Stock Buyback Tax Raises Questions as to Application and Practical Effect

Joe Soltis, Claude Stansbury, and Robert Scarborough are partners at Freshfields Bruckhaus Deringer LLP. This post is based on a Freshfields memorandum by Mr. Soltis, Mr. Stansbury, Mr. Scarborough, Sarah Solum, and Daniel Fox. Related research from the Program on Corporate Governance includes Short-Termism and Capital Flows by Jesse M. Fried and Charles C.Y. Wang (discussed on the Forum here); and Share Repurchases, Equity Issuances, and the Optimal Design of Executive Pay by Jesse M. Fried (discussed on the Forum here).

On August 16, 2022, President Biden signed the Inflation Reduction Act of 2022 (the “IRA”) into law. Although far from the sweeping tax reform that the Biden Administration had originally envisioned, one provision from the previously proposed “Build Back Better Act” that was included in the IRA is a new 1% non-deductible excise tax on stock repurchases by publicly traded U.S. corporations (the “Buyback Tax”).

Overview of the Buyback Tax

The Buyback Tax applies, with certain exceptions, to stock buybacks and other transactions effected after December 31, 2022 that are treated as redemptions for tax purposes. A corporation is generally treated as redeeming its stock if it acquires such stock from a shareholder in exchange for property (other than its own stock or rights to acquire its own stock), regardless of whether the stock is cancelled, retired, or held as treasury stock. Corporations subject to the Buyback Tax (“covered corporations”) include publicly traded U.S. corporations and publicly traded foreign corporations that have undergone certain “inversion” transactions since September 20, 2021. Repurchases by 50%-owned subsidiaries of a covered corporation are generally treated as having been made by the covered corporation itself. Foreign public companies, including foreign private issuers that are listed on U.S. exchanges, are generally not subject to the Buyback Tax, although a purchase by certain U.S. subsidiaries of a foreign public parent company’s stock may be subject to the Buyback Tax (with certain modification).

The Buyback Tax does not apply to stock repurchases (i) that are part of a tax-free reorganization in which the redeemed shareholder does not recognize gain or loss, (ii) where the redeemed stock (or stock of an equal value) is contributed to an employer-sponsored retirement plan, employee stock ownership plan, or a similar plan, (iii) effected by a real estate investment trust (REIT) or regulated investment company (RIC), or (iv) to the extent treated as dividends for tax purposes. A de minimis rule exempts covered corporations that repurchase less than $1 million of their stock during a given taxable year, and the U.S. Department of the Treasury (“Treasury”) is directed to issue regulations that exempt certain repurchases by securities dealers.

In a given taxable year, the value of a covered corporation’s repurchased stock that is subject to the Buyback Tax is reduced by the value of the stock that the corporation issues during the taxable year, including stock (or an affiliate’s stock) issued to employees.

Why Companies Buy Back Their Stock 

Tax Considerations

For tax purposes, stock buybacks by public companies are usually treated as a sale of the underlying stock (equivalent to a sale to a third-party).  A participant in a stock buyback generally recognizes capital gain or loss equal to the difference between the proceeds from the buyback and his or her basis in the redeemed stock (typically, the amount paid for such stock).  Long-term capital gains are taxed at favorable rates (currently up to 23.8%) for individuals and other non-corporate taxpayers, compared to ordinary income, which is generally taxed at a top marginal rate of 37%. Foreign investors are generally not subject to U.S. federal income tax on capital gains attributable to the sale of stock of a U.S. corporation.

While economically similar, dividends are taxed somewhat differently. Although dividends paid by U.S. corporations are generally subject to the same 23.8% tax rate as capital gains, the full amount of a dividend is included in income and subject to tax, without a basis offset.  Dividends paid to foreign investors are subject to a 30% U.S. withholding tax, though an applicable treaty may reduce such rate, typically to 15%.

Tax-exempt investors, which constitute a large shareholder base for many U.S. public companies, do not pay tax on dividends or capital gains, leaving them generally indifferent from a tax perspective as between the two.

Non-Tax Considerations

Companies may have a variety of non-tax goals in mind when determining to return capital to shareholders in the form of a stock buyback.  Reasons for a stock buyback may include:

  • signaling that a company believes its stock is undervalued (whereas a dividend may only suggest that the company has excess cash and no favorable investment opportunities);
  • managing dilution caused by stock consideration paid by acquisitive companies as part of M&A activity; and
  • reducing equity compensation programs’ dilutive effect, particularly for companies in high growth-sector industries (e.g., technology companies).

The principal political argument underlying criticism of stock buybacks seems to be the belief that companies use buybacks to boost their stock price.  In theory, buybacks should not affect a company’s value as they eliminate an equal amount of assets and equity claims on assets, but market reality is more complex.  The increased demand caused by a buyback may drive up stock prices, while some commentators have also expressed concern that buybacks improve financial metrics on which investors focus, such as earnings per share, and may as a result affect market perceptions of value. [1] In addition, companies often use their stock price as one of the performance measures that affect executive and other employee compensation, and increases in stock price would also increase the unrealized value of options and other equity compensation arrangements (which often do not participate in dividend distributions)—which critics argue can distort management incentives when considering whether to pursue a buyback.

These and other concerns led the Securities and Exchange Commission to propose new rules related to stock buybacks which are designed to enhance transparency, enable more timely public disclosures of stock buybacks and alleviate information asymmetries. For more on the proposed SEC rules on stock buybacks, check out this post.

Outstanding Questions 

Many uncertainties remain regarding how the Buyback Tax will apply in various scenarios.  Treasury is granted broad authority to issue regulations regarding the Buyback Tax, although it is unclear whether it will be in the position to issue guidance prior to the tax taking effect on January 1, 2023.

