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Are Foreign SPACs PFICs, and Should Investors or the IRS Care?

Posted on June 21, 2021
Andrew B. Motten
Andrew B. Motten
Jeffrey D. Hochberg
Jeffrey D. Hochberg

Jeffrey D. Hochberg is a partner and Andrew B. Motten is an associate with Sullivan & Cromwell LLP in New York. A prior version of this report was presented to the Tax Forum. The authors thank the members of the Tax Forum for their comments, some of which are incorporated herein.

In this report, Hochberg and Motten examine whether foreign special purpose acquisition companies (SPACs) will be treated as passive foreign investment companies, and they explore the tax consequences for investors in SPACs that are classified as PFICs.

Copyright 2021 Jeffrey D. Hochberg and Andrew B. Motten.
All rights reserved.

I. Introduction

The special purpose acquisition company (SPAC) phenomenon that dominated the initial public offering universe in 2020 has dramatically increased in 2021. In the first quarter of 2021, there were 297 IPOs for SPACs that were registered with the SEC, with an aggregate principal amount of approximately $86 billion. In all of 2020, there were 247 of those issuances, with an aggregate principal amount of approximately $75 billion.1 Although the number of SPAC offerings in the second quarter of 2021 significantly declined in response to an SEC announcement regarding the tax accounting for warrants,2 many SPAC transactions in the pipeline are expected to proceed in the remainder of 2021.3 Moreover, the overwhelming majority of outstanding SPACs have not consummated a business combination transaction (also called a “de-SPAC transaction”),4 and, as a result, numerous de-SPAC transactions will presumably be executed in the months and years to come.

While almost all SPACs that were launched before 2020 were formed as U.S. corporations, approximately 40 percent of the SPACs that were filed with the SEC in 2020 and 2021 were formed as foreign corporations, typically as Cayman Islands corporations.5 Further, these figures do not include the many SPACs that are not SEC-registered but are marketed to U.S. investors, which are almost always formed as foreign corporations. As discussed in more detail later, the migration to foreign corporations is in part because many SPACs expect to acquire a foreign target, in which case a foreign SPAC would be more efficient from a U.S. tax perspective than a U.S. SPAC. Moreover, as discussed in more detail later, if a SPAC is unsure whether it will acquire a domestic target or a foreign target, it is generally more straightforward and tax-efficient for a foreign SPAC to acquire a domestic target than for a domestic SPAC to acquire a foreign target. As a result, most SPACs are formed as foreign corporations unless they are very likely to acquire a domestic target.

Much attention and many pages of cautionary tax disclosure have been devoted to the fact that foreign SPACs could be classified as passive foreign investment companies (PFICs) for tax purposes and to the tax consequences to SPAC investors if the SPAC is so treated. This report discusses whether foreign SPACs will be treated as PFICs, and it explores the tax consequences to U.S. investors of PFIC treatment. We posit that the risks to SPAC investors of PFIC status are far less severe than one might glean from the typical disclosure in SPAC offering documents and that although investors could be subject to certain adverse tax consequences, many of them may be mitigated, or perhaps eliminated, with proper planning and structuring.

II. Overview of SPAC Transactions

This section provides a brief summary of the general structure of a typical SPAC transaction in order to frame the discussion below. It is not intended to provide a comprehensive discussion of all the terms of a SPAC transaction, and some SPAC transactions may have features that differ from those described below.

A SPAC is typically formed by a sponsor partnership that is affiliated with an investment manager. The sponsor generally contributes $25,000 to the SPAC in exchange for all the equity in the SPAC.6 The formation and contribution are usually carried out before the sponsor enters into an underwriting agreement or files a registration statement with the SEC, and significantly before any marketing of the SPAC units.

The SPAC later issues investment units consisting of shares and warrants to public investors for a price that is generally equal to $10 per unit. The shares that are held by the public investors typically represent 80 percent of the value of the SPAC, while the shares that are held by the sponsor generally represent 20 percent of the SPAC’s value. The shares that are held by the sponsor, however, hold all the voting rights for the SPAC for the period before the business combination.

The SPAC is formed to acquire or combine with a target business that is neither known nor identified when the SPAC issues units to the public. All the proceeds that the SPAC receives from the sale of the units to the public investors are held in a segregated trust account and are invested in low-yielding passive assets. If the SPAC does not consummate the business combination by a specified date (generally 18 to 24 months after the initial offering), it must liquidate and distribute its assets to the public shareholders.

The shares and warrants that are held by the public investors are initially stapled together, but they may be separated on a specified date after the issuance of the units. The tax disclosure in the offering document for the SPAC treats the shares and warrants as separate instruments for tax purposes, and investors are required to allocate their purchase price for the units between the shares and warrants based on their respective fair market values on the date the units were issued.

The warrants generally have an exercise price of $11.50 per share and may be exercised only after the later of the date of the business combination and a specified number of days after the issuance of the warrants. Accordingly, the warrants will expire worthless if the SPAC does not proceed with the business combination. The warrants often provide that the SPAC can redeem the warrants under specified circumstances for a minimal price in order to effectively force the public warrant holders to exercise their warrants. Also, the warrants may be exercised on a “cashless basis” under some circumstances.

If the SPAC enters into an agreement to consummate a business combination, the public shareholders will have the right to approve the transaction. Further, even if the shareholders provide the requisite consent, each shareholder will have the right to demand a redemption of its shares for its pro rata share of the funds that are held in the trust account (which will generally be approximately $10 per share). Accordingly, each holder of public shares effectively has an option to either participate in the business combination transaction or demand the return of all (or substantially all) its initial investment in the SPAC units.

The sponsor will generally also purchase warrants that have the same terms as the warrants that are issued to the public investors, except that the private warrants typically do not include the redemption provision described earlier. The sponsor will sometimes enter into a forward purchase agreement (FPA) with the SPAC under which the sponsor will commit to acquire additional shares in the SPAC for a fixed price if the SPAC consummates a business combination transaction. Finally, the SPAC will often obtain private funding from private investors through a private investment in public equity (PIPE) to provide additional funding for the business combination transaction.

A SPAC’s business combination transaction can take many forms. A comprehensive discussion of the different types of combination transactions and their tax treatments is beyond the scope of this report (although the discussion below considers some of the PFIC consequences of some of the more common types of combination transactions). That being said, in most de-SPAC transactions, the SPAC acquires the target business, as opposed to the target business acquiring the SPAC.7 Further, in most cases, the SPAC shares represent the entire consideration paid in exchange for the target, although in some cases, the SPAC may use some of its cash (that is, the cash in the trust account and any cash raised from the sponsor under the FPA or from the PIPE investors) as a portion of the consideration that is paid to the target investors.

III. Jurisdiction of SPAC

This section summarizes the most relevant U.S. tax considerations in determining whether to form a SPAC in a U.S. or foreign jurisdiction. This provides background and context as to why many SPACs have been formed as foreign corporations despite the potentially adverse PFIC consequences. However, a comprehensive discussion of this issue is beyond the scope of this report because it would require one to consider, among other factors, many different types of structures for de-SPAC transactions, the identity and residence of the participants in the sponsor, and various nontax corporate (and potential litigation) issues concerning the jurisdiction of the SPAC.

As a general matter, the most important tax factor in selecting the SPAC’s jurisdiction is whether the SPAC expects to acquire a U.S. target or a foreign target. If a SPAC expects to acquire a U.S. target, the SPAC will generally be formed as a U.S. corporation, because if it were a foreign corporation, any dividends paid by the U.S. target to the foreign SPAC (assuming the foreign SPAC does not domesticate) would be subject to U.S. withholding tax. Further, if a foreign SPAC acquires a domestic target, the foreign SPAC could be subject to the section 7874 inversion rules, and it may be more difficult for shareholders of the target to exchange target shares for SPAC shares tax free because of the requirements of section 367(a) and the regulations thereunder.

If a SPAC expects to acquire a foreign target, it will generally be formed outside the United States (generally, the Cayman Islands). The reason is that it would be inefficient for a domestic SPAC to hold a foreign target because the earnings of the foreign corporation would be subject to U.S. tax under the subpart F and global intangible low-taxed income rules in addition to any taxes that are imposed by the target’s tax jurisdiction.

If a SPAC is unsure whether it will acquire a foreign or domestic target, it would usually be preferable from a tax perspective to form the SPAC in a foreign jurisdiction, because it would generally be more tax efficient and simpler for a foreign SPAC to acquire a domestic target than for a domestic SPAC to acquire a foreign target. As detailed in Section VIII, if a foreign SPAC seeks to acquire a domestic target, it could generally convert or merge into a domestic corporation in an F reorganization and then acquire the domestic target. SPAC shareholders that make specific elections will generally not be subject to a material amount of tax on the domestication transaction. Moreover, although the warrant holders might be subject to tax on the domestication transaction if the SPAC is a PFIC, there are strong arguments to support the position that they would not be, as discussed in sections VI and VIII.

By contrast, if a domestic SPAC seeks to acquire a foreign target, the SPAC could not simply convert or merge into a foreign corporation before acquiring the target without triggering the inversion rules under section 7874. Accordingly, many (perhaps most) transactions in which a domestic SPAC acquires a foreign target are implemented through a double-dummy structure in which the shares of the SPAC and the target are contributed to a newly formed holding company in a contribution that qualifies under section 351. However, while the contribution will generally be tax free to the shareholders of the SPAC and the target, it will be taxable to the SPAC warrant holders because, unlike the reorganization provisions, section 351 does not apply to warrant holders. Moreover, although a discussion of the inversion rules is beyond the scope of this report, the holding company might in some cases be subject to the inversion rules. Further, the double-dummy structure may be more difficult to implement from a nontax standpoint because it requires the contribution of two entities to a newly formed holding company. As a result, many SPACs that are uncertain whether they will acquire a domestic or foreign target are formed in a foreign jurisdiction despite the PFIC issues that are discussed here.

IV. Is a Foreign SPAC a PFIC?

A. Income and Asset Tests

A foreign corporation is treated as a PFIC if it satisfies either of two tests: an income test or an asset test. The income test is satisfied if 75 percent or more of the corporation’s gross income is passive. For this purpose, passive income generally means income of a kind that would be foreign personal holding company income for a controlled foreign corporation (for example, dividends, interest, rents, and royalties).8

The asset test is satisfied if at least 50 percent of the average assets held by the corporation during its tax year are passive.9 A passive asset is one that produces passive income or is held for the production of passive income. A corporation’s average assets for the year are measured by reference to the corporation’s gross asset values at the end of each quarter in the corporation’s tax year.10 If the corporation has a short tax year, the quarterly measuring dates are the same as for a full tax year, except that the final measuring date is the last day of the tax year.11

A corporation would apply the asset test for each year by computing the numerator and denominator of the asset test fraction. The numerator will equal (1) the sum of the value of the corporation’s passive assets at the end of each quarter in the tax year, divided by (2) four. The denominator will equal (1) the sum of the value of all the corporation’s assets at the end of each quarter in the tax year, divided by (2) four.12 The corporation will be treated as a PFIC under the asset test if the fraction is equal to at least 0.5.

Finally, under the “once a PFIC, always a PFIC” rule, stock in a corporation is treated as PFIC stock (subject to some exceptions discussed below) if the corporation — or a predecessor — was a PFIC for that shareholder at any time during that shareholder’s holding period.13

There are several exceptions and special applications of these rules, including for tiered entities, banking and insurance companies, start-up companies, and companies changing businesses. Although most of these exceptions are inapplicable to SPACs, the start-up exception may apply in some cases and is described in greater detail later.

B. Cash as a Passive Asset

As described in Section II, SPACs are essentially cash boxes before the business combination transaction. Thus, the first question in determining whether a foreign SPAC is a PFIC is whether cash is a passive asset in this context.

Section 1297 defines passive assets as those “which produce passive income or which are held for the production of passive income.”14 Interest is clearly within the definition of passive income for this purpose. Consequently, cash that is held in an interest-bearing account should presumably be treated as a passive asset for this purpose. That being said, it might be possible to argue that the purpose of cash held by a SPAC is not to produce the nominal interest income that it earns but rather to eventually enable the SPAC to produce active income from the assets that it acquires in the de-SPAC transaction. Nevertheless, the government stated in a 1998 notice of proposed rulemaking that cash is a per se passive asset for this purpose even if held as working capital of an active business.15 Further, although the government issued proposed regulations in 2021 that provide a limited exception for working capital, a SPAC would not satisfy that exception.16 Accordingly, it seems that the IRS’s current position would be that cash that is held by a SPAC is treated as a passive asset.

