Tax

On April 9, 2024, the Treasury Department (the “Treasury”) and Internal Revenue Service (the “IRS”) issued two sets of proposed regulations (the “Proposed Regulations”) regarding the application of the section 4501 excise tax on repurchases of corporate stock (the “Excise Tax”) and the reporting and payment of such taxes. The Proposed Regulations generally follow the approach of Notice 2023-2 (the “Notice”), which was issued on Dec. 27, 2022, with some clarifications and modifications. For a further discussion of the Notice, see “Notice 2023-2: Proposed Guidance on the Stock Buyback Excise Tax” posted on December 29, 2022.

Applicability Date and Transition Relief

The Proposed Regulations providing guidance on the application of the Excise Tax generally apply to (i) repurchases of stock of a covered corporation occurring (a) after December 31, 2022, and (b) during tax years ending after December 31, 2022 and (ii) to issuances and provisions of stock of a covered corporation occurring during tax years ending after December 31, 2022. Any new rules set forth in the Proposed Regulations that were not described in the Notice apply to repurchases, issuances, or provisions of stock of a covered corporation occurring after publication of the Proposed Regulations in the Federal Register.

To the extent the rules are consistently applied, a covered corporation may rely on: (i) the Proposed Regulations with respect to repurchases and issuances and provisions of stock occurring after December 31, 2022, and on or before the date of publication of final regulations in the Federal Register or (ii) the Notice with respect to repurchases and issuances and provisions of stock occurring after December 31, 2022, and on or before April 12, 2024. Further, a covered corporation that relies on the provisions of the Notice may also rely on the provisions of the Proposed Regulations with respect to repurchases and issuances and provisions of stock occurring after April 12, 2024, and on or before the date of publication of final regulations in the Federal Register, provided such rules are consistently applied.

Under the Proposed Regulations, the tax returns reflecting any Excise Tax for tax years ending after December 31, 2022, and on or before final regulations are published, are due with the Form 720 for the first full calendar quarter after the date the final regulations are published.

Weil Tax Observation: While several commentators sought transitional relief from the Excise Tax for certain types of entities and transactions formed or entered into prior to August 16, 2022 – such as (i) redemptions by, and liquidations of, SPACs, (ii) repurchases pursuant to accelerated share repurchase agreements, (iii) certain payments (or liquidating distributions) made in connection with merger and acquisition transactions and (iv) redemptions of non-participating, non-convertible preferred stock, and complete redemptions of tracking stock – Treasury and the IRS determined that no such transition relief would be provided.

Application of the Excise Tax to Various Financial Instruments

The Notice defines “stock” as any instrument issued by a corporation that is stock or that is treated as stock for U.S. federal tax purposes at the time of issuance, regardless of whether the instrument is traded on an established securities market. The Proposed Regulations generally maintain this definition of stock but do provide a very limited-scope exception for “additional tier 1 preferred stock” that does not otherwise qualify as “common equity tier 1 capital.” The Proposed Regulations clarify that the Excise Tax applies broadly to all instruments characterized as “stock” for U.S. federal income tax purposes. Accordingly, other than “additional tier 1 preferred stock,” there are no exceptions for any equity instruments characterized as “stock” for U.S. federal income tax purposes, including, plain-vanilla preferred stock, mandatorily redeemable stock and tracking stock.

The Proposed Regulations also clarify that, for purposes of the Excise Tax, whether an instrument is debt or equity should be determined at the time of issuance under U.S. federal income tax principles, and that this characterization should not be re-tested while the instrument is outstanding. For example, convertible debt that qualifies as debt at the time of issuance would not be subject to the Excise Tax; however, deep-in-the-money options characterized as stock on issuance would be subject to the Excise Tax.

Options and Similar Financial Instruments

The Notice excludes options from the definition of “stock” other than options that are treated as stock for U.S. federal tax purposes at the time of issuance (e.g., “deep-in-the-money options”). Thus, to the extent option contracts are not treated as stock at the time of issuance, the acquisition of such a contract is not viewed as a repurchase for purposes of the Excise Tax. Rather, a repurchase or an issuance of stock under an option contract only occurs at the time of exercise of a physically settled option. The Proposed Regulations generally adopt the approach taken in the Notice with some clarifications.

