April 03, 2023
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Notice 2023-2[1] (the “Notice”) provides guidance regarding the scope and application of the excise tax on buybacks of stock of publicly traded domestic corporations and certain publicly traded foreign corporations (the “Excise Tax”) imposed by section 4501 of the Internal Revenue Code of 1986, as amended (the “Code”).[2] Although section 4501 on its surface primarily applies to publicly traded domestic corporations, the Notice contains a “per se” funding rule that appears to cause the Excise Tax to apply to many publicly traded foreign corporations with domestic affiliates engaging in common intercompany transactions, regardless of whether such transactions are entered into with a purpose to avoid the application of the Excise Tax. According to the Notice, the funding rule is anticipated to apply to repurchases and acquisitions of stock by applicable foreign corporations made after December 31, 2022, that are deemed to have been “funded” on or after December 27, 2022 by certain domestic affiliates. Given the broadly-drafted rules in the Notice, while we await future administrative guidance, foreign corporations should carefully review their stock buybacks and intercompany transactions to ensure that their intercompany transactions with U.S. affiliates do not unexpectedly cause the Excise Tax to apply.
Generally, section 4501 imposes on publicly traded domestic corporations (referred to in the Notice and the remainder of this discussion as “covered corporations”[3]) an excise tax equal to 1% of the fair market value of any stock of the covered corporation that is (i) “repurchased”[4] by the covered corporation or (ii) purchased by a “specified affiliate”[5] of the covered corporation (other than a purchase from the covered corporation or a specified affiliate of the covered corporation).[6] During any taxable year, the fair market value of the stock of the covered corporation treated as repurchased by such covered corporation (or purchased by a specified affiliate of the covered corporation) is reduced by the fair market value of any stock of the covered corporation issued or provided to employees of such covered corporation or a specified affiliate of such covered corporation (such rule, the “Netting Rule”).[7]
While the Excise Tax generally only applies to buybacks of a publicly traded domestic corporation’s stock, it may apply to a foreign corporation in two specified circumstances. First, the Excise Tax applies where a “covered surrogate foreign corporation”[8] repurchases its own stock or a specified affiliate purchases the stock of the covered surrogate foreign corporation.[9] Second, section 4501 provides that the Excise Tax applies where the stock of an “applicable foreign corporation”[10] is purchased by a specified affiliate of such corporation that is (i) a domestic corporation, (ii) a domestic partnership or (iii) a foreign partnership with at least one domestic entity as a direct or indirect partner (such rule, the “Indirect Domestic Repurchase Rule”).[11] In this note, we refer to such an affiliate as a “domestic affiliate,” while the Notice refers to such an affiliate as an “applicable specified affiliate.”[12]
However, as discussed in more detail below, the Per Se Funding Rule (as defined below) appears to significantly expand the scope of the Excise Tax to repurchases, or purchases, of stock of applicable foreign corporations that are not actually made by a domestic affiliate.
The rules set forth in the Notice are to be included in Treasury regulations that have not yet been proposed. The Notice was issued pursuant to Congress’s direction that Treasury write regulations and other guidance “as are necessary or appropriate to carry out, and to prevent the avoidance of,” section 4501, including regulations and other guidance for the application of the Indirect Domestic Repurchase Rule.[13]
However, while section 4501 itself applies the Excise Tax to repurchases or purchases of the stock of publicly traded foreign corporations only in limited instances discussed above, the Notice greatly expands the circumstances in which the Excise Tax may apply to such repurchases or purchases.
Of particular concern, while section 4501(d)(1) applies the Excise Tax to purchases of stock of an applicable foreign corporation only if made by a domestic affiliate, the Notice applies the Excise Tax to a repurchase of the stock of an applicable foreign corporation, or the purchase of such stock by a foreign specified affiliate, where (i) the repurchase or purchase is funded “by any means” by a domestic affiliate, including through distributions, debt and capital contributions, (ii) such funding is undertaken for “a principal purpose”[14] of avoiding the Excise Tax and (iii) such funding occurs on or after December 27, 2022 (the “General Funding Rule”).[15] When the General Funding Rule applies, the Excise Tax will apply to the domestic affiliate in the same manner as if the domestic affiliate repurchased the stock of the applicable foreign corporation, but the fair market value of the stock treated as acquired by the domestic affiliate is capped at the funding provided by the domestic affiliate.[16]
Furthermore, the Notice contains a “per se” rule that deems the principal purpose of avoiding the Excise Tax to exist where: (i) the domestic affiliate funds by any means, other than through distributions, the applicable foreign corporation or its foreign specified affiliate and (ii) within two years of such funding, the applicable foreign corporation or its foreign specified affiliate repurchases or purchases the stock of the applicable foreign corporation (the “Per Se Funding Rule”).[17]
The language of the Per Se Funding Rule raises two important interpretive questions.
