President Biden signed H.R. 5376, the Inflation Reduction Act of 2022, into law on August 16, 2022. (the "Act"). Companies will be subject to a new 1% excise tax on the purchase of their own shares, essentially incurring a penalty for a strategy they've long used to return cash to investors and boost stock prices. In 2023, the tax goes into force.
Buybacks have skyrocketed in recent years — they are projected to surpass $1 trillion in 2022 — as companies have amassed astronomical profits and stockpiled vast amounts of cash.
Investors, such as pension and retirement funds, like the buybacks. However, vociferous opponents of large businesses and Wall Street, such as Senators Ben Nelson and Rand Paul, are adamantly opposed to Elizabeth Warren and Bernie Sanders despise the tactic, which they refer to as "paper manipulation" to reward top executives and major shareholders.
The biggest S&P 500 companies purchased a record amount of their own stock, $882 billion, in 2017. In the twelve months ending in March, their buybacks hit $984 billion, a new high.
Apple, the parent company of Facebook, Meta, and Alphabet, the parent company of Google, are among the largest repurchasers of stock.
In spite of growing inflation, higher interest rates, and the possibility of stifled economic development, companies have been investing more of their wealth in the purchase of their own stock. Their costs for raw supplies, transportation, and labor have increased. Companies have generally been able to pass on these expenses to consumers, but rising prices for food, clothes, and everything else might affect consumer spending, resulting in slowed sales growth for many companies. The newest official figures indicate that Americans continue to spend, but with less vigor.
Buybacks may boost a company's profits per share since the number of outstanding shares is reduced. Executives' confidence in a company's financial outlook may also be signaled via share buybacks.
Description
The Excise Tax is often a nondeductible one percent tax on the value of stock of a "covered corporation" that is either repurchased by or acquired by specified affiliates of the covered corporation during the taxable year. The statute applies to buybacks occurring after December 31, 2022, and there is no "grandfathering rule" for repurchases approved on or before this date (for example, pursuant to a Rule 10b5-1 plan).
A "covered corporation" is a domestic corporation (or some non-US businesses classified as domestic for tax purposes under the "inversion" regulations) whose stock is sold on a "established securities market." In restricted cases, domestic subsidiaries of certain non-domestic public companies shall be considered as repurchasers liable to the Excise Tax when acquiring the stock of certain non-domestic public corporations.
The value of shares recognized as repurchased during the taxable year for purposes of calculating the Excise Tax is decreased by the value of shares issued by the corporation during the same taxable year (the "Netting Rule").
The statute broadly defines "repurchase" by referencing Section 317(b) of the Internal Revenue Code of 1986, as amended (the "Code"), which typically encompasses any acquisition of stock by a corporation in exchange for cash or property other than its own stock or stock rights. The Excise Tax expands this definition to include any additional "economically comparable" transactions, as decided by the Treasury.
Excluded from the Excise Tax under the Act are the following repurchases:
- To the extent the repurchase is part of a tax-free reorganization under Section 368(a) of the Code, and no gain or loss is recognized by the shareholder by reason of the reorganization.
- The repurchased stock, or an amount of stock equal to the value of such repurchased stock, is contributed to an employer-sponsored retirement plan, employee stock ownership plan, or similar plan.
- The total amount of repurchases within the taxable year does not exceed $1 million.
- Under regulations prescribed by Treasury, the repurchase is by a dealer in securities in the ordinary course of business.
- The repurchase is by a regulated investment company or a real estate investment trust.
- To the extent the repurchase is treated as a "dividend" (as opposed to being treated as a "sale or exchange") for US federal income tax purposes.
Issues
Convertible Debt
An issuer of convertible debt may repurchase shares of its own stock before to or in conjunction with the issuing of convertible debt in order to mitigate the dilutive effect of the future conversion of the debt. Unless the debt is converted into stock in the same taxable year, the repurchase would be liable to the Excise Tax without a reduction for the amount repurchased under the Netting Rule.
The Excise Tax might potentially influence stock hedging transactions typically executed by companies in conjunction with their convertible debt issuances. Issuers of convertible debt often engage into a capped call or a bond hedge with a warrant to reduce possible share dilution and offset financial outlays related to debt conversions. Upon conversion, these hedge transactions permit issuers to buy back shares from hedging counterparties at predetermined prices (i.e., physically settle the transaction) or, alternatively, to cash settle the hedging transaction by obtaining the upside entirely in cash or net share settle the transaction by obtaining only the number of shares representing the upside.
In the event of a physical settlement or a net share settlement of such a hedging transaction, the issuer will get its own shares at a below-market price; hence, the Excise Tax may be applicable. However, it is unclear whether and to what degree the Excise Tax and/or Netting Rule would apply to net cash settlements of such hedging transactions or convertible debt. For example, additional guidance could clarify that in situations (such as a cash settlement of these hedging transactions) where a cash payment could be considered the economic equivalent of a series of transactions involving a repurchase followed by an issuance (or vice versa), the Excise Tax will apply in the same manner as it would have to such equivalent transactions when viewed collectively.
