IRS issues robust guidance on stock buyback tax

The IRS released two sets of proposed regulations on April 9, 2024, that provide important details on the definitions of key terms, operating rules and reporting and payment requirements for the new excise tax on repurchases of corporate stock under Section 4501 — the stock repurchase excise tax. The proposed regulations were highly anticipated because the tax applies to repurchases on or after Jan. 1, 2023.

The more substantive proposed regulations (REG-116710-22) provide key definitions and operating rules related to the stock repurchase excise tax. The other set of proposed regulations (Reg-118499-23) provides important details about the record keeping requirements, reporting, and payment of the stock repurchase excise tax and is covered in our prior story.

Prior to the proposed regulations, the IRS released limited guidance related to the stock repurchase excise tax in the form of a notice (Notice 2023-2). The proposed regulations are generally consistent with Notice 2023-2 but have some clarifications, modifications and additions, including:

• Clarifying transactions that constitute a repurchase or an economically similar transaction
• Delineating issuances that are disregarded for purposes of the netting rule
• Significantly revising rules whether there is a principal purpose to avoid Section 4501(d) applicable to a U.S. corporation that has a foreign parent with publicly traded stock
• Declining to provide broad exceptions for certain types of preferred stock or special rules for special purpose acquisition companies (SPACs) and leveraged buyouts
• Clarifying the determination of fair market value (FMV) of stock for purposes of Section 4501

Comments on the proposed regulations in REG-116710-22 are due no later than June 11, 2024.

Taxpayers will not need to pay or report the tax until after final regulations related to the proposed Reg-118499-23 are issued, but should consider evaluating the impact on the rules for past and future transactions. The tax could have significant implications for employee stock compensation plans, certain M&A transactions, stock redemption programs, and affiliate companies. 

Overview

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 covered corporation includes a domestic corporation that has stock traded on a national securities exchange (e.g., NYSE and NASDAQ).

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 (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 (the de-minimis exception)
• 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 treated as a dividend

The acquisition of stock of a covered corporation by a “specified affiliate” of that covered corporation (defined below) is treated as a repurchase by the covered corporation. The tax may also apply to certain acquisitions or repurchases of stock of foreign corporations that have stock traded on an established securities market.

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.

Stock repurchase excise tax computation

The proposed regulations state how taxpayers compute their stock repurchase excise tax in a given taxable year consistent with Notice 2023-2. Generally, the stock repurchase excise tax is equal to 1% of the covered corporation’s stock repurchase excise tax base.

The stock repurchase excise tax base means the dollar amount (not less than zero) obtained by: (i) the aggregate FMV of stock repurchased by the corporation and stock of the covered corporation acquired by a specified affiliate; which is reduced by (ii) the FMV of the stock of the covered corporation to the extent that any statutory exception applies; and then reduced further by (iii) the aggregate FMV of stock of the covered corporation issued by the covered corporation, or provided by a specified affiliate of the covered corporation during the covered corporation’s taxable year under the netting rule.

Stock of a covered corporation that the corporation repurchased, or that a specified affiliate acquired before Jan. 1, 2023, is not included in the stock repurchase excise tax base and is not taken into account for the de-minimis exception.

Covered corporation

The proposed regulations provide that the Section 4501 applies to repurchases (and issuances for purposes of the netting rule) made by a corporation only during the period in which that corporation is considered a “covered corporation.” The proposed regulations clarify that a covered corporation becomes a covered corporation at the beginning of the corporation’s “initiation date,” which is the date on which stock of a corporation begins to be traded on an established securities market.

A corporation ceases to be a covered corporation at the end of the corporation’s “cessation date,” which is the date which all stock ceases to be traded on an established securities market.

The proposed regulations specify that the term “established securities market” has the meaning under Treas. Reg. Sec. 1.7704-1(b) consistent with Notice 2023-2. The IRS explicitly rejected the notion that a rule similar to the “involvement safe harbor” under Treas. Reg. Sec. 1.7704-1(b), related to interests of partnerships, should apply.

If a corporation ceases to be a covered corporation pursuant to a plan, and such plan includes a repurchase, the corporation will continue to be a covered corporation with regard to each repurchase pursuant to the plan until the end of the date on which the last repurchase pursuant to the plan occurs.

In addition, if a foreign corporation transfers its assets to a domestic corporation as part of an “inbound F reorganization,” the corporation is not treated as a domestic corporation until the day after the reorganization.  Similarly, if a domestic corporation transfers its assets to a foreign corporation as part of an outbound F reorganization, the corporation is not treated as a foreign corporation until the day after the reorganization.  

Stock

The proposed regulations provide that stock for purposes of Section 4501 means any instrument issued by a corporation that is stock (including treasury stock) or that is treated as stock for federal tax purposes. The characterization of whether an instrument is stock or debt is made at the issuance under federal tax principles and is not retested subsequently.

