In order to mitigate potential tax liabilities, a buyer should seek to include a tax covenant and tax warranties in the transaction documents to ensure that pre-completion tax liabilities and risks remain liabilities/risks of the seller(s). There are significant differences between a tax covenant and tax warranties, but it is important that both are negotiated together. This is because issues that come to light in the tax warranties (e.g. from a disclosure) can be specifically addressed in the tax covenant.
This article aims to briefly explain the purpose of a tax covenant and of the tax warranties and sets out some key points for buyers and their advisors to note.
Covenant to pay or tax indemnity
A tax covenant is a promise by the seller to the buyer to pay the buyer for any unprovided tax liability that arises in a target company. It is a promise to pay an amount if certain circumstances exist, (i.e. payment on an indemnity basis). It is different to an indemnity which is a separate enforceable contract which reimburses losses and for which consideration is given.
The tax covenant is used to protect the integrity of the balance sheet. Ideally the way in which it should work is if a pre-completion liability arises, it puts the parties back into the position they would have been in had the tax liability not happened. Therefore, a tax covenant allocates two risks (i) pre-completion risk which is a seller risk and (ii) a post-completion risk which is a buyer risk. The purchaser may be liable for tax that belongs to the seller, so the seller covenants (i.e. promises) to the buyer that if a pre-completion tax liability arises it will pay such amount to the buyer. It is also a more efficient recourse (in comparison to the tax warranties) for the buyer because it provides a pound-for-pound protection and it is (usually) not limited by disclosure nor does a buyer have a duty to mitigate the loss.
Tax warranties
A tax warranty is a statement of fact about the affairs in the target company. For a buyer to make a claim under the tax warranties it needs to prove loss (i.e. the value of the shares has decreased due to the unforeseen tax liability), but the buyer also has a duty to mitigate the loss. The tax warranties are also limited by disclosure. One of the key uses of the tax warranties is to prompt disclosures from the seller which the buyer can then specifically address in the tax covenant or seek to address from a commercial perspective (e.g. reflect in the agreed pricing).
However, the tax warranties can protect the buyer when there is no recourse under the tax covenant because the tax covenant does not generally protect a buyer in connection with post-completion events where reliefs were claimed on chargeable assets which decreases the base cost.
Key points
Further key points to consider when drafting a tax covenant and the tax warranties include:
• Time limits (e.g. not notifying in time, time bared etc.) – it is key that the dates provided in the conducts clause are adhered to with the risk that a claim can be made out of time.
• Specific indemnities – if there is a known tax liability and a deal is covered by insurance then the policy may not cover such risk. Commercial discussions may be required to cater for such risk. This could be achieved by way of a price chip, by way of including a separate tax covenant which is not covered by the W&I policy, etc.
• Current market environments – in the past few years there has been a trend to include specific indemnities to cover issues arising from R&D credits claims and under the Coronavirus Job Retention Scheme.
If you’d like to discuss anything related to negotiating the terms of a tax covenant and tax warranties, please get in touch with Armando Goncalves from the A&L Goodbody Corporate M&A Team in Belfast at agoncalves@algoodbody.com