Tax covenants: lessons from the Court of Appeal

Glencore sold shares in Xstrata Peru SA (Xstrata), a Peruvian company, to Minera Las Bambas and another company. At the time of the transaction, Xstrata had significant input VAT credits, some of which had already been repaid to Xstrata in cash under the Peruvian "early refund scheme".

The share purchase agreement (which was governed by English law) contained a tax covenant to protect the purchasers in respect of certain historic tax matters. The tax covenant covered "the amount of any Tax payable by a Group Company" relating to any pre-closing period. It also sought to give protection for the loss of the VAT credits, but unusually (for an English law tax covenant) this was contingent on there being a breach of certain tax warranties.

After closing, Xstrata and one of the purchasers were merged into another company. For simplicity, the purchasers and beneficiaries of the indemnity are referred to as "Minera" and the target company is referred to as "Xstrata".

After closing, the Peruvian tax authorities levied an assessment on Xstrata for VAT relating to a land exchange agreement. The assessment also determined that Xstrata had incorrectly claimed input VAT credits. This created a liability for Xstrata to repay some of the refunds it had received under the "early refund scheme" and cancelled some of Xstrata’s input VAT credits which had not yet been refunded.

Under Peruvian law, a tax assessment creates a liability to pay tax but (if the assessment is appealed) that liability cannot be enforced until the appeal is determined. Interest and penalties can be reduced if payment is made early.

Key points from the case

First, a covenant to pay an amount equal to tax "payable" by a company is not engaged until the payment becomes enforceable (rather than when the tax liability arises).
The court held that the word "payable" must be given its ordinary meaning. In this context, that required an enforceable obligation, rather than simply a liability. The court reasoned that this was consistent with the nature and purpose of an indemnity: until the tax has been enforced (and so paid), the purchasers have no loss. Further, it would be unreasonable to require Glencore to put Minera in funds to pay tax which may not become enforceable. Whilst this seems reasonable, the interaction with the exclusions is surprising (see below).

In practice: parties should consider carefully what the trigger for payment should be under tax covenants. Further, tax assessments can take a long time to be determined, so purchasers must ensure that notification and conduct provisions allow claims to be made before tax becomes "enforceable".

Second, the loss of a right to receive a repayment of tax is not a "liability to pay tax" (even if the loss puts the taxpayer in a net tax payment position). The court held that Xstrata’s loss of its input tax credits was not a liability to pay tax. Therefore, any claim for that element had to be made under the bespoke limb of the covenant giving protection for loss of tax credits.

In practice: if a purchaser requires protection for loss of a right to receive a repayment of tax, this must be expressly drafted for (rather than relying on the general covenant for unexpected tax).

Third, a VAT credit is not itself a right to repayment of VAT. Instead, it is an amount which may be deducted from tax otherwise due. The fact that ‘an asset has the same economic value as a right to repayment does not mean that it is such a right’. This meant that the claim for loss of VAT credits failed, because it had been drafted by reference to ‘a right to repayment of VAT’.

In practice: where a tax covenant seeks to give protection for tax assets, care needs to be taken to distinguish between rights to repayment of tax and other tax assets such as tax credits.

Fourth, exclusion clauses need careful attention. The tax covenant contained an exclusion for tax which would not have arisen "but for" an act or omission of the purchasers. The court found that this is a purely factual test and does not incorporate any question of legal causation. In other words, it is irrelevant whether the tax should be treated in law as "caused" by the purchasers’ act or omission. For example, there is very limited scope to disregard reasonable omissions, such as not paying tax early.

On the facts, Minera had not paid the disputed tax early enough to get the maximum discount against penalties. This meant that Minera could not claim for penalties which could have been mitigated had the disputed tax been paid earlier. This was the case even though Minera could not claim for the tax until it was enforceable.

In practice: the court accepted that this interpretation allocated more risk to the purchasers than they would have borne under common law rules (which enable a claimant to recover losses that could have been avoided, provided it has not acted unreasonably). Purchasers should study the exclusions in a tax covenant carefully, particularly any exclusions which purport to exclude liability for acts or omissions of a purchaser.

Conclusion

As well as the points flagged above, the key lesson from this case was put clearly by the court itself: "within very wide limits, English law leaves the parties free to make their own bargain and affords them the respect ... of treating them as having meant what they said." Parties should take care when drafting tax covenants: responsibility for ensuring that the indemnity works as intended rests firmly with the parties and their advisers.

This article was first published by Tax Journal.