The proposed regulations provide a new exception that stock does not include certain preferred stock that qualifies as additional tier 1 capital (within the meaning of 12 CFR 3.20(c), 217.20(b), or 324.20(b)), for certain financial institutions, and does not qualify as common equity tier 1 capital. 

The preamble discussed how American depository receipts (ADRs) issued by foreign corporations that provide full voting and other shareholder rights may be treated as a direct ownership interest of the underlying stock consistent with Rev. Rul. 65-218. Similarly, global depositary receipts (GDRs) issued by domestic corporations that are traded on foreign exchanges may be relevant in determining whether the domestic corporation has stock that is traded on an established securities market.

The IRS also clarified that “stock” generally excludes options, other than options that are treated as stock for federal tax purposes at the time of issuance, and convertible debt.  However, the cash settlement of “deep-in-the-money” options determined to be constructively exercised at the time of grant under federal income tax principles would be treated as a repurchase of the underlying stock.

Repurchases

The proposed regulations clarify which transactions will be considered “repurchases” for purposes of Section 4501 consistent with the notice.

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 proposed regulations provide an exclusive list with two exceptions for transactions that are redemptions under Section 317(b) but will not be considered repurchases:

• Section 304(a)(1) transactions regardless of whether the deemed redemption is under Section 302(a) or 302(d))
• 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.
  

Similar to the notice, the proposed regulations have 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 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
• An exchange by the recapitalizing corporation shareholders of their recapitalizing corporation stock as part of an “E Reorganization” under Section 368(a)(1)(E) when the recapitalizing corporation is a covered 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
• The exchange by distributing corporation shareholders of their distributing corporation stock for controlled corporation stock, and other property if applicable, in a split-off distribution qualifying under Section 355 when the distributing corporation is a covered corporation
• Each component distribution for which 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
• A forfeiture or clawback of stock of a covered corporation pursuant to certain legal or contractual obligations, including certain stock subject to post-closing price adjustments, stock for which a Section 83(b) election was made, and stock subject to a clawback agreement related to the occurrence of an event.

Finally, the proposed regulations provide a nonexclusive list of transactions that are not repurchases:

• A distribution in a complete liquidation of a covered corporation that either section 331 or section 332(a), but not both, apply
• A distribution pursuant to the resolution or plan of dissolution of the covered corporation reported on the original Form 966
• A distribution pursuant to a deemed dissolution of the covered corporation, e.g., a deemed liquidation due to a check-the-box election under Treas. Reg. Sec. 301.7701-3
• Any distribution during a taxable year of a covered corporation if the covered corporation completely liquidates during such taxable year, dissolves during such taxable year pursuant to resolution or a plan and reported on Form 966, or is deemed to dissolve during such taxable year
• A distribution by a distributing corporation that is a covered corporation of stock of a controlled corporation under Section 355 that is not a split-off
• Distributions subject to section 301(c)(2) or 301(c)(3) in which the distributee does not exchange stock of the covered corporation, and
• The net cash settlement of an option contract or other derivative financial instrument

Stock of a covered corporation is generally treated as repurchased by the covered corporation, or acquired by a specified affiliate, on the date on which the ownership of the stock transfers to the covered corporation or specified affiliate. For a “regular-way sale,” which is a transaction in which a trade order is placed on trade date and settlement of the transaction does not occur until a standard number of days set by a regulator, the repurchase or acquisition occurs on the trade date.

Specified affiliate

The statute defines a specified affiliate of a corporation as any corporation, or any partnership, in which the first corporation has more than 50% ownership, directly or indirectly. The proposed regulations specify that “ownership indirectly” means a corporation’s proportionate ownership in equity interests through other entities.

The proposed regulations also provide that the determination of whether a corporation or a partnership is a specified affiliate is made when such entity acquires stock of a covered corporation or provides stock of the covered corporation to its employees.

Fair market value

The FMV of stock for purposes of determining the stock repurchase excise tax base is the FMV price of the stock on the date the stock is repurchased or issued, as determined under certain permitted methods.

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 proposed regulations:

• 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 proposed regulations provide a consistency rule requiring that the method used to determine the FMV of stock that is traded on an established securities market must be applied to all repurchases and all issuances through the covered corporation’s taxable year, except for stock issued or provided in connection with the performance of services. The value of stock issued or provided in connection with the performance of services is determined under the valuation rules of Section 83.

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. Sec. 1.409A-1(b)(5)(iv)(B)(1).

In addition, the proposed regulations provide that the same valuation method must be used for all repurchases and issuances of privately owned stock of the same class throughout the covered corporation’s taxable year unless: (i) the stock of the covered corporation was issued in connection with the performance of services; or (ii) the application of that method to a particular issuance would be unreasonable under the facts and circumstances as of the valuation date. 