The Proposed Regulations clarify that the fair market value of shares acquired or issued upon a physical settlement is the fair market value of such shares on the date of exercise (rather than the strike price) and include several examples illustrating this concept. The Proposed Regulations also clarify that the net cash settlement of an option contract (or an embedded option) would not result in a repurchase or an issuance for purposes of the Excise Tax. Finally, with respect to certain synthetic debt instruments, the Proposed Regulations also indicate that the determination of whether and when stock is repurchased or issued is determined without regard to the integration of a qualifying debt instrument with a hedging transaction(s).

The Proposed Regulations include several additional rules relating to the forfeiture and clawback of restricted stock, which was not expressly addressed in the Notice. Under the Proposed Regulations, the forfeiture of restricted stock would be treated as a repurchase on the date of forfeiture if the covered corporation previously treated such forfeited stock as issued or provided under the netting rule (e.g., as a result of a section 83(b) election). Equivalent rules are likewise provided for stock received pursuant to an employee clawback agreement where vesting conditions were not satisfied and with respect to certain shares received as part of an earnout or potentially subject to forfeiture pursuant to an indemnification.

Section 301 Distributions

The Proposed Regulations clarify that an actual distribution subject to section 301(c)(2) or (3) (i.e., a distribution treated as a return of basis and/or capital gain) is not a repurchase (and, therefore, is not subject to the Excise Tax) because such a distribution is neither a section 317(b) redemption nor economically similar to such a redemption. However, the Proposed Regulations provide that an in-form redemption that is dividend equivalent (to which section 301(c)(2) or (3) applies) is a repurchase based on the plain language of the statute, regardless of whether the redemption is pro rata. Similarly, the Proposed Regulations clarify that a 100% pro rata redemption would be a repurchase because the distribution (i) constitutes a section 317(b) redemption or (ii) is an economically similar transaction; however, such a pro rata redemption, at least in part, may be eligible for a statutory exception (e.g., dividend exception).

With respect to the dividend exception, the Proposed Regulations now provide a rebuttable presumption that the dividend exception does not apply to repurchases. Such presumption, however, can be rebutted by a showing that the relevant corporation: (i) obtained certification from the shareholder that the repurchase was treated as a distribution under section 301 (including by virtue of sections 302(d) and 356(a)(2)), (ii) treated the repurchase consistent with the shareholder certification, (iii) had no knowledge of facts contrary to such shareholder certification, and (iv) had sufficient earnings and profits to treat the repurchase as a dividend.

Complete and Partial Liquidations

Consistent with the approach taken in the Notice, under the Proposed Regulations a distribution in complete liquidation of a covered corporation to which either section 331 or 332 (but not both) applies is not a repurchase and is not subject to the Excise Tax. Further, several commentators sought clarification on whether a distribution is in “complete liquidation” for purposes of sections 331 and 346 if some classes of the liquidating corporation’s stock do not receive a distribution. Treasury and the IRS clarified that, in addition to “complete liquidations” pursuant to sections 331 and 332, a distribution pursuant to a plan of dissolution of a covered corporation that is reported on an original (but not a supplemented or an amended) IRS Form 966, Corporate Dissolution or Liquidation (or any successor form), or a distribution pursuant to a deemed dissolution of the covered corporation (for instance, pursuant to a deemed liquidation pursuant to a check the box election), is not a repurchase and is not subject to the Excise Tax.

Weil Tax Observation: Section 346(a) generally requires a distribution on all classes of stock in order for a dissolution of a corporation to qualify as a distribution in “complete liquidation” to which section 331 applies. Accordingly, for liquidations involving insolvent companies (or companies where the liquidation preference on preferred stock exceeds equity value) filing an IRS Form 966 to reflect that a “corporate dissolution” has occurred generally renders the Excise Tax inapplicable to the dissolution.