Because there is no grandfathering for previous transactions, companies with these hedging activities must pay strict attention to the Excise Tax, particularly when choosing the mode of settlement.
What "Stock" "Repurchases"?
The Excise Tax applies liberally to all repurchases of covered corporation's stock. Repurchases of non-traded stock acquired in privately negotiated transactions and stock that is puttable by the holder, callable by the issuer, or mandatorily redeemable pursuant to its terms (such as mandatorily redeemable preferred stock) appear to fall under the statute's broad applicability, even if the stock was issued before January 1, 2023.
The Excise Tax might also be triggered by the repurchase of instruments, such as penny warrants, that are not considered equity securities for business purposes but are classified as stock for tax reasons.
ASRs
Accelerated share repurchases are another another sort of transaction that might be liable to the Excise Tax ("ASR"). In an ASR, a company enters into a forward transaction with a dealer in which, in exchange for a prepayment amount (which corresponds to the amount the company is committing to spend on repurchasing its shares), the company receives a number of shares typically representing about 80% of the total number of shares it could repurchase at the then-current price. Throughout the life of the ASR, the dealer would engage in open market trades to acquire the company's shares and close out its borrowed holdings. Generally speaking, the ultimate price per share of the company's repurchase under an ASR is the volume-weighted average price of the shares during the duration of the transaction. Depending on the ultimate price per share, the dealer would provide additional shares to the firm at the final settlement, or the company might be required to refund shares or cash to the dealer (e.g., if the final price is higher than the share price at the prepayment date).
An ASR is the anticipated application of the Excise Tax on the company's repurchase of its own shares. It is unclear, however, whether the Excise Tax would apply at the first prepayment date (i.e., when the firm first gets the bulk of its acquired shares) or the ultimate settlement date (i.e., when the final price of the repurchase is determined). This distinction is especially important for ASRs entered into this year with a final settlement date occurring on or after January 1, 2023, the day the Excise Tax takes effect. Similar to the discussion on convertible notes and associated hedging activities, it is unclear how and/or to what degree the Excise Tax and/or Netting Rule would apply to cash settlements of an ASR.
Additional M&A Deals
The 1% share repurchase excise tax, if applicable, raises the cost of stock repurchases for businesses, including (i) ordinary open market purchases, (ii) privately negotiated purchases, and (iii) purchases in registered self-tender offers. This increased expense is anticipated to diminish the frequency of stock repurchases as a method for firms to redistribute surplus cash to shareholders.
This 1% share repurchase excise tax likely applies to "leveraged buy-out" acquisitions of applicable target corporations, which typically result in corporations borrowing money and redeeming a substantial amount of stock in connection therewith, and (ii) retirement of whole classes of preferred stock upon their maturity, if issued by a corporation whose common shares (or any other class of stock issued by such corporation) are traded on an established securities market.
It is unclear if this excise tax would apply to a tax-free split-off, which under the Code is essentially a "redemption" (or stock repurchase).
Several additional forms of transactions that do not seem to include a repurchase in form, but do represent a "redemption" under Section 317(b) of the Code, might also result in the unexpected application of the Excise Tax. For example, where a covered corporation is acquired with transaction consideration funded in part from cash on the covered corporation's balance sheet and/or debt proceeds borrowed (or treated as borrowed) by the covered corporation, such transaction consideration is typically treated as paid to the shareholders in redemption of their stock for federal income tax purposes.
Similarly, in partially tax-free reorganizations in which a covered corporation is acquired by another corporation for at least the required minimum stock consideration and taxable cash "boot," it is possible that all or a portion of the cash consideration would be treated as paid to shareholders in redemption of their shares for income tax purposes. It is also not entirely clear on the face of the statute whether the stock component of the consideration in such transactions (which is generally allowed to be received on a tax-deferred basis) would trigger the Excise Tax, as the statutory exclusion only exempts repurchases that are part of a tax-free reorganization in which no gain or loss is recognized.
A sort of tax-deferred reorganization known as a "split-off" may also trigger the Excise Tax under the terms of the statute. A split-off is an exchange (treated as a redemption for income tax purposes) of some shareholders' stock in a corporation for stock of the firm's corporate subsidiary in a transaction that otherwise fulfills tax-deferral conditions. There is a technical dispute over whether shareholder-level tax deferral in the split-off is accessible "by reason of" the reorganization, which generates doubt as to whether the appropriate statutory exclusion would apply.
Conclusion
An overriding issue is the degree to which taxable entities might alter their conduct to avoid or minimize the Excise Tax. These modifications may include limiting buybacks, scheduling issuances to occur in the same year as buybacks, favoring dividends over buybacks, and/or arranging M&A deals to avoid triggering technical repurchases, as stated above. The effect of the statute will largely be determined by Treasury's regulatory advice.
