Equity Considerations and Incorporation Issues for SPACs
Special Purpose Acquisition Companies (SPACs) have increased in popularity as a way to offer potentially higher yields with some downside protection and an easier way to go public than via an initial public offering (IPO) to raise capital. However, sponsors need to take into consideration their equity structure and incorporation matters to ensure they are complying with the appropriate tax guidelines.
Equity Structure Considerations
Sponsor’s Cheap Stock
Sponsors receive founder shares in exchange for a relatively nominal investment. They are also typically involved in raising capital for the SPAC, identifying the target, and closing the acquisition. However, they are not compensated for these services. With this, the IRS may re-characterize the receipt of founder shares for a nominal investment as the payment of compensation for services provided by the sponsors if the value of the founder shares at the time of issuance exceeded the amount invested. This is referred to as the “cheap stock” issue because the sponsors may be viewed as acquiring the founder shares at an extremely low rate. There is a possibility that the difference between the amounts paid by the sponsors for the founder shares and the value of those shares will be taxable to the sponsors in the year of issuance at ordinary income tax rates.
Although there is little authority directly regarding the cheap stock issue, recent case law has provided guidance for sponsors seeking to avoid having their founder shares re-characterized as compensation for services. The case law suggests founder shares should be issued as soon as possible because the sponsors may increase the value of the shares through various activities such as raising capital and identifying the target after the date of issuance and before the date of the acquisition.
As the IRS may re-characterize this transaction as compensation for services, issues under IRC Sec. 83 arise. IRC Sec. 83(a) applies to property transferred in connection with the performance of services. When that transfer occurs, IRC Sec. 83(a) requires a service provider to recognize ordinary income equal to any excess of fair market value over the amount paid for the property. The transfer occurs when that property becomes either transferable or no longer subject to a substantial risk of forfeiture. However, a sponsor may elect under IRC Sec. 83(b) to recognize the fair market value of the equity received in its income at the time the founder shares were issued.
Class A Shares and Warrants
Generally, SPACs offer a bundle of Class A shares and warrants to public investors, and the bundle continues to trade as a single unit for a period (usually a few months) after the SPAC’s IPO. Although the issuance of this bundle is widely considered not to be a taxable event, SPACs typically provide no assurance for this treatment due to the lack of administrative guidance. Further, holders of these bundles must allocate the purchase price paid between the one Class A share and the fractional warrant based on the relative fair market value of each at the time of issuance. Normally, the warrant has nominal value because of the restrictions placed on its rights and lack of ascertainable value upon issuance. When an investor exercises a warrant to buy the underlying stock, they pay the stated strike price to the issuing company. The basis in the shares acquired is the amount allocated to the warrant originally, and the amount paid upon exercise of the warrant. Further, when a holder of a SPAC bundle disposes of it, for tax purposes, this is treated as a disposition of the Class A share and fractional warrant. The amount realized upon the disposition should be allocated between the Class A share and warrant based on their respective fair market value at the time of disposition.
If a Class A shareholder does not agree with the target a SPAC has identified, the shareholder has the right of redemption to receive cash in exchange for some or all of the Class A shares. The tax treatment of this redemption depends on whether the redemption satisfies one of the tests enumerated in IRC Sec. 302(b). Under IRC Sec. 302(b), the tests most relevant to SPACs are: (1) a redemption in complete termination of a shareholder’s interest; (2) substantially disproportionate redemption; and (3) a redemption that is not essentially equivalent to a dividend. If one these tests is met, the redemption is treated as a sale or exchange of the Class A shares. If the redemption does not meet one of the tests under IRC Sec. 302(b), it is taxed as an ordinary distribution under IRC Sec. 301.
Generally, SPACS are incorporated in the Cayman Islands or British Virgin Islands because of the flexibility provided by their corporate laws. Due to this, a potential inversion occurs in that a foreign corporation (the SPAC) acquires substantially all of a domestic business (target). Inversion transactions can generally be classified as one of the following transactions, which directly or indirectly reference the size of the U.S. corporation relative to the foreign acquiring corporation: a 50% inversion under IRC Sec. 367(a); a 60% inversion under IRC Sec. 7874(a); or an 80% inversion under IRC Sec. 7874(b).
A 50% inversion generally results in an otherwise tax-free transaction being treated as taxable to all U.S. shareholders under IRC Sec. 367(a). A 60% inversion not only results in the application of IRC Sec. 367(a), but also the expatriated entity (the former U.S. parent) is subject to a minimum tax for ten years after the 60% inversion. An 80% inversion results in the foreign acquiring corporation being treated as a U.S. corporation for all federal income tax purposes.
Passive Foreign Investment Company (PFIC)
A SPAC will be considered a PFIC for a given tax year if at least 75% of its gross income in that tax year is passive income or if at least 50% of its assets are assets held for the production of passive income. Passive income generally includes dividends, interest, rents and royalties, and gains from the disposition of passive assets. Because SPACs are generally blank-check companies with no operations or assets other than cash proceeds raised in the IPO, and no income other than possible interest earned in the trust account, the SPAC is likely to be treated as a PFIC unless it can meet one of the exceptions.
If a SPAC is deemed to be a PFIC, the U.S. shareholder must recognize gain upon specific distributions referred to as “excess distributions” and upon a sale or other taxable disposition of PFIC shares. The gain is subject to tax at the highest rate applicable for ordinary income, and an interest charge would be imposed on the tax liability for each specified year. Further, IRC Sec. 1298(a)(4) provides that any person that has an option to acquire stock of a PFIC will be treated as owning that stock. Therefore, holders of a SPAC warrant may also be subject to the PFIC rules.
A U.S. shareholder may make a qualified electing fund (QEF) election to mitigate adverse PFIC tax consequences regarding its shares. The U.S. shareholder is then required to include in income its allocable pro rata share of the SPAC’s net capital gains and other earnings and profits annually, regardless of whether those amounts are actually distributed. The allocable amount a shareholder would have to include before a business combination because of a QEF is most likely to be negligible or possibly even $0.
However, the potential PFIC consequences to U.S. holders of warrants are especially harsh when a foreign SPAC domesticates in connection with an acquisition of a U.S. target. Because a QEF election may not be made for PFIC warrants, a U.S. holder of PFIC warrants could be required to recognize ordinary income subject to an interest charge on its warrants at the time the SPAC domesticates, resulting in a “disposition” of the warrants by the U.S. holder.
A U.S. shareholder may qualify under a start-up exception in IRC Sec. 1298(b)(2), which would deem the SPAC as not a PFIC. Under the start-up exception, a foreign corporation will not be treated as a PFIC for the first tax year if (1) no predecessor of that corporation was a PFIC; (2) the corporation establishes to the satisfaction of the Treasury secretary that it will not be a PFIC for either of the first two tax years following its start-up year; and (3) the corporation is not in fact a PFIC for either of the first two tax years following its start-up year. However, given the narrow wording of the start-up exception, it may be difficult for a SPAC to qualify. Planning techniques have been implemented to qualify the SPAC under the start-up exception. For example, if the SPAC invests its IPO proceeds in a non-interest bearing trust account, it will not earn gross income until the business combination occurs and should be able to avail itself of the exception.
SPACs involve numerous sophisticated tax issues, which require careful analysis and appropriate professional advice.
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