By Joyce Beebe, Ph.D.
Fellow in Public Finance
Despite the pandemic, the stock market thrived in 2020 after a brief decline in March. Equally remarkable during this time was the growth of Special Purpose Acquisition Companies (SPACs). SPACs are used as mechanisms to take private companies public in two stages — a SPAC first registers as a public entity through the initial public offering (IPO) process, and then a private company becomes publicly listed by merging with the SPAC. There were 59 SPAC IPOs in 2019, and this number quadrupled in 2020. A record 248 SPAC IPOs took place in 2020, accounting for over 50% of IPOs last year. The popularity of SPACs continues into 2021: There are already 310 SPAC IPOs as of April 2021, more than there were during all of 2020. Given their rise in popularity, this blog post discusses how SPACs work and key income tax considerations for SPAC transactions — which are often overlooked in the deal-making process.
Basic Structure of SPACs
SPACs are typically formed by well-established institutional investors (known as “founders” or “sponsors”) and are commonly known as a type of “blank-check company.” Sponsors purchase SPAC shares at a low price (typically for less than $1), which means their tax bases are low.
After a SPAC’s formation, there are two major milestones: First, sponsors need to raise equity capital through an IPO, which makes the SPAC a publicly traded entity. Experienced private equity or hedge fund sponsors typically rely on their reputation and expertise to attract investors during the IPO process. Founder shares convert to public shares during the IPO, and the conversion ratio is often structured such that founders own 20% of the outstanding shares after the IPO (known as the “promote”).
SPAC public offerings are typically sold in “units.” Each unit includes one common share and a fraction (usually half or a third) of a redeemable warrant, collectively priced at $10 per unit. Proceeds from the IPO are saved in a trust account that is used to fund reporting obligations and the business combination process (discussed below). Up to this point, the SPAC has no operations or revenue, and often the only assets it has are cash or low-risk Treasury securities in the trust account.
The second major milestone after a SPAC’s formation happens when the publicly listed platform identifies a promising, privately held operating business (known as the “target”) and merges with that company. In the end, the target becomes a publicly listed company (the business combination is typically called a “de-SPAC process”). SPAC investors have a chance to redeem their cash from the trust account prior to the conclusion of the merger. For instance, if they do not believe the target presented by the sponsor is a good investment, they can cash out and avoid losses. A SPAC has two years to find a target, otherwise the entity needs to be dissolved, and the funds are returned to investors.
Fans and Foes
Supporters tout SPACs as ideal vehicles to transition a private company to a publicly traded one. Compared with the traditional IPO process, this approach avoids certain paperwork and regulatory scrutiny, which can be lengthy, time-consuming and costly for the operating company. Essentially, they argue that the target gets a “short cut” to a public listing by merging with a SPAC.
Some also believe that SPACs are advantageous for niche companies that the general public may have trouble valuing, or for specialized firms with information that is hard to convey to investors during the traditional IPO process. These companies may be valuable, but typically they are not fully appreciated under the existing IPO mechanism. SPACs often utilize private investment in public equity (“PIPE”) arrangements in conjunction with a merger, where sponsors seek funds from large institutions or accredited investors in a private setting instead of on the open market. This process allows large investors to more thoroughly review the company information than in an IPO.
In addition, some describe SPACs as the “poor man’s private equity,” meaning that retail investors can invest in publicly-listed SPACs and rely on the skills of professional managers to deliver a target, navigate through the complicated process and grow the combined company after the merger. As such, they believe SPACs are great instruments for anyone who is typically unable to access private equity types of investments but wants to.
However, not everyone is a fan of SPACs. Charles Munger, an American billionaire investor and businessman, has commented that “the world would be better off without them,” emphasizing the speculative nature of these investment vehicles. Indeed, their “blank check” nature means that when investors put funds in SPACs, they often do not know what they are investing in for months — and sometimes for more than a year. Because the target will be selected down the road, it could be in an industry that investors are not familiar with, or in a country that investors have not invested in before.
Some suspect the pressure from SPAC investors to monetize their investments means that unsuitable companies are rushed through the process instead of letting the SPACs dissolve. Historically, it is unlikely that SPACs liquidate without a business combination: Only about 10% of SPACs were dissolved between 2009 and 2021. Currently, there is a large number of SPACs searching for opportunities. In April 2021, there were 427 SPACs seeking target companies, with another 273 in the pre-IPO stage. Observers are concerned that as many unprepared companies become public, unsophisticated investors may disproportionally incur losses.
Recent statistics of de-SPAC companies’ post-merger performance seem to validate these concerns. Although there are hidden gems, such as DraftKings, which generated envious returns exceeding 600% on the units, there are also unqualified ones, such as the electric truck company Nikola that was accused of fraud three months after it went public through a SPAC. In addition, most companies’ post-merger returns are not as good as expected. Evidence from 2015-2016 showed that more than half of SPACs are traded below their IPO price of $10, and a study using data from 2019-2020 revealed that SPAC shares lost roughly a third of their value within one year after the de-SPAC process.
