New Buyback Tax Expected To Hit Preferred Stocks

The Inflation Reduction Act enacted by Congress last August contains a new 1% excise tax on companies that buy back their stock. The tax will raise an estimated $74 billion over 10 years.

Beyond the money involved, the tax is intended to penalize companies for seeking to raise their stock price rather than invest in production or increase dividends.

The new law took effect January 1, 2023. Congress left the details of enforcement up to the Treasury Department and its Internal Revenue Service, which is drawing up regulations.

One question is whether it will apply to preferred as well as common shares. Right now, it looks like the answer is yes.

The initial guidance notice issued by the IRS on December 27 gives an example of a mandatorily redeemable preferred stock not traded on public markets and says it would be subject to the tax.

According to the law firm Mayer Brown:

“The Notice does not describe any current exception for preferred stock redemptions, regardless of whether the preferred stock was issued prior to the IRA or was itself traded on an established securities market. The Treasury Department and the IRS are requesting comments on whether there are certain circumstances under which special rules should be provided specifically for redeemable preferred stock.”

Unfair To Include Preferred

A reader alerted me to this issue via private message, saying it is unfair for the new tax to apply to preferred.

“We need to convince the IRS that Congress was not thinking about preferred stock when they wrote the law,” he wrote, and continued:

“Preferred is very different from common stock because it 1) is really a fixed income security, 2) has a non-zero par value and liquidation preference, and 3) redemptions of preferred stocks are really a return of the originally invested capital. The IRS should exempt preferred redemptions at the original par value.”

Watson McLeish, senior vice president for tax policy at the U.S. Chamber of Commerce, wrote an op-ed piece opposing the tax, arguing it will make it more difficult for companies to expand:

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.”

Comment Period Under Way

The IRS is taking comments on its proposed regulations and recommends they be submitted within 60 days of publication, which would be February 25. Instructions on how to submit comments can be found on Page 51 of this notice.

While a 1% tax may have little effect on how banks and other corporations think about issuing and redeeming preferred stock, the imposition of any new tax invites Congress to raise revenue by simply adjusting the rate.

For example, the federal income tax began during the Civil War with a top rate of only 3% for the highest earners, but rose in fits and starts and by World War II had topped out at 94%.

One possible benefit is that the tax might make banks and other corporations less likely to redeem preferred issues, thus giving investors longer to enjoy higher dividends. As a longtime preferred investor, I have seen companies like Wells Fargo (WFC) call issues when their cost of credit goes down and replace them with lower-rate preferreds, to the detriment of investors.

However, any reduction in call frequency would be minor compared to the long-term damage to the preferred market if companies avoid the tax by choosing to issue bonds instead.

Let’s hope there a lot of objections and the IRS takes notice.