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Starting next year, a provision of the Inflation Reduction Act (IRA) will impose a 1% excise tax on corporate stock buybacks, potentially impacting the special purpose acquisition companies (SPACs) that have served as a popular vehicle for taking a company public. SPAC activity has seen a sharp decline over the past year due to numerous regulatory changes by the Securities and Exchange Commission (SEC), and this latest provision could further hurt the market.
Despite the pessimism, partner Melanie Chen noted it is possible the excise tax will not affect SPACs. "There is a very high level of uncertainty as to how this excise tax is going to be applied to SPAC redemptions," she said. "It's not clear whether SPACs will be treated as an investment company. In the Inflation Reduction Act, there are specific exemptions for the investment companies. The SEC proposed rules to subject SPACs to investment company requirements. In general, the Inflation Reduction Act is not going to have a negative impact. The question is the level of the impact, and that's the biggest uncertainty."
SPACs could be vulnerable to the excise tax if the SPAC stock issued to shareholders does not offset any SPAC stock repurchases during the same taxable year. "Basically the excise tax is imposed on the net amount between the value of a repurchased stock and the value of the issued stock," Chen explained. "The net amount is what is subject to the 1% excise tax. But it's tricky because when a SPAC has a redemption — when it's either an extension or when it's expired — then investors will redeem their shares. When they redeem their shares, they may not have new shares issued and therefore there's no reduction in the repurchase price. For a SPAC that is doing a liquidation or a redemption without issuing new shares, the 1% excise tax could be costly."
And while more companies may choose to issue dividends over stock buybacks, SPACs may remain an exception. "For regular operating entities, it could be a strategy that many companies would consider, but for SPACs, they would not have the option to issue or distribute dividends because the lifespan of a SPAC for stock is short, like 12 or 18 months," she said. "It does not really make money and there is no profit to be distributed as dividends."
In the meantime, the market does anticipate more SPAC liquidations before the end of the year to avoid the excise tax. "Some of the SPACs expire in February and March of 2023, and those SPACs may accelerate their expiration," said Chen. "To liquidate like that would require a shareholder vote because the SPAC has not reached its official expiration date, but they want to avoid the excise tax and therefore they probably want to accelerate the liquidation. That's why the industry is expecting a rush of liquidation of SPACs before the end of the year and also acceleration of a closing off of transactions before the end of the year."
Many professionals are also looking for further guidance from the Treasury to address these tax issues. "One of the challenging issues with SPACs is making them only applicable to transactions in the same taxable year," said Chen. "For example, if a SPAC is extended three months and they get the extension in 2022, some shareholders or investors may have redeemed their shares in 2022. But then in 2023, if they've closed the transaction, they cannot net the shares that are being redeemed with the shares reissued in 2023. That is another challenge with SPACs that will also increase the cost."
Even when subject to the tax, there are concerns SPACs will not have the available liquidity to pay. "SPACs do not generate revenue," said Chen. "The only revenue they may generate is the interest income generated from the IPO proceeds saved in the trust account. For example, if they have a 2% interest rate and they generated some interest income, that interest income in many of those trust agreements can only be used to pay income tax and franchise tax. It cannot be used to pay any other expense. Even if it does not have that restriction, the interest income would not be sufficient to pay the 1% excise tax. Who's going to pick up that cost? It would be paid out of the working capital of a SPAC or be paid by a target."
Unfortunately, this could leave investors responsible for the bill and present a new area of focus for auditors. "Once we get to 2023, from an auditor's perspective, we will have to look at the SPACs' cash flow and the date of expiration," said Chen. "They probably have to start to accrue that excise tax in case there is a liquidation or reduction. If a SPAC does not have sufficient cash to pay the anticipated excise tax, that will probably generate a potential going-concern issue." And though the excise tax may slow the SPAC market further, "[the] excise tax only applies to domestic companies, and if you set up a company in the Cayman Islands, you could potentially avoid it," she pointed out. "So another trend you may see is that all the SPACs are set up somewhere offshore."
As the leader of UHY's China Group, Chen has extensive experience with SPACs in foreign jurisdictions and with international companies and sponsors. "UHY's specialty is our international capability, and that's why many sponsors and underwriters come to UHY when they have international components in their SPACs," said Chen. "We are really veterans in the SPAC space," she said. "I joined UHY in 2005 and we audited our first SPAC in 2006. At that time there were about 20 or 30 SPACs a year, and we audited about two or three SPACs a year. We audit approximately 50 SPACs, and most of them have international sponsors with the goal of acquiring a target outside of the U.S."
The next hurdle for SPAC sponsors is identifying companies to acquire and take public while contending with capital market volatility, high inflation, and rising interest rates. "For many of those investors, their funds are borrowed money, so when the interest rate is high, the cost of capital is higher," said Chen. "They have a limited source of capital to invest in SPACs. Investors have started to request additional interest that has to be paid by sponsors. In the past, if you put the money in trust, then you have a 2% Treasury bond as the fixed income. But now sponsors have to provide additional 1.5 or 2.5% interest to pay investors and make investors whole. The cost of doing SPACs has become significantly higher than 2020 and 2021. That is a major factor that has slowed down the SPAC market. In July, there was not a single SPAC IPO, which is the first time since the pandemic."
"Another factor that has slowed down SPACs is that there are so many SPACs looking for targets, and it's getting very competitive finding targets," said Chen. "We're seeing every day a transaction that's being terminated because targets are finding they have better deals doing a private placement than a merger with a SPAC. There are so many transactions being terminated because the market capital market is not doing well, and some companies decided to stay private instead of going public. That's another reason why there are more SPACs than quality targets or targets willing to do a transaction with SPACs."
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