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Proposed regulations (REG-115710-22) released by the IRS and Treasury Department on April 9, 2024, would implement the excise tax under IRC Section 4501, which imposes a 1% surcharge on certain corporate stock repurchases occurring after December 31, 2022. The proposed regulations adopt much of the interim guidance that was released in Notice 2023-2 (see Tax Alert 2023-0054) with some modifications.

In separate regulations REG-118499-23 released simultaneously, the IRS and Treasury describe the procedures for reporting and paying the new excise tax (see Tax Alert 2024-0785).

Comments and requests for a public hearing must be received by June 11, 2024.

Background

IRC Section 4501, which was enacted under the Inflation Reduction Act, imposes an excise tax on a "covered corporation" to the extent its stock is repurchased by the covered corporation or its majority-owned or controlled subsidiary during the tax year. A "covered corporation" is generally defined as any publicly traded domestic corporation. A repurchase by the covered corporation includes a repurchase by its specified affiliate from a person that is not the covered corporation or its specified affiliate. A specified affiliate is generally a greater-than-50% subsidiary of the covered corporation that is treated either as a partnership or corporation.

For foreign corporations whose stock is publicly traded, IRC Section 4501 treats a domestic specified affiliate of the foreign parent corporation as a covered corporation with respect to certain purchases of the foreign parent corporation's stock.

For inversions under IRC Section 7874, additional special rules apply to a "surrogate foreign corporation." In that case, repurchases of stock by a covered surrogate foreign corporation or a specified affiliate of that corporation result in the "expatriated entity" (i.e., the domestic entity described in IRC Section 7874(a)(2)(A)) being treated as the covered corporation that repurchased stock. Subject to certain exceptions and adjustments, the excise tax equals 1% of the fair market value (FMV) of the stock repurchased by the covered corporation during the tax year. The excise tax payment is non-deductible for income tax purposes. The repurchase amount subject to the excise tax decreases by the value of any stock issued by the covered corporation during the tax year, including stock issued to the covered corporation's or a subsidiary's employees (the netting rule).

IRC 4501 defines a "repurchase" as (1) a stock redemption under IRC Section 317(b) (i.e., any acquisition of stock by a corporation from a shareholder in exchange for property, which, under IRC Section 317(a), is almost anything other than stock of the corporation), or (2) any other economically similar transaction as determined by Treasury. The statute provides the following exceptions:

• A repurchase that is part of an IRC Section 368(a) reorganization, and for which the shareholder did not recognize gain or loss (i.e., the exclusion appears to apply only to exempt reorganization exchanges for shareholders that only receive qualifying stock)
• A contribution of repurchased stock or its equivalent value to an employee pension plan, employee stock ownership plan or similar plan
• Total stock repurchases of $1 million or less during the tax year
• A repurchase by a securities dealer in the ordinary course of business
• A repurchase by a regulated investment company (RIC) or real estate investment trust (REIT)
• A repurchase that is treated as a dividend

The FMV of the repurchased stock resulting from one of the statutory exceptions listed previously is treated as a reduction from the covered corporation's stock repurchase excise tax base.

Proposed regulations

The proposed regulations adopted much of the guidance in Notice 2023-2, which went into detail about multiple aspects of the excise tax, including how to calculate the stock repurchase excise tax base, how to treat acquisitive reorganizations, the elements of IRC Section 317(b) redemptions and reducing the FMV for stock contributions to an employer-sponsored retirement plan (see Tax Alert 2023-0054 for more information).

The proposed regulations modified Notice 2023-2 in several areas, however, including the funding rule for foreign parented groups, the exemption for certain preferred stock, the stock taken into account for purposes of the netting rule, the treatment of partial liquidations and the determination of stock’s FMV.

Funding rule for foreign-parented groups

If a specified affiliate of an "applicable foreign corporation" (i.e., a domestic subsidiary of a publicly traded foreign corporation) acquires the applicable foreign corporation's stock from a person that is not the applicable foreign corporation or its specified affiliate, IRC Section 4501(d) treats the acquisition as a repurchase by a covered corporation; in other words, the specified affiliate is treated as a covered corporation with regard to the acquisition.

If a domestic subsidiary that is treated as an applicable specified affiliate "fund[ed] by any means (including through distributions, debt or capital contributions) the acquisition or repurchase" of an applicable foreign corporation's stock, the funding rule in Notice 2023-2 deemed the affiliate to have acquired that stock where the funding "is undertaken for a principal purpose of avoiding the stock repurchase excise tax.&quot

The proposed regulations retain the Notice 2023-2 funding rule with some modifications. The proposed regulations would establish a principal purpose test; under that test, an applicable specified affiliate of an applicable foreign corporation would be treated as acquiring stock of the applicable foreign corporation to the extent the applicable specified affiliate funds, by any means (including through distributions, debt or capital contributions), directly or indirectly, a covered purchase with a principal purpose of avoiding the stock repurchase excise tax (referred to as “a covered funding”). A “covered purchase” refers to an applicable foreign corporation repurchase or acquisition of stock of an applicable foreign corporation.

