Background
Section 4501 imposes a 1% excise tax on the value of covered corporation stock that is repurchased by the covered corporation or a 50% affiliate. A covered corporation generally means a publicly traded US corporation. However, certain repurchases (or fundings of a repurchase) by a US affiliate of a foreign corporation are also subject to the excise tax.1 USD 1,000,000 in stock repurchases per year is treated as de minimis so that the excise tax does not apply unless that threshold of stock purchases is exceeded. There is an exception to the excise tax for repurchased stock that is contributed to an employer-sponsored retirement or similar plan. In addition, the statute contains a "netting" rule, that reduces the excise tax base by, for example, the fair market value of stock issued by the covered corporation (or in some cases by a specified affiliate), including to employees in connection with services.
What amount is subject to the excise tax?
The value of stock a covered corporation repurchases generally is subject to the excise tax. The excise tax applies to the market value of the stock on the date of repurchase and this is the case even if the market value differs from the price paid for the stock. The regulations use the trade date, rather than the settlement date, for purposes of determining the date both of stock repurchases and of issuances of stock for purposes of the "netting" rule described below.2 The value of a publicly traded company's stock is required to be determined using one of four acceptable valuation methods: (i) daily volume-weighted average price on the date of repurchase, (ii) closing price on the date of repurchase, (iii) average of the high and low prices on the date of repurchase, and (iv) trading price at the time of repurchase.3 For stock not traded on an established market, the stock is required to be valued using section 409A principles, such as by a valuation by an independent appraiser no more than twelve months before the transaction date.
Note that Prop. Treas. Reg. § 58.4501-2(e)(2)(vi) treats a forfeiture or clawback of stock of a covered corporation (or specified affiliate) as a repurchase if the stock was treated as issued or provided for purposes of reducing the excise tax under the netting rule (discussed below). Thus, for example, restricted stock that was treated as taxable to a service provider due to a section 83(b) election, and that was subsequently forfeited, is treated as repurchased at its fair market value on the date of the forfeiture and subject to excise tax at that time (assuming the stock was previously treated as issued for purposes of the netting rule). Similarly, restricted stock units (RSUs) that vest and settle and are taxable to a service provider, but then are clawed back under a clawback agreement (e.g., due to the employee's detrimental behavior or a financial restatement), also are treated as repurchased at fair market value on the date of the clawback (again, assuming the shares were previously counted under the netting rule). The Proposed Regulations appear to assume a clawback will occur by means of the covered corporation taking back stock (rather than offsetting against other compensation due) and do not specify when in the process of reacquiring the stock a clawback should be treated as occurring.
What amounts reduce the excise tax?
Two compensation-related items can reduce the excise tax: (i) issuing or providing stock of the covered corporation to employees/service providers, and (ii) contributing repurchased stock to an employer-sponsored retirement plan, each as explained below.
Application of the netting rule for stock issued or provided to employees/service providers
Section 4501(c)(3) provides that the amount taken into account for purposes of the stock repurchase excise tax "shall be reduced by the fair market value of any stock issued by the covered corporation during the taxable year, including the fair market value of any stock issued or provided to employees of such covered corporation or . . . of a specified affiliate." (Emphasis supplied.) The netting rule applies whether the shares are newly issued shares or Treasury shares.4 The Proposed Regulations interpret section 4501(c)(3) to mean that the value of stock issued by a covered corporation is allowed to be net against the stock repurchased whether the stock is issued to an employee or to a non-employee service provider (director or consultant) of the covered corporation in connection with services provided to the covered corporation, or even if issued not in connection with services.5 By contrast, in order for the netting rule to apply to shares provided by a specified affiliate of a covered corporation, the shares must be provided to an employee of the specified affiliate in connection with the employee's performance of services for the affiliate. Shares provided by a specified affiliate to non-employee service providers or employees of other entities do not count for purposes of the netting rule.6 This is true even if the shares are provided directly by a US parent company to service providers of the specified affiliate.7 In other words, if the parent issues the shares to employees of a specified affiliate, the value of those shares reduces the amount subject to the excise tax under the netting rule, but if the parent issues the shares to non-employee service providers of the specified affiliate, they do not. In order to avoid double counting, the shares issued by the covered corporation to the specified affiliate do not count towards the netting rule, and only once the shares are transferred to an employee of the specified affiliate do the shares count towards the netting rule.8
As was the case in the IRS guidance in Notice 2023-2, the Proposed Regulations follow section 83 rules to determine when the stock was issued or provided to an employee for purposes of this netting rule, including with respect to stock transferred on exercise of an incentive stock option or pursuant to a Section 423 employee stock purchase plan (ESPP) or with respect to stock transferred to a foreign employee who is not subject to US tax.9 In other words, restricted stock is treated as provided to the employee when it vests, or if the employee makes a section 83(b) election, at transfer. Stock issued on settlement of an RSU is treated as provided to the employee when the corporation initiates the transfer of the stock.10 Similarly, stock issued on exercise of an option (including under an ESPP) is treated as provided to the employee when the employee exercises the option. The valuation method used for repurchases (e.g., daily volume-weighted average, closing price, or average of high and low prices (all determined on the date of the transaction)) must also be used for valuing shares issued for purposes of the netting rule.11 This may be a value different than what is reflected on the service provider's Form W-2, given the difficulty companies may experience in running payroll using value on the day of the income event (rather than a prior day), as is not uncommon in connection with RSU vesting events.