Will the Buyback Tax apply to extraordinary transactions?

Although seemingly not the intended political target of the Buyback Tax, a liquidating distribution, or a formal redemption as part of a larger change of control transaction, typically does include both the delivery of property to shareholders and the redemption or cancellation of their shares.  Absent an exemption, a variety of M&A and other extraordinary transactions that would not colloquially be considered “stock buybacks” could become subject to the Buyback Tax.

For example, a target corporation with substantial cash on its balance sheet may redeem some of its stock immediately prior to a buyer acquiring the remainder of its shares (a so-called “Zenz transaction”). Under current law, a selling shareholder is generally indifferent as to whether it receives cash from the target company in the redemption or from the buyer in the sale.  If the redemption is subject to the Buyback Tax, it may motivate the parties to restructure the transaction such that all cash comes from the buyer. This could increase borrowing or other transaction costs for the buyer and has the dubious distinction of treating two economically identical transactions differently for tax purposes.

In addition, if the Buyback Tax is interpreted to apply to liquidating distributions or redemptions in connection with extraordinary transactions, it could have significant implications for SPACs, whether undergoing initial business combinations (“de-SPACs”) or dissolving at the end of their lifespans.  In a de-SPAC, in which shares of investors who elect not to participate in the de-SPAC are redeemed, the parties to the de-SPAC could negotiate responsibility for the Buyback Tax, like any other transaction cost. In this situation, the effect of the Buyback Tax could be mitigated to the extent of the value of the stock that the SPAC issues during the same taxable year, including, presumably, stock issued to other investors in the de-SPAC. By contrast, in an end-of-life dissolution, in which a SPAC that has not completed a de-SPAC returns its capital to shareholders, the Buyback Tax presumably reduces the amount of cash available to the public shareholders, changing the expected return model of a SPAC investment.

If the Buyback Tax does apply to extraordinary transactions, it would effectively constitute a transfer tax applicable to certain deal structures.

Will the Buyback Tax cause acquisitive companies to shy away from equity consideration?

If there is an added cost to managing dilution in the future, a company may be less inclined to issue shares. Often, parties use stock consideration to align the interests of the buyer and the sellers. However, at 1%, it seems unlikely that the Buyback Tax will move acquisition structures away from stock consideration; transactions can usually be structured such that the receipt of stock consideration is tax free and ultimately results in capital gain when sold, whereas phantom stock or other equity-linked consideration that is not treated as stock for tax purposes may align interests but generally results in compensation income taxed at ordinary income rates. Although managing dilution via buybacks in the future may trigger the Buyback Tax, equity consideration issued in an acquisition would generally reduce the amount of a company’s Buyback Tax in the year it is issued (by offsetting the value of other stock the company may have repurchased). It remains to be seen whether the market will develop a marginal incentive for contingent value rights, convertible debt, or other instruments with equity-like features. [2]

Will the Buyback Tax affect competition for talent?

High growth sector companies wanting to attract talent often issue substantial equity compensation to employees and executives. If prospective hires think that a potential employer is unlikely to engage in stock buybacks, they may believe that their equity compensation will not increase in value as quickly compared to that issued by a different employer that is not subject to the Buyback Tax. In that regard, the Buyback Tax creates a difference between public and private U.S. employers, as well as between U.S. and foreign public companies. Although equity compensation does reduce the amount of the Buyback Tax in a given taxable year, U.S. public companies may be less enthusiastic about issuing stock if they expect the Buyback Tax to make managing dilution expensive. To the extent that U.S. public companies do move towards paying dividends rather than conducting stock buybacks, competition for talent could result in equity compensation programs being revised to capture the value of dividends in more circumstances.

How will regulations address timing questions?

Programs like accelerated stock repurchases (“ASRs”) generally accelerate the timing of the delivery of shares to the redeeming corporation while allowing the facilitating financial institution to acquire shares from public shareholders over time. When those shares are considered “redeemed” for purposes of the Buyback Tax is unclear, as is whether ASRs or similar arrangements could be available to accelerate a repurchase into 2022, before the Buyback Tax takes effect.

How will the Buyback Tax apply to instruments other than common stock?

The regulatory grant in the IRA’s statutory text specifically contemplates that Treasury may issue regulations to address special classes of stock and preferred stock. It is unclear whether any such regulations or other guidance will attempt to apply the Buyback Tax to the repurchase of other instruments with an equity-linked component (e.g., convertible debt).

Who will bear the Buyback Tax in negotiated repurchases?

A negotiated stock buyback is often the outcome of a shareholder activism campaign, and the Buyback Tax adds an additional cost to such negotiated resolutions. As with M&A and other extraordinary transactions, the Buyback Tax will presumably be viewed as a transfer tax, the cost of which may have a marginal effect on negotiations among the parties and their bargaining positions.

As of now, it is unclear what effect the Buyback Tax may have on market activity. Reports in the popular press suggest that, at 1%, the Buyback Tax is likely to be seen as a cost of doing business, rather than causing market participants to change their capital allocation structure or strategy. Whether the Buyback Tax actually affects a company’s decision-making process and, to the extent it applies, who ends up bearing the cost, remains to be seen.

Endnotes

1Absent other dilutive issuances of a company’s stock (including in securities offerings and as merger consideration or equity compensation), buyback activity decreases the number of shares of a company’s stock. Since shares are included in the denominators of such metrics, a decrease would, all else equal, cause such metrics to improve.(go back)

2It is unclear how hedges to prevent dilution arising from convertible debt issuances, such as capped calls or other equity derivatives, may be treated for purposes of the Buyback Tax.(go back)

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