First, is the period “within two years of the funding” (i) the four-year period beginning two years prior to the date of the funding or (ii) the two-year period beginning on the date of the funding?
Although additional guidance would be helpful, similar to the approach taken (although more explicitly) in another well-known per se funding rule,[18] one might surmise that Treasury and the IRS intended to capture the four-year period beginning two years prior to the date of the funding.
Second, what transactions, other than distributions, loans and capital contributions, will be considered “funding by any means” under the Per Se Funding Rule? While the Notice does not provide any additional insight into the meaning of such phrase, the ordinary meaning of the term “funding” is broadly defined as “[t]he action or practice of providing money for a particular cause or purpose.”[19]
The phrase “funding by any means” is used in the anti-avoidance rules in sections 1.956-1(b)(1)(ii) and (iii) of the Treasury regulations.[20] For this purpose, examples of “funding” include: (i) the sale of inventory,[21] (ii) a loan[22] and (iii) a loan repayment.[23] In the preamble to the final Treasury regulations under section 956, Treasury and the IRS stated that “funding by any means” would include “all fundings. . . regardless of the form of the funding” because “[t]he policy concerns addressed by the anti-avoidance rule are not limited to fundings by debt or equity.”[24] Indeed, the IRS stated in Chief Counsel Advice 202203013 that the term “funding” in this context “generally [extends] to common business transactions.”[25] However, such advice clarified that sections 1.956-1(b)(1)(ii) and (iii) of the Treasury regulations contain an “avoidance” requirement that “ensures that ordinary course transactions are not picked up by their funding rule.[26] This language indicates that the IRS did not intend for the anti-avoidance rules contained in sections 1.956-1(b)(1)(ii) and (iii) of the Treasury regulations to apply to true ordinary course transactions that were not entered into for a principal purpose of avoiding the application of section 956.
The IRS’s authority to expand the scope of the Excise Tax beyond what is provided for in section 4501 is limited by the fact that Congress directed it to issue guidance “necessary or appropriate to carry out, and to prevent the avoidance of,” section 4501. Because the Per Se Funding Rule would apply regardless of the purpose for the funding transaction, Treasury regulations implementing the Per Se Funding Rule may ultimately substantially reduce the scope of ordinary course transactions to which it applies, perhaps by clarifying that certain ordinary course transactions are not considered to be “funding” transactions. In this regard, any transaction which has a principal purpose of avoiding the Excise Tax should not be regarded as an ordinary course transaction and should therefore still be subject to the General Funding Rule, which does contain a “principal purpose” test similar to that contained in sections 1.956-1(b)(1)(ii) and (iii) of the Treasury regulations.
However, pending the issuance of future Treasury regulations limiting the scope of the Per Se Funding Rule, there are many common intercompany transactions that could constitute funding “by any means,” under the Per Se Funding Rule as described in Notice 2023-2, even if they are entered into for bona fide business purposes unrelated to the Excise Tax:
A broad reading of the term funding “by any means” in the Per Se Funding Rule may also pick up certain customary transactions entered into by foreign banks, including transactions entered into for regulatory purposes. Examples of such transactions include:
Moreover, additional questions remain about how the General Funding Rule and Per Se Funding Rule will function mechanically. The term “funds by any means” could be interpreted to refer to indirect fundings, as well as direct fundings; for example, if a domestic affiliate purchases inventory from a foreign affiliate, which then makes an unrelated loan to the applicable foreign corporation, these two seemingly unrelated transactions could be collapsed and regarded as a means by which the domestic affiliate funded the applicable foreign corporation. Such a reading would make it even more likely that routine intercompany transactions cause the Excise Tax to apply to the repurchase or purchase of the stock of the applicable foreign corporation.