While this position is not surprising for cash held in an interest-bearing account, it is somewhat surprising that the IRS treats cash as a passive asset even if it is held in a non-interest-bearing account. For example, suppose a foreign SPAC were to provide that it is not permitted to invest its cash in an interest-bearing account. In that scenario, the cash would not generate passive income because it would generate no income at all. Also, the cash would be held for the acquisition of an active business, not for the production of passive income. Although the 1988 notice and final regulations issued in 2021 do not explicitly address cash that is held in a non-interest-bearing account, they provide that cash is a per se passive asset, which suggests that it is irrelevant whether the cash produces interest income.17 It is difficult to provide a rationale for why cash of this type should be treated as a passive asset under the terms of the PFIC statute or as a policy matter. Still, that seems to be current law (or at least the IRS’s position regarding the law). A SPAC is therefore likely to be a PFIC unless it qualifies for one of the exceptions described below.

C. Second-Tier Domestic Subsidiaries

A foreign SPAC created before 2021 may have been able to avoid PFIC classification by depositing its cash in a second-tier domestic subsidiary — that is, a domestic subsidiary that is held by another domestic subsidiary that is directly held by the SPAC. Section 1298(b)(7) provides that stock of a second-tier domestic subsidiary that is indirectly held by a foreign corporation that is subject to the section 531 accumulated earnings tax (or that waives an exemption from that tax under a treaty) will not be treated as a passive asset. Accordingly, the foreign corporation would not look through to the assets of the subsidiary for purposes of the PFIC asset and income tests. Thus, if all the SPAC’s cash (and any other passive assets) are held in the second-tier domestic subsidiary, the SPAC should not be classified as a PFIC.

However, final regulations issued earlier this year provide an antiabuse rule under which this exception is unavailable if a principal purpose for the formation of the second-tier domestic subsidiary is to enable the foreign corporation to indirectly hold passive assets while avoiding PFIC classification.18 The antiabuse rule applies to a corporation’s tax years that begin on or after January 14, 2021.19 A SPAC that contributes cash to a second-tier domestic subsidiary to avoid PFIC classification would fall squarely within this antiabuse rule, and thus that contribution is not a workable solution for a PFIC that is formed in 2021 (unless formed in the first 13 days of 2021) and beyond.20 A SPAC that was formed in 2020, however, could use this approach because it would not be subject to the antiabuse rule in either 2020 or 2021 (assuming it has a calendar tax year).21

D. The Start-Up Exception

The PFIC rules provide a so-called start-up exception under which a foreign corporation will not be a PFIC for the first year in which it has gross income if (1) no predecessor to the company was a PFIC, (2) it is established to the IRS’s satisfaction that the company will not be a PFIC for either of the two years following the start-up year, and (3) the corporation does not actually become a PFIC in those two years. A SPAC should easily satisfy the first prong of this test because it will typically not be a successor to another PFIC. For ease of discussion, the remainder of this part first considers the application of the third prong of this test and then considers the second prong, in each case as applicable to a SPAC.

1. The third requirement of the start-up exception.

If a SPAC consummates the de-SPAC transaction in the year of its IPO, it generally will satisfy the third prong of the start-up exception because it will typically not be a PFIC in its second and third years after formation.22 If a SPAC consummates the de-SPAC transaction in the third year after its IPO, it generally will not satisfy the third prong because it will typically be a PFIC in its second year after formation. If a SPAC consummates the de-SPAC transaction in its second year after formation (which may be the most common time for that transaction), whether the SPAC satisfies the third prong of the start-up exception will depend on the specific application of the asset test in that year.

The four most significant factors that will affect whether the SPAC will be a PFIC in that year are (1) the time in the year in which the de-SPAC transaction is completed, (2) the amount of cash that the SPAC holds before the de-SPAC transaction, (3) the amount of cash (or other passive assets) that the SPAC holds immediately after the de-SPAC transaction,23 and (4) the amount of gross assets that are held by the target relative to the amount of cash that is held by the SPAC. As illustrated in the following examples, a SPAC will often not be a PFIC in the year of the de-SPAC transaction even if the transaction closes late in that year, and in some cases, even if it closes in the last few weeks of the year.24

For example, suppose a SPAC raises $300 million in its IPO and acquires a foreign target with a value of $600 million on September 15 of the year after its IPO.25 Assume that (1) the SPAC holds $300 million of cash at all times during the calendar year (including after its acquisition of the target),26 (2) all the target’s assets are active assets,27 (3) the target has liabilities of $200 million (so that the target’s gross assets have a value of $800 million at the time of purchase), and (4) the target’s gross assets have value of $800 million — the same as their value on the acquisition date — on September 30 and December 31 of that year.28

In this scenario, the sum of the total passive assets at the end of each quarter would be $1.2 billion,29 so the numerator of the asset test fraction would be $300 million. The sum of the total assets at the end of each quarter would be $2.8 billion,30 so the denominator of the asset test fraction would be $700 million. This would yield a passive asset percentage for the tax year that is just under 43 percent. The SPAC in this example would therefore satisfy the asset test and, assuming it also satisfies the income test,31 would not be a PFIC for its second year (and thus may also qualify for the start-up exception in its first tax year), even though all its assets were passive for more than two-thirds of the tax year.

To take another example, assume the same facts above, except that (1) the SPAC acquires the target on December 15 of its second tax year; and (2) the target has a value on December 15 (and December 31) of $900 million, with debt of $400 million, so its gross assets have a value of $1.3 billion. In this scenario, the sum of the total passive assets at the end of each quarter would be $1.2 billion, so the numerator of the asset test fraction would be $300 million. The sum of the total assets at the end of each quarter would be $2.5 billion,32 so the denominator of the asset test fraction would be $625 million. This would yield a passive asset percentage of approximately 48 percent for the tax year. The SPAC in this example would therefore satisfy the asset test and, assuming it also satisfies the income test, would not be a PFIC for its second year (and thus may also qualify for the start-up exception in its first tax year), even though the SPAC held exclusively passive assets until the last 15 days of the year.

As discussed earlier, a SPAC will not qualify for the start-up exception if the business combination is completed in its third year, and the likelihood that the SPAC will qualify for the start-up exception if the business combination is completed in its second year will decline the later in the year the transaction is completed. Thus, a SPAC has a longer runway for this exception if it is formed in the early part of a tax year.33 For SPACs formed later in the year, it may be advantageous to adopt a non-calendar fiscal year that begins shortly before the SPAC’s formation so that it could also adopt that year as its tax year and thereby extend the duration of the start-up year (and possibly the post-combination period in the second year).34 However, this strategy will generally be unavailable for a SPAC that is a CFC (which, as discussed below, will generally be the case if a domestic partnership is the sponsor), because a CFC is generally required to use the same tax year as its majority U.S. shareholder.35

Foreign SPACs that acquire a domestic target have an additional hurdle to overcome in using the start-up exception. As discussed in sections III and VIII, a foreign SPAC that plans to combine with a domestic target will typically domesticate before the combination by way of an F reorganization. The reorganization would terminate the corporation’s tax year.36 Thus, if a foreign SPAC relied on the start-up exception for its first year but domesticates in its second year in preparation for a business combination, the domestication results in a short second tax year, with the business combination occurring in the SPAC’s third tax year. Because there would be no active business in the short tax year, the foreign SPAC would almost certainly be treated as a PFIC for that short year, causing it to fail to qualify for the start-up exception.

2. The second requirement of the start-up exception.

As noted, the second prong of the start-up exception requires that taxpayers establish to the satisfaction of the IRS that the company will not be a PFIC in its second or third year. A SPAC will presumably not automatically pass this test by satisfying the third prong (that is, by not being a PFIC in its second and third years), because there would then have been no reason for the statute to include the second requirement. However, as discussed below, the statutory language raises several questions for which there is no authority or easy answers.37

First, when does a taxpayer have to establish this information to the satisfaction of the IRS?38 Is it at the end of the corporation’s first year? Is it when the taxpayer files its first tax return after the close of the corporation’s first year? Can a taxpayer extend the time at which it needs to satisfy this test by electing to extend the due date for its tax return?

Second, this test states that the taxpayer has to establish that the company “will” not be a PFIC in its second and third tax years. If that is taken literally, the test will almost never be satisfied, because although a taxpayer may often expect or reasonably believe that a start-up company will not be a PFIC in its second and third years, it will rarely, if ever, be able to establish that the company will in fact not be a PFIC in those years. This will particularly be the case if the taxpayer is required to establish that information early in the second year of the company.

Third, the statute does not provide for the format in which a taxpayer is supposed to establish this information to the IRS’s satisfaction. Unlike other areas of the tax law in which a taxpayer is required to attach a factual statement to its tax return to sustain a factual position,39 a taxpayer that treats a corporation as subject to the start-up exception is not required to provide any information to the IRS in order to satisfy this requirement, and there is no format for it to do so. This suggests that the taxpayer would have to establish this information to the IRS’s satisfaction only if it is subject to audit, which could be years after it takes the position on its tax return.

In light of these uncertainties, there will always be some risk that the IRS could assert that a SPAC that is not a PFIC in its second and third year has still not qualified for the start-up exception, because it failed to meet the second requirement of the exception. That being said, given the lack of clarity and guidance regarding the meaning of this requirement, the IRS is presumably unlikely to make that assertion, particularly because, as discussed elsewhere in this report, there is no policy reason to treat a SPAC as a PFIC in the first place.

E. Non-Interest-Bearing Accounts

As noted, the start-up exception applies only in the first year that a company has gross income. One strategy that some commentators have suggested to extend the time horizon for this exception is for a SPAC to deposit all its cash in non-interest-bearing accounts for the first year. Under this theory, the SPAC’s second year would be the first year under the start-up exception (because that is the first year in which it has gross income), in which case the SPAC could potentially qualify for the exception even if the de-SPAC transaction closes in its third year.

Problematically, however, the PFIC tests are clearly disjunctive — that is, even if there is no income in the first year, the company will still be a PFIC if it fails the asset test. Moreover, under the “once a PFIC, always a PFIC” rule, the company would then be disqualified from the start-up exception based on this initial-year failure. The IRS reached this conclusion in a field service advice memorandum, in which it advised that a company that had no income in its first year but had more than 50 percent passive assets in that year was ineligible for the start-up exception because the company was a PFIC in its first year, and the “once a PFIC, always a PFIC” rule would apply to later years.40

Thus, it appears that using this strategy may make matters worse, because the SPAC would then be completely unable to use the start-up exception regardless of how quickly it could find a target. Rather, when the start-up exception may be available, it would be preferable for a foreign SPAC to invest its assets in interest-bearing accounts in the first year to maintain the possibility that it could qualify for the start-up exception.

F. Policy Considerations

Setting aside the technical issues discussed earlier, SPACs should not be classified as PFICs as a policy matter. Congress enacted the PFIC rules because of a concern that otherwise, U.S. holders could hold investment assets in an offshore corporation and thereby defer the inclusion of investment income and convert ordinary investment income into capital gain.41 SPACs do neither. Any interest earned on the cash is generally de minimis, and the typical lifespan of a SPAC is quite short (generally 18 to 24 months), so any deferral or character conversion would be immaterial. Finally, the ultimate goal of a SPAC is the opposite of a passive investment fund; the goal of a SPAC is to find and acquire an active business and to use the cash in that business (or to use the cash to acquire the business).

Despite policy arguments to the contrary, many foreign SPACs will likely be treated as PFICs under current law. The remainder of this report discusses the tax consequences to U.S. investors in a SPAC classified as a PFIC.

V. Consequences to Holders of SPAC Shares

This section addresses the tax consequences to U.S. holders of shares of a SPAC classified as a PFIC for tax purposes. As discussed below, the holder will generally not be subject to significant adverse tax consequences under the PFIC rules if it makes the qualified electing fund election for its PFIC shares.

