1% Excise Tax, SPACs, and Independent Director Personal Liability: The Rock and the Hard Place

Being stuck between the choice of either disappointing investors or facing potential personal liability is the very definition of being caught between a rock and a hard place. Tax liability insurance can take you to a more comfortable place—something SPACs may want to consider.

HR5376 and the Excise Tax

On August 12, 2022, the US congress voted to pass the Inflation Reduction Act of 2022 (also known as HR5376 or the “Act”). Included within the act was a new 1% excise tax on stock repurchases (netted out against certain issuances) by certain publicly traded domestic corporations. The administration expressed the hope that this new tax would discourage publicly traded companies from engaging in stock buybacks as a way to avoid taxes and enrich corporate executives. The tax applies to repurchases occurring after December 31, 2022.

Given how broadly HR5376 was written, a legion of talking heads immediately began debating the impact the excise tax could have outside of its intended target. There was much discussion on its ability to affect redemptions of even privately held stock, SPAC transactions, and M&A in general.

Interim Guidance Provides Comfort to SPACs

On December 27, 2022, the IRS issued a notice of interim guidance. The notice did not specifically reference SPACs or explicitly grant them any exemption. However, there was a key point that provided some comfort to SPACs, namely an exemption from the excise tax for distributions made in the same taxable year the redeeming corporation liquidates and dissolves. The language on the surface was heartening. However, numerous questions remain. There are also some deeply technical questions that could be problematic when it comes to efforts to avoid the excise tax, as the law firm Cooley and others have observed.

Also, at this stage, the interim guidance is just that, interim. Final regulations may be a long way off. There are numerous separate questions within the notice, opening the door for final regulations that may be different or interpreted differently than people expect.

Indeed, we have already seen two consequential examples in SPAC-land of defeated regulatory expectations. The SEC has twice made pronouncements that were contrary to public opinion and culminated in a complete rewrite of how certain accounting practices are handled (accounting treatment of warrants as well as the treatment of temporary versus permanent capital).

Risk Scenarios for Directors and Officers of SPACs

Interim guidance from the treasury can be helpful. By its nature, however, it is not the final word on a tax topic. As a reminder, here are the three scenarios that directors and officers of SPACs could consider:

1. The SPAC completes a business combination in which, notwithstanding redemptions, on a net basis, more shares are issued than redeemed.
2. The SPAC completes a business combination in which, on a net basis, there are more redemptions than issued shares.
3. The SPAC runs out of time to complete its deal (either before or after receiving an extension), and all shares are redeemed as part of a liquidation.

In the first scenario, it makes sense that no excise tax would be due. Whether or not an excise tax would be due in the second and third scenarios is less clear. However, in the second scenario, there is an ongoing company and presumably, the sponsor had some positive economics. In other words, sources of funds to pay an excise tax exist.

But what about the third scenario? This is where directors and officers may want to pay attention.

Whose Risk Is It? 

The proceeds of a SPAC IPO go into a trust account and earn interest while the SPAC seeks its target. SPAC trust agreements often specify that interest on the principle (but never the principle) can be used to pay taxes.

So then could this interest also be used to pay the excise tax?

SPAC shareholders may prefer to argue that the answer is no. They do not want to suffer any diminishment of their pro-rata share of the interest earned by the trust. With this in mind, SPAC shareholders may be very comfortable with the risk of having to pay the excise tax falling on the directors and officers of the SPAC rather than themselves.

On the other hand, in the scenario where the SPAC cannot complete a deal and the SPAC is liquidated after all shares are redeemed, the SPAC sponsors will have already lost their at-risk capital. The directors and officers will have also spent an enormous amount of time and energy with no return. On top of that, dissolution is not an instantaneous process. For example, Delaware corporations must make certain filings, provide certain notices, and settle outstanding claims. This might take more than a year from the time shares have been redeemed.

A SPAC sponsor that lost all the at-risk capital is unlikely to take the risk of having to pay more. Moreover, directors and officers typically do not expect to be personally on the hook for corporate taxes.

Everyone else, however, must confront the issue.

On the one hand, given the uncertainties surrounding the excise tax, SPAC directors and officers who do not otherwise have a source of funding at the ready might reasonably decide to place funds into escrow (until after final regulations clarify that no excise tax is due) out of the interest earned on the SPAC trust to cover the 1% excise tax.

On the other hand, SPAC investors will always want their full payout of interest sooner rather than later. They are likely to argue that a) the guidance was clear so there is no need for a hold-back, and b) even if the guidance was not clear or later changed, the directors and officers officers should pay the tax rather than have the tax taken out of interest earned on the trust account.

Rock, hard place: Meet an insurance solution.

Solving the Problem

Purchasing a tax liability policy to address the excise tax risk is a far superior option to having SPAC officers and directors personally take on the potential risk. A tax opinion liability policy can be designed to specifically cover their position that, because they are fully liquidating, the excise tax does not apply. The carrier accepting this risk will pay the excise tax if the treasury disagrees and, after contesting the treasury’s position, the tax must be paid to the government.

Tax liability policies are frequently used in more traditional M&A. Carriers typically will conduct diligence on a company’s tax position and then provide insurance in case the government ultimately disagrees with the tax position.

The limit purchased would need to take into account the cost of defense as well as fines, penalties, and a gross-up in the event of a loss.

As with all tax liability insurance policies, a pre-condition for the carriers would be an analysis provided by a well-respected law firm that backs the position being taken by the insured.

Thus, insurance can provide an elegant way to resolve what would otherwise be unbearable tension for directors and officers of a SPAC who want to support the wishes of their shareholders but are unwilling to bear the risk of having to personally pay a tax bill that could run to millions of dollars.

Note: A partner of Woodruff Sawyer serves as an independent director of a SPAC that purchased a tax liability policy relating to the SPAC. To avoid any potential concerns about conflicts of interest, Woodruff Sawyer did not place that or any other insurance policy for this SPAC.