Bloomberg Tax
Feb. 25, 2021, 9:46 AM

Tax Traps Await Early SPAC Investors Without Ideal Timing, Luck

Siri Bulusu
Siri Bulusu

SPACs lure big-time investors partly with the promise of being able to cash out more quickly than they can with traditional IPOs.

But there’s potentially a big trap in what’s become Wall Street’s hottest investment: The blind nature of these pools can set up these investors for tax bills that could outsize their gains when they exit, unless they have luck and perfect timing on their side.

It’s becoming a growing concern for advisers who say the tax code hasn’t kept up with the soaring interest in SPAC deals, which totaled $83.9 billion in 2020 as investors like hedge-fund billionaires Bill Ackman and Paul Singer got in on the ground floor. SPAC deals this year are on track to outpace 2020, with 62 deals totaling $42.8 billion closing early in the first quarter, according to data compiled by Bloomberg.

“People tend to assume incorrectly that there’s some tax advantage associated with doing a SPAC deal, but there isn’t—in fact, there’s a lot of tax uncertainty and hidden costs,” said Kimberly Blanchard, a partner at Weil, Gotshal & Manges LLP in New York.

Investments in SPACs—also known as blank-check companies—are speculative, meaning investors don’t know for months or even years what the vehicle will acquire. That could spell trouble for investors that are unaware of the complex tax hurdles U.S. shareholders face when they own stock in certain foreign companies.

When a SPAC deal crosses borders, it could trigger passive foreign investment company (PFIC) tax rules aimed at closing a loophole that lets U.S. taxpayers use offshore hedge funds or other investment vehicles to shelter money. Those rules also can be triggered when an offshore SPAC places capital it raises from U.S. investors into an interest-bearing trust account.

“These things are set up on speculation, so the sponsors really don’t know where the target will be and the problems start there,” Blanchard said.

To avoid that tax hit, a SPAC deal has to be executed within a very narrow window of time, or have a perfect mix of assets to qualify for exceptions carved out in the tax code.

“There’s so much money chasing deals, and there’s impatience from private equity and investors to be able to monetize their investments,” said Friedemann Thomma, a partner and international tax chair at Venable LLP in San Francisco.

Tax Hit Exceptions

PFIC status—under tax code Section 1291, 1297, and 1298—applies if a foreign corporation has at least 75% of passive income, such as investments, or at least 50% of assets that generate passive income or are held for generating passive income. The rules prevent the U.S. shareholders of those foreign corporations from deferring income that they would be paying taxes on, had they invested in a U.S. mutual fund.

The rules include an exception for offshore start-ups that happen to hold large stores of cash before becoming profitable. But that exception only applies if the company has active operations after its first year.

“It’s extremely narrow and your timing has to be exquisite to fall within that time frame,” Blanchard said. “You basically have to hope you acquire an active business before it’s too late, but it’s not that simple—we have no guidance from the IRS.”

SPACs can sometimes take longer than a year to identify a target, and rushing the process isn’t prudent from an operations standpoint, practitioners said. If a SPAC fails to acquire or combine with a target company within that deadline, its shareholders are taxed on fixed income and dividends from the PFIC. Shareholders would also pay a higher rate of tax plus interest on future sales of PFIC stock.

“All of this could more than double investors’ tax bill,” said Irina Pisareva, partner at Sullivan & Worcester LLP in New York.

QEF Election

Shareholders that are getting taxed on their PFICs have the option to make a qualified electing company (QEF) election to avoid the tax treatment of being a PFIC.

If the election is made the first year a company is deemed a PFIC, its shareholders are taxed annually on any income the PFIC earns. But they are no longer subject to punitive aspects such as excess interest charges and higher income tax rates, Pisareva said.

But the QEF election, under existing tax guidance, doesn’t apply to warrants that are treated like stock options and are typically part of a SPAC’s capital structure. That means when U.S. shareholders want to exit their PFIC which they acquired through a SPAC, they have to purge those leftover warrants of PFIC status or risk carrying that tax treatment forever.

The purging election, under the PFIC rules, is itself punitive, essentially punishing U.S. shareholders for the length of time they held PFIC options and charging them a steep toll on their gains to remove the PFIC designation from those options.

“Basically the more successful these SPACs are the worse the tax outcome for option holders,” Blanchard. “In an extreme case, the actual tax owed could be more than your proceeds.”

Tough Choices

The IRS failed to weigh in on the treatment of options or warrants in final PFIC rules issued in December 2020, but a senior-level official indicated at a January ABA virtual conference that investors must interpret the rules as they are.

“I think you have to be wary because there are tax issues that are out there—I guess you’d call them tax traps,” said Andrew Silverman, a Bloomberg Intelligence government analyst.

An IRS spokesperson told Bloomberg Tax that the agency monitors market developments and studies emerging issues before issuing tax guidance.

“One should focus on commercial pros of each SPAC deal and view tax as an expense with the potential to reduce the rate of return on each deal as opposed to a potential benefit,” Pisareva said.

In the absence of updated guidance, practitioners say SPAC investors should carefully model best-case and worst-case scenarios before making an investment.

While the business advantages of SPACs may continue to draw investor interest, it remains to be seen if the tax complications prompt some to change their business models to C-corporations—which face far fewer tax issues when doing cross-border deals, Pisareva said.

To contact the reporter on this story: Siri Bulusu in Washington at

To contact the editors responsible for this story: Meg Shreve at; Bernie Kohn at