Final regulations on the Section 4501 excise tax on the repurchase of corporate stock

Elimination of the Funding Rule

Prior guidance provided a broad anti-abuse rule under which 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), certain purchases with a principal purpose of avoiding the Stock Repurchase Excise Tax (the “Funding Rule”). The Final Regulations exclude the Funding Rule. This eliminates significant challenges previously faced by non-US parented groups in establishing that their stock buybacks were not subject to the Stock Repurchase Excise Tax.

Exceptions for preferred stock

The Final Regulations generally define the term stock to mean any instrument issued by a corporation that is stock or treated as stock for federal tax purposes at the time of issuance.¹ However, the Final Regulations exclude a repurchase of preferred stock that is described in section 1504(a)(4) (commonly referred to as “plain vanilla” preferred stock) from the Stock Repurchase Excise Tax.² Plain vanilla preferred stock is stock that is not entitled to vote, is limited and preferred as to dividends and does not participate in corporate growth to any significant extent, has limited redemption and liquidation rights, and is not convertible into another class of stock.³ Commentators argued, and the IRS agreed, that such stock is similar to debt and thus does not implicate the policy concerns underlying the Stock Repurchase Excise Tax.

In addition, transition relief is provided for mandatorily redeemable stock and stock subject to a unilateral put option of the holder, if such stock was outstanding prior to August 16, 2022 (the date of the enactment of the Inflation Reduction Act of 2022).⁴ This relief acknowledges that corporations have pre-existing obligations to repurchase such stock and should not be penalized for actions required by those obligations. Carve-outs are also generally expanded going forward for certain types of preferred stock used to capitalize banks.

Exclusion for leveraged buyouts and “take-private” transactions

 Under prior guidance, the portion of the consideration in a leveraged buyout or other “take private” transaction that is funded by the target corporation would be treated as a repurchase in computing the target corporation's tax base for the Stock Repurchase Excise Tax. In the Final Regulations, the IRS acknowledges that Congress did not generally intend the Stock Repurchase Excise Tax to apply to leveraged buyouts and other transactions that “fundamentally restructure corporate ownership or control through combinations of separate business entities.” Accordingly, the Final Regulations included a specific exception for a “redemption by a [C]overed [C]orporation that occurs as part of a transaction in which the corporation ceases to be a [C]overed [C]orporation.”⁵

Exclusion for acquisitive tax-free reorganizations

Under prior guidance, a target corporation in an acquisitive reorganization would have been subject to the Stock Repurchase Excise Tax to the extent of the fair market value of target corporation stock exchanged for boot (i.e., property the receipt of which fails to qualify for non-recognition treatment under section 354). However, acquisitive reorganizations, similar to leveraged buyouts, “fundamentally restructure corporate ownership or control through combinations of separate business entities.” Recognizing this and viewing such transactions to be outside of the scope of Congressional intent, the IRS provides an exception for acquisitive reorganizations from the Stock Repurchase Excise Tax in the Final Regulations.⁶

Clarification regarding the treatment of single-entity reorganizations

Prior guidance treated single-entity reorganizations under section 368(a)(1)(E) and (a)(1)(F) as transactions that are “economically similar” to a repurchase under Section 4501(c)(1)(A) and thus subject to the Stock Repurchase Excise Tax under Section 4501(c)(1)(B). The statutory exception in section 4501(e)(1) for a repurchase that is part of a reorganization within the meaning of section 368 where no gain or loss is recognized (the “Reorganization Exception”) effectively limited the application of the Stock Repurchase Excise Tax in single-entity reorganizations to the fair market value of the corporation's shares that are repurchased with boot. The Final Regulations clarify that a reorganization under section 368(a)(1)(E) is treated as a repurchase subject to the Stock Repurchase Excise Tax only if and to the extent that shareholders receive boot and the receipt of such property is not treated as a distribution under section 301.⁷ Because a receipt of money or other property in a section 368(a)(1)(F) reorganization is treated as a separate transaction that is treated as a section 317(b) redemption (see Treas. Reg. § 1.368-2(m)(3)(iii); § 58.4501-5(b)(10) (Example 10)), the Final Regulations do not provide an explicit rule treating section 368(a)(1)(F) reorganizations involving money or other property as “economically similar” transactions.

