On-Demand: Real Estate SPAC Life Cycle | De-SPAC & Post-Merger
In Part III, we discussed the SPAC lifecycle, focusing our time on Phase 3 – the de-SPAC merger and Phase 4 – the post-merger.
Lisa Knee:Good afternoon everyone. My name is Lisa Knee, and I'm the co-chair of EisnerAmper's real estate services group. And we're happy to welcome you to part three of our real estate SPAC webinar series, time flies when you're having fun.
Lisa Knee:So please also check out part one, the basics and part two, structuring. Today though we're going to focus specifically on the phase three de-SPAC merger and phase four, the post-merger of the SPAC lifestyle. I also want to make sure we thank our friends at Hunton Andrews and Kurth for co-sponsoring all these sessions with us, and being a pleasure to work with on this collaboration.
So in this session today, we're going to describe the activities and the phases and in particular, the accounting, legal and tax implications related to these phases. Joining me today from our EisnerAmper team is Angela Veal, managing director and our technical advisory in accounting practice. And Michael Torhan, tax partner and our real estate services group.
And from our co-presenters at Hunton Andrews Kurth, Michael O'leary, partner and co-head of the corporate group and Taylor Landry, partner in the corporate group. So with that, let me thank you for joining us today. And let's start this off with a polling question. Let's see if we can get that polling question moved over.
Great. So which of the following are you categorized under? SPAC management, real estate companies and funds, private equity venture capital firms, investors, including investment companies, hedge funds and individuals, current or potential service providers to SPACs and target companies, or none of the above. And while we're waiting for that polling question Mike or Taylor, I'm going to throw this question out at you. So how are you seeing the real estate SPAC activity thus far and are any new SPAC SPACs ramping up?
Taylor Landry:Sure. Yeah, I would say SPAC activity remains pretty hot. In the last week or so there've been 10 or 11 SPAC IPOs go out. So I know in previous sessions we discussed the warrant treatment issue with the chief accounting office of the SEC. That came out that obviously caused a little bit of a pause for people to reassess where things stood and to adjust accordingly.
But we're still continuing to see plenty of activity on that front. And there were still a lot of SPACs looking for deals, and deals are still getting done. So I would say that was a pause or a slight cooling off but we're still seeing plenty of activity on that front.
Lisa Knee:Great. And hopefully now we have some responses to who we have attending the session with us today, if we can move that polling question on. Oh, interesting. So none of the above, wins in today's session would love to hear who these people are categorized under but interesting response. So with that let's begin today's session on phase three. And I'm going to hand this over to Angela Veal.
Angela Veal:Thank you Lisa, for the very nice introduction. I'm excited today to be back for the discuss SPACs in the last part of our webinar series. SPACs have intrigued many in the marketplace, including those within the real estate industry. WeWork has also recently gone public via a SPAC merger. SPACs have been around for decades, but they have made an impressive comeback last year with $83 billion capital raise. And they even outperformed the traditional IPOs by raising five times more capital.
In 2021 this year, SPAC transactions, like Taylor has mentioned earlier, started off strong, but they are at a standstill amid some pressure from the SEC and Congress. To level set for everyone who did not join us for the first two sessions, SPACs stand for special purpose acquisition companies. And they are sometimes known as blank check companies.
The three key players include the sponsors, investors and target companies. The sponsors would raise money from the public market investors with the purpose of merging with a target company in the near future. And the selected target company may or may not be from a specific target industry. So moving on to highlighting the lifecycle of a SPAC at a high level, it consists of four phases.
Namely the formation and IPO, pre-merger, de-SPAC as well as post-merger after the de-SPAC transaction is closed. The first phase is the IPO of the SPAC, and IPO proceeds are then placed in a trust that invest in instruments that earn interest. The next phase is the pre-merger phase whereby the merger generally needs to happen within 18 to 24 months.
And if the merger does not materialize, the SPAC would be liquidated and the IPO proceeds will be returned to the investors. There's definitely a lot of capital out there waiting for the market to ramp up and finding the right target company. As Lisa has mentioned earlier, we took a deep dive into the first two phases of the SPAC life cycle during our last session.
So you'll find the links to the archive versions at the end of this presentation deck. The third phase will be the de-SPAC itself. De-SPAC is basically another term for the merger of the SPAC and target company. There is a lot to talk about in terms of the de-SPAC process, where most of the actions of the SPAC lifecycle are taking place.
The target company needs to become public company ready, shareholder votes generally need to be obtained, and proxy statement or S-4 have to be filed as well. All within a very limited timeframe of a few weeks to five months. And the last phase would just relate to the post-merger phase of the combined public entity.
