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Tax Implications You Need to Know Surrounding SPACs | Part 1

calendar iconApril 6, 2021

By now, many have at least heard of – if not become more intimately familiar with – the hot topic of Special Purpose Acquisition Companies (“SPACs”). These “blank check” shell corporations go public and then identify a private company to acquire. Once the acquisition is complete, the formerly private company in essence becomes publicly traded. In 2020, nearly 250 SPACs executed their IPO, accounting for half of all IPOs for the year. Incredibly, approximately 300 have done so in the first three months of 2021 alone (Potter, 2021) (SPACInsider, 2021). With this much frenzy surrounding the opportunities SPACs can bring from the IPO perspective, we wondered: Do our readers know about the tax implications?

Join us for our three-part series to learn all about tax considerations when dealing with SPACs, with a particular focus on the shareholders. In later posts, we’ll dive into passive foreign investment companies (“PFIC”) and other international tax issues as well as tax considerations for when a SPAC makes an acquisition or returns the funds to the shareholders. For now, we’ll get a general overview of SPACs and the tax issues that matter to their founders.

Formation of the SPAC

The SPAC sponsors are responsible for creating the SPAC entity and preparing the SPAC for the IPO transaction and fundraising. The sponsor then works to identify potential targets for acquisition and shepherds the acquisition through the approval process and consummates the acquisition. In exchange for these services, that sponsor will normally receive founder’s shares which are a different class from the shares being issued to the public in the IPO. These shares will generally convert to the same class issued to the public after the acquisition. When converted, they will typically account for approximately 20% of the outstanding stock and prior to conversion they will generally not be entitled to any proceeds in the case of a liquidation or be entitled to redemption rights.

Potential tax issues may arise if the founders do not pay adequate consideration for their shares. Because the founder shares can be difficult to value, the timing of the issuance of the shares can be critical to avoiding this issue. The founder’s shares should generally be issued at the beginning of the process before the activities of the SPAC such as SEC registration or identification of any potential acquisition targets are undertaken. If this process is properly planned, then the conversion of the founder’s shares after the acquisition should generally not result in a taxable transaction to the sponsors.

In addition to founder shares, there may also be warrants issued to the founders. The tax treatment of warrants depends on whether the warrant is issued with equity or in the nature of compensatory warrants. For those warrants that are not considered compensatory, the investment warrant rules generally apply.

If the warrants are considered investment warrants, they are issued with the stock as part of a single unit consisting of a share of stock and a warrant. The price paid by the shareholder is allocated to each piece based on the relative fair market values of the warrant and the stock. When the shareholder exercises the warrant, they pay the strike price indicated in the warrant for the share. The shareholder’s basis in the share acquired is the amount originally allocated to the warrant plus the amount paid upon exercise. This would then be the basis in those shares acquired.

On the other hand, if the warrants were not issued in conjunction with the issuance of the stock, they would generally be considered compensatory warrants. Compensatory warrants issued for services are taxed like compensatory non-qualified stock options. Generally these warrants are not taxed upon receipt as long as the strike price in the warrants is at least fair market value on the date they are issued. The exercise of the warrant is a taxable event with the warrant holder receiving ordinary income based on the difference between the strike price and the fair market value of the stock on the date of exercise.

Once the founders have formed the SPAC and completed the registration process they would then issue shares to the general public in an IPO. The SPAC will generally set an overall dollar amount they want to raise and issue the initial shares. Typically the issuance price is $10 a share and there will typically be warrants attached. In the typical transaction the investment unit will include a share of stock and a full warrant or a fractional warrant to buy another share of stock at $11.50 per share. If fraction warrants then multiple shares must be purchased to receive a full warrant. As an example, if an investment unit consists of a share of stock and ½ warrant, two shares must be acquired in order to receive a full warrant. Typically only full warrants can be used to acquire shares or be traded.

The stock acquired will generally begin trading immediately as of the IPO and the warrants will generally begin trading within 52 days of the IPO. These shares will trade before the identification of any potential target.

De-SPACing

De-SPACing is when the SPAC either completes the targeted acquisition or returns the capital it raised to the shareholders. Generally SPACs have a two year time frame in order complete an acquisition before the SPAC must liquidate and return the capital. Generally the shareholders will be entitled to vote on whether to go through with the acquisition transaction and they will generally also have a redemption right. Once a target is identified, the shareholders will vote on whether to proceed with the acquisition. If the acquisition is approved the shareholder could still exercise their redemption rights which would occur immediately before the transaction is consummated.

If a shareholder elects to exercise their redemption right or receives payment on account of the SPAC liquidating then that shareholder will compute a gain or loss on their return for the difference between their basis in their stock and the amount they received. How the gain is taxed is dependent on how long the shareholder held the stock and, as will be discussed later, whether the SPAC was a PFIC. The warrants that were acquired would also be handled the same way.

Assuming that the shareholder kept their shares and the SPAC completed its acquisition then the shareholder would only recognize gain or loss once they sold their shares.

Related Guidance

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