A typical agreement for the sale of a company will include a list of tax warranties (often a long list) and also a tax indemnity. For someone who has not previously bought or sold a company these provisions can all too often seem impenetrable.
This article aims to provide prospective buyers and sellers of companies with an overview of the purpose of these provisions and their scope. The aim is to provide some background knowledge of the topic so that buyers/sellers are in a better position to provide instructions to their advisers and ensure that their transaction proceeds smoothly and efficiently.
The article addresses the case where shares in a company are being sold. It does not consider the position where a business is sold (i.e. the assets and goodwill of a business are sold, rather than shares in a company which owns the business). With a business sale much less warranty and indemnity protection is required for a buyer due to the fact that most tax liabilities of the seller of the business will remain with the seller. A buyer of a company will take the company together with its assets and liabilities.
Readers of this article might also want to read our further the article looking at non tax warranties, which includes a general introduction to the subject of warranties.
Purpose of tax warranties and indemnities
Clearly a buyer does not want to acquire a company and then find that the company has unexpected tax liabilities. The buyer therefore wants assurances from the seller that no such liabilities exist and recompense if those assurances prove to be incorrect. In part this is about due diligence - finding out about what you are buying before you commit yourself - and in part it is about ensuring that appropriate compensation can be obtained if unexpected tax liabilities arise (liabilities which, if they had been known about, would have affected what the buyer agreed to pay).
The seller will typically give warranties which are designed to confirm that the company does not have any unexpected tax liabilities. If the seller knows that the company is, or may be, liable to tax contrary to the statement contained in a warranty, then the seller can disclose the existence of that liability in a letter addressed to the buyer (the disclosure letter). A proper disclosure of this type will mean that the buyer cannot make a claim for a breach of the warranty. The buyer will know about the liability and can consider, before completing the purchase of the company, what action to take (e.g. an adjustment to the purchase price to reflect the existence of the liability). The function of the warranties can be seen in this context to be part of the process of probing for information about the tax affairs of the company so that the buyer is well informed.
If a warranty is given and no relevant disclosure is made, and if the warranty proves to be incorrect (i.e. a tax liability which the seller represent does not exist does in fact arise) then the buyer should be able to claim for breach of warranty. The amount which can be claimed is broadly the difference between what the shares were worth without the tax liability in question and what they are worth with the liability. A buyer will also typically be obliged to take steps to mitigate any loss which would otherwise have arisen. All of this opens up room for argument about how much compensation can be claimed for a breach of a warranty. This is one of the reasons why buyers will invariably insist on there being a tax indemnity which provides a defined basis for being compensated one pound for each pound of tax liability and associated costs.
As indicated above, a typical share purchase agreement will also have a tax indemnity. The purpose of this indemnity is to specify which tax liabilities should properly be borne by the company without the buyer having recourse against the seller and which should lead to compensation for the buyer; and providing a clear basis for quantification of what amount should be paid by way of compensation. The fact that the existence of the liability in question may have been mentioned in the disclosure letter would not typically stop the buyer from claiming under the tax indemnity (unless a specific exclusion is negotiated and included within the indemnity, e.g. because the purchase price has already been adjusted to reflect the liability).
So the normal practice of having tax warranties and a tax indemnity is mainly based on:
Scope of tax warranties
All too often a long list of "precedent warranties" will be produced. There will be some general warranties saying that the company has paid all tax which has become due, made all tax returns and generally complied with all requirements of tax legislation; and then a long list of specific warranties saying that the company has not incurred liabilities under specific legislative provisions.
A good adviser, who has been provided with information about the company being sold and the basis on which the price has been negotiated, should be able to cut back the long list of specific warranties so that they are focused on issues which will be of interest to the buyer. This should save time and costs in the negotiation process. The latest statutory accounts of the company being sold are a very good starting point for identifying what tax issues are likely to be relevant.
There is also an argument for saying that the general warranties should be deleted or restricted. The buyer will in any event have the benefit of the tax indemnity which is expressed in general terms and which defines in a specific way how much should be paid if a relevant liability arises; whereas the general warranties could open up other arguments about how much compensation is due for a breach of the warranties. Why go to the lengths of agreeing specific indemnity provisions dealing with the quantum of liability only to have this undermined by offering the buyer an alternative basis of claiming under the warranties? Also experience suggests that the specific warranties are rather better at getting a seller to focus on what might need to be disclosed and therefore perform a better role in extracting information about the tax affairs of the company.