So today we'll focus on these next two phases and highlight some of the associated activities and insight from legal taxation and accounting perspective. With this I will hand it over to Mike and Taylor to talk through the activities relating to de-SPAC, and their legal take on this process.
Mike O’Leary:Thank you Angela. So the phase three, what we call phase three activities really start with when the SPAC has identified as target, negotiated with the target, and it's going to sign the definitive agreement with the target or definitive agreements. And that kicks off what we referred to as phase three.
In conjunction with that, if there's going to be a pipe, private investment and public equity raised, then you released the commitment papers for those PIPE commitments from the subscribers at the same time as you release the signature pages to the definitive agreement. In conjunction with that, we'll be the first of what is referred to as the "Super" 8-Ks.
You have to file an 8-K with the definitive agreements, announcing that the transaction typically including slides relating to for investors to see about the transaction, and a press release. And those are all filed in an 8-K, you described the transaction in the 8-K. And so it's a very long and detailed document that you've got to get on filed.
And that really convinces for the first time, the target has to be thinking about what have I got to do from a public security law compliance perspective. Because everything that the target company has done after that point is typically been done in the private company realm, without the oversight of the FCC rules.
And from that point forward, any press releases, tweets, anything they're going to say they are targeted toward potential investors or their customers, they need to be concerned about and really advise their counsel. And make sure their counsel is aware so they can advise us what's going to have to be filed with the SEC under rule 425.
Also at the same time, typically in conjunction with the initial public offering by a SPAC, the founders or sponsors will have committed to vote in favor of an initial business combination propose to the stockholders, the target company, and its counsel will want to review that commitment. And if necessary to make sure it's a good firm commitment that can be enforced. But they typically are.
And that also starts the time period when the target and the SPAC will begin working on the S-4. And the S-4 is going to be the document that has the proxy statement, and if security are going to be issued, and they typically are. The perspectives that will be submitted to the SPAC's stockholders to vote on the business combination when you've cleared the SEC.
And the perspectives related to the registration of the securities to be issued in conjunction with the closing. And we've mentioned before that one of the gating issues for a target company, this going down this path is they need to engage their auditors, make sure that they're having the auditors begin the work on the PCAOB compliant audits.
And that can take time. It's very involved, very detailed, may require the target company staff up, but that's going to be required before you can file your S-4 with the SEC. So it is a gating item in that sense. And because of the time period and the onboarding requirements of your auditors, you need to make sure that you've got that target company has that taken care of.
So once you've gotten through that, you've got your audits, you've prepared the performance, you've described the background with business combination. Then you file your S-4, respond to SEC comments. and get cleared with the SEC. That can take 60, 70 days just depending on SEC review. The SEC is very backed up right now.
They're trying to be responsive. They're sticking to that 30 day commitment to give you their first round of comments, but they're a little slower than you'd like to see on the next rounds of comments. And remember in conjunction with preparing the S-4 and getting it out the door, there is also a redemption offer to be made to the target, to the SPAC's stockholders.
And that will close a couple of days typically before the actual date of the stockholder meeting to vote on the combination. And so that at the time you're having to vote, the target company knows whether or not the minimum cash commitment lever letters commitments, that are a part of the business combination agreement are going to be satisfied.
Typically their conditions preceding that there be a minimum amount of cash on hand. That part of which will constitute that whatever the cash consideration is, the balance of the consideration would be typically equity of the SPAC. And assuming the transactions approved by the stockholders, and whatever conditions preceding are met have been satisfied, then you close and there will be another "Super" 8-K that's filed.
And this "Super" 8-K also talks about the fact that you'd close the transaction, what documents were executed to closing. And also needs to conform to form 10, because you've got to include information now about the combined company. It satisfies, there's a very long and detailed document.
As we've talked both in our second part of this seminars. And again just a moment ago, remember the target company, this is the first time it's going to be a public company. It's got to address a lot of new issues. It's important that they be working with their outside auditors and their outside legal advisors.
And if they have an outside financial advisors that they typically do, the financial advisors typically lead these processes in terms of identifying companies that might be interested in combining with them. And advise them on what's going to be necessary to get through this process as smoothly as possible. They're going to have to describe their business. It's important that that gets started.
It looks like SPACs are really going to be your most likely acquirers, the company might want to get started on that. They need to get going on their audits. PCAOB compliant audits. And the last thing a target company wants to getting the de-SPAC transaction done on a reasonable timeline. There will be a new combined company charter and bylaws.
