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Tax Bite – W&I insurance-backed M&A deals – Cover for tax liabilities

Warranty and indemnity insurance is now a common feature in M&A deals.

Sellers will typically anticipate at the outset that if the deal is backed by W&I insurance, their liability under the SPA warranties and Tax Covenant will be capped at £1.

What is often not appreciated (sometimes by buyers and sellers alike) is that there will be a number of things that a Tax Covenant (and Tax Warranties) will typically cover, that will be excluded from cover under the W&I policy. This is not an issue exclusive to tax of course, although several typical W&I cover exclusions are tax-specific. Among the tax issues / areas that a typical W&I policy will not cover are:

• Any issues of which the Buyer (or its team) has knowledge, or which are referred to in DD reports or which are disclosed against the warranties.
• Secondary tax liabilities.
• Transfer pricing.
• Future non-availability of tax assets (e.g., losses or other deferred tax assets).
• Increasingly, employment related securities / options issues, and COVID (CJRS) issues.
• Tax avoidance / evasion warranties / liabilities.
• Overseas jurisdiction issues or other areas where insufficient due diligence has been performed to get the insurer comfortable.

It should also be remembered that a W&I policy will typically have de minimis and deductible (basket) financial limits on claims, which a Tax Covenant will very rarely feature.

So, the question then becomes, who is expected to be liable for uninsured tax matters? The practical difficulty in answering that question at the outset is that the buyer will not have concluded its financial and tax due diligence yet, so the scale of any transaction-specific issues will not be known.

Sometimes sellers will be in a position to insist that their liability will be capped at £1 in all circumstances, although buyers typically will be very reluctant to formally concede that until due diligence is complete. If the sellers do have a £1 cap on liability, the buyer would need to try and price any known issues / risks into the deal at the outset. Some insurers will also consider covering certain typically excluded areas (e.g., availability of tax assets) albeit potentially for an additional premium. Further, it may be possible to seek a bespoke specific tax liability insurance policy for some specifically-identified risks.

On many W&I-backed deals we see the sellers having at least some “skin in the game”, for example by being liable up to the amount of the W&I policy deductible (i.e., the “excess”), and/or for one or more specific issues identified during the transaction.

The buyer will of course prefer that the sellers are liable for everything that is excluded from W&I cover. Given the scope of tax exclusions under W&I policies, particularly for any disclosed / known issues, sellers will often be uncomfortable with this allocation of risk, particularly if they have been asked to contribute to the cost of the W&I policy. Obviously in that case it is important when acting for the sellers that they are aware of the scope of their liability under the Tax Covenant (and SPA generally) – it’s very important to ensure that sellers are not mistakenly assuming they are bound to have no liability if there is a W&I policy in play.

The negotiation of the Tax Covenant and Tax Warranties will typically be a little different on a W&I-backed deal compared to a simple uninsured deal and can be more complex particularly where the sellers are liable for some issues or up to a certain threshold. Most importantly for the buyer, the Tax Covenant provisions (e.g., around conduct of claims, third party recoveries, and corresponding tax savings) must not oblige the buyer to take or procure the taking of any action that could prejudice its ability to recover under the W&I policy, or to credit the sellers amounts for which the W&I insurer also has claimed / will claim credit.

We have acted for the sellers on several W&I-backed M&A deals recently where the buyer’s advisers have taken an aggressive approach to cutting out any seller-favorable provisions, however often this is not appropriate or justified on the terms of the deal unless the sellers’ liability is capped at £1 for all claims.

If you have clients entering into W&I-backed deals and would like to discuss the tax position and impact on the transaction documents, please do get in touch.