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 proposed regulations provide 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.

Other statutory exceptions

Generally, the FMV of stock repurchased by a covered corporation in a repurchase that qualifies for a statutory exception reduces the amount of the covered corporation’s stock repurchase excise tax base. The statutory exceptions as described in the proposed regulations are detailed more below.

Reorganization exception

The FMV of stock repurchased by a covered corporation in certain specified reorganizations 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 proposed regulations provide the reorganization exception applies to the following:

• A repurchase by a target corporation as part of an acquisitive reorganization
• A repurchase by a recapitalizing corporation in an E reorganization
• A repurchase by a transferor corporation in an F reorganization
• A repurchase by a distributing corporation in a split-off (regardless of whether part of a D reorganization).

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 proposed regulations define 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) described in Section 4975(e)(7).

The proposed regulations provide a special rule for leveraged ESOPs that treats allocations of qualifying employer securities from the ESOP participants’ accounts that are attributable to employer contributions (and not to dividends) as contributions of stock for this purpose.

Similar to the notice, the proposed regulations provide different rules for determining the amount of the reduction depending on whether the same or a different class of stock is repurchased and contributed. The proposed regulations specify that a covered corporation that had a taxable year that began before Jan. 1, 2023, and ended after Dec. 31, 2022, may include the FMV of all contributions of its stock to an employer-sponsored retirement plan during the entire taxable year.

Repurchases by a dealer in securities

The FMV of stock repurchased by a covered corporation (or acquired by a specified affiliate) 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 proposed regulations stipulate requirements to qualify for this exception similar to Notice 2023-2.

Repurchases by a RIC or a REIT

The FMV of stock of a covered corporation that is a RIC or a REIT that is repurchased by the covered corporation (or a specified affiliate) 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 proposed regulations detail that a covered corporation must have the following to meet the sufficient evidence requirement: 

• Obtain certification from the shareholder
• Treat the repurchase consistent with the shareholder certification
• Have no knowledge of facts that would indicate that the shareholder certification is incorrect, and
• Demonstrate sufficient earnings and profits for dividend treatment.

Netting Rule

Under the netting rule, the stock repurchase excise tax base for a taxable year of a covered corporation is reduced by the aggregate FMV of stock of the covered corporation that is: (i) issued or provided by the covered corporation and (ii) stock of the covered corporation that is provided by a specified affiliate to employees of such specified affiliate.

General rules

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, consistent with the rules for determining market price described above.

However, the proposed regulations list several incidences when the issuance of stock is disregarded 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 (i.e. a distribution of stock under Sections 305(a) or 305(b))
• Stock issued by a covered corporation to its specified affiliate unless the specified affiliate then transfers such stock to a person that is not a specified affiliate if that transfer meets certain requirements
• Stock issued by the covered corporation as part of a transaction qualifying as a reorganization under Section 368(a) or a distribution under Section 355 and that stock is used by another corporation to repurchase its stock and the repurchased stock is not included in such second 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 in exchange 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)
• Any stock issued by a covered corporation in exchange for stock of the covered corporation in a transaction that qualifies under Section 1036(a)
• Any stock issued by a controlled corporation in a distribution qualifying under Section 355 that is not a split-off
• Any stock withheld by a covered corporation to satisfy the exercise price of a stock option or pay any withholding obligation, is disregarded for purposes of the netting rule
• Any issuance of a non-stock instrument that is treated as stock for U.S. federal income tax purposes (e.g. certain deep-in-the-money stock options); however, upon repurchase of the non-stock instrument, the proposed regulations treat the issuance as occurring at the time of the repurchase.

Stock issued or provided to employees

The proposed regulations provide specific rules for stock issued or provided to employees. The proposed regulations provide that stock issued in connection with the performance of services to employees or other service providers of the covered corporation, as well as stock of the covered corporation provided by a specified affiliate to an employee of the specified affiliate, are treated as stock issued by the covered corporation for purposes of the netting rule.

In regard to stock issued or provided for the performance of services, stock is considered transferred only if the transfer is described in Section 83 and the recipient is the beneficial owner of the stock when the stock is both transferred by the covered corporation and substantially vested within the meaning of Treas. Reg. Sec. 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. Sec. 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). Stock transferred to an employee pursuant to an option under Treas. Reg. Sec. 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, on the date the stock is issued or provided to the employee. Stock that is withheld to satisfy the exercise price of a stock option issued in connection with the performance of services is disregarded for purposes of the netting rule. Said differently, the net amount of stock transferred to the recipient after shares are withheld to satisfy the strike price, or a federal tax withholding tax obligation, are treated as issued for purposes of the netting rule. The proposed regulations provide the following example:

