SPECIAL PURPOSE ACQUISITION COMPANIES – ACCOUNTING AND TAX ISSUES

INTRODUCTION
SPACs. The word does not sound very exciting but it is a phenomenon that is taking stock markets (at least in the USA) by storm. The abbreviation expands as Special Purpose Acquisition Companies but a more street-sounding name is ‘blank cheque companies’. These are companies that are set up with next to nothing and list on the stock exchanges only for the purpose of raising capital for acquisitions. In India, SEBI is planning to come out with a framework on SPACs ostensibly to facilitate Startups to list on the exchanges. SPACs are usually formed by private equity funds or financial institutions, with expertise in a particular industry or business sector, with investment for initial working capital and issue-related expenses.

Private companies would benefit from SPACs as they go on to become listed entities without going through the rigours of an Initial Public Offering (IPO). It is not that SPACs is a new phenomenon – the concept of reverse mergers resembles a SPAC in many respects. SPACs are different from normal companies in that they have only one object – to list on the exchanges with the sole intention of acquiring a target company. One of the main advantages of a SPAC is the fact that it can use forward-looking information in the prospectus – this may not be permitted in a usual IPO.

In case the SPAC is not able to identify and acquire a target company within the set time frame it winds up and the funds are returned to the investors. In case the SPAC identifies a target company and enters into a Business Combination, the shareholders of the SPAC will have the opportunity to redeem their shares and, in many cases, vote on the initial Business Combination transaction. Each SPAC shareholder can either remain a shareholder of the company after the initial Business Combination or redeem and receive its pro rata amount of the funds held in the escrow account.

Investors in a SPAC put in a small amount of money for a stake in the company (usually around 20%). They get allotted shares with a lock-in period of up to a year. They have the option of exiting once the lock-in period is over. SPACs would also have similarities with Cat-1 alternate investment funds (AIF’s) – an angel fund listing on the SME platform.

THREE STAGES
Usually, a SPAC will have three phases with different time frames:

Ind AS accounting standards
Since all SPACs have to list on some stock exchange, they would have to follow Ind AS accounting standards as it is mandatory for all listed entities.

Stage 1
In Stage 1, SPACs normally issue different types of financial instruments to the founders / investors such as equity shares, convertible shares or share warrants. Investors would be keen to invest in these instruments since the warrants give them an opportunity to get some more shares in case a target company has been identified. Usually, the IPO price is fixed at par (say Rs. 10) while the exercise price of the warrants is fixed about 15% higher. SPACs are forced to invest at least 85% of their IPO proceeds in an escrow account. Accounting for these instruments would be driven by Ind AS 32 / Ind AS 109. Since the SPAC would not be undertaking any commercial activities at this stage, very few Ind AS standards other than Ind AS 32/109 would need to be applied. Typically, at this stage SPACs do not own too many assets. The nature of the financial instruments issued to the investors would determine the accounting. These instruments could be equity instruments, share warrants that are exercisable, convertible shares or bonds and other instruments that are entirely equity in nature. The type of the instrument would determine whether it would be accounted for as equity share capital, under other equity, or as a separate line item ‘instruments that are entirely equity in nature’.

Stage 2
Once a target company has been identified and the acquisition is formalised, Ind AS 103 Business Combinations would have to be applied. There are seven steps in Business Combination accounting:

1.    Is it an acquisition
2.    Identify the acquirer
3.    Ascertain acquisition date
4.    Recognising and measuring assets acquired, liabilities assumed, and NCI
5.    Measuring consideration
6.    Recognising and measuring Intangible Assets
7.    Post-acquisition measurement and accounting

First step – Is it an acquisition?
An amendment to Ind AS 103 has made the distinction between an asset acquisition and a Business Combination clearer. The main pointers are:

1.    Business must include inputs and substantive processes applied to those inputs which have ability to create output / contribute to ability to create output.
2.    Change in definition of ‘output’ – it now focuses on goods and services provided to customers.
3.    Omission of ability to substitute the missing inputs and processes by the market participants.
4.    Addition of ‘Optional Concentration Test’.

Remaining steps
Once the transaction meets the definition of a Business Combination, the other six steps would need to be followed. These would invariably be: identifying the acquirer, determining the acquisition date, measuring acquisition date fair values, measuring the consideration to be paid, recognising goodwill and deciding on post-combination accounting. Business Combination Accounting permits the recognition of previously unrecognised Intangible Assets – this clause would be important for SPACs since they would invariably look at technology companies that have some Intangible Assets for an acquisition.

GOING CONCERN?
Most SPACS have a limited shelf-life of about two to three years. One of the fundamental principles on which the Framework to Ind AS Standards has been formulated is the principle of Going Concern. An interesting question that arises is whether the management will need to comment on the going concern concept since it is clear that the SPAC will not be a going concern in a few years from the date of listing. Usually, SPACs provide a disclosure on their status in the financial statements. The disclosure given below is from the Form 10K (annual report) of Churchill Capital Corp IV for the year ended 31st December, 2020:

‘Our amended and restated certificate of incorporation provides that we will have until 3rd August, 2022, the date that is 24 months from the closing of the IPO, to complete our initial business combination (the period from the closing of the IPO until 3rd August, 2022, the “completion window”). If we are unable to complete our initial business combination within such period, we will: (1) cease all operations except for the purpose of winding up; (2) as promptly as reasonably possible, but not more than ten business days thereafter, redeem the public shares at a per share price, payable in cash, equal to the aggregate amount then on deposit in the trust account, including interest (net of permitted withdrawals and up to $100,000 of interest to pay dissolution expenses), divided by the number of then outstanding public shares, which redemption will completely extinguish public stockholders’ rights as stockholders (including the right to receive further liquidating distributions, if any), subject to applicable law; and (3) as promptly as reasonably possible following such redemption, subject to the approval of our remaining stockholders and our board of directors, dissolve and liquidate, subject in each case to our obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law. There will be no redemption rights or liquidating distributions with respect to our warrants, which will expire worthless if we fail to complete our initial business combination within the completion window.’

