If you are following Wall Street, you have no doubt witnessed the current boom in Special Purpose Acquisition Companies (SPACs). While it's not a new phenomenon, the market volatility caused 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 contributed to this, including the shift of SPAC operations to US markets and the maturation of the cannabis sector.
Regardless of where the capital is raised, SPACs continue to offer Canadian private entrepreneurs the opportunity to raise capital, dispose of controlling interests and strengthen their management. As with all capital transactions, understanding income tax matters is important when looking for opportunities.
Don't take these losses into account
Canada's capital market has traditionally made it easy for young mining companies to go public. While some succeed, many fail and eventually go out of business. These companies often remain publicly traded and are later used by private companies to facilitate initial public offerings through a court-ordered plan of arrangement. The result is a reverse acquisition (RTO) of the publicly traded company.
RTO transactions are a common way for private companies to list themselves in Canada and would typically involve a merger with the special purpose vehicle established by the founders as part of a SPAC. According to Canadian tax law, the successor company takes over the tax positions of the predecessor companies immediately before the merger.
It is common for idle resource companies to bring forward large pools of idle, unused losses and Canadian exploration / development costs. While these pools are kept on record with the Canada Revenue Agency, they often do not survive an RTO. An RTO often results in the acquisition of control of the publicly traded company, and Canadian tax law contains rules that address such loss control events.
After an acquisition of control, the use of losses is limited to income from the same or a similar company. In addition, the business that caused the loss must be continued from the time the loss occurred until the period in which the loss was used. The latter point is highly unlikely as most publicly traded letterbox companies have run out of active employees or a formal business.
Know the tax goals of your target
Canada's middle class is dominated by individuals and their families. Canadian Controlled Private Companies (CCPCs) are typically structured to take advantage of certain tax breaks for Canadian entrepreneurs. Here are three common tax planning tools that your goal may be considering:
Lifetime Capital Gains Exemption (LCGE)
Subject to certain qualification criteria, individual owners of CCPCs can benefit from the LCGE, which enables them to receive the first $ 892,218 of sales proceeds tax-free. Often times, business owners plan to multiply the LCGE to family members by using a family fund. It is important to know if your goal is to use the LCGE, as this represents a tendency for stocks to sell versus assets. To take an example for Ontario residents, the LCGE is a tax saving of $ 238,847 per person. Often sellers who want to waive this exemption ask for a higher offer price in order to compensate for the lost tax protection.
Save income
If your goal has a history of positive income, providers may be able to take advantage of Safe Income (SIOH). “Secure income” is the after-tax profit that a company generates every year. “Safe Stock” means total after-tax profit during the period in which the seller held the shares in the company. If properly planned, a shareholder or group of shareholders can return this SIOH to a holding company prior to sale.
This “safe income dividend” can either be in the form of cash, which reduces the target's fair value and taxable sales proceeds, or through an increase in reported capital (or “paid-in capital” under Canadian tax law), which reduces the Adjusted Cost Base (ACB ) the share of the seller is increased. Both approaches reduce the tax liability to the seller and defer taxes that would otherwise have to be paid at the level of the individual shareholder.
It is important to note that like the LCGE, secure income planning is used in the context of a stock sale. In addition, the risk is assumed by the seller company, not the dividend payer. For example, if the guaranteed income dividend exceeds the SIOH, that excess is taxable as a capital gain for the recipient.
Rollover planning
The qualified transaction of a SPAC contains a cash component. For target companies with values that exceed the available funds, share capital can be issued as additional consideration. Canadian tax law provides for a rollover option when a taxpayer sells property to a taxable Canadian corporation and receives share capital in either partial or full consideration.
This choice, known as a Section 85 rollover, allows the seller to defer part or all of the profit as long as the share consideration is received from the SPAC entity. The Section 85 rollover is a joint choice between the Seller and the SPAC filed in relation to the SPAC Eligible Acquisition.
A Section 85 transfer is not available for a US SPAC because it is not a taxable Canadian corporation. This is an important benefit to Canada-listed SPACs and should be considered by any SPAC looking for a qualifying opportunity in Canada.
Understand a change in tax status
Once acquired by a SPAC, the target loses its status as a CCPC. Here are two common implications for newly listed public companies:
SR&ED
The most notable downside to a Canadian company that has lost its CCPC status is the loss of refundable R&D tax credits. Canada's Scientific Research & Development Program (SR&ED) offers a 35% refundable tax credit on the first CAD 3 million (US $ 2.4 million) of qualifying expenses for CCPCs operated within certain size limits. A 20% credit is available for expenses over CAD 3 million and is non-refundable.
Canadian public corporations are eligible for SR&ED tax credits, but are limited to a 15% non-refundable tax credit regardless of the amount spent. This is an important accolade as Canada's SR&ED program is a major financier for both developing and mature businesses. There are also parallel provincial-level programs that could be affected by the SPAC takeover. These sources of cash flow are eliminated upon IPO and should be considered in business planning after the qualified transaction.
Employee stock options
Stock option compensation agreements are well established ways to motivate managers and their teams in Canada. While these programs are widespread among publicly traded companies, it is not uncommon for a CCPC to take advantage of these arrangements, especially when they anticipate a liquidity event.
When properly structured, employees of both public companies and CCPCs are taxed under similar rules, although CCPC employees may be entitled to postpone the resulting income statement until the sale of the underlying shares. In addition, CCPC employees may, under expanded scenarios, have more access to the preferential tax treatment afforded to employee stock option benefits than those of public companies.
However, with effect from July 1, 2021, the new tax legislation has created an even bigger difference between the taxation of stock options in listed companies and CCPCs. For options granted on or after that date, employees of certain public companies will be limited to preferred stock option treatment for the first $ 200,000 of the benefit received in a year.
The same restriction will not apply to CCPCs. SPACs looking to enter into new compensation agreements with newly acquired teams may experience tax disadvantages and should take this into account when setting up market-based compensation programs.
This column does not necessarily represent the opinion of the Bureau of National Affairs, Inc. or its owners.
Information about the author
Greg MacKenzie is National Practice Leader, Tax Reporting & Advisory at Grant Thornton LLP (Canada).
The information and comments contained herein are provided for the general information of the reader and are not intended as advice or opinions to be relied on with regard to any particular circumstance. The reader should seek professional advice for any particular application.
Bloomberg Tax Insights articles are written by seasoned practitioners, academics and policy experts who discuss developments and current issues in the tax arena. To make a contribution, please contact us at [email protected].