And depending on the negotiations between the SPAC and the target company, often the target company's counsel takes the lead in working with the target company and the SPAC and compiling, those charter and bylaws. And making sure that it has the provisions for the go-forward company to live by, until the time comes when they've got to amend the charter and or bylaws in the normal course, post to de-SPAC.
Who are going to be the combined company's management and board, or need to be worked out and are part of the negotiations of who is going to be management. Typically, the target companies management ends up paying up the management of the combined company unless there's special circumstances in which some of the SPAC sponsors may continue.
The SPAC sponsors often are typically members of the board, at least until they sell down their position post the de-SPAC combination. And some of the concerns in conjunction with SPACs, post the de-SPAC is, is there going to be enough publicly tradable securities that you can maintain and satisfy the listing standards with a stock exchange?
Often not only are the sponsor's shares subject to lockups and therefore restriction on transfer, that the target company's management and which may be getting significant amounts of stock, that stock will be locked up. The stock from the PIPE, which was sold or restricted securities. That's not going to be publicly tradable until the registration statement to register those shares, post the de-SPAC pack is up and available to those potential selling stockholders.
So there's an issue depending on how many of the SPAC shares were in fact redeemed in conjunction with the redemption offer about being able to maintain your listing. And so target companies and SPACs need to be aware of those issues. I mentioned a minute ago lockup considerations for the management, as I'm sure you're all aware most of these combinations involve private companies.
And the evaluation is based that the SPAC was willing to offer, to buy the target company or combined with the target company is based on projections. Maybe three year, maybe five year. And so it's important that the management team of the target company, be there to in fact prove up those projections.
So the lockups typically are longer than management wants to have, it's their shares are going to be locked up from time to time. There may be early release mechanisms, typically are early release mechanisms to release at least a portion sometimes 20 to 25% is subject to early release. But management should be prepared to have whatever equity in the combined company they're going to receive.
Likely to be subject to up to a lockup for significant period of time post-closing. And then also the post-closing compensation for that management team, needs to be addressed not only the cash component, but also whatever equity incentive they're going to have. And the SPAC, when the SPAC IPOs there are no equity incentive plans that the SPAC has.
Those are put in at the time of the business combination. And so the S-4 will describe whatever those new plans are that are being put in place. And one of the things that they just submitted for approval by the SPAC stockholders in conjunction with improving the overall business combination, are approval of new incentive plans.
There are several restrictions that affect blank check companies or shell companies like a SPAC, when one of those is that a SPAC, post de-SPAC cannot use form S-8 until 60 days, basically after closing. 60 days after the form 10 information has been filed with the SEC. So that "Super" 8-K that's filed post the business combination is going to satisfy and start that 60 day clock for you to be able to use an S-8 to issue equity from your incentive plans. We can move to the next page I think. I think it's time for our poll question.
Mike O’Leary:That's right.
Lisa Knee:So when closing your de-SPAC transaction, which area has the most legal counsel attention so far? Finalizing combined company charters and bylaws, investor relations, and queries and DNA disclosures, getting shareholders votes on various matters, valuation of target company and other. And so before you address the answer on that, I'm going to throw another question out at you Mike, if you don't mind. Is it possible to reverse merge a private mortgage REIT with de-SPAC?
Mike O’Leary:I'm not a REIT expert but having talked to some of my tax partners about that I do think it's possible to reverse combine an existing REIT with a SPAC, where the REIT would continue. There's some particular rules about the type of income you can have from the pre de-REIT period.
And so in terms of the income that the SPAC has earned, it may be that they've got to pay out a dividend but I'm not a REIT expert. And we would need really a REIT tax expert to be able to address what steps would have to be done before that combination could be done in a valid manner.
Lisa Knee:Great. And I'm sure after this we can get back to people on questions on that too, with some of our internal tax people. Yeah.
Mike O’Leary:And Michael may have the answer for that, I don't know.
Lisa Knee:Yeah, maybe we'll push that one off. So I think we can get to the response and maybe you can address the response of the polling question. Over.
Mike O’Leary:It is. That's interesting. The MD&A disclosures, I'm surprised that's really not a big issue. But getting the votes can be a big issue and you need the SPAC and the target company need to engage proxy solicitor early on. So that you're getting the best advice about getting it in. Because institutional investors tend to vote in these things, even if they've sold their shares, post record to date.
Retail investors don't. And so if you've had a big movement into retail investors hands, it could be problematic if you have a lot of sales posts your record date. That's all I'll say on that.
Lisa Knee: Great. And I think Angela now we're moving towards you again, right?
Angela Veal:Yeah. Thank you. Yeah. Mike has mentioned really good insight in terms of the de-SPAC process and some of the legal implications. So for this section, we're just going to layer on what we see from accounting perspective as well. So readiness is definitely the key for a real estate target company, because the de-SPAC is considered the more complicated phase from an accounting and financial reporting standpoint.