Furthermore, it is not clear if a taxpayer can limit the application of the Per Se Funding Rule by segregating cash received by an applicable foreign corporation (or a foreign affiliate thereof) from domestic affiliates in separate bank accounts or by formally or informally limiting the use of such funds.[27]
While we expect there to be changes to the General Funding Rule and the Per Se Funding Rule before they are included in proposed and final Treasury regulations, applicable foreign corporations and their affiliates should carefully review their intercompany transactions and stock buybacks in the meantime to mitigate the risk that they may inadvertently attract liability for the Excise Tax.
[1] 2023-3 I.R.B. 374 (Dec. 27, 2022).
[2] Unless otherwise indicated, all “section” references contained herein are to sections of the Code.
[3] A “covered corporation” is any domestic corporation the stock of which is traded on an established securities market (within the meaning of section 7704(b)(1)). Section 4501(b). An established securities market for this purpose is (i) a national securities exchange registered under section 6 of the Securities Exchange Act of 1934, (ii) a national securities exchange that is exempted from registration under section 6 of the Securities Exchange Act of 1934 due to its limited volume of transactions, (iii) a foreign securities exchange that, under the law of the jurisdiction where it is organized, satisfies regulatory requirements that are analogous to the regulatory requirements under the Securities Exchange Act of 1934, (iv) a regional or local exchange or (v) an interdealer quotation system that regularly disseminates firm buy or sell quotations by identified brokers or dealers by electronic means or otherwise. Treas. Reg. § 1.7704-1(b). It is important to note that the Excise Tax will apply to buybacks of a class of non-traded stock if another class of stock is traded on an established securities market.
[4] For this purpose, stock is generally treated as having been “repurchased” if it is redeemed or is purchased in any transaction that is determined to be economically similar to a redemption. Section 4501(c).
However, section 4501(e) provides that certain repurchases are not subject to the Excise Tax, including: (i) repurchases occurring as part of a reorganization pursuant to section 368(a) and in which no gain or loss is recognized by the shareholder, (ii) transactions in which the repurchased stock is contributed to an employer-sponsored retirement plan, employee stock ownership plan or stock option plan, (iii) de minimis repurchases (i.e., where the total value of repurchased stock in the taxable year is less than $1,000,000), (iv) under regulations, repurchases by a dealer in securities in the ordinary course of business, (v) repurchases by a regulated investment company and (vi) repurchases that are treated as dividends. Section 4501(e).
[5] Section 4501(c)(2)(A). A “specified affiliate” of a corporation is (i) any corporation more than 50% of the stock of which is owned (by vote or value), directly or indirectly, by such corporation and (ii) any partnership more than 50% of the capital interests or profits interests of which are held, directly or indirectly, by such corporation. Section 4501(c)(2)(B).
[6] Section 4501(a). This rule applies to any repurchases occurring after December 31, 2022.
[7] Section 4501(c)(3).
[8] A “covered surrogate foreign corporation” is defined as a corporation that is a “surrogate foreign corporation” (as defined in section 7874(a)(2)(B), but by substituting “September 20, 2021” for “March 4, 2003” each place it appears, and whose stock is traded on an established securities market (as discussed in more detail in footnote 3, above)). Section 4501(d)(3).
However, a foreign corporation is only a covered surrogate foreign corporation for the period described in section 7874(d)(1) (i.e., the 10-year period beginning on the first date that the properties are acquired as part of the acquisition described in clause (i) of the immediately succeeding paragraph).
Section 7874(a)(2)(B) defines a “surrogate foreign corporation” as: (i) a foreign corporation that completes the direct or indirect acquisition of substantially all of the assets held by a domestic corporation or substantially all of the properties constituting a trade or business of a domestic partnership, in each case, after March 4, 2003; (ii) following the acquisition described in clause (i), at least 60% of the stock (by vote or value) of such foreign corporation is held by former shareholders of the domestic corporation or domestic partnership by reason of owning equity in the domestic corporation or domestic partnership; and (iii) following the acquisition described in clause (i), the expanded affiliated group which includes such foreign corporation does not have substantial business activities in the foreign country in which such foreign corporation is organized when compared to the total business activities of the entire expanded affiliated group.
[9] Section 4501(d)(2) (treating any such repurchase or purchase as a repurchase of stock of a covered corporation).
[10] An “applicable foreign corporation” is defined as any foreign corporation the stock of which is traded on an established securities market within the meaning of section 7704(b)(1). Section 4501(d)(3). An established securities market has the same meaning as described in footnote 3, above.