Distributions During Taxable Year. The Proposed Regulations retain the rule in the Notice that, if a covered corporation or a covered surrogate foreign corporation (as appropriate) completely liquidates and dissolves during a taxable year, no distribution by that corporation during that taxable year is a repurchase. The Proposed Regulations also clarify that this general exception for distributions occurring during the same taxable year as the liquidation does not apply in a situation where the complete liquidation is a transaction to which sections 331 and 332 both apply.

Weil Tax Observation: If a liquidation straddles tax years, the bright-line exception provided by Treasury and the IRS does not appear to provide relief to taxpayers who undertake repurchases in connection with a plan of liquidation if the final liquidation occurs in a tax year subsequent to the repurchases. Accordingly, making all liquidating distributions (for U.S. federal income tax purposes) in a single tax year is necessary to avoid some liquidating distributions from being considered repurchases.

(Excise) Taxable Transactions

Leveraged Buyouts. The Proposed Regulations retain the approach set forth in the Notice that, unless a statutory exception applies, the target-corporation-funded portion of the consideration in a leveraged buyout (“LBO”) or other taxable acquisition of the stock of a target corporation (which is generally treated as a redemption of target corporation stock for U.S. federal tax purposes) is treated as a repurchase for purposes of the Excise Tax. The Proposed Regulations do not provide special rules or relief for LBOs. Additionally, the Proposed Regulations clarify that stock issued by a corporation after it ceases to be a covered corporation is not taken into account under the netting rule. Accordingly, for “take-private” transactions, only stock of the target corporation that is issued during the period in which the target corporation is a covered corporation (i.e., prior to the take-private transaction) counts for purposes of the netting rule.

Weil Tax Observation: Treasury and the IRS did not provide relief for LBOs, even though taxable “take private” transactions do not generally present an opportunity to manipulate earnings per share or other financial metrics that Congress intended to discourage through enactment of the Excise Tax. LBOs can, subject to financing considerations, be structured in ways to potentially mitigate the application of the Excise Tax. For instance, a buyer could consider financing the acquisition of a public company at a parent/holding company. Assuming the parent/holding company finances the purchase via third party borrowing, such that the buyer is treated as providing all of the purchase price and no amount is treated as provided by the target corporation (e.g., a parent/holding company could incur the acquisition debt and transfer the total purchase price to an acquiring subsidiary that then makes the acquisition), depending on the facts, such a structure could potentially render the Excise Tax inapplicable.

Section 304 Transactions. Consistent with the Notice, Treasury and the IRS take the position that the complexity of drafting regulations to apply the Excise Tax to section 304(a)(1) transactions would outweigh significantly any benefit of applying the Excise Tax to those transactions and would create difficultly in administration. Accordingly, the Proposed Regulations provide that the Excise Tax should not apply to a redemption or issuance that is deemed to occur by virtue of section 304(a)(1). However, the Proposed Regulations do not exempt section 304(a)(2) transactions from the application of the Excise Tax.

SPAC Attack: No Direct Relief for SPACS

As described above, Treasury and the IRS decided it was neither necessary nor appropriate to adopt special rules for SPACs in the Proposed Regulations. Thus, SPACs are generally subject to the rules of the Proposed Regulations in the same manner as other taxpayers. Accordingly, the Proposed Regulations do not provide an exception for redemptions of stock subject to a mandatory redemption provision or unilateral put option, which is a type of stock commonly issued by SPACs, nor do the Proposed Regulations expand the netting rule to apply to de-SPAC transactions in which the SPAC is not the acquiring corporation, such as “double dummy” transactions.

Weil Tax Observation: Despite the fact that SPACs are not offered any specific relief under the Proposed Regulations, if a SPAC is going to liquidate, (i) any redemptions in connection with an extension of an unsuccessful de-SPAC which occur in the same taxable year as the SPAC’s liquidation would not be considered repurchases subject to the Excise Tax and (ii) to the extent holders of founders’ shares do not receive distributions, Treasury and the IRS confirmed that this would be considered a liquidation under the Proposed Regulations if an IRS Form 996 is filed (or other criteria are satisfied).

