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.
General explanation of the Excise Tax
Generally, section 4501 imposes on publicly traded domestic corporations (referred to in the Notice and the remainder of this discussion as “covered corporations”) an excise tax equal to 1% of the fair market value of any stock of the covered corporation that is (i) “repurchased” by the covered corporation or (ii) purchased by a “specified affiliate” of the covered corporation (other than a purchase from the covered corporation or a specified affiliate of the covered corporation). 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”).
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 provides that the Excise Tax applies where the stock of an “applicable foreign corporation” 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”). 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.”
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 funding rules under Notice 2023‑2
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.
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.
General Funding Rule
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” of avoiding the Excise Tax and (iii) such funding occurs on or after December 27, 2022 (the “General Funding Rule”). 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.
Per Se Funding Rule
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”).
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, 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.”
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. For this purpose, examples of “funding” include: (i) the sale of inventory, (ii) a loan and (iii) a loan repayment 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.”
Indeed, the IRS stated in Chief Counsel Advice 202203013 that the term “funding” in this context “generally [extends] to common business transactions.” 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. 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: the entering into or repayment of intercompany loans;
- cash pooling arrangements
- payments for the provision of services
- sales or transfers of property (including inventory)
- payments of royalties or licensing fees.
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:
- loans between affiliated securities dealers in order to access securities or funding for customers (including where shares are loaned in order to permit an affiliate’s customers to cover their short sales)
- hedging and offsetting transactions between affiliates to facilitate securities repo transactions,
loans, margin loans and structured notes
- loans or capital contributions to cover liquidity shortages as required by banking regulators.
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. 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.
