IRS issues final regulations on stock buyback tax

The IRS published final regulations (T.D. 10037) for the excise tax on repurchases of corporate stock under Section 4501. The rules contain significant differences from previously released proposed regulations, have immediate effect, and can be applied retroactively to past taxable years.

The IRS previously released proposed regulations on April 12, 2024. These proposed rules provided key definitions and operating rules for calculating the stock repurchase excise tax. Final regulations related to procedural considerations, reporting and payment of the tax, were published on July 3, 2024.

The final regulations introduced taxpayer-favorable rules that reduced the scope of transactions subject to the stock repurchase excise tax, among other significant changes from previously proposed rules for the buyback tax.

The final regulations apply to repurchases and issuances of stock of a covered corporation occurring in taxable years after Dec. 31, 2022, except in regard to certain rules that were first introduced in the proposed regulations, in which case the final rules apply for repurchases and issuances made after April 12, 2024 (see Reg. Section 58.4501-6(b) for full list).

In addition, the final regulations provide that if a covered corporation consistently applies all final rules, a covered corporation can apply all rules in the final regulations to repurchases and issuances occurring on or before April 12, 2024.

Key changes in the final regulations from the proposed regulations include:

• The exclusion from the tax of preferred stock described in Section 1504(a)(4)
• The exclusion of a repurchase in a “take-private” transaction
• New rules to clarify the exchange of stock in certain reorganizations
• Changes to requirements of “sufficient evidence” for repurchases that are treated as dividends
• Rejection of the proposed “funding rule” which provided that a subsidiary could be subject to the tax related to its foreign parent’s repurchase of foreign parent stock

The stock buyback tax created complicated regulations, which corporations were expected to follow during the proposed rulemaking period. The full detail of what companies should know about the differences between those proposed rules and the final rules, and how that may present opportunity to retroactively lower tax burden through amended filings, is covered in the rest of this article. 

Overview

Section 4501, created by the Inflation Reduction Act of 2022, imposes an excise tax on each covered corporation equal to 1% of the fair market value (FMV) of the corporation’s stock repurchases during the taxable year (the stock repurchase excise tax).

A “covered corporation” is any domestic corporation with stock traded through an established securities market, as defined by Section 7704(b)(1) (e.g., the New York Stock Exchange and NASDAQ).  

The stock repurchase excise base is determined from the fair market value of all repurchases made by a covered corporation in the taxable year. This amount is then reduced by repurchases subject to an exception, and further decreased by the fair market value of stock issued from the covered corporation during the taxable year under the “netting rule” in Section 4501(c)(3). 

A repurchase, for purposes of the stock repurchase excise tax, includes a redemption within the meaning of Section 317(b) of the Code (Section 317(b) redemptions) and any transaction determined by the Treasury secretary to be economically similar to a Section 317(b) redemption (economically similar transactions).

Certain exceptions under Section 4501(e) are excluded from being treated as a “repurchase.” The statutory exceptions consist of the following:

• Reorganization: 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
• Employee retirement/stock ownership: Repurchases where the stock repurchased (or stock of equal value) goes to an employer-sponsored retirement plan, employee stock ownership plan (ESOP), or similar plan
• De minimis: Repurchases in which the total value of stock repurchased during the taxable year does not exceed $1 million
• Dealer in securities: Repurchases by a dealer in securities in the ordinary course of business as prescribed in regulations
• RIC/REIT: Repurchases by a regulated investment company (RIC) or a real estate investment trust (REIT)
• Dividend: Repurchases to the extent treated as a dividend

The acquisition of stock of a covered corporation by a “specified affiliate” of such corporation is also treated as a repurchase. A specified affiliate is defined in the statue as any corporation or partnership, in which the first corporation has more than 50% ownership, directly or indirectly.

Section 4501(d) provides special rules for the acquisition of stock of an applicable foreign corporation. Specifically, 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. The acquisition is then treated as a stock repurchase for purposes of Section 4501.

Section 4501(f) gives the Treasury secretary authority to issue regulations and other guidance as necessary or appropriate to carry out, and to prevent the avoidance of, the stock repurchase excise tax, including:

• To prevent the abuse of the exceptions under Section 4501(e)
• To address special classes of stock and preferred stock
• For the application of Section 4501(d)

The stock repurchase excise 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.

Definition of stock

The final 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, with two exceptions.

Consistent with the proposed regulations, there is an exception for preferred stock that does not qualify as common equity Tier 1 capital but does qualify 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.

In a noteworthy development, the final regulations added a new exception for preferred stock that is described in section 1504(a)(4).

Repurchases

The final regulations clarify which transactions will be considered “repurchases” for purposes of Section 4501. As defined above, the term “repurchase” means: (i) Section 317(b) redemptions; and (ii) economically similar transactions.