A readiness assessment can be conducted as part of the formal workshop, or it can be happening concurrently as part of the work streams during the process itself. Usually there won't be much time for a formal workshop to identify gaps. So the readiness would just happen organically. We have recently published an article specifically on the accounting considerations for real estate SPAC target companies.
So feel free to reach out if you would like the link from us. First area relates to the audits. So like Mike has mentioned earlier, they would require PCAOB audits on their financial statements. And one thing I would like to add is that the target companies should actually also confirm with its existing auditor, if it is a PCAOB registered public accounting firm that is independent under the SEC and PCAOB independence rules. And if not, they have to go through the time-consuming process of selecting and engaging a new audit firm. And if previous year's financials are audited under the ASCPA standards, they will now need to be reordered it under PCAOB standards. And it may include at least two to three years of comparatives.
So that's definitely pretty time-consuming as well. And from what I've seen based on the projects that I have been on, the auditors would often ask for supporting documents that would date as far back as years ago, two to three years ago. Including formation documents, that agreements sales and lease contracts, employment contracts, as well as prior acquisition agreements.
Secondly, the target company's financial statements must be in compliance with SEC reporting requirements. So financial statement disclosure areas may require a substantial uplift, including related parties, EPS, segment reporting, adoption of new standards as well as quarterization. And if the company has previously adopted the private company council standards or PCC, sSuch as their accounting treatment for goodwill, this effect would need to be reversed as well.
Some target companies may qualify for reporting accommodations provided to emerging growth companies or EGC, or smaller reporting companies or SRC. So such relief would actually meaningfully impact the time and effort required to consummate the transaction.
So as an example, target companies should discuss with their advisors early on so that they can plan on how to best use their resources and not spend time adopting a new accounting standard. Such as the lease standard, when they can potentially use a private company adoption date, which would happen at a later stage.
So as you can see from the slide as well, de-SPAC transaction or process does have its own unique technical accounting and reporting matters that a target company would have to address. There are a lot to talk about but we just highlight three interesting ones today. The first one relates to the conversion of financial statements.
This would apply to some real estate entities whereby their financial statements are prepared on a cash or tax basis. And they would need to be converted to an accrual or GAAP basis for the financial statements. And the second area, which is the hot topic or the key area that everyone needs to look at would be the business combination analysis.
It is a very critical step to determine who the accounting acquirer is, and this involves a high level of judgment. This conclusion would drive the overall presentation of financial statements, and may even impact accounting for other items such as earn outs as well. So the ASC, a master glossary defines acquirer as an entity that obtains the control of the acquiree.
However, in a business combination, in which a variable interest entity or VIE is acquired, the primary beneficiary of that entity is the acquirer. Therefore, the very first step for everybody is to determine the accounting acquiree is to go through the consolidation guidance, and evaluate if the legal acquiree is a VIE.
And the primary beneficiary of the VIE will be the team accounting acquirer. And if the legal acquiree is a voting interest entity rather than a VIE, then we would need to consider other guidance relating to the existence of a controlling financial interest. So to summarize, we should then consider the business combination guidance that states that in an acquisition effected primarily by transferring cash or by incurring of liabilities.
The acquirer usually is the entity that transfers the cash and assets or incurs the liabilities. However in a pretty standard de-SPAC transaction where the acquisition is effected primarily by exchanging equity shares. We would need to be careful in terms of our analysis, and evaluate factors under ASC 805-10-55-11 through 15.
For example, on the composition of the senior management of the combined entity and the relative size of the entities. So in many instances we have seen cases where the legal acquirer, which is the SPAC itself, it is actually the deemed accounting acquiree and the target company becomes the accounting acquirer for accounting purposes.
So this will be considered what you call a reverse recapitalization or reverse acquisition as well. In a reverse acquisition very interestingly, the financial statements of the combined entity would just represent a continuation of the financial statements of the target company, who is the deemed accounting acquirer.
And the assets and liabilities would be stated at the historical carrying values of the target company as well. And the transaction cost would not be expensed off, and instead it would be recognized as a reduction in APIC, and there's no goodwill recognized in this instance. On the retrospect, just to highlight if the SPAC is deemed accounting acquirer, and the target is deemed a business, the SPAC would then apply push down accounting by recognizing assets and liabilities of the target. At fair value and also recognize any goodwill.