A. Consequences of PFIC Status if No Election

If a SPAC is a PFIC and a U.S. holder of SPAC shares does not make any of the elections described below, the holder will be subject to significant adverse tax consequences. Any gain that the holder recognizes on its shares would be ordinary income that is treated as recognized over the shareholder’s holding period for the shares, and that gain will therefore be subject to an additional interest charge.42 Similar treatment will apply to any excess distribution that the holder receives from the SPAC.43 Further, any dividends that are paid by the PFIC would not be treated as qualified dividends that are subject to tax at a reduced rate.44 Moreover, under the “once a PFIC, always a PFIC” rule,45 the PFIC consequences will continue to apply to the SPAC after the de-SPAC transaction, even though the SPAC will generally not be a PFIC in tax years that begin after the completion of the transaction.

B. QEF Election

1. Consequences of a QEF election.

A U.S. shareholder of a SPAC that is a PFIC could avoid all the adverse tax consequences applicable to PFIC shares described earlier if the holder elects to treat the SPAC as a QEF for each year of its holding period for the SPAC in which the SPAC is a PFIC.46 This is commonly referred to as a QEF election. The U.S. holder would be required to include its allocable share of the ordinary income and capital gains of the SPAC in income other than in tax years in which the SPAC is not a PFIC.47 This would generally not materially increase the tax liability of a shareholder in tax years of the SPAC before the de-SPAC transaction, because the SPAC will typically have minimal (if any) net income in those years. Moreover, the QEF election will generally not affect a shareholder in tax years of the SPAC that begin after the de-SPAC transaction, because the SPAC will typically not be a PFIC after that transaction, and the “once a PFIC, always a PFIC” rule does not apply to shares that have always been subject to a QEF election.48

A QEF election, however, could cause a holder to be subject to adverse tax consequences in the year of the de-SPAC transaction. As discussed in Section IV, a SPAC could be treated as a PFIC in the year that it completes its business combination transaction. In that case, a shareholder’s QEF inclusion would also include its allocable share of the target’s income during the post-transaction portion of the year. As a result, depending on the income of the target, the holder could include a material amount of income in that year under the QEF election, even though it may not receive any corresponding distributions to fund the tax. This would be merely a timing issue (and possibly a character issue) because the holder would increase its basis in the SPAC by the amount of the inclusion.49

Further, a shareholder could be subject to a QEF inclusion for the income of the target even if the shareholder sells its shares before the de-SPAC transaction. That is because the QEF rules allocate the PFIC’s annual income ratably to each day in the tax year, irrespective of when the PFIC actually realizes the income.50 Accordingly, a portion of the target’s income will be allocated to the portion of the tax year that precedes the date of the de-SPAC transaction, including to holders that no longer hold SPAC shares as of the de-SPAC transaction.51

2. How to make a QEF election.

A shareholder can make a QEF election for a tax year of a SPAC by filing a Form 8621, “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund,” as an attachment to its tax return no later than the extended due date for the filing of that return.52 A QEF election applies to all future years of the shareholder, and once made, a QEF election cannot be terminated except with the consent of the IRS.53 However, the shareholder will generally be permitted to make the QEF election for a tax year only if it receives an annual information statement from the SPAC that includes required information specified in the regulations, including information to enable the shareholder to determine its allocable share of the SPAC’s income and gains for the tax year.54 The statement must also either provide that the PFIC will permit the shareholder to inspect and copy the PFIC’s books and records to establish that the information was computed in accordance with U.S. tax principles, or include a description of alternative documentation approved by the IRS under a closing agreement.55

Although many foreign corporations that are, or may be, PFICs are often reluctant to provide this information because of the burden of converting their financial information into U.S. tax computations, this burden is much less significant for a SPAC because it will earn interest income only in tax years that close before the de-SPAC transaction. Further, a SPAC generally expects that it will not be a PFIC, and thus will no longer be required to provide this information, in tax years that begin after the completion of the de-SPAC transaction. The SPAC may be subject to an increased burden, however, if it is a PFIC in the year of the de-SPAC transaction, because it would then need to compute and provide U.S. tax information regarding the target’s income in the period after the combination transaction.

The offering document for most SPACs provides that if the issuer determines it is a PFIC, it will endeavor to provide the annual information statement to a shareholder upon the receipt of a written request from the shareholder.56

This approach seems quite cumbersome for both the issuer — which may receive many of these letters — and for the shareholders, which have to prepare a written request and determine to whom the request should be directed. A more sensible approach would be for the SPAC to post the required information online and to state in the offering document that it plans to do so, as is common for many non-SPAC entities that are classified as PFICs.57

An important practical issue for shareholders in a SPAC that may be a PFIC in its first tax year is that the shareholder will generally not know by the time it files its tax return for that year whether the SPAC will be a PFIC in its first year, because it will not know whether the SPAC will qualify for the start-up exception. As discussed in Section IV, this will often be the case even if the SPAC has announced a future business combination, because whether the SPAC will be a PFIC in its second year and thus potentially qualify for the start-up exception will depend on the many factors described above, which include information that will not be available until later in the year (and possibly after the close of the year).

In this case, a shareholder can pursue one of two alternatives. Under one approach, the shareholder could make the QEF election and file its tax return based on the assumption that the SPAC is a PFIC.58 The shareholder will generally not be subject to a material amount of tax as a result of making the election for the first tax year of the SPAC, although doing so would impose a compliance burden on the shareholder.59 If the SPAC is ultimately not a PFIC for that year, the taxpayer could amend its tax return, although the cost and burden of doing so would likely outweigh any tax savings.

Alternatively, the regulations permit a shareholder in a foreign corporation to make a protective filing, which would permit the taxpayer to later amend its tax return to make a QEF election when it is able to determine whether the corporation is in fact a PFIC.60 In general, to make this filing, the shareholder must (1) reasonably believe, as of the original election due date for the first QEF election year, that the corporation was not a PFIC for that year; (2) file a protective statement applicable to the retroactive year; and (3) comply with the terms of the protective statement.61 The protective statement must describe the basis for the shareholder’s reasonable belief that the corporation was not a PFIC, and it must include the shareholder’s agreement to extend the statute of limitations for PFIC-related taxes for all years to which the protective statement applies.62 The description of the shareholder’s basis for reasonable belief must discuss the application of the income and asset tests and the factors that affect the results of those tests.63 The regulations state that relevant factors include reasonable predictions regarding future income and assets when PFIC status in the current year depends on PFIC status in a later year. This is directly applicable to the start-up exception. Finally, the retroactive election must be made on the shareholder’s return for the year in which the shareholder determines, or reasonably should have determined, that the corporation was a PFIC.64

It is not clear whether or how a shareholder of a SPAC could demonstrate that it has a reasonable belief that the SPAC is not a PFIC when it does not have information regarding the timing or target for the business combination transaction. For example, consider a case in which a shareholder of a SPAC that was formed in year 1 files its tax return for that year on April 15 of year 2. Assume that the SPAC has not made any announcement regarding the timing or target for the business combination transaction. Would the shareholder in that case have a reasonable belief that the SPAC is not a PFIC in year 1 based on the statement in the offering document for the SPAC that it could qualify for the start-up exception? Would the answer be different if the shareholder files its tax return on June 15 and there is still no such announcement?65 While no authority addresses these questions, one would hope that the IRS would permit the protective filing in this case, particularly because the shareholder cannot determine whether the SPAC will qualify for the start-up exception when it files its tax return, and there is no policy reason to preclude the shareholder from making a QEF election once it determines that the SPAC was in fact a PFIC in its initial year.

The rules that provide for a retroactive QEF election state that the shareholder does not need to own shares of the PFIC at the time of the retroactive election.66 Thus, a shareholder that sells all its shares before it is clear whether the start-up exception is met can still make the retroactive election (assuming it satisfies the rules described above) to avoid the negative consequences that would otherwise apply to that sale.

C. Other Elections

In addition to the QEF election, SPAC shareholders could also make either a mark-to-market election or a purging election, in which case they would not be subject to the adverse tax consequences set forth in Section V.A. Both options are generally less favorable than a QEF election. A mark-to-market election requires the shareholder to include in ordinary income at the end of each tax year the excess (if any) of the FMV of the SPAC at that time over the shareholder’s basis in the stock.67 A purging election restores the PFIC to pedigreed QEF status (thereby removing the PFIC taint) but requires the holder to make a deemed sale election, in which case any gain would be ordinary income that is subject to the interest charge described earlier.68 Because both these approaches apply to gain on the stock (rather than just income of the PFIC), a QEF election will generally be the preferable method for SPAC shareholders to mitigate the negative consequences of holding shares in a PFIC.

D. The CFC/PFIC Overlap Rule

For many SPACs, the sponsor is a domestic partnership that holds all the voting rights for the SPAC before the business combination transaction. Accordingly, the SPAC will be treated as a CFC, and the sponsor will be treated as a U.S. shareholder in the CFC, in tax years that close before the business combination transaction.

If a PFIC is also a CFC, the code provides an overlap rule (the CFC/PFIC overlap rule) under which the CFC rules, and not the PFIC rules, will apply to any U.S. shareholder of the entity.69 Accordingly, a U.S. shareholder in a SPAC that is a CFC and a PFIC — which will generally be only the sponsor — will include its ratable share of the CFC’s subpart F income and GILTI for the year and will not be subject to the PFIC/QEF rules discussed earlier.70 As a practical matter, the CFC inclusions will generally be similar to the inclusions of a shareholder that makes a QEF election.71 For a SPAC, when there will generally be little (if any) income, the CFC rules are probably a bit more straightforward than the QEF election regime. However, the sponsor will in any case generally be subject to the PFIC/QEF regime in the year of the de-SPAC transaction if the SPAC is a PFIC in that year, because it generally will no longer be a U.S. shareholder of the SPAC after the de-SPAC transaction.

Some sponsors may prefer to be subject to the PFIC/QEF regime rather than the CFC regime, in which case the sponsor may choose to be formed as a foreign partnership so that it would not be a U.S. shareholder of the SPAC. The code provides that the CFC/PFIC overlap rule does not apply to options unless they relate to shares that are subject to a QEF election.72 This exception presumably would not apply to a warrant for shares that have not yet been issued. Accordingly, if a sponsor takes the position that the warrants are subject to the PFIC rules (see the discussion in Section VI below regarding this issue), the sponsor could be subject to the CFC rules for the shares and the PFIC rules for the warrants. The sponsor may believe that it would be simpler to be subject to the PFIC rules for both the warrants and the shares. Moreover, as discussed in Section VI, a holder of warrants may be subject to a more advantageous tax treatment under the PFIC rules if it also holds shares that are subject to a QEF election. If that is the case, then the sponsor may be in a better tax position regarding its warrants if it holds shares that are subject to a QEF election rather than shares that are subject to the CFC rules.

Moreover, it is unclear whether the CFC/PFIC overlap rule applies to a partner in a domestic sponsor partnership that owns less than 10 percent of the partnership (a small partner). More specifically, a domestic partnership can be a U.S. shareholder of a CFC, and thus subject to the discussion below, a small partner in such a partnership is required to include its share of the subpart F income of the CFC. Accordingly, the IRS has stated in numerous private letter rulings that the CFC/PFIC overlap rule applies to a small partner of a partnership that is a U.S. shareholder of a CFC.73 Congress, however, later enacted the CFC GILTI rules, and the GILTI regulations provide that a small partner in a partnership that is a U.S. shareholder of a CFC is not required to include any GILTI of the CFC.74 Moreover, the IRS also issued proposed regulations that would provide that, unlike under current law, a small partner of a domestic partnership that is a U.S. shareholder of a CFC is not required to include subpart F income of the CFC.75 Although these proposed regulations are effective only for tax years of foreign corporations beginning on or after the date the proposed regulations are finalized, a domestic partnership that is a “U.S. shareholder” in a CFC, taxpayers may currently elect to apply the proposed regulations subject to specified consistency requirements.76

The CFC/PFIC overlap rule is intended to prevent a taxpayer from being subject to both the CFC and PFIC rules.77 If, however, a small partner in a domestic partnership is not required to include any subpart F income of a CFC, then the CFC/PFIC rule, at least as a policy matter, should not apply to the small partner, because otherwise the small partner would then be exempt from both the CFC and PFIC rules.78 It is therefore likely that CFC/PFIC overlap rule would not apply to a small partner in a domestic partnership that is a U.S. shareholder of a CFC once the proposed regulations are finalized, and that it would not currently apply in such a case if the partnership has elected to apply the proposed regulations. In that case, the partnership would need to make a QEF election for its small partners so that those partners are not subject to the adverse PFIC consequences described above, even though its other partners are not subject to the PFIC rules under the CFC/PFIC overlap rule.79 This would obviously create additional complexity for such a partnership and might outweigh any benefit of applying the CFC/PFIC overlap rule.

