New U.S. law creates a SPAC tax: or does it?
Cameron Tousi assesses the U.S. Inflation Reduction Act’s implications for SPACs
The U.S. Congress recently passed the Inflation Reduction Act which also threw a jab at public corporations for their stock buybacks: a new 1 per cent excise tax. But the law of unintended or perhaps intended consequences is alive and well. A vanilla reading of the language would stick it to SPACs as well.
SPACs: why the hype?
An honest and fair question you ask. SPACs (Special Purpose Acquisition Companies) have become a popular way for businesses to go public in recent years. They are formed by investors who agree to put money into the trust account of a blank-check company that will then be used to acquire another business. Once the acquisition is complete, the SPAC is like a normal publicly-traded company. Because SPACs provide a simplified and faster way to go public and, on the surface at least involve fewer fees, they have attracted the attention of many businesses and investors.
They are called blank check companies because the investor, in effect, gives a blank check to a SPAC without it having a business plan or particular purpose. They invest because of the name and business reputation of the SPAC’s sponsors who are trusted to find merger targets and carry them out.
The investor is awarded a measure of protection: SPACs are required to liquidate and return funds to shareholders if the merger acquisition never happens within two years, or three years with shareholder approval, for whatever the reason. This redemption right means if the SPAC is unable or unwilling to find a suitable company to acquire or is incapable of completing the merger, shareholders will get their money back.
Tax on stock repurchases
House Resolution 5376 became law on August 16, 2022, as the Inflation Reduction Act. With it came a significant tax provision, namely a 1 per cent excise duty to be imposed on stock buybacks by public corporations.
If a publicly traded US corporation repurchases its own stock from shareholders after December 31 2022, the tax could apply. For this purpose, the ‘repurchase’ would arguably include any transaction classified as a redemption for income tax purposes. It also includes transactions U.S. Treasury determines will have economic term effects, generally including buybacks or other exchanges where the corporation gets its stock back for value.
The tax is assessed on the difference in fair market value between repurchased and issued stock in the same taxable year. This ‘netting rule’ means for purposes of determining how much is owed in taxes, stock issuances are netted against repurchases. The effect is to mitigate the impact of the tax. So, in any year where the value of issued stock exceeds the value of the repurchase, there is no such tax.
A number of common stock issuances would notably facilitate mitigation under the netting rule. Included are compensation (from options exercises or otherwise), private investment in a public offering, convertible debt conversions, exercised warrants and also public offerings. The latter presumably includes a SPAC IPO (initial public offering).
The question is whether a new tax has actually been created on SPACs. The answer is likely ‘yes’ for nearly all SPACs.
As an initial consideration, note U.S. excise tax rules do contain certain exceptions, where a non-U.S. SPAC entity does not convert to a U.S. entity. However, based on their plain language, all other SPACs are simply not tax exempted.
SPACS must award shareholders certain redemption rights and on the plain meaning of the Inflation Reduction Act, the redemption rights would trigger the Inflation Reduction Act’s tax. They give shareholder rights to stock redemption and refund if they do not approve of the transaction or if the merger is not timely completed. To the uninitiated SPAC sponsor, caveat emptor if shareholders exercise redemption after year end of 2022, when the legislation kicks in.
Advantages and concerns
SPACs have become an increasingly popular way for companies to go public in recent years and there are a number of reasons why.
One key advantage is the lower cost associated with SPAC transactions. In a traditional IPO, the target company itself bears the entire cost of the underwriting fees, which can amount to 7 per cent or more of the proceeds raised. By contrast, in a SPAC transaction, the sponsor pays an underwriting fee of 2 per cent at IPO, followed by an additional 3.5 per cent underwriting fee (based on IPO size) paid by the combined company upon completion of merger.
SPACs additionally give the sponsors more certainty over control of merger deal terms and price setting. Investors are also awarded greater control and reduce their exposure for they can vote against the merger and redeem their shares. SPAC sponsors typically invest their own money into the SPAC, meaning they have skin in the game, which further assures shareholders and eases raising of capital.
However, in harsher times like the present, SPACs can quickly lose their appeal and they have. Moreover, the new 1 per cent excise tax means sponsors risk not just the return of capital if the merger does not go through, but an additional 1 per cent out-of-pocket to the taxman. The market has responded accordingly: 27 SPAC liquidations nearing $13bn have occurred so far in 2022.
The new U.S. legislation also creates pitfalls for how the M & A deal is structured legally. Any structure where few if any shares are issued to net against the redemption of shares would deny the benefits of the law's netting rule. Formerly tax-efficient structures such as an umbrella partnership corporation (UP-C), or limited partnerships, or combining multiple operating companies under the new corporation (double dummy) may now have devastating tax consequences.
SEC lawyers have not been sleeping on the job either, at least not for big multinationals. SPACs have already started disclosing the financial risks of the new tax in their SEC filings.
The warnings state the tax could make it harder for SPAC mergers to happen, lower the value of securities after a merger is completed and limit how much money is available if there's a liquidation event. A number of filings explicitly recite the applicability of the new tax to SPACs is uncertain.
It is clear federal guidance, in the name of the U.S. Internal Revenue Service, is required.
Corporate redemptions have been accused of not promoting business growth, but rather allowing manipulation by corporate insiders, such as senior executives. In this way, they are said to enrich opportunistic share sellers like hedge funds and investment banks.
Stock buybacks do little for society, as many a politician has espoused and even renowned investors such as the likes of Benjamin Graham have viewed them prone to management’s abuse of outside shareholders. Here, Congress' new legislation was meant to rein in the practice with a tax punishment.
However, redemptions in the context of SPACs are not remotely analogous to those of public corporations. SPAC redemption rights grant power to the public shareholders as opposed to inside management. In other words, they counter-balance corporate insiders versus favoring them.
SPACs are also not as readily amenable to manipulation for insider profit. Instead of distributing profits otherwise payable to shareholders as dividends, SPAC redemptions simply return capital to the outside shareholders. In fact, the capital raised in a SPAC IPO is available only for completion of the transaction or return to shareholders and nothing else.
Cameron Tousi is managing partner of Integrated Professional (IP) Law Leaders, a leading U.S. boutique law firm ipllfirm.com
ique law firm ipllfirm.com