Insights

Why Choose a SPAC?

The U.S. capital markets have seen record levels of merger and acquisition activity over the last few years, including record use of special purpose acquisition companies (SPACs) to facilitate initial public offerings (IPOs). Why are SPACs so popular? With proper planning, SPACs can make the process of going public faster and easier than the traditional IPO route as well as provide other benefits for the acquired company and investors.

SPACs are publicly traded companies formed for the sole purpose of raising capital through an IPO and using the proceeds to acquire one or more unspecified businesses at a future date. A SPAC can provide several benefits for target companies, including:

  • Access to significant capital;
  • Immediate liquidity;
  • Strategic partners and management expertise; and
  • Use of public company stock to fund add-on acquisitions.

The SPAC approach to an IPO takes much less time to complete as compared to a traditional IPO, therefore the amount of time needed to work with investment bankers, attorneys and other professionals to take a company public is potentially reduced. In addition, SPACs generally have a window of approximately two years or less to find a suitable acquisition target, which can increase competition and drive up the values being offered to target companies.

In addition to understanding the benefits of using a SPAC, it is important that SPAC sponsors and shareholders of target companies understand and plan for the federal income tax consequences associated with SPAC structures.

Tax Treatment of SPAC Sponsors

 

The SPAC sponsors (or founders) are responsible for forming the SPAC entity, raising capital with investment groups, and taking the SPAC public. Once the SPAC is public, the SPAC must identify potential acquisition targets, undertake due diligence, and complete the acquisition (known as the “de-SPAC” transaction) on terms that will maximize the sponsors’ return on investment.

The sponsors are generally granted an initial, separate class of “founders shares” for a nominal cost, which normally convert to public shares on the completion of the de-SPAC transaction. The timing of the issuance of the founders shares should be carefully planned to avoid undesirable tax consequences for the sponsors.

The sponsors may also receive warrants to purchase additional SPAC shares. For federal income tax purposes, the warrants received are treated as investment warrants as long as the issuance of the warrants is not dependent on the sponsor’s employment status or in exchange for services provided as an employee of the SPAC. Investment warrants are not taxable when issued or exercised but result in taxable capital gain for the sponsor when the underlying shares are sold (a sale will result in long-term capital gain for the sponsor if the underlying stock is held for more than a year).

Warrants received by sponsors that have employment arrangements with the SPAC may be treated as compensatory warrants issued for services. Recipients of compensatory warrants generally do not recognize taxable income upon the grant of the warrant as long as the warrant provides for a fair market value (FMV) exercise price. However, the excess of the FMV of the warrant over its exercise price generally is taxable income to the sponsor at the time the warrant becomes transferable or is not subject to a substantial risk of forfeiture (generally when the warrant is exercised). This also marks the time when the issuing company is entitled to deduct the compensation expense on its corporate federal income tax return.

Tax Treatment of Target Shareholders

A traditional de-SPAC transaction is structured as a “reverse triangular merger” for federal income tax purposes. The SPAC creates a transitory merger subsidiary that merges with and into the target, with the target surviving as a subsidiary of the public SPAC. Shareholders of the target receive SPAC stock in exchange for their target shares.

The de-SPAC transaction is generally structured to be tax-free to the target shareholders, provided the merger meets the statutory requirements needed to qualify as a tax-free reorganization for federal income tax purposes. These requirements include:

  • The target company’s shareholders exchange stock constituting control of the target company for voting stock of the SPAC;
  • At least 80% of the total consideration paid to the target company’s shareholders is SPAC voting stock; and
  • After the merger, the target company holds “substantially all” of its assets.

The target entity that can be a party to a traditional de-SPAC transaction reorganization is normally an S corporation or a C corporation. An entity taxed as a partnership can participate in what is known as an “UP-SPAC” transaction (see discussion below). It is important to note that if the target is an S corporation, its S status will terminate in the de-SPAC transaction since a SPAC (which is taxed as a C corporation) is not an eligible S corporation shareholder.

Although SPACs can provide advantages over other deal structures, the SPAC IPO process and the de-SPAC transaction are highly regulated and complex transactions that require intensive planning and preparation. In addition, there are a number of tax challenges and complexities for financial statement and tax reporting purposes that should be considered up front. Rushing through the process without the right expertise can put a successful outcome at risk, not to mention loss of funding and reputation of the sponsors. Companies should employ trustworthy and experienced legal, capital, and accounting advisors to ensure a smooth transaction.