E. Reporting Requirements

Finally, on top of the substantive consequences described earlier, shareholders of a SPAC will be subject to additional tax reporting and compliance requirements if the SPAC is classified as a PFIC.80 Specifically, a U.S. shareholder must file a Form 8621 each year as an attachment to its tax return,81 and if a QEF election is made, the shareholder must include additional information from the PFIC that is pertinent to the QEF election.82 Further, as discussed earlier, many SPACs have stated that they will provide the annual information statement to a shareholder only if they receive a written request for that information from the shareholder. In addition, a shareholder that makes the protective QEF election will be required to provide the IRS with a statement that includes the extensive information described above. Moreover, the shareholder would need to determine whether the SPAC is a PFIC in each tax year, which may not be obvious based on the financial information that is provided by the SPAC. Although these reporting and compliance issues may not be a material problem for institutional taxpayers, they may be significant for individual investors (perhaps even more so than the substantive consequences), which may dissuade them from investing in shares of a foreign SPAC that could be classified as a PFIC.

VI. Consequences to Holders of Warrants

This section discusses the tax treatment of U.S. holders of SPAC warrants if the SPAC is classified as a PFIC for tax purposes. As detailed below, the holder may be subject to adverse tax consequences because it will not be permitted to make a QEF election for the warrants. However, as discussed later, the position that SPAC warrants are subject to the PFIC rules is highly questionable, and it may be possible to structure the warrants in a manner that reduces the risk that the warrants will be so treated.

A. Options Under the PFIC Rules

Section 1298(a)(4) is the statutory provision that could cause the PFIC rules to apply to warrants that are issued by a SPAC. It provides that for purposes of the PFIC rules, “to the extent provided in regulations, if any person has an option to acquire stock, such stock shall be considered as owned by such person.” Proposed regulations issued in 1992 provide that “if a U.S. person has an option to acquire stock of a PFIC . . . such option is considered to be stock of a PFIC for purposes of applying Section 1291 and these regulations to a disposition of the option.”83 Those regulations are proposed to be effective April 1, 1992.84 Thus, although the regulations are not effective until issued in final form, taxpayers have been put on notice that the proposed regulations could be applied retroactively if finalized.

Also, the regulations provide that if an option for shares of a PFIC is subject to the PFIC rules, the holder of the option cannot make a QEF election for the option.85 Further, the mark-to-market election applies only to shares that are traded on a recognized exchange and will thus be unavailable for options.86 Accordingly, if SPAC warrants are subject to the PFIC rules, any gain that a holder recognizes upon a sale of the warrants would be treated as ordinary income that is subject to the interest charge described earlier. As discussed in Section VI.E, a holder may then also be subject to negative tax consequences for the shares that it acquires upon the exercise of the warrants.

As a policy matter, SPAC warrants should not be subject to the PFIC rules. As discussed earlier, SPACs do not invoke the potential abuses that the PFIC rules were introduced to prevent. As a result, there is no need to subject SPAC warrants to the PFIC rules. Moreover, SPAC warrants are not intended as — and as an economic matter, do not operate as — an economic equivalent to ownership of SPAC shares or as a means to bypass the PFIC rules. Nonetheless, given the statutory language and proposed regulations, we next consider whether warrants are subject to the PFIC rules and what the tax consequences may be if they are.

B. Section 1298(a)(4)

Although the PFIC option regulations are “only” proposed, the regulatory delegation in section 1298(a)(4) could be self-executing, in which case options to acquire PFIC stock could be subject to the PFIC regime even in the absence of final regulations. In examining whether statutory provisions that call for regulations are self-executing, courts have generally divided regulatory authorizations into two categories: regulations that will define whether a rule applies and regulations that will delineate how a rule applies.87 If the regulations would be “whether” regulations, the regulatory delegation is typically not applied until the final regulations are issued. But if the regulations would be “how” regulations, the courts often apply the rule even in the absence of final regulations.88

In 2016 the Tax Court considered this issue in the context of a regulatory delegation in the charitable contribution rules.89 It noted that mandatory regulations (“how” regulations) typically include language stating either that “the Secretary shall prescribe regulations” or that a particular result “shall happen ‘under regulations prescribed by the Secretary,’” and most often make some tax benefit available to taxpayers. In contrast, discretionary delegations (“whether” regulations) often include the term “may” but also arise when formulated as “to the extent provided in regulations prescribed by the Secretary.”90 These delegations often arise in situations that set forth a definite requirement but allow for the possibility of exceptions.91 The Tax Court also examined the legislative history to support its analysis of the underlying statutory grant of authority.92

Starting with the wording of section 1298(a)(4), it would appear that this regulatory authorization is a “whether” authorization. The operative language is preceded by the phrase “to the extent provided in regulations,” which, as noted, the Tax Court has stated is generally a “whether” regulation that is not self-executing in the absence of final regulations. This wording stands in sharp contrast with statutes that include language such as “the Secretary shall prescribe such regulations as may be necessary or appropriate to carry out” stated purposes.93 While section 1298(a)(4) describes the specific outcome Congress had in mind, it does not affirmatively direct the secretary to write those regulations. Moreover, the use of the phrase “to the extent” clearly contemplates that not all options should necessarily be treated as ownership of the underlying PFIC stock.

The legislative history to section 1298(a)(4) also supports this view, saying that “the committee anticipates that regulations will provide this treatment where necessary to prevent avoidance of the imposition of interest” (emphasis added).94 Thus, this provision appears to be intended as an antiabuse measure rather than a flatly applicable rule. However, as discussed earlier, SPACs do not implicate the underlying policy concerns that motivate the PFIC regime, and SPAC warrants are not structured to circumvent the PFIC rules or to replicate the economic profile of the SPAC shares. Presumably, then, SPAC warrants are not the type of situation Congress had in mind when it enacted section 1298(a)(4).

Finally, even if a court would conclude that section 1298(a)(4) is not self-executing — at least, if the court was considering the section in the context of SPAC warrants — the proposed regulations still have an April 11, 1992, effective date.95 That means that Treasury could technically finalize the proposed regulations with a draconically retroactive effective date, although this seems unlikely.96 One would hope that Treasury would revisit the effective date of the proposed regulations after 29 years of further consideration, at least for taxpayers that have filed tax returns before the issuance of the final regulations. Also, even if the regulations were finalized with a retroactive effective date, Treasury ought to include some relief for holders of SPAC warrants. As noted, those warrants do not implicate any abuse of the PFIC rules, and the government will presumably consider the tax treatment of SPAC warrants when finalizing the option rule in the proposed regulations because they would be one of the primary financial instruments affected by those rules.

Moreover, even if the proposed regulations were finalized retroactively, it is unclear whether a taxpayer that filed its return before that finalization would be required to affirmatively file an amended return to reflect the retroactive application of these rules.97 Accordingly, even if the proposed regulations are finalized with the 1992 effective date and without any relief for SPACs, the IRS might only be able to apply the PFIC rules to SPAC warrants upon an audit of a particular taxpayer.

Thus, between the arguments against concluding that section 1298(a)(4) is self-executing and the near absurdity of finalizing regulations retroactively after close to 30 years, it seems that the better answer is that SPAC warrants should not be subject to the PFIC rules under current law, although there is a significant amount of uncertainty in this regard.

C. Limits on Warrant Exercise

Even if one takes the position that an option to acquire PFIC shares is subject to the PFIC rules under current law, it is questionable whether SPAC warrants constitute an option to acquire SPAC shares, because the warrants can be exercised only if the SPAC completes a business combination transaction. Although there is no authority that interprets the phrase “option to acquire” in the PFIC context, there is authority that interprets the meaning of the identical phrase under the section 318 constructive ownership rules.98 The IRS issued a revenue ruling in 1968 stating that an option is treated as an option to acquire shares for section 318 purposes only if the shares “may be acquired at the election of the shareholder and there exist no contingencies with respect to such election.”99 The IRS later issued a second revenue ruling clarifying that a holder will be treated as holding an option to acquire shares even if the option can be exercised only after a specified date.100

The IRS has also cited these revenue rulings in private letter rulings addressing the treatment of stock options under section 280G, which also applies the constructive ownership rules of section 318(a)(4).101 In those letter rulings, the IRS concluded that options that were exercisable upon the occurrence of an insubstantial condition precedent were treated as outstanding stock under section 318(a)(4). In contrast, options that were exercisable only upon the occurrence of “a substantial condition precedent” were not treated as outstanding stock under section 318(a)(4).102 In LTR 200036025, for example, warrants that were exercisable only after a period of continued employment were not treated as stock under section 318(a)(4) for purposes of section 280G.

In the SPAC context, warrants are typically exercisable only upon the later of a business combination or a fixed number of days after issuance of the warrants. Although the fixed period would not be a substantial contingency under the authorities cited above, the business combination condition may very well be one. Business combinations are not inevitable, and a significant number of SPACs have liquidated without completing a de-SPAC transaction.103 The IRS might assert that the combination transaction contingency is an “insubstantial condition precedent” because relatively few SPACs (at least thus far) have liquidated without completing that transaction, and the sponsors are presumably economically motivated to the complete a de-SPAC transaction. This position would be weakened if additional SPACs liquidate without completing a business combination transaction. Also, it seems too difficult to assert that a contingency as fundamental as an acquisition for which there is no specific target when the warrants are issued is not a substantial condition precedent, even if it is extremely likely to occur.104 Further, a warrant holder could respond to this argument by noting that the revenue rulings did not distinguish between substantial and insubstantial conditions — they simply required that the option holder have the unilateral right to acquire the shares. Although the IRS has made this distinction in private letter rulings, they have no precedential authority.

D. Cash-Settled Options

A SPAC could further strengthen the position that its warrants should not be subject to the PFIC rules if the warrants provide that the SPAC could cash-settle the warrants at its election. In that case, based on the section 318 authorities, the warrant holder would arguably not hold a contract to acquire the SPAC shares because it would not have the unilateral right to purchase them.105

Even aside from the section 318 authorities, the PFIC option rule was arguably not intended to apply to cash-settled options. The proposed regulations provide that the exercise of an option for PFIC stock is not a disposition to which section 1291 applies.106 This rule makes sense only if the option can be exercised only through physical settlement so that the PFIC stock that is received upon exercise in a nontaxable acquisition is then subject to the PFIC rules. But this rule would make no sense if applied to the cash settlement of the option, because that cash settlement is treated as a taxable disposition of the option and would be the only time the PFIC rules could apply to the option. This rule thus seemingly contemplates only physically settled options and does not even contemplate options that can be optionally cash-settled.107

Moreover, the term “option to acquire stock” is used in other places in the code in reference to specific attribution of ownership rules (in addition to the section 318 rule), and there is no authority in any of those contexts that cash-settled options are treated as an option for purposes of the applicable statutory provision.108 Section 1234(c) includes a special provision that treats a cash-settled option as an option for section 1234 purposes; the implication of that rule is that the term “option” does not otherwise encompass a cash-settled option. Similarly, section 1091(f) was added to the code to specify that cash-settled options to acquire stock were to be treated as options to acquire stock for purposes of the wash sale rules.

Further, the fact that section 1298(a)(4) and the proposed regulations contemplate only options and no other cash-settled derivatives that transfer all the economics of the PFIC stock to the derivative investor (as would be the case under a forward contract or total return swap) seems to support the position that the PFIC option rules are intended to cover only cases in which the option holder has the ability to physically purchase the stock and not cases in which an investor holds a financial instrument (such as a cash-settled option), the value of which depends on the value of the PFIC stock.

Although these arguments are strongest when a warrant can only be cash-settled (which is presumably not a viable structure for a SPAC), they retain some persuasive force in the case of a warrant that can be optionally cash-settled, particularly in light of the language in the proposed regulations. Accordingly, a SPAC that is concerned that its warrants may be subject to the PFIC rules (despite the above arguments) may want to consider including a cash settlement option for the warrants to further support the position that the warrants are not subject to the PFIC rules.

