It’s a pivotal milestone when a private company recognizes its readiness for going public. An increasingly popular approach to doing so is the special purpose acquisition company (SPAC). As the boom in SPAC issuance continues, it’s important to pause and understand potential tax complexities. Decision-makers and finance executives should prepare for the rigorous reporting and control requirements that lie ahead as a public enterprise.
What is a SPAC?
Much has been written about SPACs and this article is not intended to present all their intricacies. However, at its most basic level, a SPAC is a funding mechanism for a company looking to go public. In a traditional scenario, a private company prepares to go public and then begins the arduous process of finding investors and raising capital. A SPAC involves a promoter raising capital for the express purpose of identifying companies wanting to go public. In effect, the SPAC reverses the timing of raising the capital and removes the most time-consuming aspect of a company going public. For the underlying company, the capital raise is easier – but it still has all the challenges of becoming a public company. This article focuses on the tax challenges of becoming prepared to be a public company.
Rigorous Reporting and Disclosures
One of the most important considerations for pre-SPAC companies is the reporting rigor required for public company’s financial statements. Most private companies only prepare tax provisions annually; public companies must prepare provisions quarterly and annually. A private company is evaluated by its external auditor and perhaps a bank or a few shareholders. A public company’s financial statements are subject to review by the SEC and the Public Company Accounting Oversight Board (PCAOB) are disclosed publicly, and available to analysts and other market participants. Additional disclosures are required by the American Institute of Certified Public Accountants (AICPA) and the Financial Accounting Standards Board (FASB) for companies issuing GAAP financial statements. The SEC also adds additional disclosure requirements for public companies.
Internalizing the Tax Function
Public companies have higher standards for auditor independence than private companies. The Sarbanes-Oxley Act of 2002 and the PCAOB set standards of independence that are more rigorous than those set by the AICPA and may preclude using the company’s auditor from performing certain services, such as preparation of the provision. We recommend that any company considering a SPAC transaction do an internal evaluation to reveal any potential exposures.
As a result of the increased auditor independence standards, an early challenge for pre-SPAC companies might be the lack of a dedicated internal tax function. It might long have relied on outside services from an auditor or another CPA firm. The company needs to evaluate building a tax team or continuing to outsource. Loan staffing may be a great temporary option as they build their team.
Best Practices for Internal Controls
Potentially the biggest hurdle for private companies ramping up to go public via a SPAC transaction is establishing or revising a framework of internal controls. With the pressure to perform quarterly closes, companies likely need to establish new processes for interim and annual provisions. These processes should focus on risk mitigation. Internal controls must be embedded into a company’s processes, demonstrating evidence of review and sign-off.
While internal controls must comply with the Sarbanes-Oxley Act and the PCAOB, pre-SPAC companies should also be aware of the Committee of Sponsoring Organizations of the Treadway Commission’s (COSO) frameworks and guidance on enterprise risk management, internal control and fraud deterrence. In fact, most public companies have adopted the COSO framework on internal controls, which addresses the control environment, risk assessment, control activities, communication and monitoring.
In addition to familiarizing themselves with COSO, we advise pre-SPAC companies to know what their processes are and to clearly define and follow them. Duties should be segregated in every step of every process, with a clearly-identified preparer and reviewer. Every position should be well documented and examined by more than one person. Per the adage, “If you didn’t document it, it didn’t happen!” In fact, documentation to demonstrate performance and review of controls has long been a challenge. Available tax provision software tools can enhance controls by reducing potential for manual calculation and formula errors.
We also emphasize how important it is to, “Communicate, Communicate, Communicate!” Some of the biggest breakdowns occur when tax team operates in a vacuum. Tax, accounting and legal departments must communicate with each other and establish strong cross-departmental controls. For example, if the accounting team is looking at an issue, the tax team should be in the loop. Or if legal is planning a transaction that could have tax implications, the tax department should be aware and be able to perform forward-looking tax planning.
Tax Structures and Documenting Positions
From a structural perspective, a pre-SPAC company must appropriately document its proposed organizational structure, from the attributes of the current corporate tax structure to those of the proposed post-transaction structure. For example, an S corporation or partnership might need to convert to a C corporation and complete that reorganization before any transaction. Or, a partnership might consider an Up-C structure, enabling a significant number of current owners to maintain an equity interest in the flow-through entity. A structured sale, in which the partners sell interests in the partnership to the public company, can also create a tax-favorable transaction whereby the selling partners are paid a portion of the tax savings realized by the new entity. In any case, significant pre- and post-transaction planning is needed to ensure the desired structure is tax efficient, including whether IRC §382 and §381 (SRLY rules) will create any limitations. IRC §1202 may also provide a planning opportunity for early investors.
Study Your Stock Basis
Another tax planning consideration for pre-SPAC companies is the owners’ tax basis in stock if the transaction involves a sale and exit event by existing shareholders. A stock basis study can help owners assess the scope of their capital gains or losses, and whether to consider any payouts on dividends, buyouts or redemptions. This can also aid in recognizing any deferred taxes and determining compensation. For example, complex executive compensation limits under IRC §162(m) and golden parachute treatment under IRC §280G will apply as a public company and may have to be considered for the first time. Tax accounting for share-based compensation may be another new consideration as a public entity. This all requires a lot of planning, monitoring and maintenance moving forward.
Are You Ready?
Given this reporting rigor and scrutiny, any company readying to go public must examine its people, processes, data and technology to determine if it is ready. External auditors will have enhanced audit scopes and quicker response deadlines. A private company may not have the volume of people or those with the requisite public-company skills to meet the increased workload. A company may choose to outsource or handle in-house with additional headcount.
From a data and technology perspective, companies must have the right tools and systems in place to manage the reporting rigor, including easy and timely access to historical data to support their positions and filings. Oftentimes, this creates a need to acquire tax and compliance software or to look for opportunities to enhance existing technology platforms.
Despite these challenges and the inherent risks and rigors, the journey from private company to public enterprise is an incredibly exciting one. At DHG, we take great pride in assisting companies throughout the entire SPAC lifecycle, leveraging our technical experience in not only tax, but accounting, assurance and transaction advisory. Whether your company has been approached as a SPAC target and is considering an acquisition or you have questions about various financial reporting considerations with this alternative path, we’re here to help.