Section 317(b) redemptions

The proposed regulations originally provided two exceptions for transactions that are Section 317(b) redemptions but will not be considered repurchases: (i) Deemed redemptions of stock under Section 304(a)(1) and (ii) Certain payments of cash in lieu of fractional shares if part of a transaction under Section 368 or Section 355, or pursuant to settlement of an option or similar financial instrument.

The final regulations maintain these and added two new exceptions for Section 317(b) redemptions that do not constitute repurchases for purposes of Section 4501. First, a Section 317(b) redemption that occurs as part of a transaction in which the covered corporation ceases to be a covered corporation (i.e. a “take-private transaction”) is not a repurchase. Second, there is a new exception for Section 317(b) redemptions of stock if the stock was mandatorily redeemable (or subject to a unilateral put option by the holder of stock) and was issued prior to Aug. 16, 2022. 

Economically similar transactions

The final regulations provide an exclusive list of economically similar transactions and a non-exclusive list of transactions that are not repurchases, with significant differences from the lists in the previously proposed versions of the buyback tax rules

Both the proposed regulations and the final regulations provided that the exchange of stock in an “E reorganization” under Section 368(a)(1)(E), in which the recapitalizing corporation was a covered corporation, was an economically similar transaction. However, the final regulations only include the exchange of stock in an E reorganization as an economically similar transaction to the extent it is exchanged for property that is not permitted to be received under Section 354 without the recognition of gain (i.e. exchanged for non-qualifying property).

In addition, the final regulations make an exception that an economically similar transaction does not include an exchange of stock in an E reorganization with respect to preferred stock with accrued and unpaid dividends that is treated as a deemed distribution under Reg. § 1.305-7(c)(2) or Reg. § 1.368-2(e)(5).

Notably, the exchange by the transferor corporation shareholders of their transferor corporation stock in an “F reorganization” under Section 368(a)(1)(F), in which the transferor corporation was a covered corporation, was not included on the exclusive list of economically similar transactions. The exclusion in the final regulations of such exchanges is different than that in the proposed regulations.

The preamble further confirms that, similar to an E reorganization, if the transferor corporation’s shareholders receive only qualifying property in the F reorganization: (i) the exchange is not treated as a repurchase for purposes of the de minimis exception; and (ii) the exchange does not need to be reported on the stock repurchase excise tax return. However, any distribution of money or property from either the transferor corporation, or the resulting corporation in an F reorganization, is treated as a separate transaction for purposes of the stock repurchase excise tax.

Consistent with the proposed regulations, the final regulations non-exclusive list provides that the following are not repurchases:

• 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
• The net cash settlement of an option contract, or other derivative financial instrument, with respect to the stock of a covered corporation.

The final regulations provide that the acquisition by a target corporation of its own stock in exchange for property permitted to be received by the shareholders under Sections 354 or 356 in an “acquisitive reorganization” (i.e., a reorganization defined in Sections 368(a)(1)(A), (C), (D) or (G)) is not a repurchase. Such exchanges of target stock were considered economically similar transactions under the proposed regulations and subject to the excise tax to the extent that the reorganization exception did not apply (i.e. if stock was exchanged for boot).

The final regulations excluded from a repurchase a distribution by a covered corporation in complete liquidation to which Sections 331 or 332 apply, or both Sections 331 and 332 apply. The proposed regulations included the exchange of stock under Section 331 as an economically similar transaction if such liquidation also partially qualified under Section 332. This represents another notable change in the final regulations.

Statutory exceptions

The final regulations clarify the rules related to the exceptions under Section 4501(e) as described below.

Reorganization exception

The statute provides an exception for 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.

Due to the changes regarding whether the acquisition by a corporation of its own stock in a reorganization is a repurchase, the final regulations limit the “reorganization exception” to tax-free reorganizations in connection with Section 355 transactions.

Dividend exception

The statute provides an exception for repurchases to the extent treated as a dividend. Consistent with the proposed regulations, the final regulations provide that the FMV of stock repurchased by a covered corporation is a reduction in the stock repurchase excise tax base 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 final regulations also change the sufficient evidence requirement from what was previously proposed.

The final regulations provide that the sufficient evidence requirement is met if the covered corporation:

• Establishes that the repurchase is treated under Section 301 by reason of Section 302(d), or has the effect of a dividend under Section 356(a)(2) based on information known to the covered corporation
• Has no knowledge of facts that would indicate such treatment is incorrect
• Treats the repurchase consistent with such treatment, including withholding if applicable, and
• Demonstrates sufficient earnings and profits to treat the repurchase as a dividend under Section 302 or Section 356.

Documentation of the sufficient evidence requirement must be retained and available for inspection by the IRS.

