Founder shares in SPACs represent the highest level of risk capital in a SPAC raised by industry experts and higher risk investors – the SPAC Sponsors. This capital is high risk in that it is used to finance the IPO of the SPAC and the running of the business to identify and execute the De-SPAC transaction (the merger between the private operating company and a publicly traded SPAC). If a De-SPAC transaction is not successful, the IPO investors would expect to be repaid their investment funds whereas the Sponsors would likely lose theirs.
This high risk of the capital is accompanied by a high potential return if the IPO and the De-SPAC transaction successfully complete. The SPAC Sponsors will then typically hold 20% of the equity in the listed SPAC, as well as warrant instruments that could increase this percentage if exercised.
The tax treatment of the founder shares will depend on the tax profile of the sponsors. The likely tax goal of a UK resident individual as a SPAC Sponsor is to generate a gain that is subject to the 20% standard rate capital gains tax. There are some common tax issues for UK resident SPAC Sponsors who are acquiring founder shares personally as industry experts or investment experts, which mean that they may not simply be subject to capital gains tax on their returns. This article considers some of these key issues.
Employment related securities
Often, the first consideration when looking at the tax treatment for UK tax resident SPAC Sponsors is (a) whether (and if so) (b) how, the UK’s “employment related securities” (or “ERS”) taxing provisions will apply. The answer to both of these questions for any given transaction will vary, not only between different SPAC transactions, but also between different SPAC Sponsors depending on the facts.
Is there an employment related security?
The ERS provisions will apply only if there are “securities” acquired and the securities are acquired in connection with an office or employment. The founder shares that the SPAC Sponsors acquire will often be through a sponsor vehicle (an aggregator vehicle), which may itself be a holding of shares in a company, units in an LLC or an interest in a partnership. In some cases, the ownership of the founder shares maybe directly in the SPAC. In all of these cases, one would expect these founder shares to constitute a “security” but this will need to be confirmed.
If founder shares are securities, we then need to determine whether they are ERS – are they acquired in connection with an office or employment? If the SPAC Sponsor is allowed to acquire the founder shares because he or she is taking on a role of employee or director, this would make the founder shares ERS. However, in many cases the position will be less clear. Certain SPAC Sponsors may be undertaking self-employed advisory or consultancy roles, but may also become a director in the SPAC. In this case, whether the ERS provisions apply will depend very much on the facts and may also depend on the timing of when the individual takes on the director role as compared to when they acquire the founder shares.
How will the ERS provisions apply?
In many (non-SPAC) scenarios where the ERS provisions apply to an employee but that employee is investing on arm’s length terms, the ERS provisions do not result in a less attractive tax treatment than that which applies to other investors. Entering into so-called “s431 elections” and paying the “unrestricted market value” for shares in order to secure capital gains tax treatment is a common approach for recipients of ERS, which often results in the employee or director being subject to the same tax treatment as the investor who does not hold ERS.
A key part of the analysis in this case would relate to valuation – are the founder shares being acquired for less than their market value? This will need to be considered in all cases but it is likely that the presence of arm’s length commercial investors who are investing on identical terms will give strength to any argument that the founder shares are not being acquired at an undervalue. Assuming this argument can be sustained, no employment income tax charge should arise on the acquisition of the founder shares.
However, even if the founder shares can be acquired without an employment income tax charge, further risks of employment income may exist under the ERS provisions. For example, where the mechanism through which the 20% holding in the SPAC is during conversion, the convertible securities provisions could give rise to an income tax charge. In addition, founder shares are often accompanied with an acquisition of warrants by the SPAC Sponsors, which may carry the characteristics of a share option, the exercise of which will give rise to an employment income tax charge.
There are various factors that will determine whether such employment income tax charges will arise and many of these can be planned for in the initial SPAC structure. If the SPAC Sponsors hold shares or units in an aggregator vehicle, which itself holds the founder shares, this may impact on the ERS analysis. Given that the employment tax charges that could arise as a result of the ERS provisions are likely to be at 45% with national insurance contributions also applying and the charges may arise prior to any liquidity for the SPAC Sponsor, it is key that the SPAC Sponsor understands the risk of such charges arising.
The sponsor structure
The structure of the sponsor investment will also influence the tax treatment aside from the ERS provisions. It is likely that the SPAC Sponsors will invest in the SPAC through one or even two aggregator vehicles and if these vehicles are transparent entities for tax purposes (such as a partnership), the returns arising should be taxed directly on the SPAC Sponsor as a dividend or capital gain. However, if the SPAC Sponsor is investing through vehicles that are not transparent (ie via a company) and the vehicles need to be liquidated or need to otherwise distribute their assets to investors, there is a greater risk that returns could be taxed as a distribution and subject to income tax even where the initial gain arising from the SPAC is capital.
In addition, it may be the case that the sponsor vehicle will be liquidated and taken out of the structure prior to the eventual liquidity event for the SPAC Sponsor. If the sponsor vehicle is transparent, there may be no tax implication of this restructuring but if the entity is opaque, this could give rise to income or gains arising prior to the liquidity actually arising for the SPAC Sponsor.
The other likely UK taxing provisions
Depending upon the role that the UK resident individual is playing within the SPAC, the investment manager rules may also be in point to the extent that “investment management services” are being provided. In such a case, the founder shares could be seen to form a disguised fee or carried interest and returns could be either taxed as income or at a higher (28%) capital gains rate.
Conclusion
The desirable tax outcome for the UK Resident SPAC Sponsor on the founder shares that he or she acquires is a return that is subject to capital gains tax.
This article has focussed on the employment related securities provisions that may instead result in returns being taxed as employment income. The investment structure through which the SPAC Sponsor will invest in the ultimate SPAC and De-SPAC structure could also impact on the overall tax treatment for the SPAC Sponsor, as could the potential application of the investment manager rules. These risk areas need to be considered carefully in the light of the specific facts of any SPAC and SPAC Sponsor in order to determine the likely tax outcome for the Sponsor.