The Inflation Reduction Act imposes a 1% excise tax on certain repurchases of stock of publicly traded US corporations (“Covered Corporations”) effected after December 31, 2022 (the “Excise Tax”).[1] On December 27, 2022, the Department of the Treasury (“Treasury”) and the IRS issued Notice 2023-2 (the “Notice”), providing interim guidance on the Excise Tax. The Excise Tax generally applies to the fair market value of stock repurchased in a taxable year, net of the fair market value of stock issued in the same taxable year, with certain modifications. The Notice announces that proposed regulations addressing the Excise Tax are forthcoming and that taxpayers may rely on the Notice until such regulations are issued. This post highlights key guidance from the Notice as it relates to common M&A and capital market transactions.
Application of the Excise Tax to M&A and capital market transactions
The Notice confirms that the Excise Tax may apply to transactions that are not conventionally regarded as stock buybacks, while also exempting certain transactions from the Excise Tax.
Acquisitive tax-free reorganizations and other tax-free corporate transactions
The Excise Tax applies to the extent of “boot” (cash, certain preferred stock and other non-stock property) received by a Covered Corporation’s stockholders in certain acquisitive tax-free merger and asset reorganizations under Section 368(a) of the Code[1] where the target is a Covered Corporation – including tax-free forward and reverse subsidiary mergers – as well as in certain other tax-free transactions involving Covered Corporations (including split-offs, recapitalizations and “F” reorganizations). The determination of whether the Excise Tax applies to an acquisitive tax-free reorganization is made without regard to whether the “boot” is sourced by the acquirer or the Covered Corporation and without regard to whether the acquirer is a Covered Corporation. An acquisition of a Covered Corporation pursuant to a tax-free reorganization in which the Covered Corporation’s stockholders receive solely acquirer stock (other than certain preferred stock) should not trigger the Excise Tax. A tax-free spinoff structured as a distribution on the Covered Corporation’s stock (as opposed to involving an exchange of the Covered Corporation’s stock), or a split-off pursuant to which a Covered Corporation’s stockholders exchange their Covered Corporation stock solely for stock of a “controlled corporation” of the Covered Corporation, likewise should not trigger the Excise Tax.
Cash paid in lieu of fractional shares
Cash paid by a Covered Corporation in lieu of a fractional share in a tax-free reorganization under Section 368(a) of the Code, or pursuant to the settlement of an option, convertible note or similar instrument, generally will not be treated as a repurchase subject to the Excise Tax.
Liquidations
A complete liquidation of a Covered Corporation (other than to minority owners of a Covered Corporation that has an 80% or greater corporate shareholder), as well as distributions by such a Covered Corporation during the taxable year of its liquidation (whether or not pursuant to the plan of liquidation), are not subject to the Excise Tax. As discussed in a September 2022 Cooley blog post, before the Notice there was concern that the Excise Tax might apply to the liquidation of a US special purpose acquisition company (SPAC) that does not consummate a deSPAC transaction. The Notice provides significant comfort on this point but unfortunately does not address a technical question as to whether the exemption still applies if one or more shareholders do not receive amounts pursuant to the liquidation (e.g., because SPAC sponsor shares are forfeited and not entitled to receive any distributions upon liquidation).
DeSPAC transactions
As discussed in the previously mentioned September 2022 Cooley blog post, repurchases by a US SPAC pursuant to the exercise by SPAC stockholders of their redemption rights are taken into account for purposes of the Excise Tax, but issuances of SPAC stock in the same taxable year (e.g., SPAC stock issued in a private investment in public equity financing or in a deSPAC transaction) would reduce the Excise Tax under the “netting rule.” The Notice does not extend the netting rule to deSPAC transactions where target shareholders do not receive SPAC stock (e.g., in “UP-C,” “double dummy,” or “target on top” structures) or to circumstances where the stock issuances do not occur in the same taxable year as the relevant stock repurchases. Non-US SPACs that do not domesticate to the US typically should not be subject to the Excise Tax. Although redemptions effected before a non-US SPAC domesticates to the US in advance of a deSPAC do not appear to be subject to the Excise Tax, the Notice does not provide guidance on this fact pattern.
Leveraged buyouts and other taxable acquisitions funded by a target
A taxable acquisition of a Covered Corporation that is funded in whole or in part by the Covered Corporation’s cash, or a leveraged buyout of a Covered Corporation that is financed with the Covered Corporation’s debt (including debt of a merger subsidiary that is assumed by a Covered Corporation in a taxable reverse subsidiary merger), will be treated as a stock repurchase subject to the Excise Tax. A taxable acquisition of a Covered Corporation that is financed entirely with acquirer cash or debt generally will not implicate the Excise Tax. Note that taxable acquisitions are treated more favorably than the tax-free acquisitions described above insofar as all cash received by the Covered Corporation’s shareholders in the tax-free acquisition is subject to the Excise Tax, whereas in a taxable acquisition only the cash that is sourced to the Covered Corporation is subject to the Excise Tax.