So all of this sounds very complicated, I'm sure you must be thinking of that. So our recommendations is for companies to analyze the preliminary deal documents prior to closing, to ensure that the companies is comfortable with the ultimate accounting conclusion. They should also consider consulting preliminary conclusions with the SEC if needed. Last area, I would like to highlight on this slide and I'll do it quickly is on the issuance of debt or in equity or financial instruments.
So I've seen instances where target company may have issued debt or equity in the past three years, that will be included on the financials. Definitely all of this accounting treatment would require a fresh look and formal documentation as well. And it involves going through guidance under ASC480 and the guidance under ASC815 derivatives guidance to determine classifications, and also existence of any embedded features. This is definitely one area that auditors would often look at.
Next area to highlight, it would relate to internal controls. So like Mike has mentioned earlier once it is public, the real estate company would need to establish and maintain internal control over financial reporting, or ICFR. As well as disclosure controls and procedures or DCP, upon the close of the transaction.
So this would require a lot of advanced planning and ramping up of its controls as well. And additionally, they would also need to prepare the MD&A disclosures, and all of these disclosures would require extensive data analysis and may even contain sensitive information.
And lastly, they also need to prepare the pro forma financial statements typically. The presentation is dependent on the expected accounting treatment of the transaction. The considerations would include public shareholders' redemptions, secondary transactions, as well as any impact from change in the tax status from the SPAC merger. So as mentioned earlier, we definitely like to emphasize early on coordination and planning during this process. Next, Michael is going to touch on the tax implications relating to de-SPAC.
Michael Torhan:Great. Thank you. So like Angela mentioned, I'm going to go over some of the tax implications and considerations during the de-SPAC transaction. If you were on the last session, I touched on the first consideration here when we were speaking about the structuring of a new SPAC. But like I had mentioned on that last session, I'll reiterate here some of the jurisdiction considerations for both the SPAC and the target.
Like I mentioned on the last session, a SPAC needs to form whether domestically or in a foreign country at the time that the SPAC is formed. Ultimately, whether the SPAC should be a domestic or foreign entity depends some part on the target entity. But of course, when the SPAC is being formed, that's an unknown.
So we'll talk a little bit about what happens now that the target is identified and the merger is taking place. What happens between the different scenarios between domestic and foreign SPAC versus domestic and foreign target. And I’ll also speak a little bit about how the de-SPAC differs when you have a target that's a corporation, versus a pass through entity.
And then in all these discussions, we'll talk about the different types of tax transactions and some of the underlying tax theory that corresponds to de-SPAC transactions.
So just to talk a little bit about the jurisdiction considerations, again you can have either a SPAC that's incorporated in the US or a foreign country where you would have a foreign SPAC.
And so when you created the SPAC, there was some uncertainty, whether you would have a domestic target or a foreign target. But now that a target has been identified and a merger is going to take place, here's where it becomes really important to identify how to continue. And some of the considerations, some of the reasons why this matters is when you have a domestic SPAC acquiring a domestic target, there's a lot of favorable US corporate tax law that could really drive a tax efficient de-SPAC transaction.
If you have an acquisition that's just entirely for cash, you will generally end up with a taxable transaction. But if you have a hybrid type of transaction where you have both cash and stock, there are some opportunities for tax efficiency including tax deferral, in terms of different types of reorganizations that are allowable under the tax law.
If, however, you don't have a domestic and a domestic situation, there are some complications. So if you started out as a domestic SPAC, but you ultimately acquire or look to acquire a foreign target, there are some tax issues that result in some tax inefficiencies. For example, if the domestic SPAC is going to be the parent entity as the acquirer, income from the foreign target, which is non-US income, that may be now subject to US taxation. That target could potentially be considered a CFC, which is a controlled foreign corporation. Likewise, the SPAC would need to consider any kind of foreign tax laws since it does own that the foreign subsidiary. So what do you do if you run into the situation?
There are certain scenarios where you may be able to do a domestic to foreign reorganization; where the domestic SPAC would reorganize into a foreign entity. But there's very complex rules called the anti-inversion rules, which may prevent this from happening. There’s various ownership requirements and other regulations that need to be looked at.
Because if you fail those anti-inversion rules, even though you've attempted this reorganization, the SPAC continues to be treated as a US corporation. So that's certainly something to keep in mind... the anti-inversion rules. And now let's talk about the converse if you started out as a foreign SPAC but now you've identified a domestic US target that you're looking to acquire.
What are some of the tax efficiencies? US payments from that foreign subsidiary to the foreign SPAC, it would be a subsidiary of domestic entity and that foreign entity makes, sorry if the US entity, which is a subsidiary, makes payments to the parent foreign entity which is the SPAC. Those may be subject to tax withholding generally in the US tax law.
