While more organisations are purchasing tax liability insurance to ring-fence identified tax risks during a merger or acquisition (M&A), there is limited awareness of the benefits of this type of coverage outside of a transaction. However, when used correctly, tax liability insurance can help create value and remove uncertainty.
What is tax liability insurance?
Tax liability insurance typically covers the tax charges associated with an M&A transaction, as well as interest, penalties, defence costs, and any relevant gross-up up to the chosen limit of liability in the policy. It may be an efficient solution when a tax risk is estimated to be in excess of GBP2 million and has been deemed by a reputable tax advisor to pose a low or low-to-medium risk.
There are currently more than 20 insurers globally focusing on tax risks alone, providing the capacity and appetite needed to insure a broad array of tax risks. The market remains competitive, with premiums generally between 1% and 5% of the limit insured. The premium level is typically determined by a number of issues, including the risk level, size, jurisdiction, and complexity of the risk. Depending on the complexity of the underlying tax risk, a tax liability insurance policy can generally be put in place within two to three weeks.
A wide range of tax risks can be insured, and there may even be appetite for risks already under audit or in litigation, although premiums will typically be adjusted to reflect this additional risk. While a tax liability insurance generally provides coverage for historic tax risks, it is becoming increasingly common to also insure future tax risks.
How tax liability insurance can be used in an M&A transaction
Tax liability insurance was developed to help M&A parties to de-risk known issues not typically covered by a warranty and indemnity (W&I) insurance policy. Tax liability insurance helps sellers achieve a “clean exit” and provides buyers with appropriate deal protection. This type of coverage is most commonly used in a deal context.
Although buyers are the most frequent users of tax liability insurance to mitigate potential tax risks, sellers may raise this option early in negotiations to strengthen the deal and minimise the risk of price chipping or contractual protection being sought by buyers.
Tax liability insurance may be used to facilitate efficient M&A in a number of ways, including:
- Different views of the risk: Parties involved in a transaction may have different views of the level and/or quantum of an identified tax risk. Buyers will generally take a more conservative view when it comes to assuming any liability for an identified tax risk, with the deal potentially derailed if the risk is not addressed. Tax liability insurance may be used to move the deal forward by insuring the tax risk instead of negotiating a specific indemnity, having an escrow, or reducing the purchase price.
- Auction process: Tax liability insurance may be beneficial in highly competitive transactions. This coverage may provide potential buyers with additional comfort to make a competitive bid in situations where the seller will not provide specific indemnity or escrow despite the potential of tax risks.
- Reorganisation related to a transaction: Parties involved in the transaction (usually the seller) may plan on reorganising the business before signing or closing a deal in order to achieve a more commercially viable structure. This may involve a transfer of assets, a management roll over, or other changes that often create tax risk. Depending on the commercial dynamics, neither the seller nor the buyer may wish to take on such risk, and may opt to transfer the risk to the insurance market through tax liability insurance.
How to use tax liability insurance outside of an M&A context
Tax liability insurance can be utilised outside of an M&A context, including:
- Group reorganisation: Reorganising a business — whether due to M&A activity or a simplification of the group structure — may give rise to tax risks related to one or more steps of the transaction. Tax liability insurance allows companies to transfer the risk and reduce uncertainty.
- Balance sheet protection: By keeping tax risks off the balance sheet, tax liability insurance provides companies with the option of using cash otherwise locked up as reserves on the balance sheet.
- Transfer pricing: The practice of charging another division within the same company for goods or services, known as transfer prices, may create tax risks. While not all transfer pricing risks may be insured, there is increasing insurer appetite to provide this type of coverage.
- Mitigation of VAT and sales tax risks: Businesses may find it difficult to determine which transactions are subject to value added tax (VAT) or sales tax. Since the risks may be significant, a prudent tax department and/or chief financial officer may consider tax liability insurance to minimise surprises that could have a negative impact on the company’s financial health.
- Incentive programs: Incentive programs often entail a degree of tax risk that may lead to significant tax liability, especially for an individual. Providing cover for the potential tax costs associated with an incentive program through a tax liability insurance may help businesses attract and retain skilled staff.
Whether it’s being used as part of an M&A transaction or to address an ongoing business risk, tax liability insurance can be a powerful tool to create value and reduce uncertainty related to an organisation’s tax risks.