Redeemable preferred stock
A repurchase of mandatorily redeemable preferred stock of a Covered Corporation (including any such stock issued before January 1, 2023) is a repurchase for purposes of the Excise Tax, regardless of whether the repurchased stock is itself publicly traded.
Section 304(a)(1) transactions
A deemed distribution in redemption of stock in a “brother-sister” stock purchase in which stock of one corporation is acquired by another corporation (other than a subsidiary) where both corporations are under common shareholder control will not be treated as a repurchase subject to the Excise Tax.
Repurchases treated as dividends
Stock repurchases by a Covered Corporation that are treated as “dividends” for US federal income tax purposes are excepted from the Excise Tax. There is a rebuttable presumption under the Notice, however, that such exception does not apply. The presumption can be overcome only with sufficient evidence of dividend treatment, including certain shareholder certifications, which may be administratively difficult to obtain.
Publicly traded non-US corporations
Repurchases of stock of publicly traded non-US corporations by their US affiliates, as well as repurchases funded by any means by such US affiliates (including through distributions, debt or capital contributions) if such funding is undertaken with a principal purpose of avoiding the Excise Tax, generally will trigger the Excise Tax, subject to a more limited application of the netting rule for stock issued or provided by the US affiliate to its employees. Under a “per se” rule, such a principal purpose is deemed to exist if the US affiliate funds the publicly traded non-US corporation or its other US affiliates (other than by distributions), and the funded entity repurchases or acquires stock of the publicly traded non-US corporation within two years. Under a special applicability date, the funding rules apply to repurchases and acquisitions of stock made after December 31, 2022, that are funded on or after December 27, 2022.
Calculation of the Excise Tax and the “netting rule”
The Excise Tax is imposed on: (x) the aggregate fair market value of all stock repurchases reduced by (y) the sum of (i) the aggregate fair market value of excepted stock repurchases and (ii) the aggregate fair market value of stock issuances, in each case, by the Covered Corporation in a particular taxable year. A Covered Corporation is not subject to the Excise Tax if the aggregate fair market value of all stock repurchases (before netting out excepted stock repurchases and stock issuances) does not exceed $1 million. Along with clarifying the types of transactions that may be treated as a repurchase for purposes of the Excise Tax, the Notice identifies certain exempt repurchases, restricts the types of stock issuances that can reduce the tax base against which the Excise Tax is applied and provides a framework for calculating the value of stock repurchased and issued.
Even if a Covered Corporation issues more shares than it repurchases in a taxable year, timing and valuation differences can prevent the netting rule from eliminating its Excise Tax liability. The Notice provides that stock is treated as “repurchased” and “issued” at the time at which ownership transfers for US federal income tax purposes or, for transactions that are “economically similar” to a redemption, at the time the stock is exchanged. For stock exchanged or issued in an M&A transaction, this generally will be the “closing date.” For purposes of the Excise Tax calculation, the “fair market value” of the repurchased or issued stock is its fair market value at the date of repurchase or issuance, as applicable, without regard to the amount paid or received for the stock. The Notice contains acceptable methodologies for valuing publicly traded and nonpublicly traded stock and provides specific rules applicable to determining the timing and fair market value of stock issued to employees.
Annual reporting and payment
The Excise Tax is a liability of the Covered Corporation, is not deductible by the Covered Corporation and cannot be offset by losses or other tax assets of the Covered Corporation. The Excise Tax is required to be reported once per taxable year on IRS Form 720, the Quarterly Federal Excise Tax Return, which is due for the first full quarter after the close of the Covered Corporation’s taxable year. The payment deadline is the same as the filing deadline, and no extensions are permitted.
Open questions
The Notice leaves open a number of questions, and Treasury and the IRS have requested comments on the application of the Excise Tax to, among other things:
- Redeemable preferred stock and other special classes of stock or debt (including convertible debt).
- A corporation that is not a Covered Corporation for its entire taxable year.
- Bankrupt or troubled companies.
- Financial arrangements, such as options, that may avoid the Excise Tax.
Contributors
[1] All references to the “Code” are to the Internal Revenue Code of 1986, as amended. The applicable acquisitive reorganizations are type “A” reorganizations (including forward subsidiary “(a)(2)(D)” mergers and reverse subsidiary “(a)(2)(E)” mergers), type “C” reorganizations and acquisitive type “D” reorganizations.
[1] The Excise Tax is discussed in these prior Cooley publications – Tax Implications of the Inflation Reduction Act and Did the Inflation Reduction Act Create a SPAC Tax?