Opponents also argue the benefits and costs are not evenly distributed throughout the process. Although the SPACs are described as an alternative for retail investors, the primary investors tend to be well-established hedge funds, venture capitalists, private equities and even celebrities, instead of small investors. However, either by redemption of trust shares or selling the shares on the open market, over 90% of pre-merger, large institutional investors are no longer shareholders after the merger. In other words, they are not involved in growing the combined company.
Tax Considerations
Despite the recent popularity of SPACs, the tax implications are an important but often discounted consideration. The overall tax landscape surrounding SPACs is complicated. This section briefly illustrates two potential issues: taxation of founder shares and cross border mergers.
First, the income tax treatment of founder shares is an unsettled issue. After a SPAC’s formation, the sponsors are not directly compensated for either completing the SPAC’s IPO or finding a suitable target. Their upside is the low-basis founder shares that they acquire prior to the SPAC’s IPO. As such, some argue that these stocks are essentially compensation for their work and should be taxed accordingly. Others disagree and say these are returns for taking early-stage risks.
Practitioners agree it is a judgement call depending on facts and circumstances, and the tax attributes of these founder shares often rest between two extremes. At one extreme, a sponsor is like an entrepreneur who sets up an entity (i.e., a SPAC) and owns equity of that entity. The returns of the start-up entity are speculative since the IPO may not be completed, and it is even less certain the business combination will take place. As such, if the shares are issued to the sponsor shortly after the SPAC is formed, there is a strong argument that the founder shares have no ascertainable value at that time. Alternatively, if the SPAC does not formally issue founder shares until immediately prior to the IPO, the fair market value is presumably certain, at roughly $10 per unit. In this case, sponsors are likely to pay taxes on the difference between their cost basis and the fair market value as ordinary income.
The tax issues become more complicated when there are cross border mergers, either when the target or the SPAC is not a U.S. company. For instance, when a foreign SPAC acquires a U.S. target, U.S. outbound payments to the foreign SPAC may be subject to U.S. withholding taxes. On the other hand, when a U.S. SPAC owns a foreign target, the operating entity’s earnings may be subject to U.S. taxes in addition to the taxes paid in the foreign jurisdiction. As such, it is typical to change the SPAC’s jurisdiction (i.e., “re-domicile”) to avoid negative tax consequences. However, this approach has its own tax complications.
If a U.S. SPAC identifies a foreign target and would like to expatriate to a non-U.S. jurisdiction, the move may be subject to anti-inversion rules that are in place to prevent U.S. companies from reshuffling their corporate structures to avoid U.S. taxes. In short, as long as more than 60% of U.S. shareholders overlap before and after the business combination, there will be negative tax consequences, including continued taxation as a U.S. company or the limited use of losses and other tax attributes to offset taxable gains. President Biden recently proposed to reduce this ownership threshold to 50%.
On the other hand, if a foreign SPAC identifies a U.S. target and would like to domesticate, it may trigger some passive foreign investment company (PFIC) issues that intend to stop U.S. taxpayers from using offshore investment vehicles to shelter funds. Passive income generally includes cash, dividends, interest, rents and royalties, and gains from the disposition of passive assets. An entity will be considered a PFIC if at least 75% of its gross income in a certain year is passive income or if at least 50% of its assets are used to generate passive income. Because a SPAC has no active operations, it is highly likely to fit the definition of a PFIC. As a result, its U.S. shareholders must recognize gains upon certain distributions (such as merger considerations) and sales of SPAC shares; these gains are taxed as ordinary income. There are certain mitigations, such as making a special election to have gains taxed annually at capital gains rates or having the PFIC qualify for the start-up exception — but timing is critical for utilizing these measures.
On top of a cross border merger, the tax issues could further be complicated by the nature of the target’s industry. The tax treatment of the U.S. cannabis industry is a prime example. Several news articles report that multiple Canadian SPACs are seeking U.S. cannabis companies as merging targets. As indicated, a U.S. cannabis company merging with a Canadian SPAC may run afoul with anti-inversion rules if most operating company shareholders (U.S. taxpayers) continue to own shares of the merged company (Canadian), triggering negative tax consequences.
Even with the tax complications, foreign SPACs are favoring the U.S. cannabis industry not only because of its projected high growth, but also because cannabis is not legal in the United States at the federal level. In the federal tax code, the illegality prohibits cannabis industry companies from deducting ordinary business expenses from income or using credits because it is classified as a Schedule I controlled substance. As U.S. cannabis companies look for outlets to realize their investments, foreign SPACs become one such option. But, investors need to be diligent on multiple fronts: when considering the SPACs themselves, the target (especially if it’s part of the cannabis industry), cross-border transactions and the overarching tax implications.
The surge in popularity of SPACs and the lack of detailed tax and regulatory guidance have not gone unnoticed. The IRS has commented on certain conditions that need to be satisfied for the corporate reorganization to be tax free, whereas the Securities and Exchange Commission has also cautioned that because SPACs have no prior operating history, it is even more important for investors to review all relevant public filings and evaluate sponsors’ backgrounds.