Author: Richard Hornby, Gallagher and Dawn Bhoma, Icen Risk
Over recent months, Gallagher has worked with Icen Risk clients to develop an insurance product to provide protection for the availability of tax assets. It is especially useful for funds or other investors to use insurance to buy certainty on their return on cash-generative assets by locking in the value of tax assets in a target business. These policies are being used to great effect by varying funds from private equity to pension funds, publicly quoted businesses and trade buyers.
Insurers can now cover warranties relating to tax assets and offer a standalone indemnity product
A tax asset commonly refers to net operating losses or capital expenditure, which can be used to offset historic or future profits. These can be utilised over a certain period of time with the net result being that a company pays tax on a smaller amount of profit, reducing the overall tax the company has to pay.
In the context of Mergers & Acquisitions (M&A), a buyer might be particularly interested in a target’s unused tax assets, which can be used to offset the buyer group’s profits after completion. This is especially relevant if the target has incurred costs for research, development or other capital expenditure. Common examples include real estate investments, technology companies, pharmaceuticals, infrastructure projects and manufacturers.
The difficulty for buyers is that there is always a degree of uncertainty around the valuation of tax assets and the ability to use them after the acquisition of a target (this is what we refer to as the availability of tax assets). Historically, a buyer could try to push this uncertainty onto the seller, by relying on warranties, a tax indemnity or perhaps even a specific indemnity from the seller to ensure that tax assets have been claimed/earned properly and that they are available to use after completion. In practice, however, it is difficult to get any of the above from a seller, let alone request an escrow or guarantee to secure it.
A more streamlined process
Until recently, insurers required an extensive review of tax assets to be carried out by the buyer’s tax advisers in order to cover warranties or indemnities regarding future availability of tax assets. The reality is an extensive review is not always possible, especially pre completion. Buyers rarely have access to the seller’s auditors or tax advisers and warranties only refer to the position historically and give no guarantees on future use.
Experienced tax insurers are now able to get comfortable with the risk by relying on a smaller pool of buy-side due diligence (DD), while engaging with the buyer on its financial model and future availability of the tax assets. This has resulted in a less cumbersome process and ultimately increased the number of successful tax asset insurance placements.
Is the warranty and indemnity (W&I) policy the right place to insure tax assets?
Whilst it is possible to request affirmative cover under a W&I policy, the insured’s deal team should consider the impact of additional underwriting on the W&I timetable as well as other matters such as building clear conduct provisions into the W&I policy and sharing the insured W&I limit with a specific tax risk.
Further, the loss suffered on a denial of a tax asset may well be different to the loss in value of the target’s shares when claiming for breach of warranty.
There is also a potential problem with relying on a warranty or tax indemnity to effectively guarantee the future availability of tax assets. Warranties are statements of fact about the past (not the future) and the tax indemnity only covers taxes that should have been paid up to completion. Therefore, it is understandably difficult and rare to see sellers agreeing to any specific forward-looking language to guarantee future availability of tax assets.
A specific tax policy may be the way forward
A standalone tax policy may be able to assist and give the buyer enhanced coverage beyond the seller’s offering. A key benefit of a standalone tax policy is that underwriting can run parallel to the W&I process, allowing the deal to sign without delay to the W&I placement.
Conceptually, a specific tax policy can offer greater coverage (and potentially security) than relying on the wording of a warranty in the acquisition agreement, given disclosure against the tax warranties. Other benefits of a standalone tax policy are that it offers fewer exclusions, as W&I is designed to cover historic, unknown risks.
A tax policy effectively offers an indemnity measure of damages and a standalone, bespoke definition of loss separate to the acquisition agreement. This allows for clearer demarcation of insured’s obligations when it comes to using tax assets.
How can you plan to insure tax assets, and build certainty into your financial model?
- Less information and time to plan due diligence (DD): get an initial indication of a range of pricing. An initial indication offers a rough cost and roadmap of DD required to get over the line in discussion with a tax specialist insurer.
- DD reports ready: get a non-binding indication (NBI). A NBI offers a narrower cost range and sets out the scope of cover that will closely follow the policy. The remaining work will be to review the DD and discuss with the deal team/buyer’s tax advisors before issuing the policy.
In every case, the bare minimum to get a policy put in place is the following:
- Financial model (experienced underwriters will adapt and understand the buyer’s valuation methodology).
- Buy-side analysis to consider any events that could prevent a tax asset from being available.
If a capital allowance technical report is available that can be exceptionally helpful to underwriters, however this should not be a gating issue.
The M&A insurance market is now offering insurance for availability of tax assets. Gallagher and Icen Risk would recommend considering the utilisation of tax insurance as opposed to seller warranties, given W&I is aimed at covering unknown, historic risk and the loss suffered on a denial of a tax asset may well be different to the loss in value of the target’s shares.
Whilst tax assets commonly arise from buy-side requests during M&A, it is also possible insure standalone cases, such as insuring the historic use of tax assets for end of fund life transactions, winding ups and sell-side preparation for sale to enhance value for sellers. The premium payable is generally a small percentage of the tax benefit and creates certainty for future modelling of returns.
The sole purpose of this article is to provide guidance on the issues covered. This article is not intended to give legal advice, and, accordingly, it should not be relied upon. It should not be regarded as a comprehensive statement of the law and/or market practice in this area. We make no claims as to the completeness or accuracy of the information contained herein or in the links, which were live at the date of publication. You should not act upon (or should refrain from acting upon) information in this publication without first seeking specific legal and/or specialist advice. Arthur J. Gallagher (UK) Limited and Icen Risk Limited accepts no liability for any inaccuracy, omission or mistake in this publication, nor will we be responsible for any loss, which may be suffered as a result of any person relying on the information contained herein.