PFIC considerations for non-US SPACs

Editor: Anthony S. Bakale, CPA

The popularity of special-purpose acquisition companies (SPACs) has exploded in the aftermath of the financial crisis and even more so in the last two years. SPACs, also known as blank-check corporations, have ridden a wave recently of private companies looking to raise capital in the public domain. SPACs enable private companies to become publicly traded without the legal/regulatory ramifications involved with a normal initial public offering (IPO). SPACs also have created a back door for retail investors, normally crowded out of an IPO, to become early investors by initially investing in the SPAC. As common as they have become in financial markets and trading portfolios, the basics of what they are and the potential investment pitfalls related to non-U.S.-domiciled SPACs can be lost on investors, especially retail investors.

Generally, a SPAC is a publicly traded corporation set up with the sole purpose of acquiring another company. The initial offering of the SPAC generally has a minimum value associated with equity positions as well as a stock warrant component allowing investors the opportunity to purchase shares at a given price. Both the stock and warrant of the SPAC become tradable in the market, normally before any potential acquisition is publicly identified. Upon acquisition, the SPAC and the target company participate in a reverse merger whereby the SPAC becomes the target company in exchange for the capital it raised originally selling shares and warrants.

For investors in U.S.-domiciled SPACs, the tax accounting is relatively straightforward. The shares and warrants are treated like other publicly traded equity positions. The reverse merger generally is a tax-free transaction that has little impact on the tax situation of the original SPAC investor. However, as SPAC activity has increased, non-U.S.-domiciled SPACs have become more prevalent and carry major U.S. tax-compliance ramifications due to their potential treatment as a passive foreign investment company (PFIC) for U.S. investors.

The following discussion examines PFIC considerations for non-U.S. SPACs.

PFIC implications

PFICs are foreign corporations that are passive in nature. Under Sec. 1297(a), a foreign corporation qualifies as a PFIC if 75% or more of its gross income for the tax year is passive income and the average percentage of the assets it held during the tax year that produce, or are held for the production of, passive income is at least 50%.. The consequences of qualifying as a PFIC last indefinitely until the security is disposed of by the investor, under what is known as the “once a PFIC, always a PFIC” rule under Sec. 1298(b)(1). The PFIC regime and default excess distribution treatment are meant to eliminate any economic benefits to a U.S. investor of deferring U.S. federal income tax on income from a non-U.S. corporation. This objective is accomplished by imposing higher-than-usual income tax rates as well as interest charges on certain “excess distributions” received by U.S. investors that may have a direct or indirect holding of shares in a PFIC. Non-U.S. SPACs raising and holding capital before acquisition fall into the PFIC regime by nature of their cash-focused balance sheet, a passive asset for purposes of the 50% asset test.

The impact of PFIC classification requires U.S. investors to report the investment on a Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, and pick up income based on the rules and elections made available to them on an individual and investment basis. It should be noted with regard to SPACs, specifically, the warrant component is not immune from PFIC treatment. Investors in the warrants are ruled to have owned the stock if they have the option to purchase later. Making matters worse, first-year elections would not be available until the warrant is exercised, thus defaulting to PFIC treatment of the SPAC when held as a warrant under the excess distribution regime.

Though the excess distribution calculation and treatment within the PFIC regime can be punitive, there are exceptions that can help mitigate them, such as the startup exception, coupled with potential elections made at the onset of the initial investment including the qualifying electing fund (QEF) or mark-to-market (MTM) elections. Each is discussed in more detail below.

Startup exception

The preferred method for non-U.S. SPACs to avoid the PFIC regime altogether is the startup exception under Sec. 1298(b)(2). The exception allows for companies in their initial tax year to be exempt from the PFIC asset and income tests. This exception would provide the non-U.S. SPAC time to raise capital and acquire a company without having to consider a PFIC qualification. To qualify for the startup exception under Sec. 1298(b)(2), the SPAC cannot have qualified as a PFIC under any prior form, and one must make assurances/confirmations in tax years 2 and 3 following the startup year that the entity would not qualify as a PFIC or risk defaulting back into the PFIC regime.

