The Inflation Reduction Act of 2022 (the “Act”) was signed into law on August 16, 2022. The Act created new Section 4501 of the Internal Revenue Code of 1986, as amended (the “Code”), which imposes a non-deductible 1% excise tax on certain stock repurchases (the “Excise Tax”).
The stated purpose of the new Excise Tax is to encourage corporations to invest in their business and employees, rather than repurchase their stock. The Excise Tax had previously been proposed as part “Build Back Better” legislative package. It was added to the Act at the last minute to raise revenue when proposed changes to the carried interest rules were dropped in order to obtain the votes necessary for the Act to pass.
Which Corporations Are Subject to the Excise Tax?
The new Excise Tax applies to “covered corporations,” which include any domestic corporation the stock of which is traded on an established securities market, as defined by Section 7704(b)(1) of the Code. Established securities markets include:
a) a national securities exchange registered under Section 6 of the Securities Exchange Act of 1934 (the “Exchange Act”) (e.g., the New York Stock Exchange or Nasdaq);
b) a national securities exchange exempt from registration under Section of the Exchange Act because of the limited volume of transactions;
c) a foreign securities exchange that satisfies local regulatory requirements analogous to Section 6 of the Exchange Act or is exempt from such local regulatory requirements because of the limited volume of transactions (e.g., the London Stock Exchange, the Frankfurt Stock Exchange and the Tokyo Stock Exchange);
d) a regional or local exchange; and
e) an interdealer quotation system that regularly disseminates buy or sell quotations by identified brokers or dealers by electronic means or otherwise.
In addition, domestic subsidiaries of non-US corporations that have shares traded on an established securities market are considered covered corporations for repurchases of the non-US corporation’s stock.
There is no size limit on being a covered corporation, so even micro-cap companies will be subject to the Excise Tax.
What Repurchases Are Subject to the Excise Tax?
The Excise Tax will apply to a “repurchase” of the stock of a covered corporation by the covered corporation or a “specified affiliate” of the covered corporation.
“Repurchases” include a redemption (within the meaning of Section 317(b) of the Code) of the stock of the covered corporation, as well as any transaction determined by the Treasury Secretary to be economically equivalent to a redemption.
A “specified affiliate” of a covered corporation is:
(a) any corporation more than 50% of the stock (by vote or by value), is owned, directly or indirectly, by such corporation; and
(b) any partnership more than 50% of the capital interests or profits interests of which is held, directly or indirectly, by such corporation
It is important to note that “repurchase” is not limited to the stock that is traded on an established securities market, but rather includes the repurchase of any stock of the covered corporation. So, repurchases of preferred stock appear to be subject to the Excise Tax.
Because they involve stock repurchases, leveraged buyouts, special purpose acquisition company (“SPAC”) redemptions in connection with a failure to identify a target, and de-SPACing transactions appear to be covered repurchases.
How Is the Total Value of Repurchases Determined?
The Excise Tax will apply to the total value of the stock repurchased during the taxable year, which is (i) the fair market value of the stock repurchased by the covered corporation of a specified affiliate during the taxable year, less (ii) the fair market value of stock issued by the covered corporation during the taxable year.
For example, in connection with equity compensation plans, shares may be netted to cover an option’s exercise price or the tax withholding on an award. The shares netted would be a repurchase, but since the total value subject to the Excise Tax is reduced by the fair market value of the stock issued, the combined effect will be a net stock issuance and the share netting itself would not be subject to the Excise Tax.
Are There Any Exceptions to the Excise Tax?
Section 4501 provides the following exceptions:
- the repurchase is part of a tax-free reorganization where no gain or loss is recognized on the repurchase by the shareholder by reason of the reorganization;
- where the stock repurchased is, or an amount of stock equal to the value of the stock repurchased is, contributed to an employer-sponsored retirement plan, employee stock ownership plan or similar plan;
- if the total value of the stock repurchased during the taxable year does not exceed $1 million;
- repurchases by a dealer in securities in the ordinary course of business (under regulations prescribed by the Treasury Secretary);
- repurchases by a regulated investment company or real estate investment trust, or
- to the extent that the repurchase is treated as a dividend for tax purposes.
Are There Open Issues Under the Excise Tax?
There are many open issues under Section 4501 that future regulations will hopefully clarify, including:
- What transactions will be deemed “economically similar” to a stock redemption?
- Will repurchases of preferred stock that is subject to a call or mandatory repurchase right be subject to the Excise Tax? Such shares often operate as a fixed investment and do not involve the same issues as repurchases of other shares.
- Whether the exception for repurchases treated as dividends is limited to repurchases treated as Section 316 dividends paid out of current or accumulated earnings and profits.
- Whether the $1 million exception applies if the total value is less than $1 million after adjusting stock repurchases by shares issued.
- Whether a covered corporation that repurchases more than $1 million can use the $1 million exception and only pay the Excise Tax on the total value of the repurchases in excess of $1 million. As written, the $1 million exception would appear not to apply if the total value of repurchases exceeds $1 million in a taxable year. As a result, if the total value of repurchases in a taxable year exceed $1 million by $1.00, then an Excise Tax of $10,000 would apply.
- Whether shares netted from directors or consultants to cover the option exercise price are also offset by the shares issued upon the option exercise. Section 4501 references employees, but hopefully it extends to directors and consultants as well.
- Whether the Excise Tax applies to share purchases by a rabbi trust to fund a nonqualified deferred compensation plan benefits that are deemed invested in company stock. Because the corporation (as the grantor of the trust) is treated as the owner of the trust assets, such transactions would appear to be covered unless subsequent guidance excludes these purchases.
Finally, there is quite a bit of uncertainty in how the Excise Tax will apply in corporate transactions. While there is the specified exception for tax-free reorganizations where no gain or loss is recognized on the repurchase by the shareholder by reason of the reorganization, corporate transactions vary widely in form and often are not fully tax-free.
When Does the Excise Tax Become Effective?
The new Excise Tax will apply to covered stock repurchases occurring after December 31, 2022, regardless of whether the repurchase is made pursuant to a plan or binding commitment entered into on or before such date.
What’s Next?
For now, we are awaiting treasury regulations and further guidance from the IRS that will clarify the many open issues. Hopefully, some guidance will be forthcoming soon given that the Excise Tax will apply to repurchases after December 31, 2022.
In the meantime, if you have any questions of the new Excise Tax, please contact a member of Harter Secrest & Emery’s Employee Benefits and Executive Compensation, Tax, or Securities and Capital Markets groups at 585.232.6500 or 716.853.1616.