Understanding the New Excise Tax on Corporate Stock Repurchases

The Inflation Reduction Act of 2022 changed the calculus of corporate finance strategy with the implementation of a 1% excise tax on stock repurchases. Specifically, the 1% tax applies to net repurchases made by covered corporations after December 31, 2022. Net repurchases are calculated as the fair market value of shares repurchased less the fair market value of any shares issued during the taxable year.

The rule’s initial language left some open questions related to stock-based compensation. The Treasury Department clarified these when it released initial guidance in late December 2022. Now that a full quarter has passed since the rule took effect, we’re here to share our interpretation of the key provisions.

What’s the goal of the new excise tax?

Stock repurchases have been on the rise, exceeding $1 trillion for the first time in 2022. This has attracted a flurry of attention, with the SEC adopting amendments to disclosure requirements in May 2023. One is that issuers must now report daily repurchase activity on a quarterly or semi-annual basis. Stock repurchases have also been a source of some controversy due to the potential to use them to increase the payouts of performance awards held primarily by executives, for instance those based on stock price or EPS hurdles.

When distributing profits to shareholders, stock buybacks have historically been more tax-effective than paying dividends. This is because dividends are generally taxed immediately and at ordinary income tax rates. In contrast, stock repurchases don’t create a taxable event for shareholders. And if they lead to stock price appreciation, those gains aren’t taxed until the shares are sold—likely at lower capital gains tax rates.

The excise tax rule was passed in an effort to reduce the disparity in the tax code between dividends and stock repurchases, as well as to steer executives toward investing profits back into the company (e.g., research and development, wage increases, or other drivers of growth).

How is the excise tax calculated?

At first glance, the excise tax is a fairly straightforward calculation. It’s simply 1% multiplied by the taxable base of shares repurchased minus shares issued. As with so many other topics, however, the devil is in the details.

For the fair value of the shares repurchased, the interim guidance provided by the Treasury Department and the IRS in Notice 2023-02 outlines four allowable approaches:

1. The daily volume-weighted average price as determined on the date the stock is repurchased (also known by the acronym VWAP)
2. The closing price on the date the stock is repurchased
3. The average of the high and low prices on the date the stock is repurchased
4. The trading price at the time the stock is repurchased

Once you choose an approach, you must be consistent and follow it for all repurchases during the taxable year.

For the fair value of shares issued, the calculation has two components: determining the fair value per share and determining the number of shares issued. Companies can use the same four methods as share repurchases to calculate the fair value. Here again, you’ll need to be consistent with the method used for all issuances during the taxable year. Note that the relevant date for both repurchases and issuances is the initial transaction date, not the final settlement date which may be several days later.

As for determining the number of shares issued, the key is when ownership of the stock transfers to the recipient for federal income tax purposes. There are a number of different cases in which shares are issued, such as RSU releases, option exercises, and ESPP purchases. Companies should already have a process for determining shares issued as part of calculating common shares outstanding in the market and our view is that you can leverage the same process for determining shares issued here. For example, shares withheld to cover income taxes wouldn’t be treated as stock issued under this rule, just like shares withheld for taxes aren’t included in common shares outstanding. Similarly, if shares are withheld by a company to satisfy the exercise price of a stock option, those shares aren’t considered issued.

However, as detailed in the IRS guidance, for sell-to-cover transactions where the gross shares exercised are transferred to a third party, the total number of shares are considered issued and therefore deductible. Outside the scope of this discussion are the pros and cons of different settlement methods, such as dilution and cash management.

What else should I know about the new rule?

Retirement-eligible employees. The guidance provided by the Treasury Department states that shares are treated as issued when ownership of the stock transfers to the recipient for federal income tax purposes. While FICA taxes are due for time-based restricted shares when the employee reaches retirement eligibility, federal income taxes are not. Therefore, we don’t believe shares are considered issued as of the date when an employee becomes retirement-eligible, but instead when they are actually paid to employees.

Non-calendar year filers. Regardless of a company’s fiscal year, the taxable base is calculated as repurchases after December 31, 2022, subtracting issuances during the entire taxable year. This means that companies with a taxable year beginning before December 31, 2022 that extends into 2023 can use issuances that took place in 2022 to net against repurchases that took place in 2023.

Fair market value consistency. For most companies, equity compensation represents the vast majority of deductible issuances. Restricted stock awards are typically valued and taxed based on the close price on the release date. In contrast, repurchases are typically accounted for using the point-in-time stock price for the transaction. Similarly, stock options will often be valued and taxed based on a midday point-in-time price. If it’s necessary to use the same fair market value methodology for both repurchases and issuances, then it may be necessary to implement a process to attach a different fair market value to a very large volume of existing records. One simplifying assumption is that all restricted stock releases are point-in-time transactions as well, just at the end of the day. We hope to see further clarification from the Treasury Department and expect a robust process will be needed in any case.

Issuances that exceed repurchases. Unfortunately, companies aren’t allowed to carry forward any excess issuances for deduction in future years.

Non-trading days. If a transaction happens on a non-trading day, companies should use the fair market value method they selected as of the preceding trading day.

Exceptions. There are currently six exceptions to the excise tax:

1. Repurchases that are part of a tax-free reorganization under Section 368(a) of the IRC where no gain or loss is recognized by the shareholders
2. Cases where the stock repurchased—or an amount of stock equal to the value of the stock repurchased—is contributed to an employer-sponsored retirement plan, employee stock ownership plan, or similar plan
3. De minimis repurchases totaling less than $1 million during the year (before any netting with issuances)
4. Repurchases made by regulated investment companies (such as mutual funds) or real estate investment trusts
5. Repurchases by a securities dealer in the ordinary course of business
6. Repurchases that are treated as dividends for tax purposes

What impact has the rule had so far and what are we predicting for the future?

As of today, we aren’t hearing about companies changing their stock repurchase strategy due to the 1% rule. That said, there have already been bills introduced in the Senate to increase the excise tax to 4% and disallow the netting of any shares issued to employees who are subject to Section 162(m). It’s hard to predict how high the excise tax would need to go before we see companies begin to shift their strategy. However, there’s certainly a point where we would expect to see changes such as fewer stock repurchases or even an increase in the percentage of compensation paid in the form of stock that can be used to net against repurchases.

In order to make an informed decision about what’s best for your company, we suggest robust modeling of your repurchases and issuances. If you have any questions on the new rule, or would like assistance creating a forecast model or standing up an automated process to calculate the excise tax, we’re here to help.