The new excise tax on stock buybacks — addressing the treatment of preferred stock
When Congress wrapped up its work on the so-called Inflation Reduction Act this summer, it left more than a few questions about the new law for others to answer. One such question, which Congress referred to the Treasury Department, is whether redemptions of preferred stock are subject to the law’s new 1 percent excise tax on corporate stock buybacks. Treasury’s answer to this question will have profound consequences for individual companies, the economy, and tax fairness.
To understand why, a little background is in order. Congress enacted the excise tax on stock buybacks to both raise revenue and deter companies from using their profits to repurchase stock, as opposed to issuing dividends or making investments. (We’ll leave aside for now Congress’s misguided desire to tax companies for returning money to shareholders.)
Businesses have several ways to raise capital to fund their operations and expansion. One way is to issue debt (bonds). Bondholders are to be repaid at a date certain, are paid interest on their loans, and are first in line to claim the assets of a company if it goes bankrupt. But they do not take an ownership stake in the business.
Businesses can also issue equity (stock). Common stock typically entitles shareholders to an equal portion of the company’s assets and the profits they generate. Common shareholders are generally able to vote on the governance of the company but are the last to be repaid if the company goes bankrupt.
Preferred stock, another way for businesses to raise capital, operates in the middle. Like bonds, preferred stock is usually entitled to a regular payment in the form of a dividend and is often subject to repurchase by the company after a specified date. While preferred stock is a type of equity ownership, preferred shareholders are generally unable to vote on the governance of the company, and in the event of bankruptcy, preferred shareholders are to be repaid after bondholders but before common shareholders.
A company’s decision to repurchase preferred stock is qualitatively different from the decision to repurchase common stock. In some cases, it isn’t a decision at all. For instance, preferred stock can be issued with a maturity date on which the company must repurchase it. In other instances, a company could have the option to repurchase preferred stock with a high fixed dividend to give it more financial flexibility to meet other needs.
When Congress enacted the new excise tax, lawmakers recognized the difference between common and preferred stock. But rather than resolve how preferred stock should be treated, Congress left the matter to the Treasury Department, directing it to prescribe such regulations and other guidance as are necessary or appropriate “to address special classes of stock and preferred stock.” [I.R.C. § 4501(f)(2).] Congress was wise to recognize the distinction between these different types of stock, and the Treasury Department would be wise to do the same.
If the Treasury Department were to impose the new excise tax on repurchases of preferred stock, including stock issued prior to the law’s enactment, it would be imposing a retroactive tax increase on businesses based on decisions they made in the past (e.g., to issue non-perpetual preferred shares). This would also effectively impose a new tax on the ability of companies to raise capital without issuing debt or diluting the interests of existing shareholders—including many retirees, tax-exempts, and institutional investors—making it harder for companies to finance capital-intensive projects that drive job creation. It is clear from the debate around the excise tax that this outcome would be the exact opposite of what lawmakers intended.
With approximately $350 billion in publicly traded preferred stock currently outstanding, the Treasury Department’s decision will have broad implications for the market and the overall economy. And with many analysts predicting a recession next year, now is not the time to impose a new tax that would only further drag down the market by failing to account for the important differences between common and preferred stock.
In our current economic environment, policymakers should be working to unleash the economic engine of U.S. businesses, not stifle their ability to thrive. We call on the Treasury Department to fulfill its statutory mandate by clarifying that, in general, redemptions of preferred stock are not subject to the new excise tax—a simple yet critical step toward allowing American businesses the flexibility they need to grow and weather any economic downturn.
Watson McLeish is Senior Vice President of Tax Policy at the U.S. Chamber of Commerce.