De Minimis Exception

The Proposed Regulations provide that a covered corporation is not subject to Excise Tax with regard to a taxable year of the covered corporation if, during that taxable year, the aggregate fair market value of all repurchases with respect to stock of the covered corporation or the covered foreign corporation, as applicable, does not exceed, in the aggregate, $1,000,000 (the “de minimis exception”). The determination of whether the de minimis exception applies is made before applying any statutory exception or the netting rule.

Weil Tax Observation: The determination of whether a transaction is a repurchase for purposes of the Excise Tax computations is independent of any of the statutory exceptions; thus, the de minimis exception is measured against a covered corporation’s gross repurchases, even if the repurchases themselves are subject to full netting. For example, if a covered corporation changes the par value of its stock with a fair market value of $10 million (which for U.S. federal income tax purposes would be treated as a recapitalization in which the corporation’s shareholders are deemed to exchange their old stock for newly issued stock): (i) this exchange would be included in the stock repurchase Excise Tax base computation as a $10 million repurchase, and (ii) although this amount wholly would be offset under the reorganization exception, the inclusion of the transaction in the stock repurchase Excise Tax base would completely exhaust the allowance under the de minimis exception.

Foreign Covered Corporations

The Proposed Regulations provide certain coordination rules relating to repurchases involving foreign covered corporations. In particular, the Proposed Regulations provide a priority rule for a transaction that is otherwise both a specified affiliate repurchase of stock of an applicable foreign corporation and a surrogate foreign corporation repurchase and, in that case, provide that the covered surrogate foreign corporation repurchase rules apply. The Proposed Regulations also provide a coordination rule for multiple expatriated entities owned by a single covered surrogate foreign corporation.

The Proposed Regulations reflect Treasury and the IRS’ view, based on the absence of a statutorily provided method of allocation, that if there are multiple expatriated entities with respect to a single covered surrogate foreign corporation, each expatriated entity is separately liable for the Excise Tax with respect to all repurchases of the covered surrogate foreign corporation’s stock. However, the Proposed Regulations also provide that if one of such expatriated entities pays the Excise Tax due, then all other relevant expatriated entities are relieved of the liability to pay the Excise Tax. For example, if there are two expatriated entities with respect to the same covered surrogate foreign corporation, and the covered surrogate foreign corporation repurchases $100x of stock during the year, then under the statute’s plain language, both expatriated entities would be liable for any Excise Tax with respect to the $100x repurchase.

Weil Tax Observation: Proposed Regulations Section §58.4501-7 (Example 7) indicates that even though each expatriated entity in a multiple expatriated entity structure is liable for the entire Excise Tax, if there is any netting available to one or more relevant expatriated entities, there is the ability to choose the expatriated entity with the highest netting available to pay the Excise Tax (thus, relieving all the other expatriated entities of their individually higher Excise Tax liability). However, there is no opportunity for using netting from multiple expatriated entities to reduce the Excise Tax due. For example, if two expatriated entities (“US1” and “US2”) owned by the same surrogate foreign corporation (“FP”) each have separate netting available (e.g., US1 provides $80x of FP stock its employees and US2 provides $60x of FP stock to its employees), the expatiated entity with the highest individual netting (US1) can elect to pay the Excise Tax and relieve the other expatriated entity (US2) of Excise Tax liability. In that case, US1 can reduce the aggregate amount of FP stock repurchases subject to the Excise Tax by its own individual netting amount (i.e., $80x) but the netting otherwise available to the other expatriated entity (US2 in this case) cannot be used to reduce the Excise Tax paid by US1.  

Revisions to the Proposed Funding Rule

The Proposed Regulations replace the ”per se” funding rule from the Notice, which, in certain instances, provides that an applicable specified affiliate is treated as acquiring stock of an applicable foreign corporation. Under the funding rule, a U.S. specified affiliate is considered to acquire the stock of an applicable foreign corporation for purposes of the Excise Tax if (1) it funds that acquisition “by any means,” (including distributions, debt, or capital contributions) and (2) avoidance of the Excise Tax is a principal purpose of the funding. The principal purpose test would be met under a “per se” rule if the applicable foreign corporation acquired or repurchased its stock within two years of receiving funding from the U.S. specified affiliate.