It would appear that a disclosure on the above lines would suffice to satisfy the ability of the entity to continue as a going concern during the limited period of its existence.

CONTINGENT CONSIDERATION
A SPAC merger agreement may include a provision for additional consideration to be transferred to the shareholders of the target company in the future if certain events occur or conditions arise. This additional consideration, commonly referred to as an ‘earn-out’ payment, may be in the form of additional equity interests in the combined company, cash or other assets. If the SPAC is identified as the accounting acquirer and the target company is a business, the earn-out payment may represent contingent consideration in connection with a Business Combination. While such payments may be negotiated as part of the merger, the terms of the arrangement need to be evaluated to determine whether the payment is part of or separate from the Business Combination. In making this evaluation, the SPAC should consider the nature of the arrangement, the reasons for entering into the arrangement and which party receives the primary benefits from the transaction.

If the arrangement is entered into primarily for the benefit of the SPAC or the combined company rather than primarily for the benefit of the target or its former shareholders, the arrangement is likely a separate transaction that should be accounted for separately from the Business Combination. For example, payments are sometimes made to shareholders of the target company who will remain as employees of the combined company after the merger. In this case, the SPAC must carefully evaluate whether the substance of the arrangement is to compensate the former shareholders for future services rather than to provide additional consideration in exchange for the acquired business. If the SPAC determines that an earn-out provision represents consideration transferred for the acquired business, the contingent consideration is recognised at acquisition-date fair value under Ind AS 103. However, earn-out arrangements that represent separate transactions are accounted for under other applicable Ind AS. For example, payments made to former shareholders of the target company that are determined to be compensatory are accounted for as compensation expense for services provided in the post-merger period.

TAX IMPACT
Shareholders
At the time of the Business Combination, shares are usually issued. For shareholders under the Indian Income-tax Act, 1961, issue of shares in any form results in a ‘transfer’ of shares held by the existing shareholders of the Indian target entity. The consideration is received in the form of SPAC shares. Capital gains tax may emerge on the sale / swap of shares of the Indian target company against the shares of SPAC. The taxable capital gains would be the excess of the fair market value over the cost of acquisition in the hands of the selling shareholders. Tax rates vary from 10% to 40% under the Indian tax laws, plus applicable surcharge and cess. Tax rates shall primarily depend upon various factors – inter alia, the mode of transfer, i.e., share swap vs. merger, residential status of shareholders, availability of treaty benefits and the period of holding of the shares.

SPAC
A SPAC is required to comply with the applicable withholding tax obligation at the time of discharge of consideration to non-residents, i.e., whether on account of a merger or swap of shares.

If an Indian target company has unabsorbed tax losses and its shareholder voting rights change by more than 49%, then the unabsorbed tax losses would lapse and it shall not be eligible to carry forward its past tax losses.

Once the shares of the SPAC are listed, it is possible that the tax implications of the indirect transfer rules outlined in section 9(1)(i) would need to be considered. However, this would apply only if the SPAC is a foreign company. [Will SPAC be an Indian or a foreign company?] If it is an Indian company, then its shares are actually located in India only. Where is the question of applying indirect transfer rules? For example, a tax liability would arise if a SPAC derives its substantial value from India (more than 50%) under the Indian indirect transfer rules. Shareholders who hold less than 5% of the voting power or the SPAC’s capital are not subject to Indian indirect transfer implications, provided certain conditions are met. For other shareholders, any transfer of SPAC shares results in Indian indirect transfer implications.

SPONSORS
Typically, a SPAC sponsor converts its Class B shares into Class A shares upon successfully acquiring a target company. Depending upon the date and timing of the Business Combination and the conversion of Class B shares into Class A shares, tax implications under the Indian indirect transfer rules need to be evaluated for the SPAC sponsor.

SPACs would also need to consider the implications of Notification No. 77/2021 dated 7th July, 2021 issued by the Central Board of Direct Taxes which clarifies that where the value of net goodwill removed from the block is in excess of the opening written down value as on 1st April, 2020, such excess will now be offered to tax as short-term capital gain.

WOULD SPACs BE A SUCCESS IN INDIA?
The answer to this question would obviously depend on the guidance that SEBI comes up with on SPACs. The Primary Market Advisory Committee of SEBI is deliberating on whether a framework for SPACs should be introduced. The Committee is also looking into any safeguards that should be built into the framework being proposed. From the information available now, SPACs are being set up by hedge funds and private equity investors who plan for a quick exit from their investments in a couple of years. The success of SPACs depends on the existence of companies that are available for a Business Combination. Traditional Indian companies may not be interested in the SPAC route as many would feel that it is too short-term in nature – they are in for the long term. Startups could provide a good source of companies that are SPAC-eligible. India has a large number of Startups but how many of them are worthy of listing remains to be seen. In addition, Indian companies do not have a history of issuing complicated financial instruments which is one of the basic requirements of a SPAC. As things stand today, it would be reasonable to conclude that there will be a few SPAC transactions in India but the concept of SPAC is not going to overly excite everyone at Dalal Street!