When you have a US entity that makes distributions or other payments to foreign individuals or entities, there are tax withholding rules. So those need to be considered and furthermore, there's certain rules called inversion rules. So in the other scenario we talked about anti-inversion rules; there's inversion rules under Section 7874 which generally prevent the acquisition of US targets by foreign parents. So what do you need to do if you've run into the situation? You would want to convert the foreign SPAC into a US entity. This does create a potential upfront tax. Essentially the SPAC’s existing earnings and profits may be subject to taxation.
But like we spoke about in the prior session, generally when the SPAC is operating post IPO and prior to de-SPAC, the income is very limited; usually the interest income that is earned on the escrow account of the cash; that tax exposure might be limited. Another consideration though with this scenario are the PFIC rules, which is the passive foreign investment company rules.
Again, another series of complex tax rules regulations, where you have foreign entities. So definitely something to look into as well. Because there's certain elections… certain shareholders might want to make a QEF election. Again, we could probably speak for a couple of hours so we're not going to get into all the details.
But I think the key takeaway from this is, once you have your original SPAC in a certain jurisdiction and a target has been identified, you want to match up those jurisdictions and if they're not matched up, you want to look into how to solve for any tax inefficiencies. So once you've accounted for any jurisdiction inconsistency, you want to consider what type of tax transaction the de-SPAC merger is going to undertake.
There's a lot of general corporate M&A considerations that you’re really thinking of. Two of the common reorganization and M&A sections are 368 and 351. 368 being the main one; generally corporate mergers and acquisitions can qualify as tax deferred if the acquiring corporation provides a significant amount of its stock as consideration to the target corporation.
So again, it's not an all cash transaction. There is a stock component. There is a requirement though that the acquirer either needs to continue the target corporation’s business, or use a significant portion of the target's assets in the business, right?
So this will generally work in the SPAC context if you think about it. If the SPAC is acquirer that's acquiring a target corporation, generally the resulting corporation will continue that underlying business. But this leads to another question, could a SPAC as a target work in a transaction? And that's something that would need to be considered further under the facts and circumstance.
If the SPAC is a target, did the SPAC really have a historical trade or business? If it was only holding cash and in pursuit of an acquisition; that's an open question out there. I do want to talk a little bit about what happens if the target is a pass through entity. So a lot of what we've been discussing so far is when you have a target that's a corporation.
But as many of you are well aware, especially in the real estate industry, there's a lot of companies out there that are in pass through form, most typically partnerships. So these could be general partnerships, limited partnerships or LLCs treated as partnerships. There’s a form of transaction called the Up-C structure that can be used for a de-SPAC merger.
Many of you on this meeting are probably familiar with the UPREIT transaction, where you have a historical operating partnership that's either historical, or it's formed for this purpose. And you have a REIT parent that's put into the structure that undertakes an IPO. The UP-C structure is an offshoot of the UPREIT structure.
In an Up-C transaction, the target company which is the operating partnership, that partnership would continue to exist, and the SPAC would then be treated as the parent. So it'd be treated as the holding company. And so the SPAC as the holding company up above, would contribute some of the cash to the operating partnership. in exchange for shares in the operating partnership. Again, very similar to what you might be familiar with in an UPREIT transaction.
The key thing to know here with these Up-C transactions is there's generally something called TRAs or tax receivable agreements. So when the SPAC purchases part of that partnership, it's entitled to a step-up in basis of its assets.
With partnerships for tax purposes, when there's a sale or exchange of a partnership interest, there’s generally a step-up in basis of assets. And so the SPAC is entitled to tax benefits from that step-up in basis. Essentially tax receivable agreements provide that the original owners are allowed to share in those tax benefits that the SPAC receives from the step-up in its basis in the partnership.
So those are common in the SPAC context. And I know that there was something raised earlier about is it possible for a mortgage REIT, I don't know if it was a reverse merger, but Mike was correct. So there are special considerations with REITs and SPACs, or if you have a C corporation that's merging into a REIT.
Again, not going to go into all the details but there are certain rules in addition to your general income requirements or your asset requirements; there's rules that you can't have accumulated earnings and profits inside a REIT, from non-REIT periods. So generally what happens is if the REIT, for example, acquires a C corporation, and a C corporation had accumulated earnings and profits, those need to be distributed by the REIT in that year.
And those distributions are not eligible for the dividends paid deduction. So most REITs are not taxable entities because they're eligible for this deduction for distributions. The distributions for these prior E&P amounts do not go into the calculation for the DPD. So that's just one of many considerations.