The assurances in these subsequent years are complicated, as SPACs in general look to acquire companies that lift them out of the passive income/asset test, but if the acquisition does not close within the startup year, there may be a period in year 2 or beyond where the SPAC fails the PFIC tests and the holding is forever tainted as a PFIC. The foresight into the acquisition activity before needing to decide on the effectiveness of the startup exception can be hedged based on tax return filing deadlines. As any beneficial election noted later would be required at the time of filing the tax return for the year of initial purchase, under the current extended tax due dates, calendar-year taxpayers would have until at least Sept. 15, or the third quarter of tax year 2, to determine if the non-U.S. SPAC has completed its acquisition and avoids PFIC qualification after its startup year.

QEF election

Given the high hurdle of having the SPAC raise capital and acquire a company in its initial tax year, it may be more prudent to look beyond the startup exception at potential elections to avoid the excess distribution treatment. The QEF election would be the next most advantageous option. The QEF election requires the U.S. shareholder to include in gross income the PFIC’s ordinary earnings and net capital gains attributable to each share the U.S. investor owns (to the extent of positive earnings and profits from the PFIC in that year under Sec. 1295(a)). This income must be recognized currently by the U.S. investor, irrespective of any cash distributions. U.S. investors would make the election and report the necessary inclusions on Form 8621.

The benefits of the QEF election are that distributions from the PFIC’s earnings and profits should generally be tax-free for the U.S. investor. Also, if the election is made in the first year, the holding would avoid PFIC taint and exclude itself from the excess distribution regime going forward, per Regs. Sec. 1.1295-1(c)(3)(ii). This would mean that in the years following acquisition, where the surviving entity does not qualify for PFIC status, the investor does not need to consider the PFIC rules or filings as they relate to the investment.

The QEF election would be made at the first U.S. holder level, most likely by a direct or indirect U.S. investor. It requires the U.S. investor to receive an annual information statement (AIS) from the non-U.S. SPAC, as outlined under Regs. Sec. 1.1295-1(f)(2)(i)(C). Though SEC S-1 documents of currently popular non-U.S. SPACs do provide language that an AIS is to be made available, most funds likely will issue a general statement that would allow shareholders to calculate their own AIS and QEF inclusions to qualify for the election. It would be the U.S. investor’s responsibility to seek out this information.

Mark-to-market election

If the QEF election is unavailable due to a lack of any AIS, the MTM election would be the last best option. The MTM election allows for marketable securities to be marked at year end to fair market value, with any current-year appreciation included as ordinary income reported by the investor under Sec. 1296(a)(1). The MTM election would allow for years where the non-U.S. SPAC is not a PFIC to be treated as such, freezing the basis and election until disposition or future PFIC determination. Again, this would mean that in the years following acquisition, where the surviving entity does not qualify for PFIC status, a U.S. investor would be able to pick up income, loss, and capital gains consistent with ownership of a foreign corporation that was never considered a PFIC since it previously recognized the MTM income and in a sense froze the PFIC-tainted years until future potential qualification, if any.

Like the QEF election, this election would be made at the first U.S. holder or U.S. investor level. The election and any necessary income inclusion would be reported on Form 8621. This election requires the non-U.S. SPAC to be “marketable” as noted and defined in Secs. 1296(a) and 1296(e)(1), respectively. Assuming industry trends persist, the marketable requirement would apply to most SPACs now and going forward, as they tend to be publicly traded on open exchanges, meeting the requirement of being regularly traded on qualified exchanges outlined in Regs. Secs. 1.1296-2(b)(1) and 1.1296-2(c)(1).

As SPACs grow in popularity, the tax ramifications related to PFICs will continue to haunt the non-U.S.-domiciled investments. The startup exception or available PFIC elections go a long way to ease the tax burden on U.S. investors and avoid any PFIC-associated tax drag on their investments. Upfront consideration of these rules and elections when opening non-U.S. SPAC positions will help mitigate the harshest tax treatment.

EditorNotes

Anthony Bakale, CPA, is with Cohen & Company Ltd. in Cleveland.

For additional information about these items, contact Mr. Bakale at tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.