Improving deal execution using Tax Insurance

Introduction

The M&A market continues to face challenges this year due to the still elevated interest levels and macroeconomic developments. Different valuation expectations of buyers and sellers (bid-ask spread), exit pressure from investors regarding vintage portfolio companies and expiring term loans are part of the reasons requiring new ways of risk management and value creation. By transferring identified tax risks to an insurer, tax insurance not only provides a welcome alternative to traditional risk transfer mechanisms such as purchase price adjustments or contractual (tax) indemnities, but also enables better cash management and execution security, thereby increasing the attractiveness of an upcoming transaction.

   I.          Differentiation between tax insurance and W&I insurance

Tax insurance must be distinguished from W&I insurance, which has become indispensable in the transaction context. Both products are specialised insurance programs that (also) cover tax risks; however, the two insurance solutions differ significantly in their scope of application.

W&I insurance is linked to the warranty and indemnity catalogue in the share purchase agreement (“SPA”) which means that the insurer is liable in the event of a breach of warranty or indemnity claim and covers unknown, historical risks. Known (tax) risks, namely those identified as part of a due diligence (“DD”) carried out by the buyer, as well as risks in the area of transfer pricing, secondary liabilities or the loss of tax assets or attributes, are generally excluded from the W&I insurance cover. Only in individual cases the scope of cover can be extended through so-called “affirmative cover” (possible for risks that are considered to be low in their qualification and, if they occur, also low in quantum).

Tax insurance, on the other hand, covers potential losses from known tax risks arising from past or future circumstances and events where the law is not black and white. The product can therefore be used not only in connection with M&A transactions (e.g. hedging tax risks identified in the DD), but also for ongoing business transactions (e.g. financing) or structuring projects that are independent of transactions.

 II.          Basics of tax insurance

1.      Development and background

Tax insurance is a product that has been developing since the 1980s and has a correspondingly long and successful history. Starting with bridging the gaps between the tax indemnities and tax warranties in the SPA as well as the associated exclusions under a W&I insurance policy for known, i.e. identified tax risks, tax insurance in the early days primarily served to provide extended cover for the buyer. In recent years, however, a special insurance market has developed to manage a wide range of tax risks: from tax risks in the context of M&A transactions to coverage for financing measures, reorganisations, and distressed investments.

2.      The basics of tax insurance

Tax risks accessible to tax insurance are essentially legal risks, i.e. legal uncertainties in the application or interpretation of a tax law, published guidance by the tax authorities or rulings of the tax courts. It is irrelevant whether the corresponding tax risk stems from an event that has already been concluded or one that is to be realised. It does not necessarily have to be a domestic tax risk; tax insurance can also cover foreign tax risks. In addition, tax risks can be insured that are associated with both legal and factual uncertainties. In these cases, insurability depends on the individual case. Examples of such mixed risks include valuation issues or permanent establishment risks.

Tax risks are usually insurable through tax insurance if the likelihood of occurrence of the tax risk is categorised as “low” or (at most) “low to medium”. This risk assessment must be accompanied by a robust legal analysis, e.g. in the form of a tax expert opinion, which considers the position taken to be at least justifiable (“more likely than not”), but at best most likely (“should-level”). Due to the minimum premiums available on the market (EUR 90 – 150 thousand) together with the conduct obligations required of the policyholder in communication with the tax authorities, an insurance solution is generally only considered if the financial quantum of the tax risk is expected to be significant when it materialises (so-called high quantum risk).

However, purely factual, implementation or behavioural risks are generally not insurable through tax insurance. Besides, the tax policy also excludes cover for abusive arrangements, fraud, wilful misrepresentation or the wilful submission of false (tax) returns as well as changes in statutory law that affect the case.

3.      Tax insurance as an alternative to binding rulings

In case of legal uncertainties for future, not yet realized, events, taxpayers could consider filing an application for a binding ruling with the competent tax office (Section 89 German Fiscal Code (Abgabenordnung).

In order not to jeopardise the binding effect of a binding ruling issued by the tax office, the planned steps may only be implemented after the successful issuance of a binding ruling. This is often an exclusion criterion for binding rulings, as it usually takes several months for the tax office to review the facts of the case and the tax assessment and to articulate the ruling. The measures intended by the taxpayer often cannot wait that long to be implemented, but are under time pressure (e.g. employee participation, reorganisations prior to a transaction). The processing time can be even longer if multiple tax offices are responsible, the tax authorities do not (yet) wish to take a position on a legal issue, factual elements are part of the risk (e.g. valuation issues) or the facts to be realised are still subject to change. It is not uncommon for applications for binding ruling to be rejected by the tax office for formal or substantive reasons. In these cases, the taxpayer not only receives no legal or implementation certainty but has – in case of implementation – also already informed the tax office extensively about the facts of the case and their own tax assessment.

