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Can an Acquired SPAC Avoid Colliding With the ‘Continuity of Business Enterprise’ Doctrine?

April 16, 2021, 8:00 AM

Otonomo Technologies Ltd. (Otonomo) is an Israeli corporation. Its business includes collecting billions of items of real-time data daily from fleets of cars and trucks, and then providing safety and location-related reports derived from such data to the fleet owners and their service providers.

Otonomo is not publicly traded. Otonomo’s investors include Dell Capital and Hearst Ventures.

Software Acquisition Group Inc. II (S-SPAC) is a Delaware special purpose acquisition corporation. In 2020, S-SPAC raised $172.5 million in connection with an IPO on NASDAQ. In a press release issued at that time, S-SPAC stated: “While the Company may pursue an initial business combination target in any business or industry, it intends to focus its search on software companies, especially those targeting enterprise vertical sectors owned by private equity and venture capital firms as well as corporate carve-outs.

Proposed Business Combination

Consistent with the quoted 2020 press release, in February 2021, S-SPAC and Otonomo issued a press release concerning a proposed cross-border share swap acquisition. Otonomo will acquire all the shares of S-SPAC from the S-SPAC shareholders, who will in exchange receive originally issued Otonomo shares. Since Otonomo’s valuation immediately after the exchange is projected by the parties to exceed $1 billion, and S-SPAC holds $172.5 million in cash, the exchanging S-SPAC shareholders will receive only a modest minority of the post-issuance Otonomo shares.

Incident to the exchange, Otonomo will then become publicly traded on NASDAQ, and S-SPAC will be delisted from NASDAQ. This negotiated SPAC transaction will thus provide to Otonomo the two key business benefits that the more uncertain alternative of an initial public offering could have achieved, namely a cash infusion plus a NASDAQ listing.

The S-SPAC–Otonomo press release announcing the share exchange notes that after the exchange, Otonomo and its subsidiaries will have S-SPAC’s $172.5 million in cash, which the press release states “will be used to fund growth of the combined company, accelerating go-to-market strategy, strengthening our leadership position and unlocking new use cases and end markets.”

Tax Aspects of the Share Exchange

The acquisition of S-SPAC by Otonomo will be accomplished by means of a Delaware law merger of a newly formed transitory Delaware subsidiary of Otonomo with and into S-SPAC, with S-SPAC as the survivor. The acquisition agreement recites that the transaction is intended to constitute a tax-deferred reorganization to the exchanging S-SPAC shareholders. The reorganization provision referred to is presumably a reverse triangular subsidiary merger described in Sections 368(a)(1)(A) and 368(a)(2)(E), and possibly a share exchange described Section 368(a)(1)(B) as well.

Section 351(a) nonrecognition seems unavailable to the exchanging S-SPAC shareholders. The press release announcing the combination states that in connection with Otonomo’s acquisition of S-SPAC, there will be a private investment by private equity (PIPE) transaction, involving a sale at original issue by Otonomo of $172.5 million in shares to private investors. Some of the investors mentioned as supporting the PIPE transaction, such as Dell Technology Investors and Hearst Capital, are pre-existing shareholders of Otonomo. However, there is no indication that the transferor group to Otonomo, including the exchanging S-SPAC shareholders and PIPE investors, will achieve 80% or greater control of Otonomo, as is required for Section 351(a) nonrecognition. If nonrecognition under Section 351(a) is unavailable, the exchanging S-SPAC shareholders must rely solely on the reorganization provisions for nonrecognition on their receipt of the Otonomo shares.

The fact that Otonomo is not a U.S. corporation will not preclude the outbound cross-border share exchange from qualifying as a reorganization. Treasury Regulation Section 1.367(a)-3(c) generally allows an exchange of U.S. corporate shares, such as S-SPAC shares, for a minority block of foreign corporate shares, such as Otonomo shares, by means of a reverse triangular merger of a transitory U.S. subsidiary of the acquiring foreign corporation with and into the U.S. target corporation, which otherwise qualifies as a reorganization described in Sections 368(a)(1)(a) and 368(a)(2)(E), or Section 368(a)(1)(B), to qualify as a reorganization, provided certain requirements are met. These requirements involve such matters as: prohibited post-exchange control of the foreign corporate acquirer by the exchanging 5%-or-greater U.S. target shareholders and U.S. officers and U.S. directors of the U.S. target corporation; execution of gain recognition agreements by exchanging U.S. shareholders seeking nonrecognition who, post-acquisition, own 5% or more of the vote or value of the foreign corporate acquirer; a requirement that the foreign corporate acquirer’s market capitalization is at least that of the U.S. target corporation; the active and continuing nature of the foreign corporate acquirer’s foreign business; and reporting requirements. S-SPAC can be expected to meet these requirements. Although there are some other tax issues involved in the S-SPAC–Otonomo transaction, a prominent issue in qualification as a reorganization is whether “continuity of business enterprise” rules or COBE will be met.

The IRS is reportedly considering how the COBE rules will be applied to acquired SPACs. IRS Revenue Procedure 2021-1, Section 6.03(2)(a) provides that although the IRS will not issue a ruling that a transaction qualifies as a reorganization, rulings on significant issues under the Treas. Reg. Section 1.368-1(d) COBE test may be available. IRS rulings branch officials have stated that they are open to Treas. Reg. Section 1.368-1(d) COBE ruling requests with respect to acquired SPACs, although they caution there is no assurance on a favorable outcome or how long such a ruling would take.

However, the March 2021 Otonomo preliminary proxy statement filed with the SEC notes: “The closing of the Business Combination is not conditioned upon the receipt of an opinion of counsel that the Business Combination will qualify as a reorganization, and neither [S-SPAC] nor Otonomo intends to request a ruling from the IRS regarding the U.S. federal income tax treatment of the Business Combination. Accordingly, no assurance can be given that the IRS will not challenge the Business Combination’s qualification as a reorganization or that a court will not sustain such a challenge by the IRS.”

COBE Regulation

Treas. Reg. Section 1.368-1(d) requires that the issuing corporation’s controlled group either continue the target’s historic business or use a significant portion of the target’s historic business assets in a business. In the case of a reverse triangular merger described in Section 368(a)(2)(E), or in a Section 368(a)(1)(B) reorganization, such as the S-SPAC–Otonomo transaction, it appears that the post-acquisition parent of the target, here Otonomo, will be considered the issuing corporation.

Thus, the question in the S-SPAC transaction is likely to be whether the post-acquisition drawdown of S-SPAC’s funds by Otonomo and Otomono’s operating subsidiaries qualifies as either a continuation of S-SPAC’s historic business or a business use of S-SPAC’s historic business assets. Unfortunately, the regulations do not provide much guidance on this point.

Instead, the regulations and related rulings focus on a transaction perceived as abusive by the IRS, where the acquired corporation operates a business, sells that business for cash, and then, as a cash company, is acquired by a corporation in a different line of business. (See, e.g., Revenue Ruling 81-92.) By contrast, in S-SPAC’s situation, there was no pre-existing business sold by S-SPAC for cash.


S-SPAC’S activities were focused on combining with a software company, which software company could profitably use S-SPAC’s cash to expand the combined group’s post-acquisition software business. S-SPAC’s acquisition by Otonomo will be consistent with that S-SPAC business objective. The S-SPAC–Otonomo transaction therefore presents a sympathetic case for a favorable IRS finding of COBE.

This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.

Author Information

Alan S. Lederman is a shareholder at Gunster, Yoakley & Stewart, P.A. in Fort Lauderdale, FL.

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