In contrast to the “per se” funding rule, the Proposed Regulations provide a rebuttable presumption that applies only for transactions defined as “downstream” fundings that occur within two years. The presumption applies where qualifying affiliates of a foreign corporation directly or indirectly fund a “downstream relevant entity” within two years of a stock purchase by or on behalf of that entity. A downstream relevant entity is one in which one or more affiliates of an applicable foreign corporation — individually or together, directly or indirectly — own 25% or more of the stock (measured either by vote or by value) or of the capital or profits interests of an entity. Such presumption can be rebutted with facts and circumstances that clearly establish that avoiding the Excise Tax was not a principal purpose of the funding.

Weil Tax Observation: While somewhat narrowed, the application of the funding rule is still broad and in circumstances where the rebuttable presumption applies, the Proposed Regulations do not clarify what facts and circumstances may be sufficient to rebut the presumption in a downstream “funding” transaction. While the “per se” rule has been replaced with the downstream rebuttal presumption rule, any “funding” may still be captured by the rule (and result in an Excise Tax liability) if done with a principal purpose of avoiding the Excise Tax.

Carryover of Stock Repurchase Excise Tax Base

While under the Notice it was unclear whether the positive or negative balance in a target corporation’s stock repurchase Excise Tax base (that is, an excess of issuances over repurchases, or vice-versa) may carry over to the acquiring corporation following an acquisitive reorganization for purposes of determining the acquiring corporation’s Excise Tax for the taxable year that includes the acquisition, Treasury and the IRS determined that a carryover approach is not appropriate for purposes the Excise Tax. Accordingly, the Proposed Regulations do not adopt a carryover approach.

Becoming or Ceasing to be a Covered Corporation

The Proposed Regulations provide that a corporation becomes a covered corporation at the beginning of the corporation’s “initiation date,” which is the date on which the stock of the corporation begins to trade on an established securities market – meaning that shares issued on or after the initiation date are counted for purposes of the netting rule, and any repurchases, issuances, or contributions to an employer-sponsored retirement plan on or after that date are taken into account in computing the corporation’s Excise Tax for the taxable year. Repurchases, issuances, or contributions before the initiation date are not counted for purposes of the netting rule.

Conversely, and unless an exception applies, a covered corporation will cease to be a covered corporation at the end of the covered corporation’s “cessation date,” which is the date on which stock of the covered corporation ceases to be traded on an established securities market – meaning that repurchases of stock on the cessation date would be subject to the Excise Tax, but repurchase thereafter would not. The Proposed Regulations, however, provide a limited exception to this general rule if a corporation ceases to be a covered corporation pursuant to a plan that includes a repurchase and such corporation’s cessation date precedes the date on which a repurchase occurs pursuant to the plan. If this exception applies, the corporation would continue as a covered corporation until the end of the day on which the last repurchase occurs.

Specified Affiliate

The Proposed Regulations clarify that the reference to “indirect ownership” (as provided in Section 4501(c)(2)(B)) means a corporation’s proportionate ownership in equity interests through other entities. For example, if P owns 60% of the stock of Sub 1, which owns 60% of the stock of Sub 2, then P indirectly owns 36% of Sub 2. Under this example, Sub 2 would not be treated as a specified affiliate of P by virtue of its indirect ownership. The Proposed Regulations also clarify that the determination of a corporation’s status as a specified affiliate should be made whenever such characterization would be relevant for Excise Tax purposes (i.e., if such potential specified affiliate acquires stock of a covered corporation or such potential specified affiliate provides stock of the covered corporation to its employees).

Under the Proposed Regulations, stock issued by a covered corporation to its specified affiliate (or stock that is treated as so issued under Treas. Reg. § 1.83-6(d)) would be counted for purposes of the netting rule under two different provisions depending on whether the subsequent transfer of such stock by the specified affiliate is in connection with the performance of services. First, if the subsequent transfer is not in connection with the performance of services, then the stock transferred would be counted as stock “issued” by the covered corporation if and when the stock is transferred, during the same taxable year as the original issuance, to a person that is not the covered corporation or a specified affiliate of the corporation. Second, if the subsequent transfer (or deemed transfer under Treas. Reg. § 1.83-6(d)) is in connection with the performance of services, then the stock transferred would be counted as stock “provided” by the specified affiliate, but only if the stock is transferred to an employee of the specified affiliate.