If a principal purpose of the covered funding is to fund, directly or indirectly, a covered purchase, the proposed regulations would deem that to be a principal purpose of avoiding the excise tax. The Preamble describes this additional language as a clarification in response to questions about how to determine whether a taxpayer has a principal purpose of avoiding the excise tax.

Under the proposed regulations, a covered funding may arise regardless of whether the funding occurs before or after a covered purchase.

Notice 2023-2 also included a “per se rule,” under which a principal purpose is deemed to exist if the funding (other than through distributions) occurs within two years of the funded entity repurchasing or acquiring the applicable foreign corporation’s stock.

In response to comments that the “per se rule” was overbroad, the IRS noted in the regulations’ Preamble that the rule would be replaced with a rebuttable presumption, which would apply in limited circumstances. Under this presumption, a principal purpose would be presumed to exist if (1) the applicable specified affiliate funds by any means, directly or indirectly, a “downstream relevant entity,” and (2) the funding occurs within two years of a covered purchase by or on behalf of the downstream relevant entity.

The proposed regulations define “downstream relevant entity” as one in which 25% or more of the stock is owned, or 25% or more of the capital or profits interests are held, directly or indirectly, by one or more applicable specified affiliates of an applicable foreign corporation (individually or in the aggregate).

The rebuttable presumption may be rebutted only if facts and circumstances clearly establish that there was not a principal purpose. “Thus, the rebuttable presumption would apply only to ‘downstream’ fundings (that is, fundings of, and covered purchases by or on behalf of, relevant entities in which one or more applicable specified affiliates have a material direct or indirect ownership interest). The rebuttable presumption would not otherwise apply,” according to the Preamble.

The proposed regulations would require an applicable specified affiliate claiming the rebuttable presumption to: (1) attach a statement to its stock repurchase excise tax return disclosing the relevant fundings and covered purchases and the facts rebutting the presumption, and (2) provide any additional information that the stock repurchase excise tax return or the accompanying instructions require.

The proposed regulations would generally apply to transactions occurring after April 12, 2024. Transactions would include a covered purchase after that date to which a covered funding that occurred on or after December 27, 2022, and on or before April 12, 2024, is allocated.

The proposed regulations also provide rules that track Section 3.05(2) Notice 2023-2 and in general, would apply to transactions occurring on or after December 31, 2022, and before April 12, 2024. Transactions would include a covered purchase during this period that is funded by a funding that occurred on or after December 27, 2022, and on or before April 12, 2024. In lieu of applying those rules in Notice 2023-2, taxpayers may choose to apply the proposed regulations, subject to certain consistency requirements.

Redemptions of preferred stock issued by banks (that qualify as tier 1 capital)

The proposed regulations would modify the definition of stock to exclude preferred stock that (1) qualifies as additional tier 1 capital and (2) does not qualify as common equity tier 1 capital. Thus, additional tier 1 preferred stock would not be subject to the stock repurchase excise tax, and the issuance of additional tier 1 preferred stock would not be taken into account for purposes of the netting rule.

According to Preamble, this change responds to comments that “the issuing corporation may not redeem or repurchase additional tier 1 preferred stock without prior approval from regulators. Moreover, if such an instrument is callable by its terms, (i) it may not be called for at least five years; (ii) the issuing corporation must receive prior approval from regulators to exercise the call option; and (iii) the issuing corporation must either replace the instrument with other tier 1 capital or demonstrate to regulators that it will continue to hold capital commensurate with risk.”

Netting rule

Under the netting rule, the repurchase amount subject to the excise tax would decrease by the value of any stock issued by the covered corporation during the tax year. Regarding specified affiliates, the proposed regulations would treat stock issued by a covered corporation to a specified affiliate as issued for purposes of the netting rule if and when that stock was transferred by the specified affiliate during the same tax year to a person that is not the covered corporation or a specified affiliate of that corporation if two conditions were met: (1) the covered corporation does not otherwise reduce its stock repurchase excise tax base for the issuing year with respect to the stock, and (2) the subsequent transfer by the specified affiliate is not connected with the performance of services provided to the specified affiliate.

