How SPACs Can Steer Clear of Year-End Tax Surprises

Special purpose acquisition companies (SPACs) were wildly popular in 2021 and 2022. SPACs were set up to raise capital through an initial public offering before having any commercial activity. Many of these companies were formed offshore in low- or no-tax jurisdictions such as the Cayman Islands or the British Virgin Islands. For the SPACs formed in these locations, state income tax considerations might initially seem irrelevant, but the reality is that many SPACs have incurred tax liabilities elsewhere.

Year-end analysis reveals tax impacts for SPACs—even those formed in a “low-tax” location

At year-end, some accounting and management teams have recently been surprised to learn about potential tax liabilities that exist in relation to their SPAC. Even if a SPAC entity is formed outside of the United States, it could create a taxable presence —or nexus— in a US jurisdiction due to the location of management, employees, or company property, including bank accounts. The capital raised by SPACs is typically held in trust interest-bearing accounts in the United States. In addition, executives employed by the SPACs live in the United States. These factors can create both US and state filing requirements.

In past cycles, it might have been common for tax parameters to be overlooked by a company if SPACs initially generated net operating losses, thus producing no federal or state income tax expense. More recently, with the increase in interest rates over the past year, the interest or dividend income earned could have created taxable income. Companies may now find themselves underreporting and underpaying taxes in certain jurisdiction(s) they had not previously considered as a taxable authority.

The failure to pay taxes is only one part of the equation. A failure to report state income tax expenses in financial statements can lead to other significant issues. If a SPAC underreports tax expenses in its 10-K and 10-Q filings, this could result in control deficiencies, qualified audit opinions, or restatements.

Identifying a SPAC’s applicable taxes via a nexus study

To mitigate the risk of control deficiencies and restatements, companies should consider performing a nexus study. The purpose of a nexus study is to determine whether a specific US state or an international jurisdiction may have a claim against the trust income due to the factors stated previously. To conduct a nexus study, the SPAC will need to ascertain the following:

1. Location(s) of directors, employees, or assets.
2. Local country tax implications.
3. Taxable income based on 2022 financial results and local tax laws.

The nexus study can be performed either as part of or in addition to a company’s regular uncertain tax positions evaluation and footnote disclosures. In practice, being proactive can support a smoother audit cycle, as at least one audit firm has recently indicated they will not sign off on a SPAC audit unless a nexus study is conducted—with the conclusions disclosed in the financial statements.

Individual shareholders and other tax considerations

Beyond corporate tax obligations, individual shareholders of the SPAC may be subject to state income tax. Federal and state tax laws may operate to tax any gains or dividends received by individuals from their investments in the SPAC.

Additionally, other relevant US tax laws may impact investors in the Cayman Islands, such as the Foreign Account Tax Compliance Act (FATCA) and the Base Erosion and Anti-Abuse Tax (BEAT). In each case, individuals should consult a tax professional for guidance on their specific tax situation.