Removal of the constructive specified affiliate acquisition rule

Prior guidance provided that an acquisition by a Covered Corporation of a corporation or partnership that owns stock in the Covered Corporation generally would be treated as a repurchase of Covered Corporation stock subject to the Stock Repurchase Excise Tax. Commentators argued that this rule was overly broad and would cover non-abusive transactions where there was no intent to avoid the Stock Repurchase Excise Tax. The IRS agreed and removed this rule from the Final Regulations.

Clarification of the reorganization exception for tax-free split-offs

The Final Regulations treat the exchange by the distributing corporation shareholders of their distributing corporation stock for the stock of a controlled corporation in a split-off under section 355 as a “repurchase” under Section 4501.⁸ Because this is the only reorganization which is defined as a “repurchase” within the meaning of Section 4501 under the Final Regulations, the Reorganization Exception is thus limited to section 355 transactions in which the shareholder of a Covered Corporation does not recognize gain or loss as a result of not receiving any boot in the transaction. The Final Regulations also reject an approach to determining whether the Reorganization Exception applies based on whether the shareholder actually recognizes gain or loss. Instead, the Final Regulations look to the type of consideration received by a shareholder (i.e., boot) to determine whether the Reorganization Exception applies.⁹ The IRS viewed this approach as consistent with the statutory language (which does not consider whether the shareholder realized gain or loss on a redemption under section 317(b)) and providing a more administrable rule.

Expansion of exception for registered investment companies to '40 Act funds

The Final Regulations expand the exception available under Section 4501(e)(5) to certain funds registered under the Investment Company Act of 1940 that do not qualify as registered investment companies for federal income tax purposes.¹⁰ Such funds are subject to similar regulatory constraints as registered investment companies, but may not qualify as registered investment companies for reasons unrelated to the Stock Repurchase Excise Tax.

Expansion of the Netting Rule to issuances by specified affiliates of Covered Corporation stock to non-employee service providers

Section 4501(c)(3), which provides the “Netting Rule,” reduces a Covered Corporation's tax base for the Stock Repurchase Excise Tax by the fair market value of certain stock of the Covered Corporation that is issued or provided by the Covered Corporation or a specified affiliate. The Final Regulations extend the Netting Rule by reducing a Covered Corporation's tax base by the fair market value of stock of the Covered Corporation provided by a specified affiliate in connection with the performance of services for the specified affiliate by non-employee service providers of the specified affiliate.¹¹

Narrowing of the special treatment for non-stock instruments

Under the Final Regulations, non-stock instruments are generally treated the same as stock for purposes of the Netting Rule. However, a limited exception exists for certain potentially abusive transactions involving non-stock instruments the offer and sale of which were not registered with the Securities and Exchange Commission and were issued to a person that owns at least 10 percent of the stock of the Covered Corporation.¹²

Increase in the ownership percentage a domestic partner must have to treat a foreign partnership as an applicable specified affiliate

The Final Regulations raise the de minimis threshold for treating a foreign partnership as an applicable specified affiliate such that a foreign partnership with one or more direct or indirect domestic entity partners is not considered an applicable specified affiliate unless the domestic entities hold, directly or indirectly, in aggregate, at least 10 percent of the capital and profits interests in the foreign partnership (as opposed to five percent under previously issued guidance).¹³

Effective date

The Final Regulations generally apply to repurchases of stock of a Covered Corporation occurring after December 31, 2022 and issuances and provisions of stock of a Covered Corporation occurring during taxable years ending after December 31, 2022.¹⁴ Taxpayers may be eligible to seek refunds for repurchases that occurred after December 31, 2022, if such repurchases are no longer subject to the Stock Repurchase Excise Tax under the Final Regulations.

Authored by Jay Michael Singer, Max Feinstein, and Kelsey Levin-Epstein.