Tax insurance can provide the desired security regarding identified tax risks. Due to the proportional development of the insurance premium to the purchased cover limit, it is often significantly more expensive than the (processing) costs of the tax authorities associated with an application for binding ruling, which are limited to a certain amount under the German Court Costs Act (Gerichtskostengesetz) (currently EUR 120,721.00). However, due to its much broader scope of application, flexibility and rapid availability, tax insurance is increasingly favoured - despite its higher costs.

III.          Exemplary areas of application of tax insurance

1.      Hedging of transactional tax risks

Historical DD risks: Historical tax risks identified as part of a DD are considered known risks and are typically excluded from the W&I insurance unless covered under "Affirmative Cover". Those tax risks that qualify as low to medium and are expected to have a high financial impact if they materialise (low risk - high quantum) can be covered by tax insurance, provided that sufficient information was provided as part of the DD and the respective analysis. The basis for the tax policy is generally the DD report or an update of the DD report on this risk, provided that the initial draft is a highly simplified, so-called "red flag" presentation.
Typical tax risks that are hedged as part of a transaction via tax insurance include:

• Taxation of reorganisations in the past for which no binding ruling was obtained from the competent tax office

•  Qualification of financial instruments as equity or debt capital (hybrid financing or mezzanine capital)

• Taxation of potential recapture gains

• Agreed debt waivers or subordination agreements

• Assumed property trading and permanent establishment risks in real estate transactions

• Income tax and VAT groups

• In individual cases: Transfer pricing and valuation risks

In the context of M&A transactions, the hedging of tax DD risks via tax insurance has established itself as a much appreciated alternative to traditional risk transfer mechanisms such as purchase price adjustments (especially in fixed-price transactions) or euro-for-euro tax indemnities.

Transaction-related tax risks: Tax risks that are triggered by the transaction itself, such as the forfeiture of loss carry forwards as well as real estate transfer tax or other transaction taxes, are often contractually shifted to the buyer and are not covered by the W&I insurance due to the effective date principle underlying the transaction. These risks can also be covered by tax insurance.

2.      Contractual indemnities as the basis for insurance

Special tax indemnities: It is not uncommon for the buyer to demand separate tax indemnities in the SPA for high quantum tax risks identified during the DD, which should apply independently of the general tax indemnity, which is often severely limited in terms of amount and covered by the W&I insurance. These so-called special tax indemnities can prevent a clean exit desired by particularly institutional investors or require a corresponding retention of the purchase price realised (escrow amount).

More and more sellers are therefore using tax insurance to protect themselves against a claim under such tax indemnities: Claims against the seller under the indemnity is considered an insured event under the tax policy. The basis for the tax policy is the (separate) tax indemnity in the SPA. As the tax policy is – in such case – directly linked to the SPA, care must be taken to ensure that the rules of conduct that apply to the policyholder under the tax policy are also reflected in the original tax indemnity and that the SPA does not conflict with the tax policy. Close coordination in the parallel negotiation of both documents is therefore essential.  

Other contractual indemnities: Further examples for insuring an indemnity can be found in the area of fund raising or other financing structures. Investors who are exposed to tax risks when providing capital (e.g. from limited tax liability or from German CFC taxation) are regularly indemnified against these risks. An example of this is the (tax) exemption of the general partner of a fund vis-à-vis its investor or limited partner.

3.      Refinancing transactions and hedging of restructuring income

German tax laws provide several uncertainties for taxpayers when implementing refinancing measures. Debt-to-equity swaps, cash cycles for debt relief, debt assumption and the liquidation of companies with significant liabilities are just a few examples. Particularly cases of debt cancellation for the purpose of business-related restructuring and the associated possibility of treating this restructuring income as tax-free have increased since last year. In order to benefit from this privilege, the law prescribes various criteria for the taxpayer, the fulfilment of which can rarely be clearly answered. A company's ability to be restructured or the creditors' intention to reorganise are examples of those requirements. In these cases, advisors usually recommend obtaining binding rulings from the tax office. These ruling procedures prove to be very lengthy or, depending on the federal state are no longer answered. To not jeopardise the restructuring project, the restructuring plan or the transaction to acquire a distressed asset and to obtain certainty, many companies or investors make use of tax insurance as an alternative to requesting a binding ruling.

4.      Reorganisation processes prior to or after a transaction

Both in preparation for a pending exit (full or partial exit) and following completion of a transaction, reorganisations may be necessary to align the corporate and tax structure of the target business to the respective commercial or structural needs of the buyer.