The Proposed Regulations continue to treat stock held back for withholding (i.e., net share withholding) or payment of the exercise price of an option as not issued or provided to an employee by a covered corporation or specified affiliate for purposes of the netting rule. By contrast, if the stock is issued and then immediately sold by the broker to cover these obligations (i.e., a sell to cover method of withholding), the stock is treated as issued or provided to the employee and does count for purposes of netting against repurchases. The Proposed Regulations clarify that amounts held back for taxes include those held back for Federal income tax withholding and Federal Insurance Contributions Act (FICA) taxes, as well as those held back for state, local or foreign taxes.12 The Proposed Regulations also clarify that cash settlement is disregarded for purposes of the netting rule.
When does stock contributed to retirement plans reduce the excise tax?
In addition to the above treatment of stock compensation, there is also a specific exemption in section 4051(e)(2) from the excise tax to the extent repurchased stock (or an amount equal to such repurchased stock) is contributed to an employer-sponsored retirement plan. An employer-sponsored retirement plan is defined to mean a retirement plan that is qualified under section 401(a) and maintained by the covered corporation or a specified affiliate.13 This includes an employee stock ownership plan described in section 4975(e)(7). The IRS and Treasury have requested comments on the extent to which broad-based foreign plans that are funded through a secular trust or another type of funded arrangement may be considered "similar plans" and thus included in the employer-sponsored retirement plans that qualify for this exemption from the excise tax.14
As was the case with the Notice, the Proposed Regulations contemplate that to qualify for exemption the contribution must take the form of actual employer stock rather than cash equal to the value of the repurchased stock. Contribution of actual stock presents some practical limitations and issues for employers. For example, no more than 10% of a tax-qualified defined benefit pension plan's assets (based on fair market value) can consist of employer stock. Defined contribution plans like a 401(k) plan are not subject to the 10% limit. However, holding employer stock in a self-directed 401(k) plan has substantial fiduciary considerations under ERISA and a number of employers no longer offer employer stock funds in their 401(k) plans given those concerns.
The Proposed Regulations address the issue of timing of such contributions for purposes of the excise tax by applying principles similar to, but more favorable than, those under section 404(a)(6). Under Prop. Treas. Reg. § 58.4501-3(d)(5), an employer can treat contributions made after the close of a year as having been contributed in the prior taxable year if contributed by the filing deadline for the IRS Form 720, Quarterly Federal Excise Tax Return, that is due for the first full quarter after the close of the taxpayer’s taxable year and if the retirement plan treats the amounts the same as a contribution made on the last day of the calendar year. In a change from Notice 2023-2, the contribution need not be treated as "on account of" the previous year for purposes of section 404(a)(6).15
What is the effective date of the Proposed Regulations?
The 1% excise tax is effective for repurchases of stock occurring after 31 December 2022, and is reduced under the netting rules by any stock issued during the taxable year. A Form 720 excise tax filing, with a Form 7208 attached, is required to be made only once per year, in the first quarter after the close of the year of the repurchases.16 The Proposed Regulations are proposed to be effective for transactions occurring after 12 April 2024 and Notice 2023-2 is obsoleted effective as of that same date.
Next steps
Stock and retirement plan professionals whose companies have repurchased shares likely will need to coordinate with their tax department colleagues who are charged with preparing the excise tax return regarding the value of stock issued to employees and stock contributed to retirement plans. Be aware that if the company determines the value of stock for ordinary income tax purposes differently from the valuation rules in the Proposed Regulations (e.g., if a company uses the value on a day prior to RSU vesting/payment initiation or uses a specific valuation rule for tax purposes under certain non-US laws), then it will not be able to use the Form W-2 value or equivalent non-US value reported to employees in connection with their equity compensation for stock buyback excise tax purposes.
1 For a discussion of the extent to which a US affiliate of a non-US publicly traded corporation may be deemed subject to the excise tax under a "funding" rule proposed under section 4501(d)(1), including whether a US affiliate's reimbursement to a foreign parent of stock-based compensation provided by the parent to the US affiliate's employees might be deemed a "funding" of the parent that triggers the tax, please see our companion alert addressing excise issues for US-inbound companies.
2 Prop. Treas. Reg. § 58.4501-2(g)(2); see also Preamble at 72 FR 25982-3.
3 Prop. Treas. Reg. § 58.4501-2(h)(2)(ii).
4 Prop. Treas. Reg. § 58.4501-1(b)(29).
5 Prop. Treas. Reg. § 58.4501-4(b).
6 Prop. Treas. Reg. § 58.4501-7(n); see also Prop. Treas. Reg. § 58.4501-7(p), Examples 1 and 2.
7 Prop. Treas. Reg. § 58.4501-5, Examples 38 and 39.
8 Prop. Treas. Reg. § 58.4501-4(f)(2).
9 Prop. Treas. Reg. § 58.4501-4(e)(5).
10 This description of the timing of section 83 income (and wages) is consistent with the IRS position in prior guidance, such as in GLAM 2020-004 (22 May 2020).
11 Prop. Treas. Reg. § 58.4501-2(h)(2)(iv)(B).
12 Prop. Treas. Reg. § 58.4501-4(f)(11)(i).
13 Prop. Treas. Reg. § 58.4501-1(a)(11).
14 Preamble, 72 FR at 26004.
15 See discussion in preamble at 72 FR 26003-4.
16 Prop. Treas. Reg. § 58.6011-1(a) and 6071-1.
