There has been a proliferation of SPACs to hit the IPO market and more and more of them are based in foreign jurisdictions. Many SPACs that choose to domicile in ”tax haven” jurisdictions, such as the Cayman Islands, face their own set of unique US tax and reporting considerations. US shareholders may have a disclosure obligation in addition to their filing obligation because these SPACS tend to be Passive Foreign Investment Companies (PFICs).
A PFIC is any foreign corporation that meets one of the two following tests:
- 75% or more of the gross income for the tax year is passive income (the “Income Test”); or
- 50% or more of the assets produce, or are held to produce, passive income (the “Asset Test”).
Passive income generally includes dividends, interest, royalties, rents, and annuities. Thus, interest income generated from US Treasury obligations would be considered passive income. Further, and although not clear, working capital such as cash received from an IPO would be considered an asset generating passive income because the IRS argues that cash can generate interest income. As such, foreign-domiciled SPACs most likely meet the Income Test and/or Asset Test and are considered PFICs as a result until a “De-SPAC” transaction occurs. There is also a start-up exception to the PFIC rules but most SPACs do not complete a De-SPAC transaction quickly enough to meet the exception.
A US shareholder investing in a foreign-domiciled SPAC meeting the definition of a PFIC is subject to the PFIC rules. The PFIC rules are an anti-deferral regime set up to prevent US taxpayers from deferring US taxation on passive income.
The PFIC rules contain the following three regimes:
- Excess Distribution Regime;
- Qualified Electing Fund (“QEF”) Regime; and
- Mark-to-Market (“MTM”) Regime.
In addition to the taxable income implications of each regime, which are discussed below, a US shareholder will be required to file Form 8621 as part of its US tax return. This form will report the regime under which the US shareholder elects into, if any, as well as any income inclusion under such regime.
Excess Distribution Regime. The Excess Distribution Regime is the default regime for a US shareholder and is the most punitive of the three regimes. An excess distribution is a current year distribution that exceeds 125% of the average amount of distributions received during the preceding 3-year period, or shorter if the holding period is less than 3 years. The excess distribution is allocated ratably to each day in the taxpayer’s holding period of the PFIC stock. The allocated amount to the current year is taxed at ordinary income rates. The amount allocated to prior years is also taxed in the current year and is considered a deferred tax amount. The deferred tax amount is subject to tax at the highest ordinary income rate in effect for that respective year and is also subject to an interest charge.
If a US shareholder does not elect into the QEF or MTM Regimes, then income generated from the investment will be fully taxed at ordinary tax rates as opposed to more favorable capital gains rates. Furthermore, the US shareholder may be taxed at a higher ordinary rate than their normal ordinary rate with respect to the deferred tax amount because they might not be in the highest income tax brackets. They will also be subject to an interest charge on the deferred tax amount.
QEF Regime. The QEF Regime is much more favorable to the US shareholder compared to the Excess Distribution regime because it allows for the retention of income character (i.e., ordinary vs. capital) and gain derived from the disposition of such stock is taxed at capital gain rates. However, as a trade-off, a US shareholder will include in current year taxable income her pro-rata share of the ordinary earnings and net capital gain generated by the QEF (i.e., a PFIC that elected to be treated as a QEF) regardless of whether a distribution is received. Ordinary earnings will be taxed at ordinary income rates and net capital gain will be taxed at the long-term capital gain rate.
An election into the QEF regime is made at the US shareholder level as opposed to the PFIC level. Also, the first US person who owns the stock directly or indirectly would make the election as part of her Form 8621 filing. The election must be made on or before the due date, including extension, of the US shareholder’s tax return for the tax year in which she wants the PFIC to be treated as a QEF. Once an election is made, it remains in effect for all subsequent tax years unless IRS consent is received to revoke such election.
In order for a US shareholder to be eligible to make a QEF election, the PFIC must agree to provide the US shareholder with a signed Annual Information Statement (“AIS”). The AIS provides the shareholder with the necessary information to compute their ordinary earnings inclusion, net capital gain inclusion, and distributions. The ordinary earnings and net capital gain are computed based on US earnings & profits (“E&P”) principles. E&P is loosely defined as a corporation’s ability to pay a dividend to its shareholders and is analogous to US taxable income.
The QEF election should be made in the initial year of acquisition of SPAC stock by the US shareholder. If the QEF election is not made in the first year, then the PFIC will be considered an unpedigreed QEF. An unpedigreed QEF continues to be subject to the Excess Distribution Regime discussed above. To cleanse the QEF of the PFIC taint (i.e., the Excess Distribution Regime), a US shareholder may be eligible to make a deemed-sale or deemed-dividend election. However, there may be US tax leakage as a result of such an election. Warrant holders have special considerations, including that they are not able to make a QEF election, so they should consider making a deemed-sale election once the warrant is exercised.
MTM Regime. The MTM Regime, while not as favorable as the QEF regime, is less punitive than the Excess Distribution Regime because the deferred tax amount implications are avoided (i.e., highest ordinary rate and interest charge). The MTM regime requires the US shareholder to include as ordinary income any stock appreciation based on the fair market value of the stock at the close of the tax year. To the extent there is stock depreciation as of the close of the tax year, a US shareholder is allowed a deduction, which is limited to the amount of the depreciation in value or the “unreversed inclusion” amount. The “unreversed inclusion” amount is equal to the cumulative ordinary income previously recognized.
In conclusion, making a QEF election in the initial year that a SPAC is acquired generally results in the best after-tax result if the SPAC is held for more than a year. The management of the non-US SPAC will need to provide investors with an Annual Information Statement or order for this election to be made. This statement is a generic statement that contains no shareholder-specific information and PFICs generally post them on their website. In most cases, based on the current low interest rate environment, the ordinary income inclusion on a per share per day basis will be nominal. Upon sale of SPAC shares held for more than one year, the investor will be rewarded with gain that is taxed as preferential long term capital gain rates.
Withum’s Financial Services Team for any further questions.
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