On a typical M&A deal, the buyer will want comfort as regards their exposure to tax liabilities of the target which arise after completion but are attributable to the seller’s period of ownership. Accordingly, it is customary to include a tax covenant to allocate the risk of such liabilities to the seller. However, that framework may not be acceptable where a seller requires a clean break on their exit – in particular, for private equity fund sellers or other institutional investors who are not involved in the management of the target business. To bridge that gap, it has become increasingly common in recent years for sellers to cap their liability under the tax covenant, and for buyers to get comfort via warranty and indemnity insurance protection.

Specific indemnity cover

Those policies will usually exclude tax risks identified pre-completion. Accordingly, where, as part of due diligence, a buyer discovers a potential liability that could crystallise in the future, they will usually need an alternative form of protection. From a buyer’s perspective, the most straightforward option may be requesting an additional specific indemnity from the seller to cover the identified risk, with that indemnity subject to a higher liability cap. However, sellers wanting a clean break will still be reluctant to offer such an indemnity.

One solution can be a specific insurance policy in respect of the identified risk. As the tax insurance market evolves, underwriters are becoming more sophisticated and flexible with accommodating such requests, and we are seeing specific transaction policies become more common. However, this may not always be the right answer commercially. Specific policies will carry a premium cost proportionate to the level of risk perceived by the underwriter, which may be greater than that perceived by the transaction parties. Additionally, procuring and negotiating a policy will take time, and - while that can often be expedited - it may present an obstacle for transactions operating on a compressed timescale.

Deferred consideration

Where insurance is not practical due to prohibitive cost or timing implications, or unavailable due to market appetite, an alternative to indemnification that we have seen work well in practice may be to address the liability via a deferred consideration mechanism. For example, the parties might agree that the buyer will hold back a ringfenced pot of consideration for a specified period of time. If the identified tax risk crystalises within that period, the pot is reduced accordingly. At the end of the period, whatever is left in the pot is released to the seller. This structure is economically similar to an indemnity, but it may be more palatable to sellers since, while it may take longer for them to receive their full consideration, they will not be put in the position where they may have to pay back to the buyer some of the consideration they have already received. Clearly, the parties will need to negotiate the parameters for such a mechanism – such as the period of deferral, the precise tax liabilities that can erode the pot, and who has conduct over any discussions with the relevant tax authority.

If you would like to discuss any of the points raised in this note, please get in touch.