Tax Implications You Need to Know Surrounding SPACs | Part 2
If you missed Part 1 of this series, which provides an overview of Special Purpose Acquisition Companies (SPACs) and the tax implications of both their formation and de-SPACing process, be sure to check that out. The second part of our series will focus on passive foreign investment companies (“PFIC”) and international tax issues related to SPACs.
SPAC Jurisdiction – Impact to shareholders
As part of the formation, the sponsor will need to determine the legal jurisdiction for incorporating the SPAC. The selection of the jurisdiction will have an impact on the taxation of the shareholders prior to the acquisition of a target company. The jurisdiction of the SPAC as either U.S. or foreign will generally depend on where the anticipated target company is likely to be located. A foreign SPAC, such as one formed in the Cayman Islands, can be tax inefficient if acquiring a U.S. target as would a U.S. SPAC acquiring a foreign target. Moving the jurisdiction of the SPAC after the acquisition could result in a taxable transaction to the SPAC and/or the SPAC shareholders. Just because a SPAC is listed on a U.S. stock exchange does not tell you where it is was formed. Only careful reading to the prospectus will provide that information.
Having U.S. shareholders owning stock in a SPAC formed in a foreign jurisdiction can cause tax issues for the U.S. shareholders. For example, the SPAC could in some circumstances be considered to be a passive foreign investment company (“PFIC”). A foreign SPAC will be a PFIC for U.S. tax purposes if at least 75 percent of its gross income in a taxable year, including its pro rata share of the gross income of any corporation in which it is considered to own at least 25% of the shares by value, is passive income (“Income Test”). Passive income generally includes dividends, interest, rents and royalties (other than rents or royalties derived from the active conduct of a trade or business) and gains from the disposition of passive assets. Thus, $1 of interest income earned on funds deposited in a bank account could cause the SPAC to fail the Income Test. A foreign corporation also will be a PFIC if the average value of its passive assets in a table year is 50 percent or more of the value of its total assets, including its pro rata share of the assets of any corporation in which it is considered to own at least 25% of the shares by value (“Asset Test”). Passive assets are assets held for the production of, or produce, passive income. Cash is considered a passive asset under the Asset Test.
Because a SPAC generally has no current active business until it acquires a target, it is likely that it could meet the PFIC Asset or Income test for the first taxable year. However, pursuant to a start-up exception, a corporation will not be a PFIC for the first taxable year the corporation has gross income (the “start-up year”), if:
- no predecessor of the corporation was a PFIC;
- the corporation establishes to the satisfaction the IRS that it will not be a PFIC for either of the two taxable years following the start-up year; and
- the corporation is not in fact a PFIC for either of those years.
The applicability of the start-up exception will generally not be known until after the close of the taxable year and, possibly, after the close of the two subsequent taxable years. After the acquisition of a company or assets in a business combination, the SPAC may still meet one of the PFIC tests depending on the timing of the acquisition and the amount of passive income and assets as well as the passive income and assets of the acquired business. If the company that is acquired is a PFIC, then the SPAC will likely not qualify for the start-up exception and will be a PFIC for a given taxable year. Accordingly, there is no assurance that the SPAC would not be a PFIC for any taxable year.
If a SPAC is considered to be a PFIC, there are unfavorable tax consequences that can result for the U.S. shareholders. These rules can include treating a portion of any gain on sale of the stock as ordinary income taxable at the highest rates. Some of this income could be attributable to prior years and could be subject to interest charges. There are elections available to help mitigate some of these rules, but they are complex and have their own timing requirements. As indicated above the timing of these elections may conflict when the SPAC is definitively identified as a PFIC. Additionally, there may be other filing requirements by a U.S. shareholder upon the initial purchase as well as ongoing filings as long as the foreign SPAC shares are held. Overall the filing requirements become significantly more complex for the U.S. shareholders of a foreign SPAC. The penalties that can result in failing to file some of the required reporting forms can be significant. You should have a discussion with your tax advisor before acquiring stock in a foreign SPAC.
If a SPAC is a U.S. corporation then all the normal rules concerning stock ownership would apply and none of the reporting and unfavorable taxation issues discussed would be applicable. After the acquisition, the SPAC could pay dividends which would be subject to tax at a beneficial tax rate if they are qualified dividends. Any sale of the SPAC stock after 12 months would be considered a sale of a long term capital asset and the gain would be subject to long term capital gains rates. If the shares are redeemed by the SPAC if a suitable acquisition was not found then the redemption would be considered a sale of the stock and any gain or loss would be reported. Additionally most SPACs stock is sold with warrants. These warrants are treated the same as the investment warrants issued to the SPAC sponsors discussed above.