchase by any means (including distributions, debt, or capital contributions); and (ii) such funding is undertaken for a principal purpose of avoiding the stock repurchase excise tax.
Under the notice, a principal purpose is deemed to exist if the applicable specified affiliate funds the applicable foreign corporation, or funds a specified affiliate that is not also an applicable specified affiliate, by any means other than distributions, and such funded entity acquires or repurchases stock of the applicable foreign corporation within two years of the funding.
Grant Thornton Insight
While the funding rule only applies if there is a principal purpose of avoiding the stock repurchase excise tax, this rule may be a trap for the unwary because a principal purpose is deemed to exist if the funded entity acquires or repurchases stock within two years of certain types of funding.
Reporting and payment
The notice provides that the IRS anticipates that the proposed regulations will provide for the stock repurchase excise tax to be reported on a new form that will be attached to Form 720, Quarterly Federal Excise Tax Return.
Notwithstanding that Form 720 is filed quarterly, the IRS expects that the stock repurchase excise tax will be reported once per taxable year on the Form 720 due for the first full quarter after the close of the taxpayer’s taxable year. For example, a taxpayer with a taxable year ending on Dec. 31, 2023, would report its stock repurchase excise tax on a Form 720 for the first quarter of 2024, due on April 30, 2024. The IRS expects that the deadline for payment of the stock repurchase excise tax will be the same as the filing deadline and that no extensions will be permitted for reporting or paying the stock repurchase excise tax.
Applicability dates
The excise tax applies to repurchases that occur after Dec. 31, 2022. However, the netting rule takes into account any issuances by a covered corporation during the entirety of its taxable year. For a covered corporation that has a fiscal year taxable year that begins before Jan. 1, 2023, and ends after Dec. 31, 2022, the stock repurchase excise tax applies to repurchases during part of the taxable year only. However, the notice provides that such a covered corporation can use the netting rule to subtract the FMV of stock issued during the entirety of that taxable year.
Grant Thornton Insight
The IRS said it anticipates that the forthcoming proposed regulations under Section 4501 will provide rules consistent with the rules in Notice 2023-2. However, the IRS requested comments on rules included in the notice as well as other questions under Section 4501 that should be addressed in guidance. Therefore, the extent that additional rules will follow in forthcoming guidance is unclear.
Next steps
The new excise tax applies to any repurchase on or after Jan. 1, 2023, regardless of the corporation’s tax year. Affected companies will need to perform at least an annual assessment, and the tax could have a significant impact on M&A transactions and stock compensation arrangements. Although the initial guidance is not exhaustive, corporations now have critical new information on what types of transactions will be excluded, and which transactions are captured as “economically similar transactions.”
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