W&I Insurance Through a Tax Lens

Introduction

Warranty and indemnity insurance (“W&I Insurance”) is frequently used in merger and acquisition (“M&A”) transactions and is commonly seen in share purchase transactions. W&I Insurance can be beneficial for both the buyer and the seller, although it is typically taken out by the buyer.

The tax warranties in a share purchase agreement (“SPA”) and the provisions of a deed of Tax Covenant (“Tax Deed”) provide protections to the buyer that the target company is compliant with all of its relevant tax obligations and doesn’t have any unknown or hidden tax liabilities. Where any such liabilities do exist, the provisions of the tax warranties in the SPA and Tax Deed set out that the seller will make a payment to the buyer in respect of the loss in value caused by such liabilities, to the extent that they have not been disclosed against in the disclosure letter (only in the case of the tax warranties). Where W&I Insurance is in place, the seller’s liability under the transaction documents will be capped at a limited sum, often at €1.

Key benefits of using W&I Insurance

W&I Insurance can be beneficial to both the buyer and the seller. For sellers, it is a way to limit their liability allowing for a ‘clean exit’ post transaction. For buyers, it can be used to entice private equity or private investors into the transaction as the buyer is in a position where it should be better protected from a breach of any or multiple warranties or indemnities by the sellers. Where any such breach occurs, the buyer would look to the insurer as a means to recovering the loss arising as opposed to seeking recovery from the sellers who may or may not be in a position to compensate the buyer.

Whilst W&I Insurance is widely recognised for its commercial benefits, it is important that a buyer understands the costs and commercial realities of taking out a W&I Insurance policy as it can be complex and alter how negotiation of the transaction documentation and deal generally are conducted. All transaction documents will need to be provided to the insurer so that it can create the bespoke policy based on the warranties and indemnities given by the sellers to the buyer and the insurer will look to exclude certain liabilities (such as those that are known liabilities, having been identified during the due diligence process).

W&I Insurance from a tax perspective

Tax warranties form part of the warranties schedule in an SPA. Under the tax warranties, the sellers will set out statements of facts about the tax affairs of the target company. In an uninsured transaction, as regards a claim under the tax warranties, a buyer is required to mitigate their losses and also must be able to prove losses as a result of any unforeseen tax liabilities. However, the buyer is not required to prove or mitigate its losses as regards a claim under the Tax Deed. The Tax Deed is a promise from the sellers to make a payment to the buyer, usually on a euro for euro basis, where any unforeseen tax liabilities relating to a pre-completion period or event arises for the target company. The aim  is to put the buyer back in the position it was in had no such tax liabilities had arisen. Where a transaction is backed by W&I Insurance, the insurer may require that the buyer mitigate their losses under both the tax warranties and the Tax Deed.

Where a buyer opts to take out W&I Insurance, the transaction documents, once agreed between the parties, including the due diligence reports and disclosure letter, are sent to the insurer who will review them and then create a policy, including a set of exclusions which details what liabilities it will and will not cover. Exclusions may include; specific issues that were identified during the tax due diligence process, transfer pricing risks, secondary tax liabilities, tax-related issues within tax groups, permanent establishment risks, tax refunds, purchase price adjustments, and leakage in the case of locked-box deals.

Tax liabilities that are identified during the due diligence process or are otherwise known to the buyer are not usually covered by W&I Insurance. In such instances, the buyer has no protection over such known liabilities or risks and may need to consider further protection in the transaction document which are not covered by the as the sellers’ capped liability for covered claims.

Typically, in a non-W&I Insurance backed transaction, the Tax Deed is not subject to the de minimis provisions provided in the SPA, ie there is no minimum threshold required in order to make a claim under the Tax Deed (as would typically be provided for under the warranties, including tax warranties). Where a W&I policy is put in place, the insurer may insist on the de minimis provisions applying to the Tax Deed, potentially preventing euro for euro recovery for the buyer. It is also worth noting that a W&I Insurance policy is likely to have a retention or excess amount that must be paid by the seller before the insurance can be paid out. This is a factor buyers should consider in comparison to a non-W&I Insurance backed deal.

Occasionally, in a W&I Insurance backed transaction where the Tax Deed is insured and contains various restrictions, a buyer may seek extra protection from the seller by way of an additional non-insured Tax Deed that covers specific liabilities that are not covered under the insured Tax Deed. The seller’s liability under the uninsured additional Tax Deed is not capped.

Specific tax risk insurance policies

A specific tax risk insurance policy is a separate product which the parties may consider in the case of known tax risks. These policies are designed to provide protection against identified tax risks, including those identified as part of the due diligence process, that could crystallise into liabilities after the deal has closed. Such policies can stand alone or sit alongside a W&I Insurance policy in order to bridge the gap in relation between insured unidentified tax risks and specific identified tax risks.  Specific tax risk insurance policies are increasing in popularity as a valuable tool in M&A transactions where specific tax risks have been identified but neither the buyer nor the seller want to take on the risk of potential tax liabilities crystalising.

Conclusion

There are a number of  upsides to using W&I Insurance for a M&A deal, as discussed above. However, the parties should consider in conjunction with their advisors whether obtaining a W&I Insurance policy will give rise to any issues or concerns from a commercial and tax perspective and, if so, if these can be managed appropriately as part of the deal. It will also be important for the parties to agree at an early stage which side will incur the cost of the policy or if this will be shared.