There will typically be some warranties designed to provide assurances that if assets were sold for the cost shown in the accounts, no tax liabilities will arise. There are circumstances in which the tax cost of an asset is lower than the accounting cost and a buyer may be concerned to know about what tax liabilities would arise if the assets were sold. That said, there will be many deals when this issue is really not of any materiality in terms of the buyer's view of the value of the company (e.g. a service business where the company's assets are insignificant) and so the process of negotiating these warranties and disclosing against them may be seen to be of little value. This type of contingent tax liability would typically not be covered by the tax indemnity.
Some advisers include additional warranties which are really just designed to force the seller to provide information to enable the buyer to deal with tax compliance matters after completion. However, very often these types of warranty are not of any materiality in value terms and a buyer might not thank its adviser for spending time negotiating extensive provisions of this nature. The buyer will have access to the company's tax compliance files after completion and may be content to rely on a warranty that the company has maintained all records required for tax purposes.
The approach to the warranties may be influenced by whether the buyer has commissioned accountants to undertake an investigation of the company's tax affairs, with the seller providing full access to the tax papers for this purpose. In such case it may be that much of the information gathering has been done and the need to use warranties to flush out information is therefore reduced.
Scope and form of tax indemnities/covenant
What is in effect a tax indemnity will typically be referred to as a tax covenant. The old approach was to have an indemnity in favour of the company being sold for tax defined tax liabilities. However a payment in settlement of a claim under the tax indemnity can in these circumstances be subject to tax. The way this problem is addressed is for the seller to covenant with the buyer to pay to the buyer an amount equal to any relevant tax liabilities which might be incurred by the company being sold. A payment to the buyer under this tax covenant can usually be treated as an adjustment of the purchase price for the shares, avoiding the tax problem referred to above.
The basic scope of the tax covenant will be for all tax liabilities relating to the period up to completion of the sale. The key limitations on this scope will depend on the basis on which the deal is taking place. The two most commonly encountered pricing structures are:
Some other provisions often included in the tax covenant are as follows:
Other points will be covered in the tax covenant with a view to trying to ensure a fair means of apportioning tax risks between the parties.
Roles of advisers and principals
The lawyers acting for the buyer and seller will lead the process of drafting and negotiating the tax warranties and indemnity, referring to their clients for instructions as necessary.
Some clients like to have a more "hands on" role in this process than others. It is clearly important that the parties understand what they will be signing; equally a good adviser with sufficient experience of deals of this nature can take much of the burden off a client, using his or her practical experience to ensure a fair and reasonable position is reached. Many larger law firms have tax specialists who should well equipped to ensure tax provisions are appropriate and to explain to their client what specific warranties mean and to prepare/review the disclosures. Law firms without specialist tax expertise will often rely more on the client's accountant to help with this process.
The seller will need to consider how best to deal with the disclosure process. Whoever has dealt with the company's tax compliance affairs will be best placed to take the leading role on this. If the company has engaged accountants to deal with the company's corporation tax returns, then those accountants will be best placed to lead much of the disclosure process. In such a case, it is often the case that the accountants do not deal with the PAYE and VAT compliance and someone at the company may need to assist with this. Relevant factual information will be provided to the seller's lawyers who can then ensure (with specialist tax input) that the wording of any disclosure is appropriate.
Prospective sellers will appreciate that ensuring that the tax affairs of the company are in good order and up to date before they get into a sale process should help the process run smoothly. Undertaking risky and aggressive tax planning, or adopting a less than thorough approach to tax compliance matters, can result in more protracted enquiries and negotiations. The buyer may also require specific indemnities to cover particular tax issues which are identified and retentions from the purchase price to cover potential liabilities.
Many deals will start with a heads of terms document or a term sheet recording the main terms of the deal. A view has to be taken as to how much effort goes into negotiating more detail for this document, rather than just setting out the key commercial terms and dealing with the detailed negotiations later when lawyers are more fully engaged. However, it will be worth bearing in mind some of the points made above (e.g. as to the scope of the tax covenant) in case any points can be recorded in the heads of terms in order to avoid arguments at a later stage.
Providing the lawyers with as much context for the legal negotiations as possible (including factual information about the company being sold and details of how the purchase price has been arrived at) should help them work more efficiently. That said, much still depends on all parties who are involved taking a reasonable approach. If both principals agree to manage the legal process in the same way, this can only help.
This article is for general information purposes only and does not constitute legal or professional advice. It should not be used as a substitute for legal advice relating to your particular circumstances. Please note that the law may have changed since the date of this article.