One of the most striking recent trends in private M&A is the increasing use of warranty and indemnity (W&I) insurance. Many of the terms of an insurance policy are negotiable and this article outlines some of the provisions that advisers may wish to focus on.
Although useful, insurance raises a number of practical and technical issues and may weaken the overall level of protection obtained by the buyer. The role of the tax covenant needs to be re-evaluated, and it becomes more important to ensure that identified issues are factored into the purchase price.
In certain respects, covering tax risk through insurance may offer advantages for the buyer. As noted above, the buyer may benefit from greater control over tax returns, and obtain a better position on overprovisions and windfall reliefs.
The process of negotiating the SPA might be easier, and it is possible that any subsequent claims may be handled more smoothly and dispassionately.
However, in many ways, insurance substantially weakens the level of protection.
A W&I policy will not cover matters that have been disclosed by the seller. This is non-negotiable and results in a fundamental weakening of the protection under a tax covenant. Similarly, a W&I policy will not normally cover matters which the buyer knows about.
A W&I policy will not cover transfer pricing. An exclusion may be worded to cover schemes notifiable under DOTAS as well.
It may be difficult to obtain cover for tax in jurisdictions such as China or India.
The policy may include other terms related to conduct and notification. These provisions will differ somewhat from those typically seen in a tax covenant, although insurers should be willing to accept some familiar safeguards, such as a mechanism to prevent appeals which are unlikely to succeed.
After a claim has been paid, subrogation rights give the insurer broad powers to step into the shoes of the insured in seeking recovery from third parties.
There is a contradiction around whether insurance should have any impact on the terms of the tax covenant. Insurers expect a normal, fully negotiated tax covenant, and will ask to see an exchange of mark-ups between the buyer and seller. However, it is perhaps unrealistic to expect a seller whose liability is capped to fight on every point of detail.
First published in Tax Journal, 29 July 2016 (www.taxjournal.com) and reproduced with kind permission of the publishers. All rights reserved.