Industry voice: Getting to grips with tax insurance
By Dawn Bhoma, Head of Tax Liability Insurance at Neon Underwriting and Oliver Walker, Tax Partner, Weil, Gotshal & Manges (London) LLP
Tax implications have always loomed large in corporate transactions, but rarely, if ever, to the extent they do today.
Fiscal legislation is becoming more and more complex right across the world, tax disputes between business and the public authorities are proliferating, and cross-border initiatives such as the OECD’s BEPS project are prompting governments continually to change the rules.
This all adds up to an increasing risk for those selling companies to be bogged down in time-consuming procedures in order to give comfort to the purchaser regarding historic tax exposures. This, in turn, may give rise to a further risk that they will remain on the hook – for up to seven years in the case of UK deals – for any resulting tax assessments.
The rise of tax insurance
Against this backdrop, it is unsurprising that parties to corporate transactions are increasingly finding that the traditional tax covenant, covering a buyer against unforeseen tax liabilities, does not fully meet their needs and are turning instead to the relatively new, but rapidly growing, world of tax insurance.
The use of both warranty and indemnity (W&I) policies, and specific tax insurance products, can shift much of the tax risk uncovered in mergers and acquisitions to specialist underwriters. This allows sellers to achieve a clean break and lets buyers take ownership, free of the anxiety generated by the continuing threat of tax assessments for previous periods.
Some funds are using tax policies to great effect to ease the deal process and transfer tax risk to obtain greater certainty. On the buy side, tax policies can enhance a bid by taking tax risk off the table. In particular, insurance can greatly assist buyers that do not have the benefit ofW&I, providing meaningful protection against historic tax exposures. This, in turn, ought to help buyers reach agreement with sellers more quickly. Although such policies generally tend to be buy-side, sellers can also seek insurance to help overcome deadlock, particularly where the risk is seen as low but severe in terms of likely sums involved. Insurance also reduces the need for sellers to settle for a lower exit price in return for the buyer assuming, in the legal documentation, any tax liabilities. Sellers get both the clean break they desire and the extraction of more value from the sale.
What does it mean for those involved in the deal?
Previous cases have seen underwriters arrange a policy for a selling fund that had already seen one deal collapse over tax concerns and were happy to pay the premium to ensure a trouble-free exit.
Institutional sellers have greater certainty on distributions to investors, thereby avoiding the need for subsequent investor drawdowns to fund tax liabilities. For CFOs and fund executives that means the impact on managing accounts and limited partnership distributions is substantially reduced. While some time may be taken up at an early stage negotiating the insurance policy (and instructing lawyers to ensure it dovetails with any transaction documents) the resulting coverage means tax costs can be funded by the underwriters without recourse to the LPs.
Insurance enables both parties to run more accurate financial models of potential transactions, allowing them to assess the likely tax costs.
There are some drawbacks to the coverage offered by W&I insurance policies compared with traditional tax covenants. Chief among these is such policies may not guard against all the historic risks you may have expected to be covered. For example, known tax liabilities, transfer pricing and secondary liabilities.
This does not mean parties to corporate transactions should avoid W&I insurance, rather they should be familiar with both the broad principles of tax insurance and details of the product they are considering buying. For instance, can they pay additional premium to insure a known tax risk?
What do parties on the buy and sell-side need to know?
Parties should ensure they also understand the claims process. Does the insurer have its own claims team and claims control department, or will the policyholder need to notify and consult with other insurers, or re-insurers, or external claims lawyers?
It makes sense also to ensure the policy matches the timing of when the tax authority can require payment. This is to minimise cash flow implications for the fund. Generally speaking, specialist underwriters are used to working with funds and their advisers to provide solutions.
To sum up, it is rarely, if ever, possible to remove completely the risk involved in an investment, but funds should not ignore the possible benefits of tax insurance, which can increase the marketability of targets and help the parties reach an acceptable agreement.