In 2024, an employee is issued stock options (as described in Treas. Reg. Sec. 1.83-7, with no readily ascertainable fair market value) to purchase 100 shares of stock from a covered corporation with an exercise price of $4 per share ($400 total). The employee then exercises the option to purchase 100 shares in 2026 when the stock has FMV of $5 per share. Instead of physically settling the option (where the employee would pay $400 to receive $500 of stock), the covered corporation withholds an amount of stock to pay the $400 exercise price (i.e. 80 shares of stock worth $5 a share), and thus issues the employee 20 shares of stock worth $100 for a net settlement of the stock options. Under the proposed regulations, the shares withheld to pay the exercise price are disregarded for purposes of the netting rule, thus the covered corporation would only include a $100 reduction in its excise tax base in 2026 for this transaction.  

Unlike the net settlement rule, the proposed regulations provide that stock issued to a third party in connection with a sale-to-cover transaction is still considered stock issued or provided in connection with the performance of services for purposes of the netting rule. A sale-to-cover transaction is a transaction in which a third party provides cash in order to either pay the employee’s exercise price on the stock options being exercised, or provides cash to satisfy withholding tax obligations, and stock is issued directly to that third party for the money advanced.

Acquisitions of foreign corporation stock

Section 4501(d) provides that if a specified affiliate acquires stock of an applicable foreign corporation from a person that is not the applicable foreign corporation or another specified affiliate, the specified affiliate is treated as a covered corporation and the acquisition is a repurchase of stock of a covered corporation for purposes of Section 4501. For determining the specified affiliate’s stock repurchase excise tax base, the netting rule only includes stock issued or provided by the applicable specified affiliate to employees.

Separate from the general definitions and rules, the proposed regulations provide definitions of key terms and rules to compute the stock repurchase excise tax under Section 4501(d) with respect to stock of a covered foreign surrogate corporation or stock of an applicable foreign corporation.

For purposes of Section 4501(d), the proposed regulations provide the term “covered purchase” to mean an applicable foreign corporation’s repurchase of its stock or an acquisition of stock of an applicable foreign corporation by a relevant entity. 

Consistent with Notice 2023-2, the proposed regulations provide an “a principal purpose rule” that treats an applicable specified affiliate as acquiring the stock of an applicable foreign corporation for purposes of Section 4501(d) to the extent the applicable specified affiliate funds by any means (including distributions, debt, or capital contributions), directly or indirectly, a covered purchase and such funding is undertaken for a principal purpose of avoiding the stock repurchase excise tax (a covered funding). The proposed regulations further stipulate that a principal purpose of avoiding the stock repurchase excise tax under Section 4501(d) exists if a principal purpose of the covered funding is to fund, directly or indirectly, a covered purchase.

Under the notice, a principal purpose would be deemed to exist if the applicable specified affiliate funds the applicable foreign corporation, or a specified affiliate, by any means other than distributions and the covered purchase occurs within two years of the funding (the per se rule).

The proposed regulations replace this per se rule with a rebuttable presumption that can be rebutted if facts and circumstances clearly establish there was not a principal purpose. In addition, the proposed regulations provide that the rebuttable presumption applies only if the applicable specified affiliate funds a downstream relevant entity and the funding occurs within two years of the covered purchase. A downstream relevant entity is defined in the proposed regulations as a corporation or partnership that is 25% or more owned, directly or indirectly, by one or more specified affiliates of an applicable foreign corporation.

An applicable specified affiliate that takes the position that the presumption is rebutted must attach a statement and provide additional information with the stock repurchase excise tax return.

Applicability dates

The proposed regulations generally apply to repurchases of stock of a covered corporation occurring after Dec. 31, 2022, and during taxable years ending after Dec. 31, 2022, and to stock of a covered corporation that is issued or provided during taxable years ending after Dec. 31, 2022.

Certain rules not described in the notice would only apply to repurchases, issuances, or provisions occurring after April 12, 2024, and during taxable years ending after April 12, 2024.

A covered corporation may rely on the proposed regulations for repurchases and issuances and provisions of stock that occur after Dec. 31, 2022, and on or before the publication date of final regulations.

The proposed regulations in Prop. Treas. Reg. Sec. 58.4501-7 (related to stock of a covered foreign surrogate corporation or stock of an applicable foreign corporation) have their own applicability dates. Generally, Prop. Treas. Reg. Sec 58.4501-7 would apply to transactions that occur after April 12, 2024. However, some rules are designated to be applicable to transactions that occur after Dec. 31, 2022, and on or before April 12, 2024. Specifically, the principal purpose rule would apply to a funding that occurs on or after Dec. 27, 2022, in taxable years ending after Dec. 27, 2022. Taxpayers may choose to apply all other rules to transactions occurring after Dec. 31, 2022.