E. Structuring Warrants as Equity

A foreign SPAC that seeks to further reduce the risk that the warrants could be subject to the PFIC regime may want to consider structuring the warrants in a manner that would cause the instrument to be treated as equity in the SPAC for tax purposes. As discussed below, it may be possible to do in a manner that maintains much of the economic position of the warrant. If successful, this approach would allow a holder of the instrument to make a QEF election, in which case, as discussed in more detail in Section V, the holder of the instrument would generally not be subject to significant adverse tax consequences if the SPAC is a PFIC. Moreover, this would have the benefit of allowing the holder of the instrument to avoid gain recognition if the de-SPAC transaction is implemented through a double-dummy structure in which the shares and warrants of the SPAC and the shares of the target are contributed to a newly formed holding company in a contribution that qualifies under section 351. As discussed in Section III, that transaction will be taxable to the SPAC warrant holders because, unlike the reorganization provisions, section 351 does not apply to warrant holders.

For example, it may be possible to alternatively issue convertible preferred shares that have a strike price that is the same as the strike price under the warrants. The convertible preferred shares would have a material liquidation amount and would have voting and dividend rights that are proportionate to its liquidation entitlement. Although this instrument would be economically identical to an investment unit consisting of nonconvertible preferred shares and a warrant, it should not be bifurcated for tax purposes, because they can’t be separately transferred, and the two components will never exist independent of the other. The leading case on this subject is Chock Full O’Nuts, in which the court held that a convertible debenture could not be separated into a debt instrument and an option, even though the debenture was economically identical to an investment unit that consists of a debt instrument and an option.109 The court focused on the indivisible nature of the instrument: “The convertible debenture is an indivisible unit; the issuer has but one obligation to meet, either redemption or conversion. It can never be required to do both.”110

Although the IRS is not likely to succeed based on a bifurcation analysis, it might assert that the single instrument as a whole should be treated as a warrant if the liquidation preference and voting rights of the shares are nominal relative to the value of the conversion feature. In that case, the IRS could assert that the instrument is in substance a warrant and should not be treated differently because of relatively immaterial features that are attached to the instrument, particularly when they are included solely to achieve a tax objective.111 Thus, the strength of the position that the convertible preferred should be respected as such for tax purposes may depend on the amount and significance of the liquidation preference and associated dividend and voting rights.

A SPAC may also consider structuring the warrants as a different class of shares in the SPAC that primarily participates in the SPAC once the value of the primary class of shares in the SPAC exceeds the strike price under a typical SPAC warrant. Although there are many variants of this proposal, and a full discussion of each is beyond the scope of this report, this may differ too significantly from typical SPAC warrants to make this a realistic alternative to the issuance of a traditional SPAC warrant.

F. QEF Election

This subsection considers the application of the PFIC rules to shares of a SPAC that are acquired upon exercise of a warrant. For ease of presentation, the discussion below assumes that the SPAC is a PFIC and that the warrants are subject to the PFIC regime under section 1298(a)(4).

As discussed earlier, a QEF election cannot be made for options (such as warrants).112 And the proposed regulations provide that the PFIC holding period for any shares that are acquired upon exercise of an option will include the holder’s holding period in the option.113 Accordingly, subject to the discussion in the following paragraph, SPAC shares that are acquired upon exercise of a warrant will not be treated as shares of a pedigreed QEF (that is, shares that have been subject to a QEF election for the shareholder’s entire holding period for the shares), and the shares will therefore be subject to the adverse PFIC tax consequences described in Section VI.A, even if the holder makes a QEF election for the shares.114 To make matters worse, this treatment will apply even if the SPAC is no longer a PFIC when the holder exercises the warrants (as will typically be the case), because the shares would be treated as shares in a PFIC under the “once a PFIC, always a PFIC” rule.

Notwithstanding the discussion above, shares acquired upon the exercise of a SPAC warrant might be treated as shares of a pedigreed QEF, and thus not be subject to the adverse PFIC tax consequences described earlier, if (1) the holder has held at least one share of the SPAC during its entire holding period for the warrants and (2) the holder makes a QEF election for each year in which it holds shares in the SPAC (excluding years in which the SPAC is not a PFIC). The regulations state that “a PFIC is a pedigreed QEF with respect to a shareholder if the PFIC has been a QEF with respect to the shareholder for all taxable years during which the corporation was a PFIC that are included wholly or partly in the shareholder’s holding period of the PFIC stock.”115 Based on this definition, the SPAC would seemingly constitute a pedigreed QEF for shares that a shareholder acquires upon exercise of a warrant if the SPAC was a QEF for the shareholder during the entire period in which it held the warrants — even if the QEF election applied to other shares (and not the warrants) that were held by the shareholder. Further, the proposed regulations provide that the tax consequences that apply to PFIC shares under section 1291 do not apply if the PFIC is a pedigreed QEF for the shareholder.116 This suggests that the shareholder described in the first sentence of this paragraph would not be subject to the PFIC rules upon a sale of the SPAC shares that it acquires upon exercise of the warrants.

That interpretation admittedly yields a curious result because it would mean that a shareholder that held a warrant to acquire 1,000 SPAC shares — but that did not own SPAC shares during its entire holding period for the warrant — would be subject to the PFIC rules for the shares that it acquires upon exercise of the warrant, whereas a holder of an identical warrant would not be subject to the PFIC rules for those shares if, during the entire period in which it held the warrant, it held at least one SPAC share that was subject to a QEF election. Although there may be no policy reason for this distinction, this result is arguably not objectionable in the SPAC context, because there is no policy reason to subject SPAC warrants to the PFIC rules in the first place. Thus, the proposed solution of making a QEF election over a single share during the term of the warrant could be viewed as a technical solution to what ought to be merely a technical problem.

VII. Consequences to Holders of FPAs

As discussed earlier, the sponsor will sometimes enter into an FPA with the SPAC under which it will commit to acquire additional shares in the SPAC for a fixed price if the SPAC consummates a business combination transaction. This section discusses whether and how the section 1260 constructive ownership rules and the PFIC rules apply to those agreements, and it considers whether a warrant that is deep in the money when acquired should be treated in the same manner for tax purposes. For ease of presentation, the discussion below assumes that the SPAC is classified as a PFIC for tax purposes.

A. Section 1260

Section 1260 provides for special rules that apply to a taxpayer that enters into a “constructive ownership transaction with respect to” a passthrough entity. For this purpose, a forward contract is treated as a constructive ownership transaction,117 and a PFIC is treated as a passthrough entity.118 As a result, an FPA for a SPAC appears to be subject to the section 1260 constructive ownership rules.

It may be possible to argue, however, that an FPA should not be treated as a forward contract for this purpose because, as discussed in Section VI regarding SPAC warrants, the sponsor will acquire the SPAC shares only if the SPAC completes a de-SPAC transaction. Under this theory, section 1260 applies only to delta-one contracts, and the forward contract in this case is not delta one because the sponsor might not purchase the shares that are the subject of the FPA. The difficulty with this argument is that section 1260 defines the term “forward contract” as “any contract to acquire in the future (or to provide or receive credit for the future value of) any financial asset.”119 Unlike other definitions of a forward contract, which require that the contract provide for a fixed purchase price for a fixed amount of property so that the holder has a delta-one position,120 the section 1260 definition does not include that requirement. As a result, section 1260 would seemingly apply to forward contracts that do not give the holder a delta-one position on the reference asset. Section 1260(g)(2) acknowledges this result when it directs Treasury to issue regulations that would “exclude certain forward contracts which do not convey substantially all of the economic return with respect to a financial asset.” Thus, assuming this regulatory delegation is self-executing,121 the result is that section 1260 would apply to forward contracts for PFICs that are not delta one but that convey substantially all the economic return of the PFIC.

While far from clear, it is likely that a typical FPA for a SPAC does convey substantially all the economic return of the reference SPAC shares, particularly if the shares are actually purchased under the contract, because it is relatively rare for a SPAC to be liquidated without completing a de-SPAC transaction. If that were not the case, taxpayers could avoid section 1260 by entering into forward contracts that will not be completed if a remote contingency occurs.122 Finally, it is questionable whether the de-SPAC transaction should even be viewed as a contingency for this purpose because the sponsor, which is the holder of the FPA, can generally control whether the de-SPAC transaction will occur.123

If the FPA is subject to section 1260, the excess gain amount (as defined below) for the FPA will be subject to tax at ordinary income rates upon the physical settlement of the FPA, even though physical settlement of a forward contract is generally not a recognition event for tax purposes.124 Moreover, that income will be treated as recognized over the term of the FPA and will thus be subject to an interest charge.125

For this purpose, the excess gain amount will generally equal the excess (if any) of (1) the excess of the value of the shares that the sponsor receives upon exercise of the FPA over the exercise price under the FPA (that is, the built-in gain in the FPA) over (2) the amount of long-term capital gain that the sponsor would have recognized if it had purchased the reference shares under the FPA on the date that it entered into the FPA and sold those shares on the date that it exercised the FPA.126 In other words, this is intended to capture any long-term capital gain that the sponsor would recognize upon a disposition of the FPA that exceeds the long-term capital gain that it would have recognized if it had instead purchased the reference shares under the FPA.

The computation of the excess gain amount in the case of a forward contract for a PFIC will depend on whether one assumes that the holder would have made a QEF election for the shares that are the subject of the hypothetical sale. This could be illustrated by an example in which the sponsor enters into an FPA for one SPAC share that has an exercise price of $10. Assume that the SPAC shares were sold to the public for $10 per share on the date that the FPA was executed; the FPA is exercised more than one year later when each SPAC share has a value of $15; and the SPAC did not recognize any net income or distribute any dividends during the term of the FPA. In that case, if the sponsor is assumed to not have made a QEF election for the shares in the hypothetical sale, it would have (1) recognized $5 of ordinary income, and no long-term capital gain, on the hypothetical sale because all the gain would be treated as ordinary income under the PFIC rules; and (2) recognized $5 of capital gain if it were to dispose of the FPA. Accordingly, the sponsor would recognize $5 of “excess gain,” which would be subject to current tax at ordinary income rates and subject to an interest charge.

By contrast, if the sponsor is assumed to have made a QEF election for the shares in the hypothetical sale, the sponsor would have recognized $5 of capital gain in the hypothetical sale because (1) the share would be in a pedigreed QEF that would not be subject to the PFIC rules; and (2) the sponsor would not have recognized any ordinary income under the QEF election if it had directly held the share (because we assumed above that the SPAC did not recognize any net income during the term of the FPA).127 Under this approach, the excess gain amount would be zero, and the sponsor would therefore not be subject to any adverse tax consequences as a result of the application of section 1260 to the FPA.128

Although no authority addresses this issue, the sponsor would presumably compute the gain in the hypothetical sale as if it had made a QEF election if it in fact holds at least one share of the SPAC during the entire term of the FPA that is subject to a QEF election. As discussed in Section VI, a QEF election is not specific to particular shares, so if the sponsor were to hypothetically hold the shares that are the subject of the FPA, those shares would have been subject to a QEF election. Accordingly, the sponsor should be mindful to make a QEF election for the shares that it directly holds in the SPAC (which it would presumably do in any case so that it is not subject to adverse tax consequences for the shares). Further, in some cases, a sponsor may hold the shares in a different entity than the entity that holds the FPA. If that is the case, the sponsor should make sure that the entity that holds the FPA also holds at least one share of the SPAC that is subject to the QEF election.129

B. Application of PFIC Rules to FPAs

If an FPA is subject to section 1260, it should not be subject to the PFIC regime. Even if a forward contract for SPAC shares could be viewed as an option to acquire shares (and there are strong arguments to the contrary),130 section 1260, which was added to the code more than a decade after the PFIC option rule,131 provides that a forward contract for a PFIC is subject to the section 1260 constructive ownership rules. It is inconceivable that Congress intended that a forward contract for a PFIC should be subject to both section 1260 and the PFIC rules, because both are designed to prevent a taxpayer from deferring the inclusion of income and converting ordinary income into capital gain. Further, if Congress did so intend, it surely would have said so in either the section 1260 statute or legislative history and would have provided for coordinating rules so that the same item of income is not subject to both regimes.

C. Deep-in-the-Money Warrants

As discussed in Section VI, a warrant that is issued by a SPAC that is a PFIC could be subject to the PFIC regime, although there are strong arguments to the contrary. A warrant could, however, be acquired in the secondary market when the warrant is deep in the money and is substantially certain to be exercised.132 In that case, the warrant might be treated as a forward contract, rather than an option, for tax purposes.133 If that is the case, the warrant would be treated like the FPAs described earlier and thus would likely be subject to the section 1260 constructive ownership rules rather than the PFIC option rules.