[11] Section 4501(d)(1).
[12] Notice at § 3.02(4). An “applicable specified affiliate” is defined as “a specified affiliate of an applicable foreign corporation, other than a foreign corporation or a foreign partnership (unless the partnership has a domestic entity as a direct or indirect partner).” Id.
[13] Section 4501(f).
[14] In the funding rule set forth in the Treasury regulations promulgated under section 385, the determination as to whether an instrument was issued with a “principal purpose” for funding a covered transaction is based on all facts and circumstances. See Treas. Reg. § 1.385-3(b)(iv) (providing that whether an instrument is “issued with a principal purpose of funding [a covered distribution or acquisition] is determined based on all the facts and circumstances.”) (emphasis added).
Other sections of the Treasury regulations provide that a taxpayer may be viewed as acting with “a principal purpose,” even though such purpose is outweighed by other purposes. See, e.g., Treas. Reg. § 1.163(j)-1(b)(22)(iv)(C), Treas. Reg. § 1.367(a)-3(d)(2)(vi)(D)(1), Treas. Reg. § 1.954-2(a)(3)(ii)(A) and Treas. Reg. § 1.882-5(d)(2)(v).
A taxpayer may be able to rebut the principal purpose test by establishing that the transaction was not circular or transitory, was entered into for bona fide business purposes or was entered into in the ordinary course of the taxpayer’s trade or business (for example, by establishing that the taxpayer regularly engaged in the same or similar transactions with the applicable foreign corporation (or any of its foreign specified affiliates) prior to the enactment of the Excise Tax and the magnitude of such transactions has not increased following such enactment). Taxpayers may also establish that the applicable specified affiliate did not purchase the stock of the applicable foreign corporation prior to the enactment of the Excise Tax.
[15] Notice at § 3.05(2)(a)(ii)(A); Notice at § 5.02 (applicability date for funded purchases).
It is worth noting that, where the General Funding Rule applies, the Netting Rule only applies to the extent that the domestic affiliate has issued its own stock or provided its own stock to employees, which would greatly limit the effect of the Netting Rule by not accounting for issuances of the applicable foreign corporation’s own stock. Section 4501(d)(1)(C).
[16] Notice at § 3.05(2)(a)(ii)(A).
[17] Notice at § 3.05(2)(a)(ii)(B).
The U.S. Treasury Department (“Treasury”) and the U.S. Internal Revenue Service (the “IRS”) explained the inclusion of the per se funding rule in the Treasury regulations under section 1.385-3 (which itself contains a general funding and per se funding rule similar to that set forth in the Notice) as follows:
The Treasury Department and the IRS continue to be of the view that, because money is fungible, an objective rule is an appropriate way to attribute a distribution or acquisition, in whole or in part, to a funding. The preamble to the proposed regulations emphasized the evidentiary difficulties that the IRS would face if the regulations relied exclusively on a purpose-based rule. Some comments suggested that a rebuttable presumption (such as the one contained in section 1.707-3(c)) that would require a taxpayer to overcome a presumption arising upon specified events by clearly establishing facts and circumstances to the contrary could address these difficulties.
After considering these comments, the Treasury Department and the IRS have determined that, even with the benefit of a rebuttable presumption, a purpose-based rule that required tracing sources and uses of funds would present significant administrative challenges for the IRS. In particular, taxpayers potentially could purport to rebut the presumption by creating self-serving contemporaneous documentation that “earmarks” the proceeds of related-party borrowings for particular purposes and attributes distributions and acquisitions to other sources of funds.
[18] T.D. 9790 (Oct. 21, 2016).
[19] Oxford English Dictionary (3d ed. 2017).
[20] Treas. Reg. § 1.956-1(b)(1)(ii).
[21] Treas. Reg. § 1.956-1(b)(4)(i) (Example 1); Treas. Reg. § 1.956-1(b)(4)(ii) (Example 2).
[22] Treas. Reg. § 1.956-1(b)(4)(iii) (Example 3).
[23] Treas. Reg. § 1.956-1(b)(4)(vi) (Example 6).
[24] T.D. 9792 (Nov. 3, 2016).
[25] Chief Couns. Adv. 202203013 (Jan. 21, 2022).
[26] Id.
[27] The language in the preamble to section 1.385-3 of the Treasury regulations may suggest that Treasury and the IRS would not be willing to entertain such an argument because they view cash as fungible.
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