Notably, the final regulations do not require that the covered corporation must obtain a shareholder certification, as previously proposed. However, a covered corporation can satisfy the sufficient evidence requirement by obtaining a shareholder certification.  

Other exceptions

The final regulations provide an exception for repurchases by non-RIC funds on the grounds that they are obligated to redeem shares at the demand of a shareholder and are limited in their ability to use stock repurchases to artificially increase share value. The preamble cites Section 4501(f) as authority to provide the new exception.

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 that corporation, under the following scenarios:

• Stock provided by a specified affiliate of the covered corporation in connection with the performance of services for the specified affiliate by an employee or other service provider of the specified affiliate
• Issuance by the covered corporation in connection with the performance of services for the covered corporation by an employee or other service provider of the covered corporation
• Issuance by the covered corporation other than in connection with the performance of services

The final regulations clarify that the netting rule includes stock in connection with the performance of services for a specified affiliate by a non-employee service provider, which was not in the proposed regulations. The final regulations have two other notable differences from the proposed regulations. 

The proposed regulations had provided a “no double-benefit rule” which disregarded stock issued by a covered corporation as part of a transaction qualifying as a reorganization under Section 368(a) or a distribution under Section 355 under certain circumstances.

The final regulations removed the “no double-benefit rule” because it was no longer necessary due to the changes in the final regulations regarding the scope of a repurchase (e.g., the exchange by target corporation shareholders of their target corporation stock in an acquisitive reorganization is not a repurchase). However, the final regulations provide a new rule that disregards:

• Any stock issued by a recapitalizing corporation as part of an E reorganization
• Any stock issued by a resulting corporation as part of an F reorganization

The final regulations also adopt a different rule related to a non-stock instrument treated as stock at the time of the issuance is considered the same as stock for the purposes of the netting rule. However, the final regulations also include a special rule for potentially abusive transactions that applies to non-stock instruments for which:    

• The offer and sale were not registered with the SEC, and
• The non-stock instrument was issued or provided to a person that owns (or is considered to own under Section 318) at least 10% of the stock of the covered corporation, either by vote or value.

This is a change from the rule in the proposed regulations that disregarded the 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) until the repurchase of such non-stock instrument.

Consistent with the proposed regulations, the final regulations provide the following are disregarded for purposes of the netting rule:

• 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 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 of a covered corporation contributed to an employer-sponsored retirement plan, or treated as contributed to an employer-sponsored retirement plan, and any stock of a covered corporation sold to a leveraged or non-leveraged ESOP
• 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
• Settlement of an option contract with respect to stock of a covered corporation using consideration other than stock of the covered corporation (including cash)

Constructive specified affiliate acquisition rule

The final regulations dispose of the previously proposed “constructive specified affiliate acquisition rule”. This proposed rule stated that an acquisition by a covered corporation of another corporation or partnership that owns stock in the covered corporation would be treated as a repurchase of covered corporation stock.

Commenters on the proposed rule argued that this rule was overly broad.

Acquisitions of foreign corporation stock

Section 4501(d) provides special rules for the acquisition of stock of an applicable foreign corporation.

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 treated as a repurchase of stock of a covered corporation for purposes of Section 4501.

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. 

Funding rule

The final regulations also do not include a previously proposed funding rule.

Under the proposed rule, an applicable specified affiliate of a foreign corporation was treated as acquiring the stock of such foreign corporation for purposes of Section 4501(d) to the extent the applicable specified affiliate funded an acquisition by the foreign corporation of its own stock, by any means (including distributions, debt, or capital contributions) directly or indirectly, and such funding was undertaken for a principal purpose of avoiding the stock repurchase excise tax. The proposed regulations also provided that there would be a principal purpose of avoiding the stock repurchase excise tax if a principal purpose of the funding was to fund a covered purchase.

Several commenters on the proposed rules requested that the funding rule be withdrawn for reasons including:  (i) its potential to apply to common business transactions such as when a foreign corporation has a historical pattern of redeeming its own stock and its subsidiaries regularly distribute dividends; (ii) the lack of clarity in determining “a principal purpose of funding a covered purchase” and whose purpose of avoiding the stock repurchase excise tax; and (iii) the application of the rule when there were more than one potential funding sources.

Section 4501(d) netting rule

For purposes of determining a specified affiliate’s stock repurchase excise tax under Section 4501(d), the final netting rule only includes stock issued or provided by the applicable specified affiliate to employees of the specified affiliate under Section 4501(c)(3).

Contrary to the general netting rule, the final regulations clarify that the Section 4501(d) netting rule does not apply to non-employee service providers of an applicable specified affiliate, and the adjustment is determined only with respect to shares issued to employees of the covered corporation. The preamble states that the Treasury and IRS “are of the view that the Section 4501(d) netting rule does not apply to non-employee service providers.”