Special purpose acquisition companies, or SPACs, continue to grow in popularity as private companies look for alternative means of accessing the public market outside of a traditional initial public offering (IPO). SPACs raised a record level of capital in 2020 — $83.4 billion — and in the first quarter of 2021 have already surpassed that amount, having raised $87.9 billion as of mid-March.

There are plenty of reasons that a company may consider using a SPAC IPO to go public, from the ease with which SPACs appear to be raising capital to the historic challenges with pursuing a traditional IPO for companies outside of the technology sector. SPACs draw investors in at an earlier stage of a company’s formation than a traditional IPO, which may bring a broader pool of capital to the table. At the same time, there are reasons you may want to remain on the sidelines with this trend, as interest rates are likely to start rising and SPAC IPOs are also showing indicators that they are highly vulnerable to changes in the market.

If your organization decides to use a SPAC, you should also be aware of some accounting and tax considerations. We addressed some of these accounting concerns with our earlier publication here. We recap some of the tax issues that may arise below.

Mechanics of a SPAC

To understand the tax issues that come with a SPAC both pre- and post-SPAC merger, it is helpful to revisit how the structure works. The SPAC is what is referred to as a blank check company; that is, a company designed specifically to raise capital. Investors contribute to the SPAC as it seeks a private company target, and if the target is not identified in a specified amount of time, the SPAC generally returns the capital to the investors.

Since the SPAC companies are primarily financial vehicles, these blank check companies are often founded in the Cayman Islands or other jurisdictions outside of the U.S. It is a common structure used in the private equity and venture capital space. To get started, investors contribute cash for shares in the company. The SPAC investors receive the benefit of their returns on investment being treated as carried interest (rather than ordinary income), just as they would if investing in a PE/VC fund. This carried interest benefit may not always be there; note that President Biden would like to eliminate the benefits of carried interests in his tax proposals.

Along with the shares in the company, shareholders in a SPAC also have redemption rights (in the event they disagree with the SPAC’s decision on which private company to target). SPACs may also employ forward purchase contracts or have equity-linked securities.

Tax Implications Prior to SPAC Transactions

The rubber hits the road with the tax considerations for a SPAC once the SPAC has identified its private company target and prepares to combine with that target, a process sometimes referred to as “de-SPACing.” What happens during the de-SPACing from a tax perspective depends on a few factors.

Domestic-Foreign Implications

As with many other taxing jurisdictions, the U.S. has ramped up its efforts to minimize potential profit shifting, which can occur when a U.S. company merges with a foreign target in a lower tax jurisdiction and becomes a foreign company in that jurisdiction. Shareholders in a SPAC transaction that involves the domestic-foreign dynamic should be aware that the reincorporation of the domestic SPAC as a foreign company will involve expatriation considerations (which are proposed to be tightened by President Biden), including built-in gain recognition rules under Internal Revenue Code Section 367 for U.S. shareholders that hold more than a 50% share in the foreign target company.

Note, if the intent of the domestic SPAC is to pursue a foreign target, there may be a way to execute the de-SPACing transaction under Section 7874 in such a way that the newly-made foreign company would not meet the threshold for a reincorporation. This involves meeting an ownership test – 80% of the ownership of the foreign de-SPACed company must be the same as the domestic SPAC.

There is also a tax play by which the SPAC incorporation and the de-SPACing transaction occur at the same time, but this may be difficult to manage because it would involve the SPAC shareholders having their ownership in the newly de-SPACed foreign target significantly diluted.

Another way to potentially minimize a significant tax consequence to the transaction would be to ensure that the de-SPACed foreign target is conducting more than 25% of its business activities — including ownership activities, assets, and income — in the foreign jurisdiction, but this is a difficult route for complex, multinational structured investments.

A third-country rule may also be relevant if, in the acquisition of the domestic SPAC, the foreign target acquires another foreign target corporation. In this scenario, the second foreign target shareholders must hold at least 60% of the stock in the first foreign company target. These shareholders must not be tax residents of the first foreign target’s country. Essentially, this makes it less likely that the ownership percentage of the first foreign target (the one combining with the domestic SPAC) would meet the criteria for an inversion, thus sparing the domestic SPAC shareholders from those tax liabilities.

Foreign-Domestic Implications

Given the U.S.’s high individual tax rate relative to other jurisdictions, it is less likely that a foreign SPAC would target a U.S. company and incorporate as a U.S. company post-SPAC. That being said, the situation may still occur, and to skirt the consequences of a domestic F reorganization, the foreign SPAC would want to become a domestic company before the de-SPACing.