The focus here is usually on the tax neutrality of the underlying reorganisation and the question of whether hidden reserves of a company or business are realised and taxed through the reorganisation (merger, demerger, change in legal form) or a contribution. Apart from that, tax implications may arise from possible German CFC taxation in the case of foreign reorganisations or - as an evergreen - potential real estate transfer tax in case of real estate ownership.

Thanks to its flexibility and speed in implementing the desired measures, tax insurance has now become a welcome alternative to binding rulings issued by the tax office.

IV.          Procedure of the insurance process

Where tax insurance is considered regarding an identified tax risk, the (potential) policyholder or their tax advisor first contacts a tax insurance broker and discusses the specific facts of the case with them regarding potential insurability (so-called initiation). The prerequisite for the further insurance process is a tax opinion (e.g. a memo or draft application for binding ruling) or a corresponding DD report from an external tax advisor that meets the requirements set out under II.2.

The broker manages the market approach by engaging in conversations with potential insurers and presenting the tax risk (so-called submission); those insurers for whom the facts of the case come into question submit an initial offer or quote after a first review of the tax opinion (so-called non-binding indication). These offers and their respective key parameters are compiled and assessed by the broker for the policyholder before the policyholder selects an insurer on this basis.

The selection of the insurer is followed by the so-called underwriting process, during which the insurer – with the help of external tax advisors – carries out its own review and plausibility check of the risk. The insurer then draws up the tax policy and negotiates it. The policyholder is supported by the broker. In the underwriting process, the policyholder incurs costs for the first time, as an expense agreement is concluded with the insurer, based on which the policyholder assumes the costs of the insurer’s external tax advisors.

The insurance process ends with the conclusion and inception of the tax policy. The total time span of the insurance process depends on the individual case but is usually between two and three weeks.

From the policyholder's perspective, it is advisable to involve their own tax advisors in the insurance process. The insurer often requests further information and/or documents as part of the risk assessment or a so-called Q&A call takes place, in which the insurer asks questions about the facts of the case or the tax analysis carried out. A quick response and cooperative behaviour on the part of the policyholder's tax advisor contributes to an efficient insurance process.

 V.          Tax insurance parameters

Depending on the case or desired policy structure, the policyholder of a tax insurance can be the buyer, seller or the company affected by the tax risk (i.e. the taxpayer itself).

The limit insured is individually agreed between the policyholder and the insurer. The scope of insurance depends on the individual case and, in addition to the specific tax risk, can also cover interest (e.g. in accordance with Sections 233 et seq. of the German Fiscal Code (Abgabenordnung)), penalties, legal costs and a so-called gross-up for taxes payable on insurance payments received.

In the current market environment, the insurance premiums are between 1.5 and 3 per cent of the sum insured plus insurance tax; a retention may be agreed for the policyholder.

The term of the tax policy is usually seven years, but can be extended to up to ten years. Yet, the expiry of the term is often suspended by the order of a tax audit (and the corresponding notification of this order by the policyholder to the insurer), so that the insured tax risk can also crystallise outside the agreed policy term without the policyholder's claim lapsing (so-called claims-made policy). For tax proceedings, i.e. both the regular tax assessment and tax audits as well as objection and legal proceedings, the insurer is granted conduct rights under the tax policy. If the policyholder is the seller as part of a M&A transaction and the policy is linked to an indemnity, these conduct rights must be reflected in the SPA; otherwise, the buyer could exclude the insurer from the tax proceedings.

If the tax to which the tax insurance relates is to be paid upfront (in advance), the insurer makes an advance payment. This means that the insurer pays the tax even if no formally binding or non-appealable tax assessment has yet been issued, but the corresponding tax proceedings (e.g. appeal proceedings) only take place subsequently.

Conclusion

Tax insurance can be used in a variety of ways for all types of transactions and gives the parties involved more flexibility and room for course of action:

• De-escalation of a negotiation by transferring the economic risk of loss from an uncertain tax position to a creditworthy third party, the insurer.

• Alternative to purchase price adjustments, contractual (tax) indemnities and escrow accounts. Instead of the actual risk amount, only the insurance premium is subject to commercial negotiations.

• Ensuring certainty on the matter in question at the speed in line with the transaction or the operating business.

• Improvement of cash management for tax risks that cannot be provisioned for in the balance sheet and would have to be paid from the company's cash and cash equivalents if realised.

• Established instrument as part of conservative tax risk management, especially for regulated companies and businesses.

Disclaimer

This article contains general information and debate on the topics discussed relating to tax insurance and is not intended to serve as professional advice in these or any other areas. The information is provided on an "as is" basis, without warranties of any kind. The authors are not liable for any damages arising directly or indirectly from the use of the content. We recommend that you always consult specialists.