Lisa Knee:Thanks for clearing that up and we're going to stay on, so we have another question during our poll for you. So which area of taxation would you like to hear more about jurisdiction, SPACs, jurisdiction of target companies, target entity type, type of tax transaction and its impact or others. So Michael, as we know there's been lots of discussions lately on tax law changes. And how do you think any of them, or would they impact SPACs?
Michael Torhan:So that's a great question. As many of you are well aware it does seem like there are significant tax changes coming down the pipeline. I don't know if anybody knows yet when, but I think some of the most significant changes clearly are in the capital gains rate. I think that's one of the largest potential changes that are coming up.
Where the tax rate for capital gains may go up as high as the ordinary income rate. Clearly SPACs are public companies. So the investors including the SPAC sponsors, they will own common stock. So clearly any changes in the capital gains rate will affect investors and sponsors of a SPAC. Another topic that has been talked about for a number of years are changes to the treatment of carried interest.
So this really comes into play. This is something that's well-ingrained in many private equity deals’ carried interest. Generally, there's a 20% carried interest that's paid out to sponsors upon some kind of event. Historically, they are treated as capital gains if the underlying income is generated as a capital gain.
So that's been talked about a lot over the last couple of years about making changes to the treatment of those amounts. And so it remains to be seen how that's going to correlate to the SPAC space. Again, the 20% that SPAC sponsors receive are similar in nature, to carried interest. But again, it remains to be seen how those will be addressed … whether there's going to be some additional rules, in regards to that additional receipt. Like I mentioned on the last session, there is a question of when the sponsors purchase their shares in a SPAC, is there some kind of initial compensation component? I think these are definitely important considerations, Lisa, going forward, as there's changes to the tax code.
Lisa Knee:Great. Thanks. And let's look at the polling responses. Excellent. Okay, Michael, we will take note of that. And let's continue.
Angela Veal:Thanks Lisa. So phase four involves the new combined entity after the merger. So it is technically not a phase with a completion deadline, like the other three phases. This combined entity would just continue on an ongoing basis. And the combined company is a public company and management should continue to be kept up to speed on cross-functional topics, such as accounting, financial reporting, FP&A, tax, internal controls, HR, enterprise risk management and cybersecurity.
The overall requirements within this space are also impacted by the new combined entities filing status. And if it's filing as an EGC or a non-accelerated filer. For example as an EGC, it may not need to provide its auditor's attestation report on ICFR on an annual basis. And as mentioned earlier, the new combined entity which should be aware of any SOX compliance and also SEC reporting requirements.
Lastly, since this is technically a merger and like any other mergers, the management teams of the target company and the SPAC may make up the management team of the new combined entity. Some of them may not have experience with public company requirements and may need to consult with outside advisors as well.
There will also be a lot of integration in terms of the systems and processes. And Michael will talk about some interesting tax considerations on a later slide.
So moving on to the accounting and control implications on phase four, some of the things that a combined company should consider that would apply to a public company relating to ICFR and DCPs.
Number one, to evaluate and disclose material changes to its ICFR on a quarterly or annual basis, two, to provide quarterly disclosures and certifications from key executives that the DCPs are effective. And lastly, disclose to the auditor and the audit committee, all significant deficiencies and material weaknesses in ICFR and any awareness of fraud.
As a public company, the combined entity, like I've mentioned earlier, would need to maintain its SEC reporting requirements such as filing on a timely basis. It's from 10Ks, 10QS, 8Ks when there's any significant transactions or changes, as well as forms three, four, and five on insider transactions.
There will also be a lot of integration and optimization in terms of systems. One example that we have seen is where the new combined entity would need to implement a new ERP system. For example, for real estate entities, they will need to launch a new lease tracking system to account for leases under ASC842.
There are also a lot of nuances like Mike and Michael have mentioned earlier relating to share-based compensation that will require a robust documentation on how they should be treated. This can include both the target company's own share-based compensation arrangements, and also the analysis of the impact of the SPAC merger on pre-existing share based payment arrangements.
So after you've done the business combination analysis, and if the target is deemed to be the accounting acquirer, you should also consider whether the pre-existing target awards were modified as part of the merger. For example, the effect of the SPAC merger on any anti-dilution provisions included in the original terms of the target awards should be evaluated. And another hot topic that I would like to touch on today, but at a high level and that relates to earn outs. So as you're aware, there may be uncertainty to the value of the operating company that's being acquired. So one way of addressing this is for the SPAC to enter into arrangements with the sponsors, employees and also selling shareholders.
That if the certain post merger, if certain performance measures are met such as the achievement of a certain stock trading price, they will receive the award. So for example, if the SPAC is the accounting acquirer and the target is deemed to be a business, we will account for this earn out under ASC805.
