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Canadian Tax Considerations for SPACs

July 13, 2021, 7:01 AM

If you follow Wall Street, you’ve undoubtedly witnessed the current boom of special purpose acquisition companies (SPACs). While not a new phenomenon, the market volatility brought on by Covid-19 has led to a surge in opportunities for SPACs to acquire private companies looking to go public.

Bay Street shows the opposite trend, as SPAC listings in Canada have declined. Several factors have contributed to this, including the shift in SPAC activity to U.S. markets and the maturation of the cannabis sector.

Irrespective of where the capital is raised, SPACs continue to offer opportunity for Canadian private business owners to raise capital, divest majority ownership interests, and strengthen their management bench. Like all capital transactions, it’s key to understand income tax matters when exploring opportunities.

Don’t Factor in Those Losses

Canada’s capital market has traditionally facilitated IPOs for junior mining companies. While some succeed, many fail and eventually cease operations. These companies often remain listed and are later used by private companies to facilitate IPOs via a court-ordered Plan of Arrangement. The result is a reverse takeover (RTO) of the listed entity.

RTO transactions are a common way for private companies to list in Canada, and in the context of a SPAC, would typically involve an amalgamation with the special purpose vehicle established by the founders. Under Canadian tax law, the successor corporation assumes the tax positions of the predecessor corporations immediately prior to amalgamation.

It’s common for defunct resource companies to carry forward large pools of unutilized non-capital losses and Canadian exploration/development expenses. While these pools will show on record with Canada Revenue Agency, they often do not survive an RTO. An RTO often results in an acquisition of control of the listed entity, and Canada’s tax code includes rules that address such loss restriction events.

Following an acquisition of control, the utilization of losses is limited to income from a same or similar business. Furthermore, the business that gave rise to the losses must continue from the period the losses were incurred through to the period in which the losses are utilized. This latter point is highly unlikely as most listed shell companies no longer have active employees or a formal business.

Know Your Target’s Tax Objectives

Canada’s mid-market is dominated by private individuals and their families. Canadian-controlled private companies (CCPCs) are commonly structured to take advantage of certain tax breaks for Canadian entrepreneurs. Here are three common tax planning tools your target may be considering:

Lifetime Capital Gains Exemption (LCGE)

While subject to certain qualification criteria, individual owners of CCPCs can benefit from the LCGE, which allows the first $892,218 of proceeds on disposition to be received tax free. Often, business owners plan to multiply the LCGE across family members by utilizing a family trust. It’s important to know if your target is anticipating utilizing the LCGE, as this provides a bias for them to sell shares vs. assets. To use Ontario residents as an example, the LCGE is worth $238,847 in tax savings per individual. Often, sellers asked to forgo this exemption may seek a higher offer price to compensate for the lost tax shield.

Safe income

If your target has a history of positive earnings, the vendors may be able to utilize “safe income on hand” (SIOH). “Safe income” is the after-tax earnings that a company earns each year. “Safe income on hand” is the total after-tax earnings during the period that the vendor has held the shares in the company. If properly planned for, a shareholder or group of shareholders can repatriate this SIOH to a holding company prior to selling.

This “safe income” dividend can either be in the form of cash, thus reducing the fair value of the target and the taxable sale proceeds, or via an increase in stated capital (or “paid-up capital” under Canadian tax law), thus increasing the adjusted cost base (ACB) of the vendor’s shares. Either approach reduces the tax liability to the vendor and defers tax that would otherwise be paid at the individual shareholder level.

It’s important to note that like the LCGE, safe income planning is utilized in the context of a share sale. Also, the risk is assumed by the vendor corporation and not the payer of the dividend. For example, if the safe income dividend is in excess of the SIOH, this excess is taxable to the recipient as a capital gain.

Rollover planning

A SPAC’s qualifying transaction will involve a cash component. However, for target companies with values in excess of the available funding, share capital can be issued as further consideration. Canadian tax law provides a rollover election when a taxpayer disposes of property to a taxable Canadian corporation and receives share capital as either partial or full consideration.

This election, known as a Section 85 rollover, allows the vendor to defer the gain, partially or fully, as long as share consideration is received from the SPAC entity. The Section 85 rollover is a joint election between the vendor and the SPAC filed with respect to the SPAC qualifying acquisition.

A Section 85 rollover is not available for a U.S. SPAC, as it is not a taxable Canadian corporation. This is an important advantage to Canadian-listed SPACs and should be considered by any SPAC looking at Canada for a qualifying opportunity.

Understanding a Tax Status Change

Following acquisition by a SPAC, the target will lose its status as a CCPC. Here are two common implications for newly-listed public companies:

SR&ED

The most notable disadvantage to a Canadian company that has lost its status as a CCPC is the loss of refundable R&D tax credits. Canada’s Scientific Research & Development Program (SR&ED) provides a 35% refundable tax credit on the first C$3 million (US$2.4 million) of qualified expenditures for CCPCs that operate within certain size limits. A 20% credit is available for expenditures in excess of C$3 million and is non-refundable.

Canadian public companies are eligible to claim SR&ED tax credits but are limited to a 15% non-refundable tax credit irrespective of expenditure level. This is an important distinction as the Canadian SR&ED program is a key financier for both developing and mature companies. There are also parallel programs available at the provincial level that may be affected by the SPAC acquisition. These sources of cash flow are eliminated upon going public and should be considered when business planning following the qualifying transaction.

Employee stock options

Stock option compensation arrangements are established methods of incentivizing managers and their teams in Canada. While these programs are prominent among public companies, it’s not uncommon for a CCPC to utilize these arrangements, particularly if they are anticipating a liquidity event.

If properly structured, employees of both public companies and CCPCs will be taxed under similar rules, although employees of CCPCs may be eligible to defer the resulting income inclusion to the time that the underlying shares are disposed of. Furthermore, access to the preferential tax treatment offered to employee stock option benefits can be achieved by employees of CCPCs under expanded scenarios more than those of public companies.

However, effective July 1, 2021, new tax legislation has resulted in an even greater difference between how stock options of public companies are taxed versus CCPCs. For options granted on or after this date, employees of certain public companies will be limited to preferential stock option treatment to the first $200,000 of benefit received in a year.

The same limitation will not exist for CCPCs. For SPACs looking to establish new compensation arrangements with newly-acquired teams, they may be at a tax disadvantage and should consider this in establishing market-based compensation programs.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Greg MacKenzie is National Practice Leader, Tax Reporting & Advisory at Grant Thornton LLP (Canada).

The information and comments herein are for the general information of the reader and are not intended as advice or opinion to be relied upon in relation to any particular circumstances. For particular application, the reader should seek professional advice.

Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.

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