In case you haven’t heard, a SPAC, or a Special Purpose Acquisition Company, is an investment vehicle used to acquire private companies with growth potential. SPACs are “blank check companies” formed by sponsors to raise investor capital through an IPO in order to acquire a private company, allowing the acquisition to go public. SPACs are also used to take out a significant shareholder from an existing public company, such as in BPW Acquisition Corp.’s deal with The Talbots Inc. in 2010.
After having a big year in 2020, there are several reasons SPACs continue to be popular. SPACs allow a private company to go public without going through the IPO process, even during market instability, and allows them access to public markets. Not only do SPACs offer IPO investors an opportunity to co-invest with successful founders, but there’s an opportunity for their initial investment to be risk free, if the investor can get in at the IPO price before a merger is completed. The investment risk depends where in the market an investor buys in; if an investor buys in above the IPO price, then their floor is the IPO price.
Founders of SPACS are attracted to blank-check companies because of the potential for a broader base of investors and a simplified capital-raising process in comparison to using a private vehicle. Not to mention, the potential of a very attractive upside.
A SPAC is a corporation that conducts an IPO to raise capital, primarily from institutional investors, but also from retail investors. After the capital raise, the SPAC finds a private company (the target company) to acquire. SPACs are traditionally created to go after targets in a specific industry, such as healthcare. The SPAC generally has two years to identify the target company and, if the target company is not identified during this period, the SPAC returns the funds to its investors.
Once a target company is identified, the investors will typically have a right to redeem their investment before the acquisition. This allows investors flexibility if they decide not to invest in the target company. The shareholders will recognize a gain or loss on the difference between the amount received and their basis upon redemption and depending on the holding period, the gain may be treated as long term or short term.
Once the acquisition is approved, the private target company becomes a publicly traded company through a merger transaction with the SPAC, thus avoiding the need to go through a formal IPO process.
When looking to invest in a SPAC you want to look for sponsors with experience and reputations for identifying solid targets and completing business combinations with one or more target businesses. Ideally, sponsors and management are firms and/or individuals with demonstrated success in identifying and operating growth businesses and with public company experience.
Investing in a SPAC is the same as investing in a public stock. Target companies of a SPAC can be domestic or internationally based. When a SPAC is formed with the possibility of acquiring an international target, the SPAC is most often domiciled offshore, usually as a Cayman Island entity. Alternatively, domestic-focused SPACs are predominantly established as Delaware Corporations.
A domestic SPAC is formed as a U.S. corporation and therefore falls under the general U.S. taxation rules. From a shareholder perspective, the shareholders owning a SPAC are treated in the same fashion as if they owned any other domestic public entity. Generally, after the merger, any dividends received would be considered as qualified dividends and subject to preferential capital gains tax rates. Shareholders who sell their stock after a year will also be subject to preferential capital gains tax rates. Reference to preferential tax rates is made pursuant to current tax law provisions.
Foreign SPACs are formed outside the U.S., typically in the Cayman Islands. U.S. shareholders should carefully consider the potentially unfavorable tax consequences before investing in a foreign SPAC. In most situations, a foreign SPAC will be considered as a passive foreign investment company (“PFIC”), specifically for those shareholders owning less than 10% of the SPAC. Overall, PFIC rules are quite complicated and create additional filing requirements. PFICs can also result in unfavorable tax consequences for a U.S. shareholder. Gains on the sale of stock would be taxed as ordinary income, as compared to capital gains. In addition, an interest charge applies for the benefit of any deferral of taxes. However, there are certain elections that can help mitigate these tax consequences. Making a Qualified Electing Fund (“QEF”) election is generally advisable under these circumstances. The SPAC must provide the investor with a PFIC Annual Information Statement reflecting their share of the SPAC’s earnings. These earnings are recognized as income currently, which increases the tax basis. Upon sale, any gain is converted from ordinary income to capital gain.
Founders of the target company, assuming it’s a corporation, are generally taxed to the extent they received cash in exchange for their stock. If the target shareholders plan to hold on to the shares after the transaction, the transaction could be structured as a tax-free reorganization. Property other than stock, referred to as “boot”, received by shareholders is generally taxable. The amount of boot permitted to be received varies as based upon the type of tax-free reorganization that is implemented. The shareholder will generally be taxed to the extent of the boot received.
The SPAC founder’s shares are generally granted as restricted stock; therefore, a Section 83(b) election is at least something to consider. A Section 83(b) election allows a startup founder to pay tax, at ordinary income tax rates, on a lower valuation when the stock is granted rather than at fair market value when vested, with the assumption that the value of the stock will increase. The shareholder will then get the preferential capital gains tax rates on the sale of the stock. There are risks associated with a Section 83(b) election; therefore, consult with a tax advisor prior to making the election.
SPAC shares are often sold with warrants, which can be compensatory or non-compensatory (investment warrants). Warrants become exercisable only if the SPAC completes a business combination transaction before the specified outside date. Compensatory warrants of a SPAC are generally treated as stock options for tax purposes. They are taxable when exercised, as ordinary income (compensation), measured by reference to the excess of the fair market value of the underlying stock over the strike price. Investment warrants are issued with the stock as part of a single unit, consisting of a share of stock and a warrant. When an investor exercises a warrant to buy the stock, they pay the stated strike price to the issuing company. The tax basis of an investment warrant includes the strike price plus the amount originally allocated to the warrant.
In summary, although there are many benefits associated with SPACs, there are also some risks associated with a SPAC investment. Investors do not know what target company a SPAC will merge with, and such an unknown could pose a risk. SPACs can also be risky to investors because target companies do not always receive the thorough vetting and due diligence of a traditional IPO, which can weigh on future performance. It is important to weigh the benefits and the risks before investing in a SPAC, as well as the tax considerations. State residency considerations, including for residents of Puerto Rico, can loom large in terms of tax considerations, specifically for SPAC founders. This article is based on current tax laws and results may differ with any tax law changes in the future.