And this earn out arrangement with target company shareholders, may be deemed to be a contingent consideration that should gross up the purchase price. And additionally, derivative analysis may also need to be performed under ASC815, on the contingent consideration. This consideration also needs to be fair value, and if this is a liability, it will need to be fair value every reporting period and as well.
And on the retrospect, if the award is issued to employees or service providers where there's a requirement for them to provide services for X amount of time after the merger, for the awards to vest, this may be considered stock based compensation under ASC718. And one interesting example is if the earn out provider is in the form of modifying an existing stock option agreement, this may be considered a modification of the existing award and any incremental fair value should be recognized as additional compensation costs.
So definitely there's a lot to talk about in terms of post-merger, even though this is post de-SPAC there's still a lot that the target or the combined entity would need to look into. So feel free to reach out to us if you have any additional questions, and to continue with the topic of share these compensations, I'm going to hand it over to Michael to discuss the tax implications.
Michael Torhan:Great. Thank you. I know we only have a couple of minutes of time so I'm going to give a high-level overview of some of the tax implications, once the de-SPAC merger has taken place. And a lot of these, outside of some of the general M&A considerations like a purchase price allocation, or new entities, if you have foreign entities, you might have to consider international tax implications, different reporting requirements.
A lot of the considerations do focus around the fact that you had a SPAC before, which was almost like a shell company … had cash. And you had a target company that was generally a private company that was not a public company. And now you have the new entity which is a publicly traded entity. And so there's certain tax considerations that need to be made because of that exact fact, that you have this public company now. For example, a lot of these issues around executive compensation … is the de-SPAC'ing event a vesting event for the restricted stock that was owned by the owners of the target companies? Are there any 1202 implications?
I don't have that here in the slide.; 1202 relates to a qualified small business stock. So if you had some private target company where owners were eligible to have some of their stock treated as qualified small business stock, and there are certain requirements for stock to be treated as such, but they may provide some tax efficiency or tax-free sales of that stock at some point in the future by those owners. There's a question of once the de-SPAC occurs, does that benefit stop on the date of the merger for those shareholders of the target companies?
Other considerations include golden parachutes. And so there are certain rules surrounding golden parachutes where certain payments may be non-deductible on these golden parachute rules, when there's a change in control of an entity. So those need to be considered.
Furthermore, Section 280G also provides that there can be a 20% excise tax for highly compensated individuals. So that needs to be considered. Section 162(m) talks about highly compensated covered employees. There are limits on deductions for compensation to certain covered employees. For example, deductions might be disallowed for compensation that exceeds a million dollars.
In section 162(m, there used to be an exception for a post IPO transitions which no longer exists. So this is definitely a consideration for the resulting company. And outside of these specific considerations, you always have your general tax compliance considerations: federal and state reporting requirements the new entity wants to consider.. what jurisdictions there's nexus in, clearly the target company was probably in existence for some time, but you definitely want to consider new state nexus that might exist, and other general information reporting such as W2's: there are special rules for combined reporting when there's mergers and acquisitions.
So definitely things to keep in mind and other information reporting like 1099s as well you want to consider which entity should be reporting what payments. Again, just some general considerations.
Lisa Knee:Thank you, Michael; while we have the last polling question, I just want to throw a question out there to the Hunton team, if they don't mind in our last minute of wrapping up. So what is the minimum revenue and earnings that you think most SPAC sponsors want to see in a real estate target company? I mean, of course everyone wants a larger deal, but are there any factors that sponsors are looking for that you can give some guidance on?
Mike O’Leary:Yeah, Angela, what I would say to that it's as we know because there've been so many de-SPAC transactions involving pre-revenue. It's not really a minimum revenue, it's sort of a minimum valuation. And I would say anything below a billion dollars is probably not large enough. While there have been some SPACs that have raised only $50 million in their IPO, and they may be targeting smaller companies.
Most SPACs are looking at a billion dollar valuation or larger, so several billion dollars in terms of size. And the amount of the revenues is not really the driver there. It's the overall valuation of the business that the de-SPAC is targeting based on the projected projections that the target has.
Lisa Knee:Great. Thanks. And so I think now we can get the answer to our polling question. Just kind of across the board here. Terrific. So I think do you want to advance for the CLE information? Yeah, I will turn it back over to Lexi. There were some Q&A questions that we will address to people directly, just to make sure that we can get some response.
And thank you to our entire team for presenting today, and thank you to all of you who attended part one, two, or three or all of the above. And it was just a pleasure working with Hunton on this endeavor.
Transcribed by Rev.com
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