VIII. De-SPAC Transactions

This section discusses the PFIC-related issues that arise when a SPAC that is a PFIC consummates a de-SPAC transaction. It addresses the two most common de-SPAC structures for a foreign SPAC: a purchase by the SPAC of a foreign target (often after a reincorporation in the target’s jurisdiction) and a purchase by the SPAC of a domestic target after a reincorporation in the United States. Although many non-PFIC issues arise in these transactions, such as general reorganization and section 367 issues, this discussion is limited to issues that are unique to PFICs that engage in these de-SPAC transactions.

A. Section 1291(f)

As background, section 1291(f) provides that “to the extent provided in Regulations,” a transfer of PFIC stock in a transaction that is otherwise subject to nonrecognition treatment will be treated as a taxable transaction despite the general nonrecognition rule. The IRS issued proposed regulations in 1992 that implement this provision, subject to exceptions that, as discussed below, may apply to some de-SPAC transactions.134 The proposed regulations have never been finalized, but like the proposed regulations regarding PFIC options, they have an effective date of April 1, 1992, when finalized.

The language in section 1291(f) and the proposed regulations raise many of the same issues that are discussed in Section VI regarding PFIC options, in which there are a similar statutory delegation and proposed regulations that could be finalized with a 1992 effective date. As noted, in examining whether statutory provisions that call for regulations are self-executing, courts have generally divided regulatory authorizations into two categories: regulations that will define whether a rule applies and regulations that will delineate how a rule applies. If the regulations would be “whether” regulations, the regulatory delegation is typically not applied until the regulations are issued. But if the regulations would be “how” regulations, the courts often apply the rule even in the absence of regulations. Like the section 1298(a)(4) discussion above, the section 1291(f) regulatory authorization is seemingly a “whether” authorization because the operative language is preceded by the phrase “to the extent provided in regulations.” This language supports the position that section 1291(f) should not be effective in the absence of final regulations.

However, as discussed earlier, in considering whether a regulatory delegation is self-executing, the courts have also considered the applicable legislative history to determine whether Congress intended that the regulations be self-executing in the absence of final regulations. For section 1291(f), the conference report states that “the conferees intend this regulatory authority to be exercised in cases where the deferred tax and interest inherent in the appreciation of the PFIC stock are potentially avoidable.”135 Thus, Congress presumably intended that Treasury issue regulations that would prevent a holder of PFIC stock from avoiding the PFIC rules by disposing of PFIC stock in a nonrecognition transaction (such as a reorganization transaction) in exchange for shares that are not subject to the PFIC rules. Accordingly, the IRS might apply section 1291(f) or the proposed regulations to a de-SPAC transaction in which a holder of securities of a SPAC that is a PFIC exchanges those securities in a nonrecognition transaction for securities that would not be subject to the PFIC rules. In fact, the IRS adopted that position in two private letter rulings stating, with no discussion regarding the lack of final regulations, that section 1291(f) turns off the nonrecognition rules for a transfer of PFIC shares when the transferor is no longer subject to the PFIC rules after the transfer.136

Further, even if one takes the position that section 1291(f) is not self-executing in the absence of final regulations, the proposed regulations could be finalized with the original 1992 effective date, in which case a de-SPAC transaction that is consummated before the issuance of the final regulations could retroactively be subject to section 1291(f). But, as similarly discussed in Section VI, one would hope that Treasury would revisit the effective date of the rules after 29 years of further consideration, at least for taxpayers that filed tax returns before the issuance of the final regulations.137 Treasury may be less likely do so, however, in the case of a SPAC nonrecognition transaction in which the investor has arguably avoided the PFIC rules than in the case of a SPAC warrant in which there is clearly no abuse or inappropriate avoidance of the PFIC rules.

Thus, section 1291(f) might apply to a de-SPAC transaction that is completed before the issuance of final regulations under section 1291(f).138 Accordingly, the following discussion considers the application of section 1291(f) to the most common types of de-SPAC transactions.

B. Foreign Target

If a SPAC that is a PFIC acquires a foreign target139 in a de-SPAC transaction and does not reincorporate before the transaction, the SPAC shareholders would not be subject to any tax consequences upon the purchase because they will not dispose of their SPAC shares in the transaction.140 In many cases, however, the SPAC will first reincorporate in the jurisdiction of the target in an F reorganization. This implicates section 1291(f) because the holders of SPAC shares and warrants would then exchange shares and warrants of the SPAC for shares and warrants of a new SPAC in a nonrecognition transaction that could then be treated as a taxable transaction under section 1291(f).141 The section 1291(f) proposed regulations, however, provide that section 1291(f) does not apply to an F reorganization between two foreign corporations.142 Accordingly, the holders of the SPAC shares and warrants should not be subject to tax on the reincorporation transaction.143

C. Domestic Target

If a foreign SPAC acquires a domestic target, the SPAC would generally reincorporate in the United States in an F reorganization and then acquire the domestic target. As discussed earlier, this would implicate section 1291(f) because the holders of the SPAC shares and warrants would exchange their SPAC securities in a transaction that would be taxable in the absence of the section 368 reorganization rules.144 Moreover, unlike the case of an F reorganization between two foreign corporations, the section 1291(f) proposed regulations do not provide an exception to section 1291(f) for an F reorganization in which a foreign PFIC merges or converts into a domestic corporation.145 The section 1291(f) proposed regulations, however, provide that shares of a pedigreed QEF (generally, shares for which a QEF election has always been in effect for the shareholder) will not be subject to the section 1291(f) recognition rules.146 Accordingly, if a holder of SPAC shares has made a QEF election for its SPAC shares, section 1291(f) would not treat the domestication transaction as a taxable transaction even if section 1291(f) is treated as self-executing or the proposed regulations are finalized with a retroactive effective date.147

Another consideration is that a holder of SPAC shares will generally recognize gain under section 367(b) in the domestication transaction unless it elects to include its share of the earnings of the SPAC in income in connection with the transaction.148 A holder that has gain in its SPAC shares and that made a QEF election for the shares should make this election because it would have already included its share of the SPAC’s income under the QEF election. The holder should accordingly have no further income inclusion as a result of the section 367(b) election. Further, this election will generally be beneficial to an investor that has gain in its SPAC shares even if it did not make a QEF election for its shares because, as discussed in Section V, a SPAC will generally recognize minimal income (if any) before the de-SPAC transaction. The investor will therefore have a minimal income inclusion (and possibly no income inclusion) as a result of the section 367(b) election. Moreover, a holder that makes this election would arguably have a stronger argument that section 1291(f) should not apply to the domestication transaction, because it would not have converted its share of the SPAC’s ordinary income into capital gains as a result of the domestication transaction. In other words, the investor could argue that the same policy considerations that exempt an investor that made a QEF election from section 1291(f) should equally apply to an investor that made a section 367(b) election, because the investor in both cases included its share of the PFIC’s ordinary income.149

As discussed in Section VI, a holder of warrants cannot make a QEF election for its warrants. As a result, a warrant holder would not qualify for the section 1291(f) exception for shares that are subject to a QEF election. If one adopts the position that warrants are subject to the PFIC rules, a holder of warrants in a SPAC that is a PFIC would recognize gain (if any) in a domestication transaction if the section 1291(f) regulatory delegation is self-executing or if the proposed regulations are finalized with a retroactive effective date.150

IX. Conclusion

We return to the three questions that are inherent in the single question posed by the title of this report.

First, will a foreign SPAC be treated as a PFIC for tax purposes? A SPAC will generally be a PFIC unless it qualifies for the start-up exception. Many, and perhaps most, foreign SPACs will qualify for the start-up exception and will accordingly not be classified as a PFIC. Many foreign SPACS, however, particularly those with a longer period between the IPO and the de-SPAC transaction, will not qualify for the start-up exception and will thus be classified as a PFIC.

Second, should foreign investors in a foreign SPAC care if the SPAC is classified as a PFIC? A holder of SPAC shares that makes a QEF election will generally not be subject to significant adverse tax consequences if the SPAC is classified as a PFIC, subject to the discussion above regarding the possible recognition of phantom income in the year of the de-SPAC transaction. An investor, however, will be subject to special tax reporting obligations under the PFIC rules, and the QEF regime could cause an investor’s tax returns to be subject to additional complexity. Further, a taxpayer would need to determine whether the SPAC is a PFIC, which may not be obvious based on the financial information that is provided by the SPAC. Although these reporting issues will generally be immaterial for institutional and sophisticated taxpayers, they may be significant for individual investors and could potentially dissuade them from investing in shares of a foreign SPAC.

A holder of SPAC warrants may be subject to adverse tax consequences if the SPAC is a PFIC and the warrants are subject to the PFIC rules. We believe, however, that the warrants are likely not subject to the PFIC rules, although the proposed regulations might be finalized in a manner that would retroactively cause the warrants to be subject to the PFIC rules. Further, it may be possible to structure the warrants in a manner that would strengthen the position that the warrants are not subject to the PFIC rules even if the proposed regulations are finalized.

A holder of an FPA for SPAC shares will likely be subject to the section 1260 constructive ownership rules rather than the PFIC rules. Although not entirely clear, it is likely that the holder of the FPA will not be subject to adverse tax consequences if it holds SPAC shares for which it made a QEF election, subject to the discussion above regarding the possible recognition of phantom income in the year of the de-SPAC transaction.

Finally, should the IRS care if the SPAC is a PFIC? For a typical SPAC, the answer is clearly no. The PFIC rules were intended to prevent shareholders in an investment company (hence the term “investment company” in PFIC) from deferring the inclusion of investment income and the conversion of ordinary investment income into capital gain. For a SPAC, that deferral or conversion will be minimal (if any) and immaterial. Further, a SPAC is far removed from an investment company — no one is investing in a SPAC to realize investment income; rather, investors are seeking the possibility of investing in the target that is acquired in the de-SPAC transaction.

FOOTNOTES

1 Deal Point Data, “Special Purpose Acquisition Company (SPAC) Market Study” (Apr. 2021).

3 In addition to the completed first-quarter SPAC IPOs, there were an additional 172 SEC filings for SPAC IPOs that were not completed in the first quarter. Deal Point Data, supra note 1.

4 As of May 1, 2021, according to SPACInsider, there were 424 SPACs that were registered with the SEC that had not yet announced a business combination transaction.

5 Id.

6 The amount that the sponsor pays for its 20 percent interest in the SPAC will be a de minimis amount compared with the price that the public investors pay for their shares in the SPAC. The sponsor generally takes the position that the difference between the price that it pays for its shares and the price that the public pays for their shares should not be treated as taxable compensation income to it. The reasoning is that when the sponsor formed the SPAC, its success was speculative because it had no agreements or understandings at that time regarding a future IPO or business combination. A discussion of the merits and risks of this tax position is beyond the scope of this report.

7 The de-SPAC transaction is generally structured as the SPAC’s purchase of the target, rather than as a purchase of the SPAC by the target, because it is questionable whether a SPAC can satisfy the section 368 continuity of business enterprise requirement to treat the latter transaction as tax free for the SPAC shareholders.

11 Id.

12 Id. The regulations also allow for the use of a measuring period that is more frequent than quarterly, but as discussed infra note 29, this alternative will generally not be beneficial to a SPAC.

15 Notice 88-22, 1988-1 C.B. 489.

16 Prop. reg. section 1.1297-1(d)(2). The working capital exception applies only to cash that (1) is held in a non-interest-bearing account, (2) is held for the present needs of an active trade or business, and (3) is no greater than the amount necessary to cover operating expenses incurred in the ordinary course of business of the corporation that are reasonably expected to be paid within 90 days.

17 As discussed above, the working capital exception in the 2021 proposed regulations requires that the cash be held in a non-interest-bearing account, thereby implying that the cash would be treated as a passive asset if it does not satisfy the other requirements of the working capital exception.

20 The 2021 proposed regulations include an exception to the antiabuse rule that would apply if the second-tier domestic subsidiary is engaged in an active trade or business within 36 months after formation. Even if this rule is finalized (or the taxpayer elects to apply the exception before it is finalized), it will be of limited use to a SPAC because, as discussed above, most foreign SPACs acquire a foreign target, in which case the domestic subsidiary would not have a domestic trade or business. Further, even if the SPAC acquires a domestic target, it will seemingly need to merge the target into the second-tier domestic subsidiary so that it would have an active trade or business.