Partial liquidation

The proposed regulations would also treat partial liquidations as repurchases even though no stock may actually be exchanged. IRC Section 302(b)(4) applies to a distribution ‘‘in redemption of stock’’;  IRC Section 317(b) defines a ‘‘redemption’’ for purposes of IRC Section 302. According to the Preamble, “[r]egardless of whether a redemption is constructive rather than actual, the redemption comprises a[n IRC S]ection 317(b) redemption to which [IRC S]ection 302(b)(4) may apply. Therefore, the Treasury Department and the IRS are of the view that a constructive partial liquidation is a repurchase subject to the stock repurchase excise tax, and the proposed regulations would not provide any special exceptions for such transactions. "

Determining FMV

Under the proposed regulations, the FMV of a covered corporation’s stock that is repurchased by the covered corporation or acquired by a specified affiliate would be the market price of the stock on the date the stock is repurchased or acquired. Thus, if the purchase price differed from the market price of the stock on the date the stock was repurchased or acquired, the stock’s FMV would be the market price on the date the stock was repurchased or acquired.

Stock-based compensation transactions and contributions

Generally, the proposed regulations are consistent with Notice 2023-2’s guidance on stock-based compensation, with some helpful clarifications.  The proposed regulations would determine, under IRC Section 83, the FMV of stock issued or provided to an employee or other service provider and taken into account under the "netting rule," regardless of whether the income inclusion is governed by IRC Section 83.  The proposed regulations would also expand the scope of net share settlement transactions to include any transaction where stock is withheld by the covered corporation or specified affiliate to satisfy the exercise price of a stock option or to cover any withholding obligation.  Shares withheld in these transactions would not be treated as issued or provided for purposes of the “netting rule.” As in Notice 2023-2, the gross amount of stock would be treated as “issued” for purposes of the netting rule if the withholding obligations were satisfied via a “sell to cover” arrangement facilitated by a third-party.

The exceptions for “repurchased” stock under IRC Section 4501(e) include stock that is contributed to an employer-sponsored retirement plan, employee stock ownership plan (ESOP) or similar plan.  The proposed regulations define “employer-sponsored retirement plan” to include retirement plans qualified under IRC Section 401(a), including ESOPs.  The Preamble to the proposed regulations notes that the Treasury Department and IRS believe that some funded, broad-based foreign retirement plans could qualify as “similar plans” under the exception.  They are seeking comments regarding which types of foreign plans should be included in the definition.

Implications

The proposed regulations generally align with the interim guidance in Notice 2023-2, with some changes.  One of the more notable changes would affect certain regulated financial entities (e.g., banks), whereby “tier 1” preferred stock issued by those entities would not be treated as stock subject to the stock repurchase excise tax. Other changes elaborate or clarify miscellaneous issues, such as determining eligibility for the $1 million de minimis test, or treating stockless partial liquidations as repurchases. Thematically, many of the “calls” in the proposed regulations attempt to avoid creating special rules that apply simply for stock repurchase excise tax purposes (i.e., stock for IRC Section 4501 purposes is whatever stock generally is for federal tax purposes, including instruments that may be treated as stock, with an exception for tier 1 preferred). Domestic publicly traded corporate groups will likely find the additional examples helpful, such as those illustrating compensatory stock option net exercises, which illustrate how and when to value covered corporation shares as offsetting issuances for purposes of reducing the repurchase excise tax base.

The proposed regulations raise interesting questions as to how the "netting rule" would apply where covered corporation stock is issued to non-employee service providers of a specified affiliate.  The proposed regulations would take stock issued to employees of a covered corporation and its specified affiliates into account for purposes of the netting rule, as well as stock issued to non-employee service providers of the covered corporation.  Stock transferred to non-employee service providers of a specified affiliate, however, would not be counted for purposes of the netting rule.  It is not clear why the proposed regulations draw this distinction.

On the compliance front, covered corporations must comply with the reporting requirements for the stock repurchase excise tax in any year that a repurchase occurs, even if it is clear that no taxes are owed by virtue of the netting rule or statutory exception.  The requirement may result in an unanticipated burden on taxpayers.

Finally, publicly traded foreign-parented groups with US subsidiaries may have a more mixed reaction to the latest regulations. While the per se funding rule was eliminated, the principal purpose test that remains—which will be a more likely consideration for “upstream” fundings by a US subsidiary—could take some taxpayers by surprise. For example, the proposed regulations do not adopt exclusions from the rules, despite commentators’ suggestions that certain ordinary course fundings should not be withing scope. Instead, according to the Treasury press release, the proposed regulations provide a targeted anti-abuse rule without inadvertently capturing “ordinary course intercompany funding transactions.”   

Nevertheless, the principal purpose test appears to suggest that a US subsidiary that never intended to avoid IRC Section 4501(d) may have an excise tax liability if a principal purpose for any particular funding is to facilitate the foreign parent’s own stock repurchases.  For example, the test could result in excise tax liability for a US subsidiary that does not or will not make open market purchases of its parent company stock but makes a distribution to its foreign company parent. Thus, given the typically fungible nature of liquid assets, a determination should be made whether, based on all facts and circumstances, a principal purpose to fund, directly or indirectly, a covered purchase, might be found to exist. 

Affected taxpayers should review the proposed regulations and consider providing comments by June 11, 2024.