At year-end, unexpected US and state income tax impacts may arise for special purpose acquisition companies—even those formed in offshore locations. SPACs are a popular vehicle for accessing the capital markets—nearly 700 were established during 2021 and 2022, raising more than $175 billion.
Many of these companies were formed in locations such as the British Virgin Islands or the Cayman Islands, which are without US tax treaties. While these locations have historically enjoyed a low- or no-tax reputation, the reality has caught some accounting and management teams off guard. As a result, many professionals have been surprised to learn that tax liabilities may now exist in relation to their SPAC.
SPACs were created to access capital through an initial public offering before conducting any commercial activity. Now, an array of tax liabilities might surface that hadn’t been considered in prior year-end cycles, as SPACs ramp up activity following initial formation stages or are impacted by shifting economic forces such an inflation.
Even when formed outside of the US, each SPAC entity could create a nexus (a taxable presence) in a US jurisdiction. Various factors can trigger both US and state filing requirements. First, nexus might exist due to the location of company property—including bank accounts. SPACs raise capital through an IPO, and the capital raised by these entities is usually held in trust interest-bearing accounts in the US.
Beyond company property and bank accounts, nexus might also exist depending on where management or employees conduct business. For example, a SPAC formed offshore might direct management activities from the SPAC’s principal office in a state such as New York or another popular, business-centric locale, with an employee base stationed across other US states.
Other Year-End Tax Triggers
For a variety of reasons, SPACs could be underpaying or underreporting taxes in jurisdictions perhaps not previously viewed as a taxable authority.
Rising rates. SPACs must closely monitor evolving developments to determine whether new tax liabilities have surfaced due to interest rate increases over the past year—in which case, the interest or dividend income earned could have created taxable income. In past cycles, SPACs might have generated net operating losses and produced no federal or state income tax expenses. Without scrutiny, it can be common for now-relevant tax parameters to be overlooked by a company.
Income and the ticking clock. SPACs typically have 18 to 24 months to identify a target company with which to merge. As of June 2022, approximately 600 SPACs had yet to merge with a private target, leaving billions of dollars invested in short-term vehicles currently earning significant levels of interest income. SPAC funds are frequently deposited in US bank accounts and invested in short-term Treasury obligations per trust covenants.
Interest rates on 90-day Treasury bills opened in 2022 at 0.051% and closed the year at 4.42%, a sizeable jump. SPAC funds also may earn interest and dividends from money market funds. In 2022, the average seven-day gross yield for money market funds began at 0.12% and ended at 4.42%, another marked increase.
In 2021, the average SPAC raised $265.1 million and earned insignificant interest income during relative to the most recent calendar year. With the increase in interest rates in 2022, the same investments potentially generated millions of dollars of interest income. Should a US or state income tax obligation exist, the corresponding tax expense for reporting purposes becomes material.
Reporting and audit impacts. A failure to pay taxes is an obvious problem, but a failure to report state income tax expenses in financial statements can also cause significant issues. Companies could face control deficiencies, qualified audit opinions, or restatements if a SPAC underreports tax expenses in its 10-K and 10-Q filings.
Auditors need to be cautious prior to signing off on financial statements, because many professionals work under the assumption that the entity is exempt from income taxes and includes only interest income. Here, auditors should consider the potential for relevant US and state income tax obligations.
Individual shareholder considerations: Beyond corporate tax obligations, each SPAC’s individual shareholders may be subject to state income tax. Federal and state tax laws may operate to tax any gains or dividends received by individuals from their investments. Further, US tax laws may impact investors in the Cayman Islands. These include the Foreign Account Tax Compliance Act or the Base Erosion and Anti-Abuse Tax, so a tax professional should be consulted on specific tax situations.
To mitigate tax-related risks, every SPAC should consider performing a nexus study. The study helps determine whether a specific US state or an international jurisdiction may have a claim against the trust income.
The nexus study can be performed either as part of or in addition to a company’s regular uncertain tax positions evaluation and footnote disclosures and should examine:
- Trust agreement tenants;
- Location(s) and activities of the SPAC’s directors, employees, or assets;
- Local country tax implications;
- Taxable income based on 2022 financial results and local tax laws.
A proactive approach can enable a better audit cycle, especially as some auditors have recently indicated they won’t sign off on a SPAC audit unless nexus study conclusions are disclosed in the financial statements.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Mary Montague is based in Atlanta and is an associate director at Riveron, where she advises businesses on state and local direct and indirect tax matters, including those related to the SPAC lifecycle.
Anne Heffington is a managing director based in Dallas and is responsible for leading the tax advisory practice at Riveron, focusing on supporting clients with accounting for income tax, sales and use tax, and general tax consulting.
Ryan Gamble is a senior managing director and national tax leader at Riveron, a business advisory firm headquartered in Dallas. Riveron’s team helps companies with accounting and tax advisory, navigating SPACs and other capital markets events, and realizing possibilities across the entire business and transaction lifecycle.
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