21 Although the antiabuse rule was introduced in 2019 proposed regulations, they were effective only as of the date of the issuance of final regulations.

22 This assumes that the target will have enough active assets so that the SPAC would not be a PFIC in the years after the de-SPAC transaction. Also, a SPAC will generally not qualify for the start-up exception if the de-SPAC transaction is carried out through a double-dummy transaction in which the SPAC is contributed to a new holding company, because in that case the SPAC will generally continue to hold only passive assets after the de-SPAC transaction.

23 The total amount of SPAC cash can be affected by several factors other than the SPAC’s initial IPO. For example, the SPAC could receive additional cash from a PIPE investment, the FPA, the exercise of warrants, and cash held by the target. Conversely, the target might use the SPAC’s cash to de-leverage, which would reduce the amount of passive assets.

24 Before the issuance of the 2021 final regulations, it was unclear whether the asset test quarterly averaging should be applied as described above or based on the average of the quarterly percentage ratios of the company’s passive assets to its total assets. For example, under the latter approach, if 100 percent of a SPAC’s assets were passive at the end of the first two quarters and all the SPAC’s assets were active at the end of the third and fourth quarters, the SPAC would be a PFIC for that year because its passive asset fraction would be 50 percent. Under this approach, a SPAC would be a PFIC in the year that it completes the business combination unless it completes the transaction before the close of the second quarter. Under the 2021 final regulations, however, the second quarter no longer represents a bright line for PFIC status in a particular year.

25 We assume for purposes of this example that the SPAC has a calendar tax year.

26 This assumes that, as is often the case in a de-SPAC transaction, the SPAC delivers solely SPAC shares, and none of its cash, to target shareholders in the de-SPAC transaction. In many cases, however, the SPAC’s cash amount will increase in the de-SPAC transaction if it attains additional funding through a PIPE transaction or the issuance of additional shares under an FPA.

27 In reality, the target will generally have some amount of passive assets (such as cash), but we have assumed that it would not have any passive assets for purposes of simplicity in the computation. However, in the first example that follows, the SPAC would still satisfy the asset test even if the target has $40 million of passive assets, because the numerator of the passive asset fraction would then be $320 million ($1.28 billion/4), and the denominator of the passive asset fraction would then be $645 million ($2.58 billion/4), which results in a passive asset fraction of 49.6 percent.

28 The value of a target will generally be primarily attributable to goodwill that is allocable to the target’s active business, and the amount of the goodwill would typically be measured based on the market value of the SPAC’s shares. Accordingly, whether the SPAC is a PFIC in the year of the business combination will often depend on the market value of the SPAC shares on September 30 and December 31 of the combination year.

29 There is $300 million of cash at the end of each of four quarters. It is also possible to adopt a more granular measuring period under reg. section 1.1297-1(d)(1)(ii), but in most SPAC fact patterns this would make the passive asset percentages higher, not lower.

30 There is $1.2 billion of passive assets, plus $800 million (gross) of additional active assets at the end of the third and fourth quarters.

31 A SPAC will usually satisfy the income test in the combination year because even if the de-SPAC transaction occurs late in the year, the target will usually have gross active income that far exceeds the SPAC’s interest income. The income test is based on income over the entire year and not based on quarterly averages, so the gross active income of the target for a short period in the second year will generally enable the SPAC to satisfy the income test. That may not be the case, however, if the target is still in a research and development phase, in which case, it may have no (or only a minimal amount) of gross revenue.

32 There is $300 million of passive assets at the end of each quarter and an additional $1.3 billion of active assets at the end of the fourth quarter only.

33 Assuming it has a calendar tax year, a SPAC formed in March could have up to 21 months to complete a business combination and still qualify for the start-up exception. In contrast, a SPAC formed in December would have a maximum of 13 months to complete a business combination if it wanted to rely on this exception.

34 A foreign corporation (other than some CFCs) generally has a tax year that is the same as its fiscal year. Section 441.

35 Section 898. The sponsor partnership would generally be required to use a calendar tax year because its partners are typically U.S. individuals who are required to use the calendar year as their tax year.

37 There have been no regulations or other interpretive authority on the application of this portion of the start-up exception.

38 The statutory language does not even state that the taxpayer is the party required to establish this information to the IRS. While that is presumably what is intended, the statute just states that “it is established” to the satisfaction of the IRS.

39 See, e.g., the discussion in Section VI below regarding a protective qualified electing fund filing.

40 FSA 2002 WL 1315676 (2002).

41 See Joint Committee on Taxation, ”General Explanation of the Tax Reform Act of 1986,” JCS-10-87, at 1023 (May 4, 1987) (“Congress recognized that U.S. persons who invested in passive assets through a foreign corporation obtained a substantial tax advantage vis-a-vis U.S. investors in domestic investment companies because they not only were able to avoid current taxation but also were able to convert income that would be ordinary income if received directly or received from a domestic investment company into capital gain income.”).

43 The term “excess distribution” is defined as any distribution that the holder receives from a PFIC (other than a distribution that a holder receives in the first year that it holds the SPAC shares) that is greater than 125 percent of the average distributions that the holder received from the PFIC in the preceding three years, or if less, the portion of the holder’s holding period that precedes the tax year of the distribution. Section 1291(b).

44 Although the excess distribution and qualified dividend rules will generally be irrelevant before the de-SPAC transaction because a SPAC will generally not pay any dividends in that period, they may be relevant if the SPAC pays dividends after the de-SPAC transaction.

46 The SPAC would then be treated as a pedigreed QEF for the shareholder, and the regulations provide that the PFIC rules do not apply to a pedigreed QEF. See reg. section 1.1291-1(b)(2)(v).

47 An electing shareholder may defer the payment of tax on these inclusions, although that deferral is subject to an interest charge. Section 1294(a).

51 The QEF rules do not provide an equivalent to the “closing of the books method” for a partnership under which a partnership can elect to periodically close its books so that a partner is not allocated income of a partnership for the portion of the year in which it is not a partner in the partnership. See section 1293(a) and reg. section 1.1293-1.

54 Alternatively, in the case of an indirect shareholder in a PFIC, the shareholder could obtain an intermediary statement that includes the same type of information as included in the annual information statement. Reg. section 1.1295-1(g)(3).

55 Reg. section 1.1295-1(g)(1)(iv). While a SPAC may understandably be reluctant to allow a shareholder access to its books and records, the shareholder will be permitted access only as is necessary to establish that the information in the annual information statement was computed in accordance with U.S. tax principles. Thus, as a practical matter, the shareholder should not require any information beyond the SPAC’s financial reports and any adjustments that were made to convert that information into the U.S. tax information included in the annual information statement.

56 The fact that a SPAC will be required to provide this information only if it determines that it is a PFIC may not be sufficient for shareholders, because a shareholder will often file its tax return for the first year of the SPAC when the SPAC is unsure whether it will qualify for the start-up exception. Thus, from an investor’s perspective, it would be preferable to state that the issuer will provide the annual information statement to a shareholder in a timely manner if there is a material possibility that the SPAC was a PFIC for the prior tax year. One would hope that a SPAC would provide the statement in such a case even if the offering document included the more restrictive language referenced above, particularly because it would require little work to do so.

57 The regulations require that the annual information statement be signed by the PFIC or an authorized representative of the PFIC, which presumably would be no more trouble than posting signed Forms 8937 (concerning transactions that affect basis), which is commonplace. Reg. section 1.1295-1(g).

58 The shareholder may want to consider filing for the maximum extension of its tax return because it may have better knowledge later in the year as to whether the SPAC was a PFIC in its first year. Further, if a taxpayer does not file for an extension and does not make a QEF election, it could still amend its return and make the QEF election before the final extension date for the return.

59 As discussed above, a SPAC shareholder could be subject to a material amount of increased tax if it makes a QEF election in the year of the de-SPAC transaction (assuming the SPAC is a PFIC in that year), but in that case, the shareholder should have sufficient information when it files its tax return for that year to determine whether the SPAC was a PFIC in that year.

61 There are two exceptions to the protective statement, but neither is particularly practical for SPACs. The first exception applies when the taxpayer holds less than 2 percent of the vote and value of the SPAC and when a public disclosure indicates either that the SPAC believes it should not constitute a PFIC or that it is more likely than not that the SPAC ultimately will not be a PFIC. Reg. section 1.1295-3(e). Current SPAC disclosures do not typically make either statement. The second exception can be obtained only through a private letter ruling, which is generally a cumbersome process. Reg. section 1.1295-3(f).

62 Reg. section 1.1295-3(c)(1). The statement must also include other more general information, including the name, address, etc. of the taxpayer; the name, address, and taxpayer identification number of the foreign corporation; and the highest percentage of each class of stock in the foreign corporation held by the taxpayer for the first year to which the protective statement applies.

64 The shareholder must also amend all open prior PFIC years and attach the election to the retroactive election years. Reg. section 1.1295-3(g)(2).

65 If the taxpayer files its tax return on October 15 and the SPAC has still not made any announcement regarding a business combination transaction, the shareholder would presumably not have basis for a reasonable belief that the SPAC was not a PFIC in its first year, because it would then be very unlikely that the SPAC will qualify for the start-up exception.

67 The shareholder would also recognize any mark-to-market loss in its shares at the end of each tax year, but only to the extent of the mark-to-market gain that it has included in income in prior tax years. Reg. section 1.1296-1(c).

68 For PFICs that are also CFCs, a deemed dividend election is also available. See reg. section 1.1298-3.

70 Sections 951 and 951A.

71 One distinction between a subpart F inclusion and a QEF inclusion is that subpart F income is always ordinary income, whereas a QEF inclusion could be capital gain if attributable to capital gain of the PFIC. This distinction, however, will generally be irrelevant in the case of a SPAC before a business combination transaction, because all the SPAC’s income would typically be ordinary income.

76 Prop. reg. section 1.958-1(d)(4). Specifically, a domestic partnership may make this election only if the partnership, its domestic partners that are U.S. shareholders, and any other related domestic partnerships also consistently apply the proposed regulations.

77 Specifically, the section 1297(d) legislative history states that “a shareholder that is subject to current inclusion under the subpart F rules with respect to stock of a PFIC that is also a CFC generally is not subject also to the PFIC provisions with respect to the same stock.” JCT, “General Explanation of Tax Legislation Enacted in 1997,” JCS-23-97, at 310 (1997).

78 For a further discussion of the application of the CFC/PFIC overlap rule to small partners in a CFC, see Michael J. Miller, “Will the Overlap Rule of Code Sec. 1297(d) Still Protect ‘Small’ Partners of Domestic Partnerships?” Int’l Tax J. (May-June 2020); Kimberley Blanchard, “Whether Treating a Domestic Partnership as an Aggregate Causes Small U.S. Partners to Become Subject to the PFIC Regime,” Int’l Tax J. (Dec. 13, 2019); and New York State Bar Association Tax Section, “Report on June 2019 GILTI and Subpart F Regulations,” Report No. 1423, at 54 and 62 et seq. (Sept. 18, 2019).

79 That is because the PFIC regulations provide that in the case of a domestic partnership that holds shares in a PFIC, a QEF election can be made only by the partnership and cannot be made by the partners in the partnership even though they are the taxpayers that would be affected by the QEF election. Reg. section 1.1295-1(d)(2)(i)(A).

80 In addition to the reporting requirements specific to PFICs, (1) U.S. holders of specified foreign financial assets (which can, in some cases, include stock of a foreign corporation) are also required to file information reports for those assets; and (2) an investor may be required to file a Form 926, “Return by a U.S. Transferor of Property to a Foreign Corporation,” upon a purchase of shares of a foreign SPAC in an initial offering (regardless of whether it is a PFIC).

83 Prop. reg. section 1.1291-1(d).

86 See reg. section 1.1296-2(a) and (e) (reserving on the treatment of options as marketable stock).

87 See Estate of Neumann v. Commissioner, 106 T.C. 216, 219-221 (1996) (summarizing cases).

88 See, e.g., International Multifoods Corp. v. Commissioner, 108 T.C. 579 (1997). See also Amandeep Grewal, “Substance Over Form? Phantom Regulations and the Internal Revenue Code,” 7 Hous. Bus. & Tax J. 42, 45 (2006); and Phillip Gall, “Phantom Tax Regulations: The Curse of Spurned Delegations,” 56 Tax L. 413 (2003).