Apart from these clarifications, the Proposed Regulations also incorporate a new rule relating to the acquisition by a covered corporation of an interest in a corporation or partnership that owns stock in the covered corporation (the “Constructive Specified Affiliate Acquisition Rule”). Pursuant to this rule, the acquisition of stock of a corporation (or equity of a partnership) by a covered corporation will be treated as a repurchase to the extent that (i) the target corporation or partnership becomes a specified affiliate of the covered corporation; (ii) at the time the target corporation or partnership becomes a specified affiliate, it owns stock of the covered corporation that represents more than 1% of the fair market value of the target corporation or partnership; and (iii) the target corporation or partnership acquired such stock after December 31, 2022. Stock treated as “repurchased” under the Constructive Specified Affiliate Acquisition Rule is treated as being repurchased at the time the corporation or partnership becomes a specified affiliate of the covered corporation and, importantly, applies regardless of whether the acquisition is structured as a taxable or non-taxable transaction or where a redemption of covered corporation stock causes the target corporation or partnership to become a specified affiliate.

Reorganizations and “Split-Off” Distributions

The Proposed Regulations generally adopt, without any significant modification, the approach to acquisitive reorganizations (i.e., “A” reorganizations, “C” reorganizations, certain “D” and forward/reverse triangular mergers), single-entity reorganizations (i.e., “E” reorganizations and “F” reorganizations) and certain “split-off” distributions pursuant to Section 355 as described in the Notice. Notwithstanding the symmetry between the Proposed Regulations and the Notice, Treasury and the IRS did clarify and address a number of unresolved and/or ambiguous provisions, which are briefly described below:

• Acquisitive Reorganizations
  • Application of Commissioner v. Clark. Treasury and the IRS clarified that the framework espoused in Clark (involving a deemed issuance and redemption) does not apply in determining the applicability of the Excise Tax to non-qualifying property furnished in the reorganization. Rather, Clark is only applicable to determine whether the receipt of non-qualifying property is subject to dividend treatment.
  • Excise Tax Applicable to “G” Reorganizations. The Proposed Regulations expand the list of “acquisitive reorganizations” treated as repurchases to now include section 368(a)(1)(G) reorganizations.
• Single-Entity Reorganizations
  • Inbound and Outbound “F” Reorganizations. The Proposed Regulations clarify that, in the case of inbound and outbound reorganizations under Section 368(a)(1)(F), the change in a corporation’s status as either a foreign corporation or domestic corporation does not occur until the day after the reorganization for Excise Tax purposes.
  • Application of the Netting Rule to Single-Entity Reorganizations and Section 1036 Exchanges. The Proposed Regulations maintain the general exclusion for netting rule purposes of stock issuances made in conjunction with single-entity reorganizations. The Proposed Regulations provide that, for purposes of the netting rule, the transferor corporation and the resulting corporation in an “F” reorganization is treated as the same corporation. The Proposed Regulations also clarify that stock issued pursuant to a Section 1036 exchange is not treated as an “issuance” for purposes of the netting rule.  
• Section 355 Transactions
  • “Spinoff” and “Split-Up” Transactions. The Proposed Regulations clarify that a distribution by the distributing corporation of non-qualifying property in exchange for distributing corporation stock in pursuance of a spinoff or split-up transaction constitutes a “repurchase” for Excise Tax purposes.
  • Exchange of Controlled Securities in a “Split-Off” Transaction. The Proposed Regulations clarify that Controlled securities that are exchanged for distributing corporation stock constitute a repurchase and that such Controlled securities do not constitute qualifying property for Excise Tax purposes – meaning that the exception for the receipt of qualifying property in a split-off is inapplicable to the Controlled securities.
  • Clarification of Examples 13 and 14 in the Notice. The Proposed Regulations clarify and revise certain examples contained in the Notice.