U.S. Owners of Special Purpose SPAC and Passive Foreign PFIC Companies Be Aware of Tax Consequences
Typically, shareholders of PFICs do not comprehend the rules that apply to foreign corporations that hold assets for any amount of time. Many believe that PFICs are foreign unregistered mutual funds that invest in stocks, bonds, and other securities. For those US SPAC investors who make the mistake to think they are merely investing in a newly formed operating enterprise, perilous tax ramifications may follow.
SPAC (Special Purpose Acquisition Company)
- A company with no commercial operations. It is formed to raise capital to acquire an existing company.
- Known as a ‘blank check company.’ IPO proceeds are typically deposited in a trust account that invests in US treasury obligations. These proceeds are the biggest asset on the Company’s balance sheet.
- The only income generated in the initial years after the IPO is the interest income earned in the trust.
- Therefore SPACs formed outside the US meet the PFIC income and assets tests right after the IPO.
PFIC (Passive Foreign Investment Company)
- Any non-US corporation that meets either the gross income test or the assets test.
- Gross Income Test
- Seventy-five percent or more of gross income for the given tax year comes from passive income.
- Assets Test
- Fifty percent or more of its assets produce or are held to generate passive income.
- Passive Income
- Includes dividends, interest, rents, and royalties that were not derived from the active conduct of a trade or business as well as gains from the disposition of passive assets.
Tax Implications To US Shareholders
- US shareholders that invest in SPACs that are PFICs are subject to the rules contained in Sections 1291 through 1298 of the Internal Revenue Code.
- The specific rules depend n the actions of the investors and the PFIC itself.
- One set of rules applies to PFICs that are qualified to elect funds (QEF).
- One set of rules applies to PFIC’s that are not QEFs.
In terms of Section 1291, as US person and shareholder of the PFIC pays tax and an interest charge on:
- Any gain recognized on the sale or other disposition of its ordinary shares.
- Any gain recognized on the sale or other disposition of its rights.
- Any gain recognized on the sale or other disposition of its warrants.
- Any excess distribution made to the US shareholder.
An excess distribution is a current year distribution on stock insofar as it represents a ratable portion of total distributions during the year that is more than 125% of the average amount of distributions during the preceding three years. Any excess distribution received during the three years is taken into account only as far as it was included in gross income.
No corporation would be treated as a PFIC for the first taxable year the corporation has gross income:
- If no predecessor of the corporation was a PFIC.
- If the corporation satisfies the IRS that it will not be a PFIC for either of the first two taxable years following the start-up year.
- If the corporation is not in fact a PFIC for the first two taxable years following the start-up year.
- It is unlikely that SPACs will qualify for the start-up exception because of it’s ‘blank check’ status. This may remain so even after the acquisition of a company or assets in a business combination, and the Company will still have to meet one of the two PFIC tests.
In terms Of These Rules
- The US shareholder’s gain or excess distribution will be allocated over the US person’s holding period for ordinary shares, rights, or warrants.
- This amount allocated to the US shareholder’s taxable year, which is included in its holding period, will be taxed at the highest rate applicable to the US holder for the year.
- The same goes for amounts allocated to other taxable years and included in its holding period. It will be taxed at the highest rate applicable to the US holder for that year.
- Interest charges applicable to the underpayment of tax will be imposed on all tax attributable to each other taxable year of the US shareholder.
Qualified Electing Fund (QEF) Election
For US investors who made a QEF-election, their share of the PFICs net capital gains (as long term capital gains) and other earnings and profits (as ordinary income) is included in gross revenue – on a current basis irrespective whether distributions were made in the taxable year in which the SPAC’s taxable year ends.
- The election to become a QEF is not made at the PFIC level on a shareholder-by-shareholder basis. It is made at the US investor level in terms of Code Section 1295(b).
- The election is made by the first US person who owns stock directly or indirectly in the PFIC, as long as the PFIC complies with the prescribed reporting requirements for the determination of the Company’s income and other requirements needed to carry out the PFIC provisions.
- Failure to comply with the reporting requirements means that the US investor cannot make the QEF election.
Once the QEF election is made, it can only be revoked with the permission of the IRS. It will remain valid even if the shareholder liquidates his investment in one tax year and reinvests in the PFIC later on. A US shareholder can separately elect to defer the payment of taxes on undistributed income inclusions under the QEF rules. Any deferred taxes will be subject to the interest charges described above.
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Deferred Tax Amount
- The deferred tax amount in respect of a distribution or disposition of PFIC stock is an amount equal to the sum of:
- The aggregate increase in taxes
- The aggregate amount of interest on that increase in taxes.
- The aggregate increase in taxes is calculated by multiplying each portion of the excess distribution allocated to a prior PFIC year by the highest tax rate in effect in that prior year.
- An applicable foreign tax credit reduces the aggregate increase in taxes.
- The jurisdictions of the Cayman Islands and the British Virgin Islands do not impose income taxes. As such, the foreign tax credit does not apply to SPACs formed there.
To comply with the requirements of a QEF election, the SPAC should provide US shareholders with a PFIC annual information statement to enable the US holder to make and maintain a QEF election.
Mark To Market Election For Marketable PFIC Stock
Shareholders of SPAC’s with stock that regularly trade on an SEC-registered national securities exchange or a national market system established under section 11A of the Securities and Exchange Act of ’34 can make the mark-to-market election described under Code Section 1296.
Those US shareholders who do the same can include in income each year an amount equal to the excess fair market value of the PFIC stock as of the close of the tax year over the shareholder’s adjusted basis in the stock.
The shareholders are allowed a basis deduction for the lesser of the excess of the adjusted basis of the PFIC stock over its fair market value as of the close of the tax year OR the unreserved inclusions concerning the PFIC stocks.
The unreserved inclusions are the excess of the mark-to-market gains for the stock included by the shareholder for earlier tax years. It consists of any amount which would have been added for any prior tax year but for the interest on tax deferral rules – over the mark to market losses for the stock that were allowed as deductions for earlier tax years.
Under Code Sec. 1296(k) the mark-to-market election applies to the tax year for which the election is made and to all later tax years – unless:
- Unless the PFIC stock ceases to be marketable.
- The IRS consents to the revocation of the election.
- The US person elects or is required to mark-to-market the PFIC stock under another Code provision.
Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. This article cannot serve as a substitute for such professional services or advice. Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation. This article is subject to change at any time and for any reason.