89 15 West 17th St. LLC v. Commissioner, 147 T.C. 557, 574 (2016).

90 Id. at 581.

91 Id. at 578-579.

92 Id. at 563-567.

93 See, e.g., section 2663, examined by the Estate of Neumann court, which concluded that the statutory provision was self-executing. Accord section 59A(i).

94 H.R. Rep. No. 100-76, at 501-502 (1987) (Conf. Rep.).

96 Under section 7805(b), Treasury is technically permitted to issue regulations that are effective on the date those regulations were proposed in the Federal Register.

97 See Badaracco v. Commissioner, 464 U.S. 386, 397 (1984); and P.H. Glatfelter Co. v. Lewis, 746 F. Supp. 511, 519 (E.D. Pa. 1990); see also American Bar Association Section of Taxation, “Specific Tax Issues Raised by the Fall of DOMA” (2013). But see Notice 89-103, 1989-2 C.B. 443 (stating, regarding a retroactive increase in the alternative minimum tax liability, that affected taxpayers “will need to recompute their AMT liability for 1987, generally using . . . [Form] 1040X, ‘Amended U.S. Individual Income Tax Return.’”).

98 The section 318 constructive ownership rules are naturally analogous to the PFIC constructive ownership rules.

99 Rev. Rul. 68-601, 1968-2 C.B. 124.

100 Rev. Rul. 89-64, 1989-1 C.B. 91.

101 See LTR 200036025 and LTR 199914032.

102 LTR 200036025.

103 Specifically, according to SPACInsider, 26 SPACs liquidated between 2010 and 2020 without completing a business combination transaction.

104 The IRS may have a stronger argument that the business combination contingency is an insubstantial condition precedent for this purpose in the case of a taxpayer that acquires the warrant after the de-SPAC transaction has been announced. Even in that case, however, the taxpayer could assert that the closing conditions constitute a substantial contingency and that the warrants therefore still should not be treated as a contract to acquire SPAC shares for purposes of the PFIC rules.

105 The IRS might, however, take the position that the cash settlement option is an insubstantial condition precedent if the issuer is economically compelled to physically settle the warrant or if in fact no SPAC ever cash-settles a warrant that includes the cash settlement option.

106 Prop. reg. section 1.1291-1(d). The proposed regulations are relevant both because they could still be finalized with retroactive effect and because they provide insight regarding the government’s position (even though, in this case, the position is not recent).

107 The preamble to the proposed regulations, however, states that the PFIC rules “recognize that the value of an option is linked to the value of the underlying stock and therefore such an option should be subject to the PFIC rules.” This statement might be interpreted as implying that the option rules should also apply to a cash-settled option.

108 See sections 544(a)(3) and 1563(e)(1); and reg. sections 1.958-2(e), 1.544-4, and 1.1563-3(b)(1).

109 Chock Full O’Nuts Corp. v. United States, 453 F.2d 300 (2d Cir. 1971).

110 Id. at 305. The courts have also held that an instrument may be bifurcated in some cases if one component could remain outstanding independent of the other component. See Farley Realty Corp. v. Commissioner, 279 F.2d 701, 703-704 (2d Cir. 1960). In this case, the preferred share component of the convertible preferred and the warrant component of the convertible preferred could not remain outstanding independent of the other.

111 See Schering-Plough Corp. v. United States, 651 F. Supp. 2d 219 (D.N.J. 2009), aff’d sub nom. Merck & Co. Inc. v. United States, 652 F.3d 475 (3d Cir. 2011) (holding that a complex set of financial instruments could be recharacterized, in part, because the transaction structure was tax-motivated).

113 Prop. reg. section 1.1291-1(h)(3).

114 As discussed in Section V, the holder could make a purging election and thereby remove the PFIC taint. But that would require the holder to recognize any built-in gain in the warrants, and that gain would be ordinary income that is subject to an interest charge.

120 See, e.g., section 1259(d)(1) (“the term ‘forward contract’ means a contract to deliver a substantially fixed amount of property (including cash) for a substantially fixed price”).

121 Unlike the regulatory delegations under sections 1298(a)(4) and 1291(f) that are discussed elsewhere in this report, this delegation states that the secretary “shall” issue regulations. As discussed in Section VI, the courts have viewed this type of delegation as “how” regulations that are often self-executing in the absence of final regulations.

122 This differs from the similar section 318 discussion above because the objective of those provisions is to determine whether the taxpayer should be treated as constructively owning the reference shares, and they therefore focus on whether the taxpayer has a unilateral right to acquire the shares (see the revenue rulings discussed above). By contrast, section 1260 does not focus on the taxpayer’s ability to acquire the reference shares; rather, it targets contracts that provide an economic return that replicates ownership of the reference asset. Thus, a forward contract that is subject to a remote (but substantial) contingency will likely be subject to the section 1260 constructive ownership rules but not to the section 318 or 1298 constructive ownership rules.

123 Although the shareholders could vote against the de-SPAC transaction and thereby prevent its completion, that presumably rarely (if ever) occurs, particularly because the sponsor and its affiliates control a large portion of the SPAC shares.

127 Although this may be a realistic assumption for years that close before the de-SPAC transaction (because the SPAC will have minimal net income and it may be completely offset by expenses), it may not be a realistic assumption if the SPAC is a PFIC in the year of the de-SPAC transaction because, as discussed in Section V, a shareholder that makes a QEF election would then include its share of the income of the target for the period after the combination transaction. In that case, the sponsor could have a material “excess gain” inclusion under section 1260 even if the hypothetical sale is computed by reference to the gain that it would have recognized if it had made a QEF election.

128 A sponsor that is a U.S. shareholder in a SPAC that is a CFC and is subject to the CFC/PFIC overlap rule discussed above should arrive at the same result, because it would not have been subject to the PFIC rules if it had hypothetically owned the shares that are the subject of the FPA.

129 A QEF election for one entity does not apply to an affiliated entity.

130 First, all the arguments discussed in Section VI about why a warrant might not be treated as an option to acquire PFIC shares under current law would equally apply to the FPA. Second, it might be possible to argue that a forward contract technically does not constitute an option to acquire because the holder of a forward contract has no option to choose whether to acquire the reference shares. The latter argument, however, is difficult to sustain as a policy matter, because before the issuance of section 1260, there would be more of a reason to subject a forward contract to the PFIC rules than to subject an option to the PFIC rules.

131 Section 1298(a)(4) was added to the code with P.L. 100-647 in 1988 (at which time it was numbered 1297(a)(4)); section 1260 was added to the code with P.L. 106-170 in 1999.

132 Presumably, a deep-in-the-money warrant would be viewed as substantially certain to be exercised for this purpose only if the SPAC has completed, or at least has agreed to enter into, the business combination transaction.

133 See Rev. Rul. 85-57, 1985-1 C.B. 182 (treating a deep-in-the-money put option sold by the taxpayer as a forward contract for purposes of the wash sale rules).

134 Prop. reg. section 1.1291-6.

135 H.R. Rep. No. 100-1104, at 12, 28-29 (1988) (Conf. Rep.).

136 LTR 8946048 (“Unless otherwise provided in regulations under section 1291(f), a gift of appreciated stock of a PFIC will result in the donor’s recognition of gain.”); and LTR 9007014 (“Pursuant to section 1291(f), gain generally is recognized to a shareholder on the transfer of stock of a PFIC to which section 1291 applies notwithstanding section 332 or 337 or any other applicable nonrecognition provision.”).

137 Further, as discussed in Section V, it is unclear whether a taxpayer that files its tax return before the issuance of final regulations would be required to affirmatively amend its return to reflect the retroactive application of the final regulations.

138 For a further discussion of whether section 1291(f) applies in the absence of final regulations, see Miller, “Is Code Section 12927(f) Self-Executing?” Int’l Tax J. (Jan.-Feb. 2021).

139 As discussed above, supra note 7, the de-SPAC transaction is generally structured as the purchase by the SPAC of the target, rather than a purchase by the target of the SPAC, because it is questionable whether a SPAC can satisfy the section 368 continuity of business enterprise test in order to treat the latter transaction as tax free for the SPAC shareholders. Accordingly, the discussion in this section addresses a case in which the SPAC acquires the target. If the target instead acquires the SPAC and one adopts the position that the target satisfies the continuity of business enterprise test, section 1291(f) could require the SPAC shareholders (and warrant holders if one treats the warrants as subject to the PFIC rules) to recognize gain in the transaction even though the transaction may otherwise constitute a nonrecognition transaction.

140 However, as discussed in Section V, the SPAC may be a PFIC in the year of the de-SPAC transaction, in which case a QEF election for that year may be more complex and adverse to investors. Also, even if the SPAC is not a PFIC in tax years that begin after the de-SPAC transaction, the SPAC will continue to be treated as a PFIC for the SPAC shareholders that did not make one of the elections described above and for warrant holders (if one takes the position that the warrants are subject to the PFIC rules) under the “once a PFIC, always a PFIC” rule.

141 Section 1291(f) would be implicated for the warrants only if one treats the warrants as subject to the PFIC rules. See the discussion in Section VI.

142 Prop. reg. section 1.1291-6(c)(1)(i). A holder of shares or warrants would have to include an attachment to the Form 8621 for the year in which the reincorporation transaction occurs. That attachment would include (1) a complete description of the transaction; (2) the name, address, and taxpayer identification number of the foreign transferor corporation and the new domestic corporation; and (3) a statement citing the applicable exception to the gain recognition rule and stating why the exception is applicable. Prop. reg. section 1.1291-6(g).

143 The IRS or a court could conceivably assert that the transaction is taxable based on the position that the delegation in section 1291(f) is self-executing and that the exception in the proposed regulations for F reorganizations is not effective because they have not been finalized. While theoretically possible, the IRS is presumably unlikely to adopt that position because (1) the proposed regulations represent the only authority regarding the application of section 1291(f), and they have been outstanding for close to 30 years; and (2) this is not the type of transaction that Congress intended to be subject to section 1291(f) because shares and warrants of the new SPAC would be subject to the PFIC rules in the same manner as shares and warrants of the original SPAC.

144 Section 1291(f) would be implicated for the warrants only if one takes the position that the warrants are subject to the PFIC rules. See the discussion in Section VI.

145 This makes sense as a policy matter because securities of the domestic corporation would not thereafter be subject to the PFIC rules.

146 Prop. reg. section 1.1291-6(a)(3). As discussed in Section V, it is generally advisable for a holder of shares of a foreign SPAC that may be a PFIC to make a QEF election, and there will generally be minimal (if any) adverse tax consequences to the holder as a result of the election.

147 Similar to the discussion in supra note 143, the IRS or a court could conceivably assert that the transaction is taxable based on the position that the delegation in section 1291(f) is self-executing and that the exception in the proposed regulations for shares that are subject to a QEF election is not effective because they have not been finalized. While theoretically possible, it is presumably very unlikely that the IRS will adopt that position because (1) the proposed regulations represent the only authority regarding the application of section 1291(f), and they have been outstanding for close to 30 years; and (2) this is not the type of transaction that Congress intended to be subject to section 1291(f) because the holder of the PFIC shares would have included its current share of the income of the PFIC under the QEF election.

148 Reg. section 1.367(b)-3(c). The section 367(b) gain recognition and alternative election rule described above does not apply to some small shareholders and applies differently to holders that hold 10 percent or more of the vote or value of the foreign corporation. Further, a holder that makes the section 367(b) election described above must comply with detailed reporting requirements to validate the election. A comprehensive discussion of these rules is beyond the scope of this report because they equally apply to a domestication of a foreign SPAC that is not a PFIC.

149 The IRS could respond that a holder that makes a section 367(b) election and no QEF election would (in the absence of section 1291(f)) convert the ordinary income that it would have recognized upon a sale of the SPAC shares into capital gain upon the sale of the shares of the successor domestic corporation. Also, if the foreign SPAC has current earnings, a holder that makes the section 367(b) election and no QEF election would defer the inclusion of its share of the SPAC’s income. The IRS may therefore assert that section 1291(f) should apply upon the domestication transaction to a holder that did not make a QEF election, even if the holder elects to include its share of the SPAC’s income under the section 367(b) election.

150 However, see the discussion in Section VI regarding why SPAC warrants are likely not subject to the PFIC rules under current law. If that is the case, a holder of SPAC warrants would not be subject to tax under section 1291(f) on the domestication transaction.

END FOOTNOTES

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