Section 367(b) generally taxes U.S. shareholders on all earnings and profits occurring as a result of the reincorporation, so to minimize the tax consequences, companies would want to reincorporate before the public market transaction, after which time the value of the SPAC would likely increase. Also note that reincorporating a foreign SPAC before the de-SPACing may not absolve the transaction from rules related to passive foreign investment companies (PFICs).

Foreign-Foreign

Section 367 rules may still come into play in scenarios where a foreign SPAC acquires a foreign target company. Foreign SPACs are often formed in the Cayman Islands whereas the foreign target company may be incorporated wherever the majority of its business activities are taking place. Reincorporating the Cayman SPAC in the target foreign company’s jurisdiction prior to the de-SPACing minimizes Section 367(b) and Section 367(a) rules for U.S. shareholders who own less than 5% of the foreign SPAC. Shareholders should be mindful that the reorganization may still come with inversion consequences if the foreign target owns a U.S. business because that business would not qualify for the foreign F reorganization tax treatment.

Foreign SPAC Ownership Calculations

Foreign-owned SPACs also have some nuances to consider under Section 7874. Shares of the SPAC owned by the foreign corporation are not calculated in the ownership percentages subsequent to the IPO, only the ownership of the domestic stockholders are included. The passive asset rules may affect the ability of the post-IPO SPAC from inverting into a foreign corporation subsequent to the transaction.

Inversion Rule Implications

Anytime there is a SPAC transaction between foreign and domestic entities, inversion rules come into play throughout the de-SPACing process. U.S. regulators are mindful of domestic companies deliberately trying to minimize their assets before the de-SPAcing transaction to reduce their SPAC transaction tax liabilities, and will be watching for non-ordinary-course distributions (NOCDs). Redemptions using the NOCDs will also be monitored carefully. Distributions often consist of cash distributions, but may also be made through tax-free spinoffs. Note that President Biden would significantly tighten the inversion rules and also expand their scope.

Passive Foreign Investment Company Implications

PFIC status — as determined under Sections 1291, 1297, and 1298 — applies if a foreign corporation generates at least 75% of its income as passive income (such as from investments), or if 50% of its assets generate passive income or are held for generating passive income. The rules prevent the U.S. shareholders of those foreign corporations from deferring income that would otherwise be taxable, had the shareholders invested in a U.S. mutual fund. The rules include an exception for offshore start-ups that hold large stores of cash before becoming profitable. But that exception only applies if the company has active operations after its first year. SPACs can sometimes take longer than a year to identify a target, and according to practitioners, SPACs should not try to rush the process due to operational complications. If a SPAC fails to acquire or combine with a target company within that deadline, its shareholders are taxed on fixed income and dividends from the PFIC. Shareholders would also pay a higher rate of tax (plus interest) on future sales of PFIC stock.

QEF Election

Shareholders that are getting taxed on their PFICs have the option to make a qualified electing fund (QEF) election to avoid the tax treatment of being a PFIC. If the election is made for the first year that a company is deemed a PFIC, its shareholders are taxed annually on any income the PFIC earns. But the QEF election, under existing tax guidance, does not apply to warrants that are treated like stock options and are typically part of a SPAC’s capital structure. That means when U.S. shareholders want to exit their PFIC (which they acquired through a SPAC), they have to purge those leftover warrants of PFIC status or risk carrying that tax treatment forever. The purging election, under the PFIC rules, is itself punitive, essentially punishing U.S. shareholders for the length of time they held PFIC options and charging them a steep toll on their gains to remove the PFIC designation from those options.

Tax Implications Post Transaction

Regulations are tightening around foreign entities that are attempting to execute multiple SPACs or other types of domestic company acquisitions. If acquisitions are occurring quickly, the acquisitions will be “lumped” together for U.S. tax purposes, increasing the chance that the transactions will be subject to inversion rules. De minimis transactions are not considered to be part of the serial acquisitions rules.

Multi-step acquisitions are also something to be mindful of, where a foreign SPAC avoids the Section 7874 rules for one domestic target but then the foreign SPAC gets acquired by another foreign corporation. In this instance, the foreign-acquiring-foreign entity may trip the inversion rules (with the foreign corporation that acquired the domestic SPAC being considered a domestic corporation for U.S. tax purposes).  If that is part of the overall plan, the transactions should be clearly distinguished from each other.

Final Thoughts

The popularity of SPACs and their use of foreign entities in the de-SPACing transaction will make companies that used SPACs to access the public markets a compliance focal point for U.S. regulators. It is highly recommended that if your  organization has a de-SPACed company, that you work with your tax professionals to minimize potential inversion consequences.

For more information, please contact a member of our tax team.

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